Partnership Tax Problems Outline

CHAPTER 1 TAXATION OF PARTNERS AND PARTNERSHIPS
SECTION 2(A): DEFINITION OF PARTNERSHIP

Problem 1: Suphuric Electric Power Co. and the Metropolis Municipal Electric Co. own a coal
mine in Kentucky as tenants in common. Each of them pays of the costs of operating the mine
and is entitled to take of the output for use in their respective electric generating businesses,
which are otherwise unrelated. Are Suphuric Electric Power Co. and the Metropolis Municipal
Electric Co. partners w/ respect to the coal mine operation?
- How do we determine whether an entity is a partnership, corporation, or disregarded entity? First,
look at the number of owners/members. If there is only one owner then it is either a corporation or
disregarded entity. If there are two or more owners then it is either a corporation or a partnership.
- How do we determine between a corporation and a partnership? Reg. 301.7701-2(b) provides a list
entities which are corporations. Reg. 301.7701-2(c) tells us that if the entity is not a corporation as
defined under -2(b) and has at least two members, then it is a partnership.
- See also Reg. 301.7701-3 (the check-the-box rule) which provides that if not a per se corporation
(under Reg. 301.7701-2(b)) then default rule is partnership (provided at least two members), but can
elect to be a corporation. However, if there is only one member then the entity is either disregarded
(sole proprietorship) or a corporation.
- Here, there is no formal agreement providing that the endeavor is a partnership.
- Reg. 301.7701-1(a)(2) provides that a joint venture or other contractual arrangement may create a
separate entity for federal tax purposes if the participants carry on a trade, business, financial operation
or venture and divide the profits therefrom.
- This problem is similar to the Madison Gas and Electric case. The output here, coal, is distributed in
kind, rather than in cash. However, they are still engaged in the business for profit and the profit is the
value of the extracted coal over the cost of extracting it. This problem is a partnership.
- Can they opt out under 761? Yes
761 applies quite narrowly: regulations have fairly significant restrictions
Cant do anything fancy w/ splitting up cost and profits
Reg. 1.761-2
Only 2 times can opt out (opposed to 3 in statute)
(a)(2): co-owners 3 requirements
(a)(3): own as co-owners and no joint marketing of what producing
But, how much does this help?
Note 2 (pg 10): MG&E did file opt out under 761, but might still be treated as joint
venture or partnership for other code sections
Casebook (Pg 19): if elect out, only successfully elected out of subchapter K ex: not
1031(a)
Summary
Business entity
Can elect out
But, wont help if dealing w/ non-subchapter K problem
Problem 2: Glenn and Helen are lawyers who share a single office suite and secretary. Glenn is a
real estate lawyer and Helen is a plaintiffs trial lawyer. They share general overhead office
expenses (e.g., office rent and utilities, computer and photocopier lease, etc.) but each pays his or
her own share of variable expenses (e.g., long distance telephone calls, travel, etc.) and they
service and bill their own clients. They do, however, refer clients to each other from time to time
for work w/in the others area of expertise. Are they partners for tax purposes?
- Reg. 301.701-1(a)(2) provides that a joint undertaking merely to share expenses does not create a
separate entity for federal tax purposes. Additionally, G and H are not sharing profits (as was
happening in Problem 1). Here, there exists the possibility for one to make a profit and the other to
have a loss.
- G and H are NOT partners for tax purposes just basically joint tenants of office building.
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Problem 3: Al, Betty, Carl and Donna purchased Blackacre, which is 500 acres of undeveloped
land on the outskirts of Gotham City, as TIC. Each contributed $100,000 toward the purchase
price.
(a) They plan to hold BA as a speculative investment for several years, until Gotham City
expands and BA appreciates, and hope then to sell it to an as of now undetermined real estate
developer. Have Al, Betty, Carl, and Donna formed a partnership? Would it make any
difference if they agreed that none of them would have a right to sell his or her undivided interest
in BA independently of the others?
- Initially, w/o the restraint on alienation, the co-tenants most likely have not formed a partnership
looks like co-investment/co-ownership
Want to know terms of agreement how easy to exit?
- A restraint on alienation is inconsistent w/ joint tenancy ownership. Further, if all partners must sell
together then all are either going to make money or lose money. But if the partners could sell
independently, then possibility exists for some partners to make money and other partners to lose
money.
- Thus, one critical factor is whether the co-tenants can alienate separately. There is a strong indicator
of partnership status if they cannot.
- Reg. 1.761-2(a)(2)(ii): to use 761 have to reserve right separately to shares
- See Rev. Proc. 2002-22 (p. 18), which lists several factors for determining whether a co-ownership
arrangement is a business entity. Factor (4) provides that, in general, each co-owner must have the right
to transfer, partition, and encumber the co-owners undivided interest in the property w/o the agreement
or approval of any person.
**They should restructure so right of first refusal**
(b) Al, Betty, Carl and Donna hire a surveyor to prepare a subdivision plat for BA, which they
plan to divide into 200 house lots. Al, Betty, Carl and Donna sell the lots in differing numbers to
20 different builders and split the profits equally. Have Al, Betty, Carl and Donna formed a
partnership? Would it make any difference they planned to sell all of the subdivision lots to one
builder, but obtained the subdivision approval first in order to increase the value of the entire
tract?
- The level of activity has gone up here and crossed the line from investment into a business.
- See Levin v. Commr (TC 1979) (pp. 14-15) The tax court found that the co-tenants were partners
b/c they engaged in an active business by leasing the properties to tenants, providing property
management services to the tenants, and sharing the gains and losses. These factors were found more
indicative of a partnership business than a mere passive investment.
Rev. Rul. 75-374: customary: ownership v. not customary: joint venture
if mgmt. had performed extra services, would have been joint venture
Problem 4:
(a) Ed and Fay each contributed $500,000 to the purchase price of a 30 unit apartment building.
Is there any way that Ed and Fay can avoid being classified as a partnership if they operate the
apartment building?
- The Levine case indicates that operating an apartment building is a partnership. The owners are
required by state law to provide services and keep the apartments habitable.
- See Reg. 301.7701-1(a)(2): a separate entity exists for federal tax purposes if co-owners of an
apartment building lease space and in addition provide services to the occupants either directly or
through an agent.
- Dont provide non-customary: Rev. Rul. 75-374 (p. 16) where co-owners of an apartment building
hired a management company to manage their apartment building, and the management company
provided customary services to tenants. The ruling held that the co-owners of the apartment building
were not partners. Further, when the management company provided additional services on its own and
received money for those additional services, the ruling held that there was no partnership between the
co-owners and the management company.
- No special allocation
(b) What if the property Ed and Fay bought was a warehouse w/ a single tenant under a 20 year
lease?
- single tenant, so usually dont perform special services
- But if really worried, File 761 opt out
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- No special allocations
- Could do net lease
(c) What if Ed and Fay are husband and wife who reside in California, a community property
state?
- Community Property Rev. Proc. 2002-69 (pp. 13-14): IRS will allow the husband and wife to treat
the entity as disregarded or as a partnership and accept that position essentially, they have a choice of
how to be treated. Note, however, that nothing in the Rev. Proc. allows husbands and wives in a
common law property state to avoid entity characterization under Reg. 301.7701-2(a).
- Non-Community Property State 761(f): if h/w file JR, joint venture not treated as partnership;
instead, treat as co-ownership w/each owning sole proprietorship)
Requirements
Non-state law IRS website: has to be joint venture that is not operated as a state law
entity (thus, if LLP and LLC, cant use 761(f))
Election
Ownerships line allocation
Both materially participate
Problem 5: Ilene purchased a vacant apartment building and agreed w/ Jake, who is an
architect-contractor, that if Jake would supervise the renovation of the apartment building for
sale as condominium units, Jake would be entitled to 30% of the profits from the resale. Are
Ilene and Jake partners for federal income tax purposes? Is whether Jake shares loses relevant?
Is whether Jake has a voice in determining the nature of the renovation, the costs to be incurred,
and the sales price asked for the condominium units relevant?
- The question here is whether Jake and Ilene are partners, or whether Jake is merely an employee.
- (Text pp. 19-20) - A partnership does not exist if the relationship between the parties is an
employment, agency or independent contractor arrangement (see Rev. Rul. 75-43). In determining
whether an arrangement is a partnership or employment, agency, or contractor arrangement, the same
standards used to determine if co-owners are partners apply. The essential factual inquiry is whether
the persons are co-proprietors of the business.
- B/c employees, agents, and independent contractors are frequently compensated on the basis of a
percentage of the employers profits, the sharing of profits aspect of the test may be difficult to apply.
The sharing of losses, which is not common in employment or similar relationships may be more
significant, but is not always necessary. Note that it is not inconsistent w/ a partnership for the person
w/ the know how to not share in losses w/ the partner who provided the capital.
- Many of the cases in the text focused on the character of the property when it was sold and whether it
was capital gain property. Many times the partners were trying to convert ordinary compensation
income into capital gains.
- if profit sharing and cost sharing looking for totality of circumstances
If only getting share of profits, fairly common
What if he has big say in how things get done? Day-to-day decisions looks more like partner
and not EE
Also, unusual for EE to share costs
Wheeler Case (20)
How holding themselves out to others? Here, joint venture name
If hold self out as operating a joint venture, strong indication you are a joint venture
Problem 6: Kyle graduated from M.I.T. and started an unincorporated computer software
development business. To finance development of a new software program, Kyle borrowed $1
million from the Pari-Mutual Venture Capital Fund. The loan is evidenced by a nonrecourse
promissory note due in 10 years. Interest is set at the prime rate plus 10% per year, plus 30% of
Kyles net profits from the exploitation of the software. Are Kyle and Pari-Mutual Venture
Capital Fund partners?
- (Text pp. 20-21) Partnership Versus Loan Occasionally, a transaction otherwise denominated as a
loan may be re-characterized as a partnership. This may occur in the case of an unsecured nonrecourse
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debt that is to be repaid only out of profits from a venture (see Hartman v. Commr).
Factors in favor of Partnership
-NRC is usually secured debt
Need to know what is securing the debt in order to know remedy how much can this person
get at if no payment
Even if there is security for the loan, if it is inadequate, the loan may be re-
characterized as an equity investment when the debt is convertible into an equity
investment (Rev. Rul. 72-350).
-Interest tied to net profit customary?
Likely not
Factors in Favor of Debtor/Creditor
-evidence of formalities
-intent (Culbertson case)
-limited downside risk
SECTION 2(B): PARTNERSHIP V. ASSOCIATION
Problem1: Anne and Bill plan to form a LLC to engage in the business of developing and
marketing computer software. They have identified between 35 and 50 potential investors who
will contribute varying amounts of cash for membership interests totaling approximately 75% to
85% of profits and losses (after Anne and Bill receive handsome salaries). Under the governing
state law, the LLC may be member-managed or manager-managed, membership interests may be
freely transferable or non-transferable, and the LLC may or may not be dissolved by the death,
bankruptcy, retirement, or expulsion of a member, all as provided in the LLC agreement. Anne
and Bill want the LLC to by managed by themselves, w/ the investors having only the minimal
rights of members required by state law. Only Anne and Bill will have authority to act on behalf
of the LLC. B/c of the limited powers that the investor-members will be granted, Anne and Bill
think it best that the investors be permitted to sell or assign their membership interests if they so
desire, although Anne and Bill think that the actual opportunities for resale will be limited by
market forces. Of course, Anne and Bill want the business of the LLC to be uninterrupted by the
death, bankruptcy, etc. of an investor-member. Will the LLC be taxed as a partnership or as a
corporation if organized in the manner contemplated by Anne and Bill?
- Default Classification: Any business entity w/ two or more owners that is not a corporation is a
partnership subject to the partnership rules. Reg. 301.7701-3 An entity will be determined under the
tax code, even when there is not an entity for state law purposes.
- The above is clearly an entity under state law conducting a business. This is a partnership under the
default rules in the regulations, even though it walks and talks like a corporation.
- Not publicly-traded There is some risk that this entity could be taxed as a corporation under 7704
if it is determined to be a publicly traded partnership (which requires trading on an exchange or
secondary market). This fact pattern is insulated against 7704 by the private placement exception
found in Reg. 301.7704-1(h) interests in a partnership are not readily tradable on a secondary market
or the substantial equivalent thereof if (1) all interests in the partnership were issued in a transaction
(or transactions) that was not required to be registered under the Securities Act of 1933, and (2) the
partnership does not have more than 100 partners at any time during the taxable year of the partnership.
- Safe Harbors to Avoid Publicly Traded Partnership
Reg. 301.7704-1(d): not technically a safe harbor, but provides comfort
Reg. 301.7704-1(j): not traded
Reg. 301.7704-1(e): trades/exchanges that dont count
Reg. 301.7704-1(h): 33 Act
7704(c): passive
Problem 2: X Corporation operates a childrens toy business and manufactures automatic
weapons. In order to separate potential liabilities, X Corporation forms a LLC, Guns-R-Us,
LLC, to which it transfers the weapons manufacturing operation. What is the tax status of the
Guns-R-Us LLC?
- This is a disregarded entity under the check-the-box rules b/c single member shareholder
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- Corp. will ignore fact of entity in calculating its Federal Income Tax treat as division/department
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Chapter 2 Formation of the Partnership
SECTION 1: CONTRIBUTIONS OF MONEY OR PROPERTY
Problem 1: Amy, Bill, and Casey are forming a limited liability company (that will be taxed as a
partnership) to conduct a bait and tackle shop, fishing guide, and marina business on the
Intracoastal Waterway. Each of them will have an equal interest in capital and profits. Each
partner will transfer the following assets:
Partner Asset Adjusted Basis Fair Market Value
Amy Marina
Land $10,000 $40,000
Buildings $30,000 $60,000
Tradename: Shark Bait $1,000 $10,000
Bill Store Fixtures ( 1245 recomputed
basis = $50,000)
$25,000 $45,000
Inventory $34,000 $65,000
Casey Fishing Boat $30,000 $20,000
Accounts Receivable $0 $5,000
Cash $85,000 $85,000
Amy and Casey previously conducted their respective sole proprietorships using the cash method of
accounting; Bill used the accrual method.
(a) At what values should the contributed property be carried on the partnerships books and
what is the amount of each partners capital account?
Book Value (pship) Capital Account
(partners) FMV AB
FMV AB
Amy: $110k $41k
Marina:
Land $40k $10k
Buildings $60k $30k
Tradename: Shark Bait $10k $1k
Bill: $110k $59k
Fixtures $45k $25k
Inventory $65k $34k
Casey: $110k $115k
Boat $20k $30k
A/R $5k $0
Cash $85k $85k
$330k $215k $330k $215k
- Why does partnership keep track in this way? This is book value and is important for tax purposes.
Need to figure out gain and loss realized by and allocated to each partner.
- The distributive share of partnership income or loss is whatever the partnership agreement says it is.
- Each partners capital account is maintained on the books of the partnership. Each partner gets a
capital account equal to the FMV of the assets he contributed to the partnership. Upon liquidation,
each partner is entitled to the amount in his capital account. Capital accounts keep track of the real deal
(the real world values). Thus, always want to know book value.
Amy: 40K + 60K + 10K = $110K
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Bill: 45K + 65K = $110K
Casey: 20K + 5K + 85K = $110K
(b) What are the tax consequences of the formation of the partnership? What is each partners
basis for his or her partnership interest? What is the partnerships basis in each asset?
Amy:
(A) What are the tax consequences of the formation of the partnership?
- Amy contributed property with aggregate basis of $41k and FMV of $110k. Pursuant to 721(a) no
gain or loss is recognized upon contribution. Note that this is similar to 351, but 721 is much
broader b/c the 351 requirements of formation and control are not present. Thus, any contribution of
property to a partnership in exchange for an interest in the partnership gets non-recognition treatment.
- What about the tradename Shark Bait? Intangibles meet the definition of property (see Rev. Rul.
70-45), and therefore also qualify for non-recognition under 721.
(B) What is Amys basis for her partnership interest?
- Amys basis is the sum of the AB of the property she contributed ($41k) plus the amount of cash she
contributed ($0). 722. Thus, Amys AB in her 1/3 LLC interest is $10k + $30k + 1k = 41k
(aggregate of the basis of the properties she contributed).
- Holding Period
All 1231 assets so she can tack holding period in all items to her partnership interest
Thus, start w/ partnership interest that is a LTCA
(C) What is the partnerships basis in each asset contributed by Amy?
- Pursuant to 723, the partnership retains a separate basis in each asset contributed by Amy equal to
the AB of each asset in Amys hands at the time of the contribution. Thus, the LLC has AB of $10k in
the land, AB of $30k in the buildings, and AB of $1k in the tradename Shark Bait.
- Holding Period
All 1231 assets so partnership can tack her holding period in all items to partnerships
holding period of the assets
* Note that the price paid for non-recognition is the exchanged (substituted) basis which preserves the
gain or loss for later recognition, thus deferring recognition, not eliminating it.
Bill:
- Section 721 generally provides for non-recognition of gain or loss to both the contributing partner and
the partnership.
- The contribution of the inventory qualifies for non-recognition, but be aware that if the partnership
disposes of the contributed inventory items within 5 years of the contribution, any gain or loss will be
treated as ordinary, rather than capital ( 724(b)).
- The contribution of the store fixtures gives us pause here b/c of the 1245 depreciation recapture.
The last sentence of 1245(a)(1) trumps 721 non-recognition by providing such gain shall be
recognized notwithstanding any other provision of this subtitle. However, 1245(b)(3) gives
jurisdiction back to 721 and provides for non-recognition - if the basis of property in the hands of a
transferee is determined by reference to its basis in the hands of the transferor by reason of the
application of 721, then the amount of gain taken into account by the transferor under subsection (a)
(1) shall not exceed the amount of gain recognized to the transferor on the transfer of such property
(determined without regard to this section). Thus, 1245 does not apply if the partnership takes a
basis in the fixtures equal to what Bills basis was.
- Why is 1245 called off b/c of transferred basis? The ordinary income potential is retained. Thus,
the conversion of OI into CG is not possible, but non-recognition is available.
(B) What is Bills basis for his partnership interest?
- Section 722 basis of contributing partners interest = sum of AB of property contributed ($59k) +
amount of cash contributed ($0) = $59k ($25k + $34k)
(C) What is the partnerships AB in each asset contributed by Bill?
- Section 723 provides for $25k basis in the fixtures and $34k basis in the inventory.
- Note: Fixtures likely depreciable property
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Partnership must continue w/ depreciation schedule of contributing party 168(i)(7)
Same rule if intangible 197(f)(2)
Casey:
- Section 721 provides for non-recognition of gain or loss to both the contributing partner and the
partnership.
(B) What is Caseys basis for his partnership interest?
- Section 722 basis = sum of AB of property contributed ($30k + $0) + amount of cash contributed
($85k) = $115k. Hempt Bros v. U.S. (1974) provides that accounts receivable from performing
services for persons other than the partnership constitutes property for purposes of 721-723.
Note: Under 704(c)(1)(A), however, the amount realized upon collection of a cash method
account receivable must be allocated to the contributing partner (Casey) when it is recognized.
704(c)(1)(C): only original contributor gets the loss deduction
Here, built-in loss potential if partnership sold boat and if Casey sold partnership
interest
No Regs
(C) What is the partnerships AB in each asset contributed by Casey?
- Section 723 provides that the partnerships AB in each asset contributed by a partner is the AB of
each asset to the contributing partner at the time of the contribution. Thus, AB of boat is $30k, AB of
A/R is $0, and AB of cash is $85k.
* 168(i)(7) Treatment of Certain Transfers
(A) In General In the case of any property transferred in a transaction described in subparagraph (B),
the transferee shall be treated as the transferor for purposes of computing the depreciation deduction
determined under this section with respect to so much of the basis in the hands of the transferee as does
not exceed the AB in the hands of the transferor. . .
(B) Transactions Covered 721, etc.
- Basically, the partnership steps into the shoes of the partner for depreciation purposes.
* 197(f)(2): same rule for intangibles
* Holding Periods:
(i) Section 1223(2) deals with holding periods to the transferee partnership (it applies to TP with a
transferred basis).
(ii) Section 1223(1) deals with holding periods for the person receiving the partnership interest in a
721 exchange (applies to TP with exchanged basis partner). This section is a two part condition. The
property exchanged must also be 1221 capital asset or 1231 property to get tacked holding period.
- What about Bills holding period for his partnership interest? The fixtures are 1231 property but
inventory is not (neither is it 1221 capital asset). So what property gets a tacked holding period? A
pro ration rule applies (see Runkle v. Commr case cited on p. 3). The same analysis applies with
respect to Casey.
Assuming boat is 1231 asset
$20/$110 is percentage Casey can tack LT capital asset
Remaining $90/$110 must start new period
(c) If the partnership sells the inventory contributed by Bill for $65,000 and collects $5,000 on the
accounts receivable contributed by Casey, how will the partners be taxed?
(i) Inventory:
Sale (Tax) Book Value
AR = $65,000 FMV = $65,000
AB = $34,000 AB = $34,000
= $31,000 gain realized = $31,000 Built-in Gain
- Section 704(c) requires built-in g/l at the time of contribution to be allocated for tax purposes to the
partner who contributed the property, even though the g/l may be allocated otherwise for partnership
accounting purposes. Reg. 1.704-1(b)(5), Ex. (13)(i). Thus, the built-in g/l goes to the partner who
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contributed the property with the built-in g/l, to the extent of such built in g/l at the time of contribution.
Any additional g/l is split between the partners according to the distributive shares provided in the
partnership agreement.
Here, Built-in gain of $31k and gain realized on sale of $31k. Thus, entire $31k gain is
allocated to Bill.
- Section 724(b) provides that any g/l recognized by the partnership on the disposition of contributed
inventory items within 5 years of contribution shall be treated as ordinary income or ordinary loss.
Thus, depending on how many years after contribution the inventory items were sold, the gain may be
ordinary or capital.
- Sections 724(B) and 704(c) prevent or discourage shifting income and converting ordinary income
into capital gain.
(ii) Accounts Receivable:
Sale Book Value
AR = $5,000 FMV = $5,000
AB = $0 AB = $0
= $5,000 gain realized = $5,000 built-in gain
- Thus, entire $5,000 gain is allocated to Caseys return under 704(c).
- Section 724(a) provides that any gain or loss recognized by the partnership on the disposition of
contributed unrealized receivables shall be treated as ordinary income or ordinary loss. Thus, the
$5,000 gain recognized on the disposition of the unrealized accounts receivable will be allocated to
Casey as ordinary income, regardless of the amount of time the partnership held the asset following
contribution.
- Increase outside basis by $5k, but no adjustment to book value
(d) If the partnership sells the inventory contributed by Bill for $80,000, how will the partners be
taxed?
AR = $80,000 FMV = $80,000 (at time of sale)
AB = $34,000 BV = $65,000 (at time of contribution)
= $46,000 gain realized = $15,000 (gain while Pship owned)
- There was a total of $46k gain realized on the sale. However, the inventory had a built-in gain of
$31k (65k 34k) at the time of contribution, which must be attributed to Bill pursuant to 704(c).
-The remaining $15k gain that occurred while the partnership owned the inventory is split between the
partners in accordance with their distributive shares (1/3 each). 704(c)(1)(A) Thus, A, B, and C are
each allocated $5k of the additional $15k gain.
Book adjustments Increase A, B, and Cs book value to $115k; Partnerships inventory
disappears and cash increases by $80k to $165k
Partners tax basis adjustments
A increased by $5k to $46k
B increased by $36k to $95k
C increased by $5 to $120k
Reg. 1.704-1(b)(2)(iv)(d)(3)
(e) If the partnership sells the fishing boat for $20,000, how will the partners be taxed?
= ($10,000) loss realized = $0 (loss while Pship owned)
- The entire $10,000 built-in loss is allocated to Casey and there was no loss while the partnership
owned the asset to be split among the partners.
- 724(c) will treat as a CA
(f) If the partnership sells the fishing boat for $17,000, how will the partners be taxed?
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= ($13,000) loss realized = ($3,000) (loss while Pship owned)
- $10,000 built-in loss at the time Casey contributed the boat is allocated to Casey and the additional
$3,000 loss is split between all the partners in accordance with their distributive shares ( 704(c)), so
$1,000 loss passed through to A, B and C.
* Suppose the partnership sold all of its assets shortly after the partnership was formed:
- Amy: $110k (FMV) - $41k (AB) = $69k built-in gain
- Bill: $110k (FMV) - $59k (AB) = $51k built-in gain
- Casey: $110k (FMV) - $115k (AB) = ($5k) built-in loss
Thus, all built-in gain or loss went to contributing partner.
If this were an S Corp, then each shareholder would have $38.33k ($115k / 3) of gain.
Thus, shifting income in S Corporations, but not Partnerships. This is a non-explicit election available
in the Code, but not expressly provided for in the Code. Professor McMahon believes that 704(c) is
the correct result from a tax policy analysis.
* Note: When a partnership forms, it appears to be duplicating gains and losses (like corporations).
However, when the partnership is liquidated, the two levels of tax are collapsed down to only one level
again (whereas with corporations the duplication is permanent).
Problem 2: Dana and Ed are forming a limited partnership to engage in the real estate
development business. Dana, a real estate agent, will be the general partner. Ed, a dentist, will
be the limited partner. Dana will contribute an installment promissory note, with a basis of
$50,000 and a face amount of $100,000, which was received on the sale of land held for
speculative investment, in exchange for a interest in partnership profits and capital. Ed will
contribute Blackacre, which has a basis of $50,000 and a FMV of $125,000, and Whiteacre,
which has a basis of $200,000 and a FMV of $175,000, in exchange for a interest in profits and
capital. Dana, Ed, and the partnership are cash method taxpayers.
(a) At what values should the contributed property be carried on the partnerships books and
what will be the amount of each partners capital account?
Partnership (Book Value) Partners (Capital Account)
Partner Asset FMV/BV Basis FMV/BV Basis
Dana: $100k $50k
Inst. Note $100k $50k
Ed: $300k $250k
Blackacre $125k $50k
Whiteacre $175k $200k
- Dana: interest in partnership profits and capital
- Ed: interest in partnership profits and capital
- Note that nothing in the Code requires profit sharing ratio to match ratio of contributed capital
(difference often suggests different levels of service to the partnership).
(b)(1) What are the tax consequences of the formation of the partnership?
(i) Dana:
- Section 721 provides for non-recognition of gain or loss on contribution of property to the partnership
in exchange for a partnership interest. Installment obligations are specifically designated as eligible
property by Reg. 1.721-1(a). Moreover, Reg. 1.453-9(c)(2) provides that 453B does not require
recognition of gain upon a transfer of an installment obligation to a partnership. Additionally, any
amount received on the installment obligation retains its character (Reg. 1.453-9(c)(3)).
- Thus, no tax consequences to Dana upon formation.
(ii) Ed:
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- Blackacre and Whiteacre are clearly property contemplated by 721, so no gain or loss recognized to
Ed on formation either.
(b)(2) What is each partners basis for his or her partnership interest?
(i) Dana:
- 722 provides that Danas basis = sum of (i) amount of money contributed ($0) + AB of property
contributed ($50k). Thus, Danas basis in her partnership interest is $50k.
(ii) Ed:
- Basis in partnership interest = sum of (i) amount of money contributed ($0) + AB of property
contributed ($50k + $200k), or $250k.
(b)(3) What is the partnerships basis in Blackacre and Whiteacre?
- Section 723 provides that the partnerships AB in contributed property shall be the AB of such
property in the hands of the contributing partner at the time of contribution. Thus, Blackacre AB =
$50k and Whiteacre AB = $200k.
(c)(1) How are the partners taxed when the partnership collects the installment note?
- Under 704(c), the remaining deferred gain on an installment obligation or the amount realized upon
collection of a cash method account receivable must be allocated to the contributing partner when it is
recognized. Under the installment method ( 453) income is recognized in the year payments are
received. Thus, in the year a payment is received, that portion of the payment that is gain will be
allocated to Dana in that year.
(c)(2) What is the character of the gain when the partnership sells Blackacre and Whiteacre?
Does it matter how long Ed held the contributed property?
- Ed is a dentist and therefore did not hold Whiteacre and Blackacre as inventory, primarily for sale to
customers in ordinary course of business, or for use in his trade or business ( 1221). Therefore,
assuming the properties are capital assets, any gain or loss from the sale would be long-term capital or
short-term capital, depending on the length of time Ed held the property.
- The partnership will get a tacked holding period pursuant to 1223(2).
- The properties were capital assets in Eds hands, but the partnership is engaged in the real estate
development business. Except as provided in 724, property contributed to a partnership in a
transaction subject to 721-723 is characterized as (i) a capital asset, (ii) a 1231 asset, or (iii) an
ordinary income asset (e.g. inventory) according to the purpose for which the partnership holds the
property (Reg. 1.702-1(b)). Thus, any gain from the sale of the properties would be ordinary b/c the
properties are ordinary income assets in the hands of the partnership.
- 724(c), however, alters this general rule with respect to capital loss property (Whiteacre here) that is
sold within 5 years of contribution. This prevents the conversion of capital loss into ordinary loss.
Thus, any loss on the sale of Whiteacre by the partnership within 5 years of contribution will be
capitalP (regardless of how long Ed held Whiteacre).
(c)(3) What would be the amount of loss recognized if Whiteacre had been Eds residential farm
property prior to its contribution to the partnership and the partnership sold it for $155,000?
= $45,000 total loss = ($20,000) loss in Pship hands
- The $25,000 built-in loss ($200k AB - $175k FMV) is allocated to Ed ( 704(c)), and is capital loss
pursuant to 724(c) (to extent of built-in loss at time of contribution).
- The remaining $20,000 loss is allocated between Ed and Dana pursuant to their distributive shares (Ed
= 75% and Dana = 25%). Thus, Ed is allocated $15,000 of loss and Dana is allocated $5,000 of loss.
These losses are ordinary b/c Whiteacre was an ordinary income asset in the hands of the partnership
and this portion of loss is attributable to time the partnership held the property.
11
SECTION 2: CONTRIBUTIONS OF ENCUMBERED PROPERTY
Problem 1: Fran, George and Helen formed the FGH General Partnership. Each of them has a
1/3 interest in partnership capital, profits, and losses. Fran and George each contributed $20,000
cash to the FGH Partnership and Helen contributed Greenacre, which is worth $50,000 and
subject to a mortgage of $30,000, which was assumed by the partnership.
(a) Assume that each partner would be responsible for 1/3 of the debt if the partnerships assets
were worthless.
Book/FMV Basis Book Basis
Cash $40k $40k Mortgage $30k
Greenacre $50k ??? Fran $20k
George $20k
Helen $20k
- How do we book in Greenacre? Book in GA at its FMV ($50k). The purpose of book value (apart
from tax) is to determine partnership profits, which only exist if GA is sold for greater than $50k (its
FMV at the time of contribution).
- How do we book Helens capital account? Pursuant to Reg. 1.704-1(b)(2)(iv)(b) book Hs capital
account at the FMV of the property contributed by her to the partnership (net of liabilities that the
partnership is considered to assume or take subject to). Thus, $50k FMV of GA less the $30k liability
that the partnership assumed = $20k.
(1) Ignoring the tax consequences, if the value of GA is unchanged, what happens to the partners
if GA is sold, the debt is paid, and all partnership proceeds are distributed to the partners?
- Here, assuming the partnership sells Greenacre for $50k, resulting in $0 book gain, and liquidates the
partnership shortly after formation. The partnership would have $50k cash from sale of GA and $40k
cash that was contributed by F and G ($90k total cash). The partnership would first pay off the
mortgage for $30k, which would leave $60k for distribution to the partners. Each partner would get
$20k distribution (the amount in their capital account). If there was anything left, it would be
distributed according to each partners distributive share.
(2) What are the tax consequences if Helens basis in GA was $35,000?
Book/FMV Basis Book Basis + Adjust = New
Greenacre $50k $35k Fran $20k $20k + $10k = $30k
George $20k $20k + $10k = $30k
Helen $20k $35k - $20k = $15k
Total $90k $75k $90k $75k $75k
(i) Start with 721-723:
- 721 initially provides for non-recognition of gain or loss on contribution.
- 722 provides for the partners exchanged basis in their partnership interests:
F = $20k
G = $20k
H = $35k
- 723 provides for the partnerships transferred basis in the contributed assets:
Cash = $40k
Greenacre = $35k
(ii) Section 752 Deemed Distributions:
12
- 752(b) provides that the decrease in Hs individual liabilities by reason of the assumption by the
partnership of such individual liabilities shall be considered a distribution of money to H by the
partnership. Thus, $30k of Hs individual liability that was assumed by the partnership is considered a
cash distribution to H.
- 752(a) provides that any increase in a partners share of the liabilities of the partnership, shall be
considered as a contribution of money by such partner to the partnership. Here, each partners share of
the liabilities of the partnership increased 1/3 of $30k, or $10k each. Thus, each partner deemed to
have contributed $10k to the partnership.
- Netting Reg. 1.752-1(f) provides that when a partners share of the liabilities is both increased and
decreased in the same transaction, only the net increase or decrease is taken into account.
- Thus:
F = $10k increase in share of partnership liabilities (worst case scenario*)
G = $10k increase in share of partnership liabilities (worst case scenario*)
H = (i) $10k increase in share of partnership liabilities (worst case scenario*), and
(ii) $30k decrease in individual liabilities (assumed by partnership)
$20k net decrease in individual liabilities (Reg. 1.752-1(f)).
(iii) 731 and 733:
- 733 provides that in the case of a distribution by a partnership to a partner (other than in
liquidation), the AB of such partner of his partnership interest shall be reduced (but not below zero)
by (1) amount of money distributed, and (2) AB of property distributed.
- 731 provides that gain shall not be recognized by the distributee partner unless the amount of money
distributed exceeds the partners AB in his partnership interest.
- Thus: H has $20k deemed distribution by 752(b) and Reg. 1.752-1(f), which will reduce her basis in
her partnership interest by $20k, from $35k to $15k.
(iv) Section 722:
- Pursuant to 722, the deemed cash contribution by the other partners under 752(a) will increase
their basis in their partnership interests by $10k each, from $20k to $30k.
(v) Conclusion:
F: AB = $20k + $10k $30k
G: AB = $20k + $10k $30k
H: AB = $35k - $20k $15k
- Thus, the only tax consequence is a basis adjustment. No gain is recognized by H b/c she had basis in
excess of the deemed distribution.
* Worst Case Scenario Analysis:
- Under Reg. 1.752-2(b) (recourse debt) assuming that the assets of the partnership, including cash,
become worthless. Thus, partnership has $90k book loss ($40k cash + $50k Greenacre).
Luke: should we use $50K or $35K for GA?
If have book tax disparity, have to use book why? must figure out partners
Economic ROL
-2(b)(2)(ii): to extent 704(c) applies, have to use book value
- Next, allocate to partners pursuant to their loss sharing ratio (1/3 each). Substantial economic effect
b/c they have deficit restoration obligation.
Book - Loss = Share of Loss in Worst Case
Debt $30k
F $20k ($30k) ($10k)
G $20k ($30k) ($10k)
H $20k ($30k) ($10k)
Liquidate Helen
$15K tax gain from sale (50-35)
$10K liability decrease As result of paying off debt, decrease from $10 to $0 (deemed distribution)
$20K distribution Each get $20k upon liquidation cash distribution
Order: 705
Increase by $15
13
Then, subtract $30
Book/FMV Basis Book Basis + Adjust = New
Greenacre $50k $15k Fran $20k $20k + $10k = $30k
George $20k $20k + $10k = $30k
Helen $20k $15k - $20k = $0k
Total $90k $55k $90k $55k $60k
(i) 721-723:
- 721: initially, nonrecognition of gain or loss on contribution of property.
- 722: partners exchanged basis in partnership interests:
F = $20k
G = $20k
H = $15k
- 723: partnerships transferred basis in contributed property:
Cash = $40k
Greenacre = $15k
(ii) Section 752 Deemed Distributions:
- 752(b): Deemed distribution of $30k to H by the partnership (amount of Hs individual liability
assumed by the partnership).
- 752(a): Deemed contributions of $10k by F, G, and H to the partnership (each partners share of the
partnerships liabilities increased by 1/3 of $30k).
- Reg. 1.752-1(f): take into account only net increase or decrease in Hs share of the partnership
liabilities.
- Thus:
F = $10k increase in share of partnership liabilities
G = $10k increase in share of partnership liabilities
H = (i) $10k increase in share of partnership liabilities, and
(ii) $30k decrease in individual liabilities (assumed by partnership)
$20k net decrease in individual liabilities (Reg. 1.752-1(f))
(iii) 731 and 733:
- 733: reduce AB of H in Hs partnership interest (but not below zero) by amount of money
distributed.
- 731: gain recognized on deemed distribution to H to extent money distributed exceeds Hs AB in
partnership interest.
- Thus, H has $20k deemed distribution by 752(a), (b) and Reg. 1.752-1(f), which will reduce her
basis in her partnership interest from $15k to $0 ( 733), and result in $5k of gain recognized ( 731).
Character of gain: capital
(iv) Section 722: The deemed cash contributions by F and G to the partnership under 752(a) will
increase their basis in their partnership interests by $10k each, from $20k to $30k.
(v) Conclusion:
F: AB = $20k + $10k = $30k
G: AB = $20k + $10k = $30k
H: AB = $15k - $15k = $0
Gain = $20k - $15k = $5k
- Here, there is tax consequence beyond simple basis reduction b/c Hs basis reduction was in excess of
her AB in her partnership interest.
- Note that H recognized gain with respect to property without getting any cash (constructive cash
distribution). Thus, the aggregate outside basis is greater than the aggregate inside basis. The idea is
that when the smoke clears, inside and outside basis will be equal. What happens when they are not
equal? There will be a later loss or gain (we will discuss this at the end of the semester).
14
Order Increase from $15k to $35k then reduce by $30k liabilities = $5k tax basis
H going to be able to take a loss under 731(a)(2)
* Note that the above problems operated under the assumption of general partnership and recourse debt.
(b) Assume that the mortgage debt is nonrecourse as to both Helen and the FGH Partnership.
(1) Ignoring tax consequences, if the value of GA is unchanged, what happens to the partners if
GA is sold, the debt is paid, and all partnership proceeds are distributed to the partners?
- The risk of loss analysis does not work with nonrecourse debt. If the property becomes worthless, the
bank gets nothing from the partnership or partners.
- Same result as in Problem 1(a)(1).
Book Basis Book Basis
Cash $40k $40k Debt $30k
Greenacre $50k $40k F $20k
G $20k
H $20k
- First, need to determine each partners share of the nonrecourse debt:
Reg. 1.752-3(a): Partners Share of Nonrecourse Liabilities
(1) Minimum Gain = $0
(2) 704(c) Gain = $0
(3) Excess Nonrecourse Liabilities = $30k (shared according to profits ratio 1/3)
$10k to F
$10k to G
$10k to H
- Thus, each partners share of partnership liabilities increased $10k.
- However, H also incurred a decrease in her individual liabilities of $30k. Therefore, pursuant to Reg.
1.752-1(f) the increase and decrease in liabilities resulting from the same transaction are netted and
result in a net decrease in Hs liabilities of $20k. Pursuant to 752(b), such decrease is treated as a
cash distribution to H, and, pursuant to 733, such cash distribution decreases Hs basis in her
partnership interest.
Greenacre $50k $40k F $20k $20k + $10k = $30k
G $20k $20k + $10k = $30k
____ ____ H $20k $40k - $20k = $20k
$90k $80k $90k $80k
Greenacre $50k $15k F $20k
G $20k
H $20k
- First, need to determine each partners share of the nonrecourse debt:
Reg. 1.752-3(a): Partners Share of Nonrecourse Liabilities
(1) Minimum Gain = $0
(2) 704(c) Gain = $15k to H
(3) Excess Nonrecourse Liabilities = $15k (shared according to profits ratio 1/3)
15
$5k to F
$5k to G
$5k to H
- Thus, F and Gs share of partnership liabilities increased $5k and Hs share increased $20k.
- However, H also incurred a decrease in her individual liabilities of $30k. Therefore, pursuant to Reg.
1.752-1(f) the increase and decrease in liabilities resulting from the same transaction are netted and
result in a net decrease in Hs liabilities of $10k. Pursuant to 752(b), such decrease is treated as a
cash distribution to H, and, pursuant to 733, such cash distribution decreases Hs basis in her
partnership interest (but not below zero).
Greenacre $50k $15k F $20k $20k + $5k = $25k
G $20k $20k + $5k = $25k
____ ____ H $20k $15k - $10k = $5k
$90k $55k $90k $55k
Problem 2: Lisa, who previously has conducted a solo medical practice, joined a partnership with
two other physicians. Each partner has a 1/3 interest. Lisa transferred $18,000 of accounts
receivable from her solo practice to the partnership, which assumed $12,000 of Lisas accounts
payable.
(a) What are the tax consequences of the transaction if Lisa and the partnership use the cash
method of accounting?
- Under the analysis used in Problem 1, L would be relieved of $12k of liabilities in her individual
capacity and be assuming $4k of liabilities in her capacity as a partner, for a net decrease in liabilities
of $8k that would be deemed a cash distribution and reduce her basis in her partnership interest.
* Reg. 1.752-1(a)(4) Liability Defined (i) In General An obligation is a liability for purposes of
752 and the regulations thereunder only if, when, and to the extent that incurring the obligation (A)
creates or increases the basis of any of the obligors assets (including cash); (B) gives rise to an
immediate deduction to the obligor; or (C) gives rise to an expense that is not deductible in computing
the obligors taxable income and is not properly chargeable to capital.
- Thus, Reg. 1.752-1(a)(4) definition of liability does NOT include a cash method account payable, and
the above analysis simply does NOT apply.
- Why are cash method accounts payable excluded from the definition of liability under 752? B/c
there was no deduction already claimed for the account payable (as there would have been under the
accrual method). If L were on the accrual method, then she already would have taken the deduction.
* Note that Reg. 1.752-1(a)(4) excludes another type of liability from 752 by inference (which has
something in common with cash method A/P). Section 461(h) economic performance liabilities, which
are not deductible until paid (e.g., environmental remediation costs).
752 Not 752
Accrual Method Payables Cash Method Payables
Bank Loans Accrual Method 461(h) Economic Perfor.
Installment Note to Buy Property
- Note how the items on the left have already received a tax benefit. The TP got a deduction on the
accrual method payable, but now someone else is going to pay the liability. Therefore, that debt must
be taken into account on receipt. The items on the right, however, have not yet received any tax benefit
b/c the amount is not deductible until actually paid. This is the distinction that justifies different
treatment of these types of liabilities.
- So what to do w/ this contingent liability?
1.704-1(b)(2)(iv)(q) put in partnership assets, but w/ negative value; Lisa gets net value of 2 assets
so book of $6; Lisas basis is $0 b/c CMTP
16
Payables(12k) null Debt _____
Receivables $18k $0k Lisa $6k $0 (b/c CMTP)
What happens when Partnership gets receivables and pays payables?
Receivables: cash of $18K (add to partnership side)
Creates $18k OI/tax to allocate
Allocate all to Lisa under 704(c)(1)(A) overrides partnership agreement
Dont increase BV b/c already accounted for
Can increase basis up to $18k b/c paying tax on $18k
Payable: use $12k of $18k cash to pay so cash goes down to $6k
$12k must be allocated to Lisa under 704(c)(1)(A)
Dont increase BV b/c already accounted for
Must decrease basis by $12k
Only adjust tax amount when recd and paid b/c already accounted for in book
Cash $6k $6k
Lisa $6k $6 (0 + 18 12)
(b) What are the tax consequences of the transaction if Lisa and the partnership use the accrual
method of accounting?
- If L were on the accrual method of accounting, she would have had the following items on her
individual tax return when she operated her solo medical practice:
Income = $18k (from A/R)
Deduction = $12k (from A/P)
= $6k net income
-b/c she already took immediate deduction, treat as 752 liability when contributed to partnership
Liability $12k
Receivables $18k $18k Lisa $6k $18k +/- ___ for liability
- L then contributes the A/R and A/P to the partnership in exchange for a 1/3 partnership interest:
- 721 no gain recognized on contribution
- 722 Basis initially = $18k (basis of A/R)
- 752(b) L shed $12k of liabilities individually
- 752(a) L incurred $4k of liabilities as a partner (1/3) post contribution
Net reduction in liabilities of $8k (distribution that reduces basis)
12-4 = $8k
Basis = $10k ($18k - $8k)
- 704(c)(3)(first sentence) allocate the whole deduction to L. Further, when the
partnership collects $18k A/R and pays out $12k A/P, L has $6k of income.
Liability $12k
Receivables $18k $18k Lisa $6k $10 ($18k - $8k)
What happens when Partnership gets receivables and pays payables?
Receivables: cash of $18K (add to partnership side)
Payable: use $12k of $18k cash to pay so cash goes down to $6k
Triggers decrease in Ls share of liabilities
Goes to $0 b/c no other liabilities from $4k to $0 = $4k decrease
Treated as distribution of money
Reduce basis from $10k to $6k
17
Cash $6k $6k
Lisa $6k $6 (10 4)
SECTION 3: CONTRIBUTION OF PROPERTY V. CONTRIBUTION OF SERVICES
Treatment of Partner
Problem 1: Avery and Blair each hold a 50% interest in the AB LLC, a limited liability company
taxed as a partnership. The sole asset of the AB LLC is Blackacre, a 1,000 acre farm worth
$1,200,000. AB LLC purchased BA several years ago for $900,000 and that amount is its current
AB. Avery and Blair each have a basis in their interests in the LLC (from cash contributions) of
$450,000. Avery and Blair have offered Charlie a 1/3 interest in the LLC capital and profits
(which would reduce Averys and Blairs interests from each to 1/3 each).
Determine the tax consequences to Charlie under each of the following situations:
* Initial Balance Sheet (before C admitted):
FMV Book Basis Book Basis
Blackacre $1.2 mil $900k $900k A (1/2) $450k $450k
B (1/2) $450k $450k
(a) Charlie is a lawyer and receives the 1/3 interest valued at $400,000 in consideration of legal
services previously rendered to the LLC in defending it against an attractive nuisance suit by a
trespasser injured on the BA premises.
- Capital interest b/c Charlie is getting immediate right to current value at liquidation
- The key to understanding these types of problems is that if the partnership had paid cash, instead of
giving a partnership interest, the service provider would have ordinary income and the partnership
would have a deduction.
(i) The initial question is whether C gets nonrecognition under 721:
- This problem is the classic partnership interest for services situation. Section 721 does NOT apply
b/c 721 only applies to contributions of property to the partnership in exchange for an interest in the
partnership. Note that 721, when it applies, trumps 1001.
- Here, C must recognize compensation for services under 61(a)(1)
Timing when does C have to include under 83 here, no risk of forfeiture so include upon
receipt
(ii) The next question is the amount of Cs compensation income:
- When 721 does not apply b/c a person exchanges services for a partnership capital interest, the
amount includable in income is the FMV of the partnership interest received.
- Here, told that the value of the partnership interest received by C is $400k. Therefore, that amount is
gross income to C under 61(a)(1).
- Additionally, 83 makes it clear that the FMV of the interest received minus the amount paid for such
interest is included in the service partners income.
(iii) The final question is Cs basis in his partnership interest received:
- The service partners basis for his partnership interest is the amount included in income, plus any
money and the basis of other property contributed to the partnership (Reg. 1.722-1)
- Here, C contributed no money or other property, so his basis in his partnership interest received is the
$400k that he included in income.
* Suppose The $400k value of the partnership interest were not provided. Is there any good
argument that Cs partnership interest is worth less than $400k? See Hensel Phelps v. Commr (TC
1980) (p. 51) where the TC determined the value of the partnership interest indirectly by reference to
the FMV of the services provided. Remember Philadelphia Parks the value of the thing received (the
18
partnership interest) is the number to be taken into account. However, if it is too difficult to value the
thing received, but can value the thing given up (services), then can presume the two are of equal value
in an arms length transaction.
- How could the value of the 1/3 interest received by C be different from 1/3 of the value of the land
($400k), which is the only asset of the partnership? The value could be less than 1/3 of $1.2 million b/c
of transactions costs involved with partitioning the property (real property is not liquid) if the partners
cannot agree to sell the property and split the proceeds. Or the value could be more than 1/3 of the
value of the land if the partnership has good will or going concern value.
* Note that we should also be concerned with the tax consequences to A and B (through the
partnership).
- The AB partnership will stipulate to the value of the interest transferred to C b/c the partnership will
have a deduction under 162 for ordinary and necessary business expenses in the amount of $400k,
that will be passed through $200k to A and $200k to B.
* Balance Sheet Before Admitting C:
FMV Book Basis FMV Book Basis
Blackacre $1.2m $900k $900k A $600k $450k $450k
B $600k $450k $450k
* Balance Sheet After Admitting C (w/ book up):
Blackacre $1.2m $1.2m $900k A $400k $400k $250k
B $400k $400k $250k
_____ _____ _____ C $400k $400k $400k
$1.2m $1.2m $900k $1.2m $1.2m $900k
- Prop. Reg. 1.704-1(b)(2)(iv)(b)(1): book value = amount included as compensation under 83
Thus, Cs comes in w/ book value of $400K
(b) Charlie is an architect who owns plans for an apartment building drawn for a project that
never was undertaken. Charlie will supervise construction of an apartment building on the land
using the plans. Avery, Blair and Charlie value Charlies contribution at $600,000 and provide
him with a capital account in that amount.
To problem 1(b), pg. 9: In determining the tax consequences to Charlie, assume that the building
plans have FMV of $200,000, and that he has $0 basis in them. Also, assume that he contributes the
plans to the partnership instead of allowing the partnership mere use.
B $600k $450k $450k
- C recd capital interest b right to underlying assets
- C must include $400K in gross income under 61(a)(1)
- Here, Cs contribution is valued at $600k. Additionally, Cs services are contributing to and creating
value in Blackacre. C is contributing plans (property) and services (construction supervision) in
exchange for his partnership interest.
- See U.S. v. Frazell (5
th
Cir 1964) (p. 50): The court held that Frazell realized OI to the extent that his
interest was received in exchange for his services, but that to the extent that the interest in the venture
was received in exchange for the oil maps (property), the nonrecognition rule of 721 applied.
- Can apply 721 to the plans
- In order to correctly answer this problem we need to know the value of the plans and the value of the
services. Assume the plans are worth $200k and the services are worth $400k. Thus:
* Balance Sheet After Admitting C (w/ book up):
19
Plans $200k $200k $0 B $600k $600k $450k
Improvement $400k $400k $0___ C $600k $600k $400k
$1.8m $1.8m $900k $1.8m $1.8m $1.3m
- Note that it is conceivable that C has a basis in the plans and improvements, but here we are assuming
$0 basis.
- Do A and B get any deduction here? No, the expenses are capitalized as intangible capitalized service
cost.
Book value and basis of $400K
* Hypothetical: What would be the result under the McDougal Model (discussed in Assignment 3(B))?
- A and B would still not get any deduction, but they would be forced to recognize some gain (and
therefore have some income), and the end result would be a little different.
(i) Balance Sheet Before Admitting C:
B $600k $450k $450k
(ii) Step 1: A and B swap 1/3 of Blackacre for 2/3 of plans and 2/3 of services. C gets 1/3 of
Blackacre, which is $400k FMV and $300 basis, which means $100k gain recognized by the
partnership and $50k passed through to each A and B.
Blackacre $800k $600k A $600k $450k + $50k = $500k
Plans $100k $100k B $600k $450k + $50k = $500k
Services $300k $300k
(iii) Step 2: C puts in 1/3 Blackacre ($400k book/FMV and $400k basis), 1/3 plans ($50k book/FMV
and $0 basis), and 1/3 improvements ($150k book/FMV and $0 basis):
Blackacre $1,200k $1,000k A $600k $500k
Plans $150k $100k B $600k $500k
Services $450k $300k C $600k $400k
$1,800k $1,400k $1,800k $1,400k
* Note how the McDougal model comes up with some different values than the proposed regulations
model b/c the plan and services generate some inside basis. This is significant b/c the inside basis is
depreciable.
(c) Charlie receives the interest in exchange for agreeing to act for four years as the manager of
an apartment complex that will be built on the land. Assume that Avery and Blair each will
contribute of the cash necessary to build the apartment complex. If, however, Charlie quits
working for the LLC during the four-year period, the interest will be forfeited. Are the value
and basis of BA (or any of the LLC assets) at the end of year four relevant to your answer?
- C gets a 1/3 partnership interest for performing services for 4 years as the manager of the apartment
complex. However, if C quits before 4 years, then he forfeits his partnership interest. How does this
change our answer? More of 83 comes into play (see 83(a) and (c)(1)). Here, there is clearly a
substantial risk of forfeiture, so no need to dig into the regulations to determine if such requirement is
met here.
- If a partnership interest received for services is subject to a substantial risk of forfeiture, pursuant to
83(a), the service partners recognition of income is deferred until the interest vests. As a result, he will
be taxable on any increase in the value of the partnership interest, whether or not attributable to
services performed by the partner for the partnership, at the time the substantial risk of forfeiture
lapses. For the meaning of substantial risk of forfeiture see 83(c)(1) and Reg. 1.83-3(c). Further,
20
the transferee is not treated as the owner of the property until the risk of forfeiture lapses.
Thus, C must decide whether to make 83(b) election
If going up in value, make election right now
- IF C does NOT make election: Thus, C does not recognize compensation income from receipt of his
partnership interest until the substantial risk of forfeiture lapses in 4 years. Note that the amount of
compensation income that C is required to recognize in 4 years could be much greater than he would be
required to recognize currently b/c the value of the partnership could increase during that time.
Additionally, under state law, C is probably a partner when he receives his contingent partnership
interest. However, under federal tax law, C is NOT a partner until the substantial risk of forfeiture
lapses. When risk of forfeiture lapses, he will be admitted and at that time look at value of interests and
that will be his book value and basis.
- If the partnership were to make a $600k profit in year 1, how would that profit be taxed to the
partners? C is not taxed at all b/c he is not a partner for tax purposes. A and B would be taxed on the
profit. Note, however, that any money actually paid to C is compensation income to C and is
deductible to the partnership. See Reg. 1.83-1(a)(1)(flush language) Until such property becomes
substantially vested, the transferor shall be regarded as the owner of such property (partnership
interest), and any income from such property received by the employee or independent contractor or the
right to the use of such property by the employee or independent contractor constitutes additional
compensation and shall be included in the gross income of such employee or independent contractor for
the taxable year in which such income is received or such use is made available.
* Can we get C out of this predicament? Yes, elect under 83(b) to take the value of the partnership
interest into taxable income in the year of receipt. Thus, when the income vests in 4 years, no
additional income is charged to C. C will get only $400k of income this year and A and B will get only
$400k deduction (which may be required to be spread over the 4 years the services are provided).
* Practice Point If represent C, then need to have thorough discussion of the ramifications of such an
election. Also be aware that the 83(b) election must be made within 30 days of receiving the interest.
If represent A and B, then need to convey to them that such an election affects the timing and amount of
their deduction. If the election is made, the deduction is accelerated, but it may be more or less
depending on how well the partnership does. If the election is not made, the deduction is deferred, but
it may be greater.
- Thus, the 83(b) election can be a negotiation point. Generally, the partnership wants the deduction
now rather than later, so both parties may actually want to make the election.
* Profits Only Partnership Interest:
- Profits only partnership interest is a legal term of art.
- Mark IV Pictures, Inc. v. Commr (8
th
Cir. 1992) Held that the test to determine whether a
partnership interest received for services was a profits-only interest or an interest in partnership capital
is an examination of the effect of a hypothetical liquidation immediately after the partnership was
formed. If the partner would receive a distribution, the interest is an interest in capital, not a profits-
only interest.
- Rev. Proc. 93-27 The Service indicated that it will not treat the receipt of a profits-only interest in a
partnership for services as a taxable event except in circumstances where it is possible to ascertain the
value of the profits-only interest.
* Example of profits only partner joining partnership:
- Before profits only partner, C, joins:
Blackacre $1.2m $900k A $600k $450k
B $600k $450k
- After profits only partner, C, joins:
Blackacre $1.2m $900k A $600k $450k
B $600k $450k
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C $0 $0
- The definition of a profits only partner is a partner who comes in with a $0 capital account and shares
in the benefits and burdens of what happens after he joins the partnership. Note that C is still a profits
only partner if he has a $0 capital account upon joining the partnership, but shares in profits and losses
after being admitted.
- See discussion of Diamond, Campbell, and Vestal cases, at pages 2-3 above.
- Suppose the partnership sold Blackacre for $1,200,000 after C, profits only partner, joined.
Book Basis
Sale Price: $1,200,000 $1,200,000
Book/Basis: $1,200,000 $900,000
$0 $300,000
Cash $1.2m $1.2m A $600k $450k
B $600k $450k
C $0 $0
- When book up assets after C joins, $300k profit is locked in to A and B.
- Suppose the partnership sold Blackacre for $1,500,000 after C joined:
Book Basis
Sale Price: $1,500,000 $1,500,000
Book/Basis: $1,200,000 $900,000
$300,000 $600,000
Cash $1.5m $1.5m A $700k $450k
B $700k $450k
C $100k $0
- Suppose the partnership sold Blackacre for $900,000 after C joined:
Book Basis
Sale Price: $900,000 $900,000
Book/Basis: $1,200,000 $900,000
($300,000) $0
Cash $900k $900k A $500k $450k
B $500k $450k
C ($100) $0
- Here, upon liquidation, C would be required to contribute $100k and A and B would each get $500k.
Thus, C is a profits only partner, even though sharing in losses. C is a profits only partner b/c he is only
sharing in the benefits and burdens of being a partner that occur after C joins the partnership.
- Thus, C (profits only partner) has received something of value in exchange for his services. He has
received a potential future stream of income that he did not own before.
- See Diamond case where the TP was taxed upon receipt of a profits only partnership interest that he
received in exchange for services. There the profits only partnership interest was susceptible to
valuation b/c the TP sold the profits only partnership interest shortly after receiving it.
- See Campbell case where the Court of Appeals held that a profits only partnership interest is
property for purposes of 83, but in that case such interest was too speculative, so it was assigned a
$0 value.
* Point An interest in partnership capital in exchange for services constitutes gross income to the
recipient and is either deductible or capitalized by the partnership. However, a profits only partnership
interest received in exchange for services, while property, is generally too speculate to value and
therefore will not be included in the gross income of the recipient and the partnership will not be
22
allowed a deduction.
Problem 2: Block & Eggers, CPA, is a certified public accounting firm with 50 general partners.
Dana, who has been an employee of the firm for 10 years, finally has been admitted to the
partnership this year. Danas opening capital account is fixed at zero, but Dana will share in all
profits and losses following admission to the partnership. Is Danas admission to the partnership
a taxable event?
- Here, we have a profits only interest in a personal service partnership. Under current law, this is an
easy case for non-recognition to D.
- Book value: $0
Diamond Case: distinguished on facts there abusive situation
Rev. Proc. 93-27: IRS will NOT treat receipt of profits-only interest as a taxable event except
in circumstances where it is possible to ascertain the value of the profits-only interest
Here, not high quality debt so D can use safe harbor of 93-27
Rev. Proc. 2001-43: When do we test/measure this? Upon receipt even if not vested
D has to be treated as partner and Partnership does not get a deduction for transfer of
interest
- Tax Basis: $0
-How will this change if Proposed Regs. finalized?
All Rev. Procs. thrown out, but Diamond still applies
What will Prop. Regs. do?
Applies 83 to profits-only interest
Creates another safe harbor where partner can use liquidation value as FMV, which
means partner pays $0 taxes at receipt
To get safe harbor, must meet same 3 requirements in Rev. Proc. 93-27
Safe harbor in Notice 2005-43 3.02 (Proposed Rev. Proc.)
Here, results same, path different
83 applies: include value at time of receipt value is liquidation value b/c falls
under safe harbor and liquidation value for D will be $0
* What if the partnership is on the cash method of accounting and Dana is entitled to a share of
any accounts receivable outstanding on the day of admission to the partnership?
- How much of past items already earned can be allocated to new partner?
706(d)(2)
Barriers to D getting share of A/R that have already been earned, but not yet paid
tax side
Regs. 1.706(d): tend to force you onto either per day ownership or closing of the
books
In addition, effect book value
Revalue possible when D enters even though profits-only interest
Reverse 704(c) allocation
- Cash method accounts receivable, so the partnership does not have the asset yet, but it will pay taxes
on the money when it receives it. Dana still has a $0 capital account and is only sharing in benefits and
burdens that occur after she joined the partnership. Therefore, Dana is still a profits-only partner.
- Rev. Proc. 93-27 The IRS announced that it would treat a partner who performs services in a
partner capacity in exchange for a profits only partnership interest as realizing income upon receipt of
the partnership interest only in the following three specific situations:
(1) The partnerships profits are derived from a substantially certain and predictable stream of
income, such as from high quality debt or a net least;
(2) the partner disposes of the partnership interest within 2 years of receipt; or
(3) the interest is a limited partnership interest in a publicly traded limited partnership as
defined in 7704(b).
- Why is this rule contained in a Rev. Proc. and not a Rev. Rul.? The IRS is not conceding that the
treatment in the Rev. Proc. is correct, just that as a matter of administrative convenience the IRS will
23
allow the treatment.
* What if the profits only partnership interest is forfeitable for 4 years, and 3 years and 11 months after
the profits only partner (C) receives his interest, the partnership sells Blackacre for $1.5 million? As
above, Cs capital account would go from $0 to $100k. Then two weeks later the risk of forfeiture
lapses.
- Rev. Proc. 2001-43 provides that classification of a partnership interest received for services will be
determined at the time the interest is granted, even if the interest is not vested. Where the requirements
of Rev. Proc. 93-27 are met, the Service will treat neither the grant of the interest, nor its vesting, as a
taxable event to the recipient. Rev. Proc. 2001-43 requires that the service provider be treated as the
owner of the partnership interest from the date of its grant. Therefore, the service provider is required
to account for the appropriate share of all partnership items. However, neither the partnership nor the
partners are allowed to claim a deduction for the cost of the services at either the time the interest is
granted or at the time the profits only partnership interest becomes vested.
- Thus, C is treated as if made 83(b) election, regardless of whether of not actually made such
election, when he receives a profits only partnership interest.
- However, if C received a partnership capital interest, then he would need to made the 83(b) election
to receive such treatment, and if such election was not filed within 30 days, then C would not be a
partner until the risk of forfeiture lapsed and C would have income when the risk of forfeiture lapsed.
Problem 3: Elliot is the investment manager for Pari-Mutuel Capital Associates, a limited
partnership, which has nearly 100 partners (but which is not publicly traded). Elliot received a
non-forfeitable, 1%, profits-only limited partnership interest in the partnership, whose assets
consist of a portfolio of New York Stock Exchange traded securities with a value of $100 million,
as a bonus for his many years of faithful service to the partnership in managing its portfolio of
investments. Income from the portfolio has been averaging $5 million per year for the last 5
years. What are the tax consequences to Elliot upon receipt of the profits interests? Should
Diamond apply? Should 83 apply?
- Issue: What counts as high quality investment?
- Carried interest situation very common technique to pay managers w/ profits interest
- Rev. Proc. 93-27 applies (meet safe-harbor) b/c
- Would also meet safe harbor in Prop. Regs.
- Thus, E has $0 tax
Treatment of Partnership Issuing a Partnership Interest for Services
Problem 1(a): In problem 1(a) of Part A, what is the tax consequence to the AB LLC on receipt of
Cs legal services in exchange for admitting to partnership as 1/3 partner w/ $400K capital
account?
B $600k $450k $450k
- Treat as selling asset worth $900K, but really selling portion worth $400K
- Thus, simple thing to do is revalue under Reg. 1.704-1(b)(2)(iv)(f)
- The purpose of the capital accounts is to determine what each partner is entitled to upon dissolution.
When C is added we book the assets up to FMV under Reg. 1.704-1(b)(2)(iv)(f), which lists a number
of events where it is permissible to book all assets up to FMV (admission of a new partner is one such
event).
By adding C, creates a book gain of $300K (1.2M - 900K)
Assigned equally to A and B $150K each to A and B
- Note that by booking up the assets upon admission of C, we have created a book tax disparity between
book value and tax basis, which will be taken into account under 704(c) (reverse 704(c)
allocation to the pre-existing partners). We will cover this later in the course. Basically, A and B will
split the appreciation in Blackacre that occurred while the partnership owned the property before C was
24
admitted in accordance to their profit sharing ratios before the admission of C ($300k appreciation =
$150k each).
- Next, deemed asset sale (under McDougal)
2 steps
Transfer $400K FMV of Blackacre for Cs services
Realization event so gain to realize
$100K tax gain to partnership: allocate to A and B b/c they got the book
gain ($50K each) technically reverse 704(c)
Doing partial fix to disparity
C has $400K wages; takes $400K basis in 1/3 of Blackacre
$400K deduction (assuming services are orindary necessary under 162)
Both book and tax deduction b/c paid this amount out of underlying capital
(book adjustment) and having to recognize the gain (tax)
Allocate no mandate on having to go to A and B, but we are assigning to A
and B (most likely partnership agreement)
Recontribution: C contributes 1/3 interest in Blackacre for 1/3 interest in partnership
(governed by 721)
* Balance Sheet After Admitting C under McDougal (w/ book up):
Blackacre $1.2m $1.2m $1m A $400k $400k $300k
B $400k $400k $300k
_____ _____ _____ C $400k $400k $400k
$1.2m $1.2m $1m $1.2m $1.2m $1m
- Under Prop. Reg. 1.721-1(b)
2 Steps
1: $400K cash to C
Wage income to C
Still allows deduction to partners ($200K to each A and B)
2: C buys 1/3 interest for $400K
- Notice 2005-43 (Prop. Rev. Proc.)
* Balance Sheet After Admitting C under Prop. Regs. (w/ book up):
B $400k $400k $250k
_____ _____ _____ C $400k $400k $400k
$1.2m $1.2m $900k $1.2m $1.2m $900k
Problem 1(b): Does your answer change if Avery and Blair hold Blackacre as JT in an
arrangement that is not treated as a partnership, then create an LLC w/ Charlie? A and B
contribute their JT interest in Blackacre for a 1/3 interest each. C receives a 1/3 interest in the
LL in exchange for his legal services.
Problem 1(c): What are the tax consequences to AB LLC of the transactions described in
problem 1(b) of Part A?
Single Asset Blackacre w/ BV and basis = $900K
A/B equal partners $450K for BV and basis
Step 1: Revalue b/c new partner Reg. 1.704-1(b)(2)(iv)(f)
$300K Book gain allocated by looking to partnership agreement as it stands b/f C joins
50/50
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Thus, $150K each to A and B
No corresponding tax gain
Step 2: Deemed sale of $400K of Blackare for $400K services plan comes under 721 non-
recognition
A) Realization of gain for partnership
Assigned basis to this portion of Blackacre $300K
Thus, tax gain of $100K
Must be allocated to partners - $50K each to A and B
Increases outside basis
B) Income to C of $400K 61; 83
C) Services for capital expenditure gives rise to $400K nondeductible expenditure
Step 3: C contributes portion of Blackacre
$400 basis blackacre and $0 in plan
Blackacre $1.2m $1.2m $1m A $600k $600k $500k
Construction $400k $400k B $600k $600k $500k
Plan $200k $0 C $600k $400k
Total $1.8m $1.4m $1.8m $1.4m
Under Prop. Regs.
Step 1: revalue (just like above)
Step 2: Cash contribution treat as though pay C $400k for services
C still has $400K service income
Partnership no g/l
Payment to C still treated as 707(c) payment still have to look at what service payment for:
here, capital construction cost (thus, no deduction)
Construction $400k $400k B $600k $600k $450k
Plan $200k $0 C $600k $400k
Total $1.8m $1.3m $1.8m $1.3m
*still $300K adjustment to be done in the future just deferred
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Chapter 3 Taxation of Partnership Taxable Income to the Partners
SECTION 1: PASS-THRU OF PARTNERSHIP INCOME TO THE PARTNERS
Problem 1: Sean and Terry are partners in an investment partnership. Seans share of
partnership profits and losses is 2/3 and Terrys share is 1/3. Sean, Terry, and the partnership
are all cash method calendar year taxpayers. For the current year the partnership received or
incurred the following items.
Receipts and Gains:
1. Rents $300,000
2. Gain from the sale of used computer ( 1245 gain) $ 3,000
3. Gain from sale of apartment building ( 1231 gain) $150,000
4. STCG on NYSE traded securities $ 12,000
5. LTCG on sale of land held for speculative investment $ 90,000
6. Interest on City of New York bonds $ 3,000
Outlays and Losses:
1. Employee salaries $ 30,000
2. Rent $ 24,000
3. Depreciation (ACRS) $ 15,000
4. Stock Brokers fees $ 3,000
5. Charitable contributions $ 9,000
6. Legal fees incurred to lobby Congress to reduce the
tax rate on capital gains $ 4,500
7. LTCL on sale of land held for speculative investment $ 60,000
8. STCL on NYSE traded securities $ 9,000
(a)(1) How should the partnership, Sean, and Terry report these items? Does it matter whether
the partnership makes any distributions?
- This problem deals with 702(a) and (b) and 703.
(i) First, determine the separately stated items (listed in 702(a)(1)-(7)):
702(a)(1)-(7) Partnership Sean (2/3) Terry (1/3)
(1) 1231 gain (1.702-1(a)(3)) $150k $100k $50k
(2) STCG & STCL (net 1.702-1(a)(1)) $3k $2k $1k
(3) LTCG & LTCL (net 1.702-1(a)(2)) $30k $20k $10k
(4) Charitable Contributions ($9k) ($6k) ($3k)
(5) Tax Exempt Interest (1.702-1(a)(7)) $3k* $2k* $1k*
(6) Lobbying Expenses ($4.5k*) ($3k*) ($1.5k*)
(7) 702(a)(8) income or loss (from below) $234k $156k $78k
$271k $135.5k
(ii) Second, determine the non-separately stated items ( 702(a)(8):
Income
(1) Rental Income $300k
Assume not passive
(2) 1245 gain $3k
$303k
Expenses
(1) Salaries ($30k)
(2) Rent Paid ($24k)
(3) Depreciation ($15k)
(4) Brokers Fee -------
($69k)
$234k $156k $78k
27
- The separately stated items are isolated b/c of the way they may interact with other items on the
partners individual return.
- Section 1231 gain or loss is passed through as 1231 gain or loss and not LTCG or LTCL b/c each
partner may have 1231 gains or losses on their individual returns. Remember that 1231 gain is
treated as LTCG only if 1231 gains exceed 1231 losses in the aggregate.
- Section 1245 gain is not separately stated here. See Week 3 notes page 10 for discussion of when
1245 gain may need to be separately stated.
- Why separately stating tax exempt interest? B/c Reg 1.702-1(a)(7) tells us to.
- Brokerage Fees: If they were incurred to manage or maintain an investment account, then deductible
under 212 (non-business expenses) and would have to be stated separately (Reg. 1.702-1(a)(8)(i)).
Need to know how incurred Here, we assumed incurred in purchase; thus, capitalized and
dont do anything w/ them
- Charitable Contributions: 703(a)(2)(C) says not part of partnership TI so why are we separately
stating?
2 Reasons Reg. 1.703-1(a)(2)(iv)
Policy in favor of allowing charitable deduction
Partnership cant take so partners take
- Lobbying Expenses: separately stated make sure basis adjustments properly taken
- Basis Adjustments
Tax exempt interest: 705(a)(1)(B) says to increase the partners AB in his partnership
interest by his distributive share of tax exempt income.
Lobby Expenses: 705(a)(2)(B) says to decrease the partners AB in his partnership interest
by his distributive share of expenditures of the partnership not deductible in computing its
taxable income and not properly chargeable to capital account.
The above two basis adjustments somehow preserve the single layer of tax
* What about issue of passive activity losses with respect to the rents received (rental activity is often a
passive activity)? If the rental activity was a passive activity, then that income would have to be set
apart. Here, assume that S and T are engaged in the business of rental and their rental income is not
passive activity income.
* Why is the basis reduction under 705 not the same as the amount of the pass through deduction for
charitable contributions? There is a benefit to contributing appreciated property. The partners reduce
their basis only by share of basis of property given (Rev. Rul. 96-11).
* Here, assuming allocations have a substantial economic effect.
- Does NOT matter whether partnership makes any distribution Bassey Case (have to pay tax on DS
even if dont get a distribution)
(a)(2) Would your answer change if Terrys primary occupation was as a dealer in real estate
and most sales of land owned by him individually resulted in ordinary income characterization?
- No, 702(b) has been interpreted to require that the determination of the character of items be made
by reference to its characterization at the partnership level. See Reg. 1.702-1(b); Podell v. Commr
(TC 1970); and Rev. Rul. 67-188.
- Note: exceptions under 724 for unrealized receivables, inventory, and capital loss assets.
(b) Assume that the basis of Seans partnership interest at the beginning of the year was $200,000
and the basis of Terrys partnership interest at the beginning of the year was $100,000. What
are their bases in their respective partnership interests at the end of the year?
- Section 705(a) governs determination of the partners basis in his partnership interest:
(a) Beginning basis = determined under 722
(1) (+) the sum of distributive share of following:
(A) taxable income of partnership ( 703(a))
(B) tax exempt income
(C) excess of depletion deductions over AB of depleted property
(2) (-) (but not below 0) by distributions from partnership
(-) the sum of distributive share of following:
28
(A) partnership losses
(B) expenditures of partnership not deductible in computing its taxable income and
not properly chargeable to capital account; and
(3) (-) oil and gas depletion deductions
Sean (2/3) Terry (1/3)
Beginning AB $200,000 $100,000
(+) Distributive Share (DS) of Income $271,000 $135,500
(+) DS of Tax Exempt Income $ 2,000 $ 1,000 ?
(-) Distributions $240,000 $120,000
(-) DS of losses $ 0 $ 0
(-) DS of 705(a)(2) $ 9,000 $ 1,500 ?
$231,000 $115,500
*all items listed in this problem effect basis
Recognition of G/L on Distribution 731
(a): partner does NOT recognize gain unless receive distribution of money exceeds outside basis
(b): partnership does NOT recognize any g/l on any distribution
Outside Basis 733 basis of distributive partners interest
Outside basis reduced by any amount of money distributed AND amount of basis to partner of
distributed partner
Timing
immediately b/f the distribution 731(a)(1)
Determine basis at the end of the year, but do make adjustments if s/e or complete liquidation.
Reg. 1.705-1(a):
Fix to the problem Reg. 1.731-1(a)(1)(ii): advances or draws
Here, assume partnership did characterize distributions as advances or draw so that
b/f end of year
Order of Basis Adjustment
Increase by income
Decrease by distribution
If basis remaining, allocate loss item
(c) What would be the tax consequences if the partnership distributed $20,000 to Sean and
$10,000 to Terry on the last day of every month during the taxable year?
- Total of $240,000 in distribution to Sean and $120,000 of distributions to Terry during the taxable
year.
- As income is earned by the partnership, the partners pay tax on that income and adjust their bases in
their partnership interests upward ( 705(a)(1)(A)). Thus, Ss basis in his partnership interest would
increase $240k and Ts basis in his partnership interest would increase $120k.
- Then, when previously taxed income is distributed, the partners owe no tax and reduce their bases (
705(a)(2). Thus, Ss basis would decrease $240k and Ts basis would decrease $120k.
Sean Terry
Beginning Basis $200k $100k
(+) DS of Income $271k $135.5k
(=) Year End Basis $471k $235.5k
(-) Distributions ($240k) ($120k)
= Final Year End Basis $231k $115.5k
- Note, however, that a partners basis is never reduced below zero. If the adjustment which would
otherwise reduce basis below zero is a distribution, 731 directs that the partner recognize gain.
Problem 2: This year the Merrill, Barney & Dean partnership sold a parcel of investment real
estate with a basis of $100,000 for $700,000. The partnership received a $150,000 down payment
29
and the purchasers 10 year promissory note (with interest, compounded semi-annually, at the
mid-term federal rate) for $550,000. On the partnerships return, the sale was properly treated
as an installment sale under 453. As a result of transactions unrelated to the partnership, Dean
had a significant capital loss carryover to this year and prefers to elect-out of 453 installment
sale treatment under 453(c). May Dean separately elect out of 453?
- Section 703(b) provides that an election affecting the computation of taxable income derived from a
partnership shall be made by the partnership, except in the case of the three listed elections.
- Section 453 installment sale treatment affects the computation of the partnerships taxable income
(would cause all gain recognition in year of sale rather than deferring gain until payments are received).
Therefore, only the partnership may make election out of 453.
Problem 3: Several years ago, Mike and Nora formed a general partnership to purchase,
rehabilitate, and rent multifamily residences. Mike contributed $200,000 in cash and Nora
contributed $100,000 in cash. Mike is a 2/3 partner and Nora is a 1/3 partner. The partnership
has made no distributions. At the end of the year, the partnership held the following assets, at
FMV, book value, and basis:
Asset FMV Book Value Basis
Cash $120,000 $120,000 $120,000
Blackacre $150,000 $90,000 $90,000
Whiteacre $240,000 $180,000 $180,000
Greenacre $60,000 $75,000 $75,000
Total $570,000 $465,000 $465,000
The partnership has no debts. Can you ascertain each of Mikes and Noras respective bases in
their partnership interests?
* NOTE: Book value and tax basis are exactly the same
- M and N initially contributed cash to the partnership of $300k total. The partnership used that money
to purchase property, but no one bothered to keep track of basis over the years. At the end of this year,
we know the partnership has assets with an aggregate basis of $465k. Is there some way to use this
aggregate partnership basis to figure out what M and Ns respective basis are in their partnership
interests?
- 705(b) provides for an alternative rule for determination of the basis of a partners interest The
Secretary shall prescribe by regulations the circumstances under which the adjusted basis of a partners
interest in a partnership may be determined by reference to his proportionate share of the adjusted basis
of partnership property upon a termination of the partnership.
- Reg. 1.705-1(b) Alternative Rule In certain cases, the adjusted basis of a partners interest in a
partnership may be determined by reference to the partners share of the adjusted basis of partnership
property which would be distributable upon termination of the partnership. The alternative rule may be
used to determine the adjusted basis of a partners interest where circumstances are such that the partner
cannot practicably apply the general rule set forth in 705(a) and paragraph (a) of this section, or
where, from a consideration of all the facts, it is, in the opinion of the Commissioner, reasonable to
conclude that the result produced will not vary substantially from the result obtainable under the general
rule. *Sentence after next is most important: important feature of partnership tax w/ exception of
events listed in sentence, when total up partners total outside basis, it will equal partners total inside
basis
Here, when add up tax basis inside partnership, adds up to $465K aggregate basis
705(a) Mike (2/3) Nora (1/3)
Beginning Basis ( 722) $200,000 $100,000
(+) DS of income ((1)(A)) $ 80,000 $ 40,000
(-) DS of loss ((2)(A)) $ 10,000 $ 5,000
(=) Ending Basis $270,000 $135,000 only $405k
- Thus, under general principles of 705(a), there was $120k of gain (income) and $15k of loss. After
passing these amounts through, M and N only account for $405k of the $465k aggregate basis in the
partnership assets. Thus, the alternative rule should be used to determine the adjusted basis of the
partners partnership interests b/c the partners cannot practicably apply the general rule of 705(a).
30
This is how I think it works, but may not be. In class, Professor McMahon did not do the above
analysis under 705(a), he only did the below analysis.
- Can only use the alternative rule in certain cases: where the partner cannot practicably apply the
general rules of 705(a) or when can satisfy the Commissioner that the result produced will not vary
from the result of the general rule in determining the partners bases.
- Here, we can use the alternative rule b/c the partners contributed cash to the partnership (no built-in
gain or loss), and the partners contributed amounts in proportion to their ultimate interests in the
partnership.
- Therefore, there is $465k of aggregate basis in partnership property, of which M gets 2/3 ($310k) and
N gets 1/3 ($155k).
- Note: NO 704(c)(1)(A) problem b/c no disparity b/t book and tax basis
Problem 4: What taxable year may the partnership adopt in each of the following situations?
* This question deals with the taxable year election of the partnership.
- Given unfettered discretion, a partnership would end its taxable year on January 31 b/c the partners
could defer tax for 11 months this way.
- 706(a) provides that a partner shall report partnership income in the partners taxable year in which
the partnership taxable year ends.
- 706(b)(1)(B) provides for the permissible partnership taxable years.
- 706(b)(1)(C) provides for a different taxable year if is it established to the satisfaction of the
Secretary that there is a business purpose therefore. Business purposes usually means the busiest time
of year (see text p. 91).
(a) The partnership is a real estate rental business conducted by 10 individuals, all of whom
report of the calendar-year.
- 706(b)(1)(B) provides that a partnership shall not have a taxable year other than (i) the majority
interest taxable year (defined in paragraph (b)(4)).
- 706(b)(4) defines majority interest taxable year as the taxable year which constitutes the taxable
year of 1 or more partners having an aggregate interest in partnership profits and capital of more than
50% (profits interest and capital interest are defined in Reg. 1.706-1(b)(4)(ii) and (iii)).
- Thus, since all 10 partners (100% is greater than 50%) were calendar-year taxpayers, then the
partnership is required to be a calendar-year taxpayer.
- If brand new partnership, can make election under 444(b)(1) limited deferral maxed at 3 months.
(Cant use if changing b/c shorter of 3 mos. Or 0 under 441(b)(2))
But total charge must be paid under 7519
(b) The partnership runs a ski resort in Colorado, which is open from November through April,
with most of its business in January and February, and consists of three-calendar year
individuals.
- As in (a) the partnership would generally be required to be a calendar year TP b/c partners having an
aggregate interest in partnership profits and capital of more than 50% are calendar year taxpayers.
- However, 706(b)(1)(C) provides that a partnership may have a taxable year not described in
subparagraphs (A) or (B) if it establishes, to the satisfaction of the Secretary, a business purpose
therefore. For purposes of this subparagraph, any deferral of income to partners shall not be treated as
a business purpose.
442
- Here, the partnership appears to have a valid business purpose for electing a taxable year different
from the calendar-year. See Rev. Proc. 2006-46 IRS will automatically approve different taxable
year that coincides with the partnerships natural business year, which is defined as any 12 month
period in the last two months of which the partnership realizes 25% of its gross receipts for three
consecutive years. Here, looks like fiscal year ending February 28 would constitute a natural business
year.
Nonautomatic requests: Rev. Proc. 2002-39
(c) The partnership operates a coal mine. Two of its partners are electric power utility
companies, Carbonic Power Co. and Sulphuric Electric Power Co. What is the taxable year of
the partnership if:
31
(1) Both power companies are 30% partners and report on an April 30
th
fiscal year. All of the
remaining partners are individuals.
- Here, again, the partnership would be required to use the majority interest taxable year, which is the
April 30
th
fiscal year, b/c partners having an aggregate interest in partnership profits and capital of more
than 50% (60% here) report on an April 30
th
fiscal year.
- Or the partnership could attempt to establish a business purpose for another taxable year under
706(b)(1)(C).
(2) Both power companies are 25% partners and report on an April 30
th
fiscal year. All of the
remaining partners are individuals.
- There is no majority interest taxable year in this problem b/c Carbonic and Sulphuric only constitute
partners having an aggregate interest in partnership profits and capital of exactly 50% (NOT more than
50%).
- Section 706(b)(1)(B)(ii) provides that if there is no taxable year described in clause (i), the taxable
year of all the principal partners of the partnership
Section 706(b)(3) defines principal partner as a partner having an interest of 5% or more in
partnership profits or capital.
- Thus, assuming that Carbonic and Sulphuric are the only principal partners of the partnership, then the
partnership will adopt an April 30
th
fiscal year.
(3) Both power companies are 25% partners. Carbonic reports on the April 30
th
fiscal year and
Sulphuric reports on a September 30
th
fiscal year. All of the remaining partners are individuals.
- Section 706(b)(1)(B)(iii) provides that a partnership shall not have a taxable year other than - if there
is no taxable year described in clauses (i) or (ii), the calendar year unless the Secretary by regulations
prescribes another period.
- Reg. 1.706-1(b)(2)(C) prescribes another period taxable year that produces the least aggregate
deferral of income.
- Reg. 1.706-1(b)(3)(i) provides that the taxable year that results in the least aggregate deferral of
income will be the taxable year of one or more of the partners in the partnership which will result in the
least aggregate deferral of income to the partners. The aggregate deferral for a particular year is equal
to the sum of the products determined by multiplying the month(s) of deferral for each partner that
would be generated by that year and each partners interest in partnership profits for that year. The
partners taxable year that produces the lowest sum when compared to the other partners taxable years
is the taxable year that results in the least aggregate deferral of income to the partners.
1.706-1(b)(3) C (4/30) S (9/30) Individual (12/31) Total
4/30 0 5 x 25% = 1.25 8 x 50% = 4 5.25
9/30 7 x 25% = 1.75 0 3 x 50% = 1.5 3.25
12/31 4 x 25%= 1 9 x 25% = 2.25 0 3.25
Here, there is a tie for the least go to Tie Breaker Rules: Reg. 1.706-1(b)(3)(i)
Need to know when S joined partnership b/f they can pick
(d)(1) The partnership operates a coal mine. It has three equal corporate general partners. Two
partners report on a May 31
st
fiscal year and one partner reports on a November 30
th
fiscal year.
- 706(b)(1)(B)(i) majority interest taxable year of May 31
st
b/c more than 50% of partners report on
May 31
st
fiscal year.
(2) What taxable year would be required if the partner on a November 30
th
fiscal period
purchased the entire interest of one of the other two partners?
- Now November 30
th
fiscal year is majority interest taxable year partner is 2/3 owner.
- 706(b)(4)(B) Further Change Not Required for 3 Years if taxable year changed b/c of majority
interest, partnership not reqd to change to another taxable year for either of 2 years following year of
change
Creates window b/f have to switch year again
- Reg. 1.706-1(b)(8)(c) Change in Required Taxable Year If a partnership is required to change to its
32
majority interest taxable year, then no further change in the partnerships required taxable year is
required for either of the two years following the year of the change.
* What about 444 election?
- 444. Election of Taxable Year Other Than Required Taxable Year (a) General Rule, a partnership
may elect to have a taxable year other than the required taxable year, but (b)(1) says that an election can
be made under (a) only if the deferral period of the taxable year elected is not longer than 3 months.
- Another downside to 444 election is that the TP has pay the deferred tax to the Treasury, which is
not a deposit against taxes or estimated taxes. Thus, TP required to make interest free loan to the
government. What good is deferral if have to loan the money to the government to purchase the
deferral.
- Note that Professor McMahon has never hears 444 mentioned in the real world.
SECTION 2: LIMITATION ON PARTNERS DEDUCTIONS OF PARTNERSHIP LOSSES
Problem 1: Gill and Harriet are general partners who share income and losses equally. Gills
basis in his partnership interest is $7,000 and Harrietts basis in her partnership interest is
$12,000.
(a) During the current year the partnership incurs an operating loss of $20,000. How much loss
can each of Gill and Harriet claim on their individual returns? What are their respective bases
in their partnership interests after taking into account their shares of partnership losses?
- G and H share losses equally. Therefore, $10,000 of the operating loss for the current year will be
allocated to each G and H.
At this point would have to ask if this allocation have substantial economic effect. Here, we
are assuming yes.
- Hs basis in her partnership interest is $12,000. Therefore, H will be allowed to deduct her entire
$10,000 distributive share of the loss.
- G, however, can deduct only $7,000 currently (his basis in his partnership interest). The remaining
$3,000 loss may be deducted in subsequent years when G obtain sufficient basis (through additional
contributions, a future share of partnership earnings left in the partnership, or the incurring of a
partnership liability).
Gill (1/2) Harriet (1/2)
Basis $7,000 $12,000
Loss Allowed $7,000 $10,000
Basis $0 $2,000
Loss Suspended $3,000 $0
- Does NOT matter if H cannot use this particular loss on her 1040 this year
- Gills suspended loss carries over indefinitely (as compared to NOLs which expire). Remember that
the partnership does not have NOL carry over under 172, they flow through to the partners.
Reg. 1.704-1(d)(2): proportional suspension
(b) In the following year the partnership realized no operating income, but did recognize a $5,000
long-term capital gain. What are the consequences to the partners in that year?
- The $5,000 of LTCG increases each G and Hs basis in their partnership interest by $2,500 ( 705(a)
(1)(A)).
- Hs AB in her partnership interest will be $4,500 ($2,000 + $2,500)
- Gs AB in his partnership interest will initially be adjusted up from $0 to $2,500. However, G still
has $3,000 of disallowed loss from the prior year, which he will be allowed to deduct in the current
year to the extent of his AB in his partnership interest (see Reg. 1.704-1(d)(1)). Thus, Gs AB in his
partnership interest will again be reduced to $0 and he will have $500 of disallowed loss deduction that
will be carried forward.
Basis $7,000 $12,000
Basis $0 $2,000
33
$5,000 LTCG $2,500 $2,500
New Basis $0 $4,500
Loss Suspended $500 $0
* Suppose the $20,000 loss was $10k capital and $10k ordinary. How would the partners determine
which portion of the loss was deductible and which was not? The regulations say to use a proration
rule. G allowed to deduct $7,000 of the $10,000 loss. Thus, 7/10 of each $5k of ordinary and $5k of
capital is deductible ($3,500), while 3/10 of each $5k of ordinary and $5k of capital is not deductible
($1,500).
(c) What are the results if in the current year, in which the partnership incurred a $20,000 loss,
between January 1
st
and December 30
th
the partnership distributed $4,000 in cash to each of Gill
and Harriet?
G (1/2) H (1/2)
Beginning AB $7,000 $12,000
(-) distribution $4,000 $ 4,000 705(a)(2) decrease
$3,000 $ 8,000
- must account for distribution first
- then, the losses ($10,000 each)
Thus, H currently deducts $8,000 and carries forward $2,000 loss deduction.
Thus, G currently deducts $3,000 and carries forward $7,000 loss deduction.
* How can we get the additional $3k loss on to Gs tax return this year (with the minimum impact on
G)?
- Basically, G needs to increase his basis by $3k. G could accomplish this by contributing $3k to the
partnership. A better solution would be for the partnership to go out and borrow $6k, which would
increase both G and Hs basis by $3k (this would minimize the impact on G this year).
Reg. 1.731-1(a)(1)(ii) treat advance or draw as happening on last day of year; thus, get to subtract
distribution b/f any other decrease
If fail to specify as advance or draw, and distribution happened in July 1 determine gain tied
to basis immediately preceding distribution
G: 10 7 = 3K gain, but 0 basis
H: 12-10 = 2 basis
Then. at end of year, do increases then decreases
(d) Gill died on January 1
st
of the year following the year in which the loss was incurred, and his
wife, Irene, inherited his partnership interest. What would be the tax consequences to Irene if
the partnership recognized a $5,000 long-term capital gain in that year?
- Recap:
Basis $7,000 $12,000
Basis $0 $2,000
- need to know FMV of partnership interest to know Irenes basis under 1014
Here, assume 10K
- Loss carryover is nontransferable
Reg. 1.704-1(d)(i): losses belong to partner interpreted to mean nontransferable
Senate Case (100):
- The point of this problem is to show that death is not always a good thing tax wise (but usually is).
Here, the loss carryover is vaporized b/c the carryover is personal to the partner who was there when it
was incurred.
- Note that this rule is not in the Code or the Regulations.
34
Chapter 4 Determining Partners Distributive Shares
SECTION 2: THE 704(B) REGULATIONS
Allocations of Items Unrelated to NRC Debt
(1)Economic Effect
Problem 1: Al and Brett each contributed $320,000 to form a general partnership, which
purchased a parcel of land for $40,000 and constructed an office building for $600,000. Assume
that the property has a 30 year cost recovery period under 168 and the depreciation method is
straight-line. Thus, the annual depreciation deduction is $20,000. The partnerships annual
rental income exactly equals its deductible cash flow operating expenses, with the result that net
partnership taxable income for each year is a loss of $20,000. The partnership agreement
allocates all items of income and loss equally, except the depreciation deductions, which are
allocated entirely to Brett. Both partners are unconditionally obligated to restore any deficit to
their capital accounts upon a liquidation of the partnership.
A (50%) -- $320k AB general partnership
B (50%) -- $320k - Purchased Land: $40k
Building: $600k
- $20k annual depreciation
- Partnership taxable income = $20k loss per year
- Partnership agreement allocates all items of income and loss 50/50
- Except depreciation deductions, which go all to B.
- Both partners are unconditionally obligated to restore any deficit capital account upon liquidation.
Land $40k $40k A $320k $320k
Building $600k $600k B $320k $320k
$640k $640k $640k $640k
(a) What additional provisions must be included in the partnership agreement for the allocation
of depreciation to be respected?
- Under Reg. 1.704-1(b)(1)(i) there are three ways in which an allocation of income, gain, loss,
deduction, or credit (or item thereof) to a partner that is provided for in the partnership agreement will
be respected under 704(b): (1) The allocation can have substantial economic effect in accordance
with Reg. 1.704-1(b)(2) (this is a safe harbor); (2) taking into account all facts and circumstances, the
allocation can be in accordance with the partners interest in the partnership under Reg. 1.704-1(b)(3)
(dont want to end up here uncertainty); or (3) the allocation can be deemed to be in accordance with
the partners interest in the partnership pursuant to one of the special rules contained in Reg. 1.704-1(b)
(4) (which we are not going to study) or Reg. 1.704-2 (relating to deductions that are grounded on
nonrecourse debt, which cannot have substantial economic effect b/c the lender bears the economic risk
of loss and is not a partner).
* Here, we are studying economic effect (Reg. 1.704-1(b)(2)(ii)(b)), and for an allocation to have
economic effect (and be respected) the partnership agreement must provide, throughout the full term of
the partnership agreement -
(1) For the determination and maintenance of the partners capital accounts in accordance with the rules
of Reg. 1.704-1(b)(2)(iv);
(2) Upon liquidation of the partnership (or any partners interest in the partnership), liquidating
distributions are required in all cases to be made in accordance with the positive capital account
balances of the partners; and
(3) If such partner has a deficit balance in his capital account following the liquidation of his interest in
the partnership, he is unconditionally obligated to restore the amount of such deficit balance to the
partnership by the end of such taxable year, which amount shall, upon liquidation of the partnership, be
paid to creditors of the partnership or distributed to other partners in accordance with their positive
capital account balances.
35
- In this situation, if the partnership agreement does not contain the third provision, we could argue that
b/c this is a general partnership, under state law there is an obligation to restore a negative capital
account to pay a positive capital account (but would need to research specific state default law).
However, if this is the real deal, be sure to always write it into the partnership agreement.
- There is nothing else required by the regulations to be included in the partnership agreement to allow
the special allocation of depreciation here.
(b)(1) What should be the amount in each partners capital account at the end of the third year
of partnership operations?
- Three years of $20k depreciation deduction ($60k total) passed through entirely to B:
Land $40k $40k A $320k $320k
Building $540k $540k B $260k $260k ($60k) deprec.
$580k $580k $580k $580k
- Note that the basis column adjustments under the partners tax items are under 702, and the book
column adjustments are under Reg. 1.704-1(b)(2)(iv).
- Reg. 1.704-1(b)(2)(iv)(g)(3) tells us that we must use the same life and method of depreciation for
book that we use for tax. However, remember that book and tax items are different when the partners
have contributed appreciated or depreciated property to the partnership (Reg. 1.704-1(b)(2)(iv)(d)(3)
and 1.704-1(b)(2)(iv)(g)). Thus, for now we will start out keeping book and tax the same, but
eventually we will get to them being different.
- It is important to remember that book and tax are actually different concepts. The tax items are what
go on the tax return.
Section 705 A B
702(a)(8) bottom line $0 $0 bottom line is $0
702(a)(7) other items $0 ($60) separately stated item to B
(b)(2) At the end of 17 years of operations?
- 17 years of $20k depreciation deductions = $340k passed through entirely to B:
Land $40k $40k A $320k $320k
Building $260k $260k B ($20k) $0k $20K suspended loss
$300k $300k $300k $300k
- Note that as long as B is obligated to restore a negative/deficit capital account, we can take is capital
account below $0.
Suspended loss
- But is it a good idea to take Bs capital account below $0? No, after 16 years B is out of basis and
704(d) prevents him from taking the depreciation deductions. Therefore, after year 16, the depreciation
deductions would be better used by allocating to A.
- Remember that the partnership agreement can be modified up until April 15 of the year following the
taxable year in which we wish to change the allocation (have until 4/15 of year 18 to change allocation
of depreciation to A for year 17). Note, however, that 706(d) limits the partners ability to make
retroactive allocations (we will study this later).
- HYPO: sell for $300k
No g/l and nothing to allocate
Partnership would have $300k cash
If liquidates, A gets all $300k cash
No tax penalty mechanism to make B pay $20K (only state law remedy) but he will lose the
suspended loss
If B does pay in $20k, all goes to A
36
Would add $20k to his basis
(c)(1) If the partnership sold the land and building for $660,000 on the first day of the fourth
year and then liquidated, how must the proceeds be distributed?
Land $40k $40k A $320k $320k
$580k $580k $580k $580k
Book Tax Basis
AR $660k $660k
AB $580k $580k
Gain $80k $80k
- Thus, there is $80k of gain to be allocated between A and B pursuant to their profit sharing ratios:
Cash $660k $660k A $320k $320k
$40k $40k
$360k $360k
B $260k $260k
$40k $40k
$300k $300k
- If the partnership were liquidated, A would walk with $360k (the amount in his capital account) and B
would walk with $300k (the amount in her capital account).
- Note how the partnership was profitable (sold assets for $660k, $20k more than paid for them), but B
has lost money (put in $320, but only got back $300k). Therefore, B will probably not be happy with
this result.
- The regulations say that if the depreciation deductions go on Bs tax return, then her capital account
must be reduced, and the partnership must liquidate in accordance with capital account. Above is
example of B getting benefits and burden of depreciation deductions.
(c)(2) What if the sales price was $540,000?
Land $40k $40k A $320k $320k
$580k $580k $580k $580k
Book Tax Basis
AR $540k $540k
AB $580k $580k
Gain ($40k) ($40k)
- Thus, there is $40k of loss to be allocated between A and B pursuant to their profit sharing ratios:
Cash $540k $540k A $320k $320k
($20k) ($20k)
$300k $300k
B $260k $260k
($20k) ($20k)
$240k $240k
- If the partnership were liquidated, A would walk with $300k (the amount in his capital account) and B
would walk with $240k (the amount in her capital account).
37
- Note how the partnership lost $100k (sold assets for $540k, but paid $640k for them), but A only lost
$20k (put in $320k and got back $300k), while B lost $80k (put in $320k and got back $240k). Thus,
taking the depreciation deductions has cost B.
- Note that the situations in Problem (1)(c), particularly the gain situation in (c)(1), are the reason for
including a gain charge back provision in the partnership agreement.
(d) Will the allocations qualify if the partnership agreement contains a gain chargeback, which
allocated first to Brett the portion of any gain on a sale that equals the depreciation deductions
specially allocated to her? Assume that the partnership sells the building on January 1 of year
four for $660,000, and alternatively for $540,000.
(1) Sold building for $660k on January 1 of year 4:
Land $40k $40k A $320k $320k
$580k $580k $580k $580k
Book Tax Basis
AR $660k $660k
AB $580k $580k Assume sold land and building
Gain $80k $80k
- Thus, there is $80k of gain to be allocated between A and B. The partnership agreement contains a
gain chargeback provision, however, requiring that B be allocated the portion of any gain on a sale
that equals the depreciation deductions specially allocated to her. B was specially allocated $60k of
depreciation deductions. Therefore, the first $60k of the $80k gain is allocated to B, while the
remaining $20k gain is split 50/50 b/t A and B, their profits sharing ratio.
Why $60K? depreciation
Cash $660k $660k A $320k $320k
$10k $10k of $20k
$330k $330k
B $260k $260k
$60k $60k gain chargeback
$10k $10k of $20k
$330k $330k
- If the partnership were then liquidated, both partners would walk away with $350k (the amount in
their capital accounts). The partnership had $20k of gain (sold building/land for $660k, but only paid
$600k for it) that went $10k to each A and B.
- Note that the character of the gain chargeback is 1231 gain b/c it is from an apartment building.
- Note also that in the real world A would sell, rather than give, the increased depreciation deductions
to B.
(2) Sold building for $540k on January 1 of year 4:
Land $40k $40k A $320k $320k
$580k $580k $580k $580k
Book Tax Basis
AR $540k $540k
AB $580k $580k Assume land and building
Gain ($40) ($40)
- Here, there is ($40) loss from the sale of the building to be allocated between the partners. This will
38
have economic effert b/c have DRO.
Cash $540k $540k A $300k $300k
B $240k $240k
$580k $580k
- If the partnership were then liquidated, A would walk with $300k (the amount in his capital account)
and B would walk with $240k (the amount in her capital account).
**Lesson: Charge back helps B if gain, but if goes down in value economic burden reflected in cash
that he will get at liquidation
(e) Will the allocations qualify if the partnership agreement provides that all non-liquidating
distributions are to be made 60% to Al and 40% to Brett?
- Basically, the above allocation means that A takes 60% of the positive cash flow from the partnership
and B takes 40% of the positive cash flow from the partnership. All other items are split 50/50, except
for depreciation deductions which all go to B. Additionally, assume that there is a gain chargeback
provision in the partnership agreement.
- The question then is whether the special allocation of positive cash flow will be respected? This
special allocation will be respected as long as the requirements in the regulations are complied with
(capital accounts properly maintained, etc). See also Reg. 1.704-1(b)(5), Ex (2), which show that this
type of allocation is acceptable (note how we can sometimes find substantive rules buried in the
examples that could only be discerned obliquely from the actual regulation).
- Note that cash flow is separate and distinct from distributive share (it is an item of income that can be
specially allocated).
- Non-liquidating distributions: Dont get affected directly dont get tested for economic effect
Do reduce capital account values
(f) Assume that the partnership is a limited partnership, with Al as the general partner and Brett
as the limited partner. As a limited partner, Brett is not required to restore a deficit in her
capital account, but as the general partner Al is required to restore a deficit capital account.
- Under the limited partnership law of every state, as a result of being a limited partner, B is not liable
for any partnership debts and his obligation to pay debts is limited to the amount provided in the
partnership agreement (which will state the maximum dollar amount that the limited partner will be
required to contribute).
Land $40k $40k A (gp) $320k $320k
Building $600k $600k B (lp) $320k $320k
$640k $640k $640k $640k
(1) May depreciation deductions be specially allocated to Brett? If so, for how many years?
How must the depreciation deductions be allocated in the 17
th
year of partnership operations?
- As an LP, B is not obligated to restore a negative capital account. Therefore, B is not unconditionally
obligated to restore a deficit balance in her capital account following liquidation, as required by Reg.
1.704-1(b)(2)(ii)(b)(3), and cannot satisfy the third requirement for the economic effect safe harbor
(General Test).
- However, Reg. 1.704-1(b)(2)(ii)(d) provides an Alternative Test for economic effect, where the first
two requirements of Reg. 1.704-1(b)(2)(ii)(b) are satisfied, but the partner to whom an allocation is
made is not obligated to restore the deficit balance in his capital account to the partnership or is
obligated to restore only a limited dollar amount of such deficit balance, and the partnership agreement
contains a qualified income offset.
- Thus, the alternative test has two major requirements, in addition to the first two from the original test:
(1) cant allow partners capital account balances to go below the amount they are obligated to restore
39
(most important factor) and (2) the partnership agreement must contain a qualified income offset
(ancillary factor).
- Qualified income offset just means that if a partners capital account does go below the amount that
partner is obligated to restore for some unforeseen reason, then that partner will have an obligation to
restore that amount from income as quickly as possible.
Thus, B may be allocated depreciation deductions for as many years as such deductions do not create a
deficit capital account she is not obligated to restore. Therefore, depreciation deductions may be
specially allocated to B for 16 years b/c she has an initial capital account of $320k ($20k (x) 16 years =
$320k).
- Under the alternative test, the regulations do not seem to require including in the partnership
agreement that capital accounts will not go negative in excess of partners obligation to restore (just
require that in practice dont violate this rule). However, probably a good idea to put it in the
* How must the depreciation deductions be allocated in the 17
th
year of partnership operations?
- After 16 years:
Land $40k $40k A (gp) $320k $320k
Building $280k $280k B (lp) $ 0k $ 0k
$320k $320k $320k $320k
- Reg. 1.704-1(b)(3)(iii) Capital Account Analysis If
(a) Requirements (1) and (2) of paragraph (b)(2)(ii)(b) of this section are satisfied, and
(b) all or a portion of an allocation of income, gain, loss or deduction made to a partner for a
partnership taxable year does not have economic effect under paragraph (b)(2)(ii) of this section,
Then the partners interests in the partnership with respect to the portion of the allocation that lacks
economic effect will be determined by comparing (i) the manner in which distributions (and
contributions) would be made if all partnership property were sold at book value and the partnership
were liquidated immediately following the end of the taxable year to which the allocation relates with
(ii) the manner in which distributions (and contributions) would be made if all partnership property
were sold at book value and the partnership were liquidated immediately following the end of the prior
taxable year, and adjusting the result for the items described in (4), (5), and (6) of paragraph (b)(2)(ii)
(d) of this section.
- Have $20k depreciation deduction in year 17, the allocation of which lacks economic effect b/c B has
no DRO and his capital account went to $0 after year 16.
- Thus, compare: (i) Distribution following liquidation after 17 years:
Book Book
Land $40k A $300
Building $260k B $0
$300k
$300k distribution to A
- with (ii) Distribution following liquidation after 16 years:
Book Book
Land $40k A $320
Building $280k B $0
$320k
$320k distribution to A
- Thus, A bore the entire ROL w/ respect to the $20k depreciation deduction and A will be allocated the
entire $20k depreciation deduction in year 17.
Based on Partners Interest in Partnership Test -1(b)(3)
Comparative Liquidation Sell everything at BV at beginning of 17 and 18
40
Yr. 17: 320K cash to distribute; no book or tax gain; all goes to A
Yr. 18: must adjust BV for depreciation - $300k cash to distribute; no book
gain
Option 1: $20k suspect depreciation assigned to B and see what
happens
A would have $320k BV and B would have ($20k) BV
A would only get $300k b/c B has no DRO
Option 2: $20K assigned to A
A: $300k BV and B: $0 BV
Thus, cash recd equals As BV
* Hypothetical: Suppose the partnership had gross income from operations of $30k and expenses from
operations of $20 (other than depreciation), which results in $10k of net income from operations. That
$10k of net income would be passed through $5k each to A and B, and B would still get the $20k of
depreciation each year such deduction did not produce a deficit capital account. Thus, As capital
account would go up $5k each year and Bs capital account would go down $15k each year (up $5k and
down $20k).
* Hypothetical: Now suppose the partnership borrowed $100k in year 15 and distributed $50k each to
A and B. The balance sheet following year 15 would look as follows:
Land $40k $40k A (gp) $320k $320k
Building $300k $300k ($50k) ($50k) Distribution
$340k $340k $270k $270k
B (lp) $20k $20k
($50k) ($50k) Distribution
($30k) ($30k)
- Here, B unexpectedly received an adjustment, allocation, or distribution that created or increased a
deficit capital account balance which she is not obligated to restore, which means that the qualified
income offset is triggered, and B is required to be allocated items of income and gain (consisting of a
pro rata portion of each item of partnership income, including gross income and gain for such year) in
an amount and manner sufficient to eliminate such deficit balance as quickly as possible.
- Thus, if the partnership had $30k of gross income, as in the previous hypothetical, that would need to
be allocate to B to get her capital account back up to $0. Then the partnership would have $40k of
deductions that would need to go to A b/c A bears the economic risk of loss for those deductions (not
sure how professor arrived at $40k of deductions going to A).
- The challenge is writing this into the partnership agreement (requires formulas).
- Note that an allocation can have partial economic effect.
* Relevant Regulations:
(1) Economic Effect Reg. 1.704-1(b)(2)(ii)(b)
(2) Alternative Test for Economic Effect Reg. 1.704-1(b)(2)(ii)(d)
(3) Economic Effect Equivalence Reg. 1.704-1(b)(2)(ii)(i)
(4) Facts and Circumstances Reg. 1.704-1(b)(3)
(5) Capital Account Analysis Reg. 1.704-1(b)(3)(iii)
(6) Partial Economic Effect Reg. 1.704-1(b)(2)(ii)(e)
- Dumb-but-Lucky Rule Economic effect equivalence coupled with capital account analysis.
(2) How would your answer change if at the end of the 16
th
year Brett contributed her
promissory note for $160,000 to the partnership?
- Reg. 1.704-1(b)(2)(ii)(c) provides that if a partner is not expressly obligated to restore the deficit
balance in his capital account, such partner nevertheless will be treated as obligated to restore the
deficit balance in his capital account (in accordance with requirement (3) of paragraph (b)(2)(ii)(b) of
this section) to the extent of (1) the outstanding principal balance of any promissory note (of which
41
such partner is the maker) contributed to the partnership by such partner (other than a promissory note
that is readily tradable on an established securities market).
- But remember Reg. 1.704-1(b)(2)(iv)(d)(2) which provides if a promissory note is contributed to a
partnership by a partner who is the maker of such note, such partners capital account will be increased
with respect to such note only when there is a taxable disposition of such note by the partnership or
when the partner makes principal payments on such note.
- Thus, B is treated as having an obligation to restore a deficit capital account balance in the amount of
$160k, but his capital account is not increased. Therefore, B could take depreciation deductions for 8
more years (through year 24) until his capital account reached negative $160k.
- However, this ultimately will not work b/c B has no basis in the note under the Bussing case, which B
need in order to be allowed to deduct the depreciation deductions allocated to him. See 704(d) which
allows loss deductions only to the extent of the adjusted basis of the partners interest in the partnership.
- Thus, we can give B the right to the deductions, but in order for B to be permitted to take the
depreciation deductions we cannot run afoul of 704(d). So this situation is unwise unless B is
simultaneously restoring basis.
* How could we get B some basis?
- If the partnership borrows money, then A and B both get an outside basis increase (but since B is a
limited partner, she would have to personally guarantee the loan to get such a basis increase).
- When borrow money:
Borrow cash $30 $30 Debt $30
Property $100 $100 A $100 $100
Income $20 $20 $10 $10 income share
$0 $15 debt share
B $0 $0
$10 $10 income share
____ ____ $0 $15 debt share
$150 $150 $150 $150
Problem 2: What would be the result in each of Problems 1(a) (d) if Al and Brett each
contributed $30,000 to form the general partnership and the partnership borrowed $580,000 to
purchase the land and construct the building?
Land $40k $40k Mort $580k
Building $600k $600k A $30k $320k ($30k+$290 ( 752a
debt)
____ ____ B $30k $320k
$640k $640k $640k
Assume Agreement has these 3 things use General EE Test
Unconditional DRO
Maintain Capital Account
When liquidates, use positive CA value in making distribution
(b)(1) What should be the amount in each partners capital account at the end of the third year
of partnership operations?
- Three years of depreciation deductions = ($60k)
Building $540k $540k A $30k $320k
____ ____ B ($30k) $260k (reduced by $60k deprec.)
$580k $580k $580k
42
- This allocation will be permissible as long is B is obligated to restore a deficit in his capital account.
(b)(2) At the end of 17 years of operations?
- Seventeen years of depreciation deductions = ($340k)
Building $260k $260k A $30k $320k
____ ____ B (310k) $0 (w/ $20k suspended loss)
$300k $300k $300k
-if liquidate: AR = $300k, no book/tax gain if assume sold at FMV
All $300 cash goes to pay off debt. B must pay $310 b/c unconditional DRO and $280 used to
pay off debt and $30 is cash available to make liquidating distribution
As tax basis goes from $320k to $290k then, get distribution of $260k to reduce basis to
$30k
B: 1) increase basis from $0k to $310k, 2) decrease by $290 deemed distribution to $20k, and
then 3) decrease by $20k suspended loss to $0
Note: Sennett must be partner to use suspended loss
(c)(1) If the partnership sold the land and building for $660,000 on the first day of the fourth
year and then liquidated, how must the proceeds be distributed?
Building $540k $540k A $70k $360
____ ____ B $10k $300
$580k $580k $580k
Book Tax Basis
AR $660k $660k
AB $580k $580k
Gain $80k $80k
- First, the bank would get its $580k.
- Next, w/o gain chargeback, A gets $40k and B gets $40k.
Capital Accounts
A $30k + $40k = $70k
B ($30k) + $40k = $10k
-Then, 752(b) distribution: $290k (does not affect capital account)
- Last, actual liquidating distribution of $70k to A and $10k to B.
(c)(2) What if the sales price was $540,000?
Book Basis Book
Building $540k $540k A $30k
____ ____ B ($30k)
$580k $580k $580k
Book Tax Basis
AR $540k $540k
AB $580k $580k
Gain ($40k) ($40k)
- The result here is a $40k loss, which is allocated $20k to each A and B (in accordance with their loss
43
sharing ratio 50/50). Has EE b/c PA has all 3 requirements.
Capital Account Basis
A $30k - $20k = $10k $300k
B ($30k) - $20k = ($50k) $240k
- First, the bank is entitled to $580k, but the partnership only has $540k in cash. Thus, the bank would
get that entire $540k cash.
- B has a negative capital account, so he ponies up $50k, $40k of which goes to the bank to satisfy the
remaining $40k owing on the mortgage, and the remaining $10k goes to A, in satisfaction of his
positive capital account.
-paying off debt of $580k triggers $290k each of deemed distributions under 752(b)
-B has basis to cover to no gain
-A gets $10k cash and $290k deemed distribution
(d) Will the allocations qualify if the partnership agreement contains a gain chargeback, which
allocates first to B the portion of any gain on a sale that equals the depreciation deductions
specially allocated to her?
(1) Assume that the partnership sells the land and building on January 1 of year 4 for $660,000.
Book Basis Book
____ ____ B ($30k)
$580k $580k $580k
Book Tax Basis
AR $660k $660k
AB $580k $580k
Gain $80k $80k
- First, the bank would get back its $580k loan, leaving $80k gain.
- B/c of the gain chargeback provision, B is allocated the first $60k of gain (the amount of the
depreciation deductions specially allocated to her).
- The remaining $20k gain is split equally (profit sharing ratio is 50/50) between A and B, so that each
receives $10k of gain.
Capital Account
A $30k + $10k = $40k
B ($30k) + $60k + $10k = $40k
- Note that the theory of the regulations is that the partners can do anything they want as far as
distributive share allocations, provided that they do the same thing in their book entries as they do in
their tax basis entries.
- Recall that without the gain chargeback, As capital account ended up being $70k and Bs ended up
being $10k. Therefore, always put in a gain chargeback provision if there is going to be a
disproportionate allocation of deductions b/c the party taking the deductions will want to recoup them.
(2) Assume the partnership sells the land and building on January 1 of year 4 for $540,000?
Book Basis Book
____ ____ B ($30k)
$580k $580k $580k
Book Tax Basis
AR $540k $540k
AB $580k $580k
44
Gain ($40k) ($40k)
- In this loss scenario, the gain chargeback does not kick in.
- The result was a $40k loss, which is allocated $20k each to A and B (in accordance with loss sharing
ratio).
Capital Account
A $30k - $20k = $10k
B ($30k) - $20k = ($50k)
- Thus, there was $540k realized from the sale, all of which goes to bank.
- B has a negative capital account, so he ponies up $50k, $40k of which goes to the bank to satisfy the
remaining $40k owing on the mortgage, and the remaining $10k goes to A, in satisfaction of his
positive capital account.
- A partnership agreement often provides for special allocations. Remember, however, that the rules for
substantial economic effect apply to all allocations (not only special allocations).
* Hypothetical:
- Suppose that the partnership agreement says to maintain capital accounts, liquidate according to
capital accounts, and the partners have an obligation to restore a negative capital account to the extent
necessary to pay creditors (but not to pay distributions to partners with positive capital accounts). How
can we validate this sort of allocation? Under the alternative test b/c only limited obligation to restore
deficit capital account.
- Suppose the same partnership from Problem 2, where the partners contributed $30k cash each, the
partnership borrowed an additional $580k and purchased land for $40k and a building for $600k. The
partnership breaks even from operations, but has a $20k loss every year as result of depreciation
deductions, which the partners agree to allocate entirely to B:
(i) Beginning Balance Sheet:
Book Basis Book
Land $40k $40k Debt $580k
_____ _____ B $30k
$640k $640k $640k
(ii) After 1 year of operation can allocate $20k depreciation to B b/c such allocation will not cause a
deficit capital account.
Book Basis Book
_____ _____ B $10k $20k depreciation
$620k $620k $620k
(iii) After 2 years of operation Can only allocation $10k of depreciation to B (partial economic effect
rule Reg. 1.704-1(b)(2)(ii)(e)). Bs capital account will be reduced to $0, and the remaining $10k
depreciation deduction will be allocated to A:
Book Basis Book
Building $560k $560k A $20k $10k depreciation
$600k $600k $600k
- After 3 years of operation Have $20k depreciation deduction that is specially allocated to B, but
cannot go to B b/c Bs capital account is $0 and B has no obligation to restore a deficit capital account.
A, however, has $20k capital account and the entire $20k depreciation deduction will be allocated to A:
45
Book Basis Book
Building $540k $540k A $0k $30k depreciation
$580k $580k $580k
- After 4 years of operation Now both A and B have $0 capital account balances, and the alternative
test provides that such allocation will be considered to have economic effect under this paragraph to
the extent such allocation does not cause or increase a deficit balance in such partners capital account
(in excess of any limited dollar amount of such deficit balance that such partner is obligated to
restore).
* Thus, how do we allocate the $20k depreciation deduction in year 4 under the alternative test, when
any additional deduction to any partner would create a deficit capital account balance?
* Revenue Ruling 97-38 (pp. 116 120):
- (Facts) - GP, general partner, and LP, limited partner, are 50/50 partners in a limited partnership, but
all depreciation deductions are allocated to GP. The partnership maintains capital accounts and the
partners are required to liquidate according to positive capital account balances. GP and LP do not
agree to an unconditional deficit restoration obligation (in general, a deficit restoration obligation
requires a partner to restore any deficit capital account balance following the liquidation of the partners
interest in the partnership). GP is obligated, however, to restore a deficit capital account only to the
extent necessary to pay creditors. In addition, the partners agree to a qualified income offset. Thus, the
alternative test for economic effect is satisfied. LP has no obligation under the partnership agreement
or state law to make additional contributions to the partnership and, therefore, has no deficit restoration
obligation. GP, however, under state law, may have to make additional contributions to the partnership
to pay creditors. GPs obligation, however, only arises to the extent that the amount of the
partnerships liabilities exceed the value of the partnerships assets available to satisfy those liabilities.
- (Law) Where a partners obligation to make additional contributions to the partnership is dependent
on the value of the partnerships assets, the partners deficit restoration obligation must be computed by
reference to the rules for determining the value of partnership property contained in the regulations
under 704(b). Consequently, in computing GPs limited restoration obligation, the value of the
partnerships assets is conclusively presumed to equal the book basis of those assets under the capital
account maintenance rules of Reg. 1.704-1(b)(2)(iv).
- (Analysis) The partnership agreement allocates all depreciation deductions and gain on the sale of
depreciable property to the extent of those deductions (gain chargeback) to GP. B/c the partnership
agreement satisfies the alternate test for economic effect, the allocations of depreciation deductions to
GP will have economic effect to the extent that they do not create a deficit capital account for GP in
excess of GPs obligation to restore the deficit balance.
- (Holding) Where a partner is treated as having a limited deficit restoration obligation by reason of
the partners liability to the partnerships creditors, the amount of that obligation is the amount of
money that the partner would be required to contribute to the partnership to satisfy partnership
liabilities if all partnership property were sold for the amount of the partnerships book basis in the
property.
* Here, both A and B have limited obligation to make additional contributions to the partnership to pay
creditors. After year 4, the book basis of the partnerships assets is $560k but the debt is $580k. Thus,
if the property were sold for book value, then the bank would get the entire $560k and look to the
partners for the remaining $20k. Since the partners agreed to split losses equally, they would each be
required to pay $10k. Therefore, each partner should be allocated $10k of the $20k depreciation
deduction for year 4, b/c they each have a limited obligation to restore a negative capital account of
$10k.
- Remember, however, that the partners are attempting to maximize the amount of depreciation
deductions to B. Is there some way that we could allocate the entire $20k of depreciation deductions to
B in year 4? Under partnership law and debtor-creditor law B in this problem is obligated to restore a
negative capital account to the extent necessary to pay partnership debt. Therefore, B has an obligation
to restore a negative capital account in the amount of $20k, and B can be allocated the entire $20k
depreciation deduction for year 4.
* Suppose after 5 years of operations the partnership pays down the debt $5k. The difference between
46
book basis and the amount of the debt would only by $35k, and Bs capital account would only be
allowed to go to negative $35k. The remaining $5k of depreciation will have to be allocated to A.
Book Basis Book
Building $500k $500k A ($5k)
_____ _____ B ($35k)
$540k $540k
* Now lets make the problem even more complicated:
Problem 3: What would be the result in Problem 1(f) if Al and Brett each contributed $30,000 to
form the limited partnership and the partnership borrowed $580,000 to purchase the land and
construct the building?
(f) Assume that the partnership is a limited partnership, with Al as the general partner and Brett
as the limited partner. As a limited partner, Brett is not required to restore a deficit in her
capital account, but as the general partner Al is required to restore a deficit capital account.
Building $600k $600k A (gp) $30k $610k
B (lp) $30k
- Assuming B, as the limited partner, has no obligation to put anything else into the partnership and A,
as the general partner, has an unlimited obligation to restore a negative capital account, then we are
using the alternative test here b/c the basic test only applies when all partners have an unlimited
obligation to restore a negative capital account.
- Year 1: B has capital account of $30k, so he can be allocated entire $20k of depreciation deductions.
- Year 2: B has capital account of only $10k, so only the first $10k of depreciation deductions allocated
to B will have economic effect. A will be allocated the remaining $10k of depreciation deductions.
- Year 3: B has $0 capital account and no obligation to restore a deficit capital account, A on the other
hand has $20k capital account and unlimited obligation to restore a negative capital account.
Therefore, A will be allocated the entire $20k deprecation deduction for year 3.
- Year 4 forward same as year 3 (all goes to A).
Thus, the reason for the transaction (maximizing depreciation deductions to B) is not possible in the
structure selected by A and B and they should not enter into this transaction.
* If the deal were to allocate depreciation deductions 50/50 between A and B, then A and B would each
get $10k in years 1 3, after which time all deductions would be allocated to A.
* Difficult Question What if B, the limited partner, personally guarantees the loan (so if the
partnership does not pay the loan then B will pay the loan)?
- We would need to know if B were entitled to indemnification from the partnership if B were required
to pay the loan. If B paid the loan and then sued the partnership and won, then A, as the general
partner, would be required to pay B.
- What if indemnification were waived? Then B has created at least the possibility that she will have an
obligation to restore a deficit capital account under Reg. 1.704-1(b)(2)(ii)(c)(2) (obligation to make
subsequent contribution treated as obligation to restore deficit balance in capital account).
- The ultimate question is who is left with the ultimate responsibility to pay after everybody sues
everybody and the issue is ultimately resolved.
(2) How would your answer change if at the end of the 16
th
year Brett contributed her
promissory note for $160,000 to the partnership?
- If B contributes a promissory note then she is treated as having a limited DRO to the extent of $160k.
Thus, B could take the deductions until her capital account reached negative $160k, after which time all
depreciation deductions would be allocated to A.
-Note
1) Increase ROL Reg.1.752-2(g)
2) DRO Reg. 1.704-1(b)(ii)(c)
-if liquidate, $640k loss
47
Try to allocate $320k loss to each under agreement but lacks EE
Thus,
Only $190 to B under EE
$450k to A
- Increase in basis by constructive liquidation
A: 30 + 420 = 450
B: 30 + 160 = 190
-Adding Note to sheet
Brett must bring in note at $0 value Reg. 1.704-1(b)(2)(iv)(d)(2)
Partnership must match Reg. 1.704-1(b)(2)(iv)(q) so comes in at $0 too
Building $600k $600k A $30k $450k
Note $0 $0 B $30k $190k
$640k $640k
(2) SUBSTANTIALITY
Problem 1: Carlos and Diana formed a general partnership to invest in a small commercial office
building. Each contributed $100,000 to the partnership, which also borrowed $800,000 from
First State Bank to acquire a building for $1 million. Unfortunately, Carlos and Diana
purchased their building at the height of the real estate boom. One year after the investment the
value of the building declined to $600,000 and the rental income was insufficient to meet
payments on the loan. In addition, Carlos, but not Diana, was insolvent. First State Bank agreed
to reduce the loan principal to $600,000. Diana contributed $5,000 to the EF Partnership to pay
the costs of the loan adjustment. B/c of Dianas capital contribution, the EF partnership
revalued its capital accounts to FMV pursuant to Reg. 1.704-1(b)(2)(iv)(f). Carlos and Diana
also amended their partnership agreement to allocate the $5,000 expenditure to Diana, allocate
the revaluation loss $300,000 to Carlos and $100,000 to Diana, and to allocate discharge of
indebtedness income to Carlos. The partnership agreement provides for properly maintained
capital accounts and for liquidation distributions to be made in accord with the capital accounts.
There is no provision for a deficit make-up. Do these allocations have substantial economic
effect?
**Based on Rev. Rul. 99-43 (CB 132)
C -- $100k CD general partnership
D -- $100k - borrowed $800k
bought $1 million building
(i) Initial Balance Sheet:
Building $1 m $1 m Debt $800k
C $100k $500k (50% of debt + cash)
D $100k $500k
- Testing for economic effect under the alternative test b/c all partners do not have unlimited capital
account deficit restoration obligation, but other two requirements of basic test are met.
- After 1 year: (1) Building declined in value to $600k (alone does not allow for revaluation)
(2) C became insolvent, but D did not
(3) Bank reduced loan principal to $600k ($200k COD income)
(4) D contributed $5k to partnership to pay for loan adjustment
(5) Partnership revalued capital accounts to FMV (b/c of contribution)
- $400k loss (Building: $1 million $600k)
(6) C and D amended partnership agreement to:
- allocate $5k expenditure to D
48
- allocate revaluation loss $300k to C and $100k to D
- allocate discharge of indebtedness income to C
* Do these allocations have substantial economic effect?
(a) First question, do these allocations have economic effect?
- The partnership agreement provides for properly maintained capital accounts and for liquidating
distributions to be made in accordance with capital accounts. Thus, the first two requirements of the
base line economic effect test of Reg. 1.704-1(b)(2)(ii)(b) have been met. The partnership agreement,
however, does not provide for a deficit make-up, the third requirement of the basic test. However, this
is a general partnership, so under state law the partners most likely have an obligation to restore a
negative capital account, and the third requirement is satisfied. Thus, the allocations have economic
effect.
(b) Second questions, are the allocations substantial?
- Under Reg. 1.704-1(b)(2)(iii)(b) (Shifting Tax Consequences) The economic effect of an allocation
is not substantial if, at the time the allocation becomes part of the partnership agreement, there is a
strong likelihood that (1) The net increases and decreases that will be recorded in the partners
respective capital accounts for such taxable year will not differ substantially from the net increases and
decreases that would be recorded in such partners respective capital accounts for such year if the
allocations were not contained in the partnership agreement, and (2) The total tax liability of the
partners (for their respective taxable years in which the allocations will be taken into account) will be
less than if the allocations were not contained in the partnership agreement (taking into account tax
consequences that result from the interaction of the allocation (or allocations) with the partner tax
attributes that are unrelated to the partnership).
- When testing substantiality, only looking as book value NOT tax basis
Reg. 1.704-1(b)(2)(iii)(b): Shifting Tax Consequences
(1) Compare net increases and decreases to partners capital accounts with and without the
allocation:
(i) The original deal was 50/50 Partners interest in Partnership:
Capital Accounts
C D
Beginning $100k $100k
COD Income ($200k) $100k $100k
Loan Adjustment
- Contribution $5k
- Expenditure Allocation ($5k)
Book Loss ($400k) ($200k) ($200k)
$0 $0
(ii) The partners amended the deal as follows:
Capital Accounts
C D
Beginning $100k $100k
COD Income ($200k) $200k $0
Loan Adjustment
- Contribution $5k
- Expenditure Allocation ($5k)
Book Loss ($400k) ($300k) ($100k)
$0 $0
- Thus, the net increases and decreases recorded in the partners capital accounts do NOT differ
substantially (they do not differ at all) between the original allocation and the amended allocation.
49
(2) Compare total tax liability of the partners with and without the amended allocation:
(i) Partners tax liability with original 50/50 allocation:
- The only thing going on the partners tax returns is the $200k of COD income
C D
$100k COD Income $100k COD Income
(ii) Partners tax liability with new allocations:
C D
$200k COD Income $0 COD Income
- Thus, D has $100k less income to be taxed on and C is not worse off b/c of the allocation b/c C is
insolvent and, under 108, discharge of indebtedness income will not be included in the gross income
of an insolvent taxpayer (C is in the exact same position under both allocations).
- Thus, the total tax liability of the partners will be less as a result of the new allocation.
The new allocations meet the requirements of shifting allocations and therefore are not substantial.
- Why did this allocation flunk the substantiality test? The partners knew that C was insolvent and that
they had COD income. Thus, allocations were tax planning with 20/20 hindsight. Note the legal
presumption under the regulations that if the partners get a good tax result from an allocation, then the
presumption arises that they knew the good result would occur.
- Note that this problem came from Rev. Rul. 99-43.
Problem 2:
(a) Eddie and Fran formed a general partnership to operate an adventure vacation tour
company, offering hunting, fishing, and whitewater rafting in the Canadian and U.S. Rocky
Mountains. Eddie is a Canadian resident; Fran is a U.S. resident. The partnership agreement
provides that the partners capital accounts will be maintained as required by the 704(b)
regulations, liquidating distributions will be made in accordance with the partners capital
account balances, and any partner must restore a negative capital account upon liquidation. The
partnership agreement provides that Eddie will be allocated 80% and Fran 20% of the income or
loss from Canadian trips, and Fran will be allocated 80% and Eddie 20% of the income or loss
from U.S. trips. The amount of income or loss from each source cannot be predicted with any R
certainty. Do these allocations have substantial economic effect?
Based on Reg. 1.704-1(b)(5) Ex. 10
(i) Do these allocations have economic effect?
- Yes, all three requirements of the base line test are met.
(ii) Are the allocations substantial?
Canadian U.S
Eddie (Canadian) 80% 20%
Fran (U.S.) 20% 80%
- Note that the amount of income or loss from each source cannot be predicted with any R certainty.
This is a good fact for E and F b/c not using 20/20 tax planning hindsight to make allocations.
However, they still may run afoul of the presumption if the allocation produces a tax benefit.
B/c cant predict w/ R certainty, does have substantial EE!!!
Suppose $100K Canada and $50K US
Under PA,
E: allocated $80k of Can and $10k of US Total: $90k
F: allocated $20k of Can and $40K of US Total: $60k
50
Compare to Partners Interest in Partnership Problem: how do we pick baseline for partners
interest in partnership if cant predict w/ R Certainty??
Worst case scenario, IRS decides 50/50 under PIP b/c dont believe income and loss
arent volatile
50/50 PA
Can US Can US
E (C) $50k $25k E (C) $80 $10
F (US) $50k $25k F (US) $20 $40
Book value
Under 50/50, E and F have $75k book value
Under PA
E: $90k even though only paying tax on $10k b/c Regs say
increase even for income that is tax-exempt (Canadian)
F: $60k even though only paying tax on $40k
Note: Situation where losses under General Test E would not get as high of a share of those losses
* Suppose the partners capital accounts are 50/50, so that the original allocation will be presumed to be
50/50, and the partners are attempting to change the allocation to the one set out above.
Original Amended
Can US Can US
E (C) $50 $50 E (C) $80 $20
F (US) $50 $50 F (US) $20 $80
- Under the original allocation, $150 would be subject to US tax.
- Under the amended allocation, only $120 would be subject to US tax.
Thus, under the amended allocation there would by $30 less subject to US tax. The question is
whether this allocation will pass the substantiality test if it is put in the partnership agreement.
- B/c E is a Canadian citizen, any allocation of Canadian income to E is not subject to US tax. Thus,
there is potentially a shifting allocation here.
* Suppose that at the end of the year the partnership had $200 from each Canadian and US operations:
Original Amended
Can US Can US Cap Acc
E (C) $100 $100 E (C) $160 $40 = $200
F (US) $100 $100 F (US) $40 $160 = $200
- Under the original allocation, there would be $300 subject to US tax, but under the amended
allocation there would be only $240 subject to US tax.
* Suppose it turned out that the partnership had $300 from Canadian operations and $100 from US
operations:
Original Amended
E (C) $150 $50 E (C) $240 $20 = $260
F (US) $150 $50 F (US) $60 $80 = $140
- Under the original allocation, there would be $250 subject to US tax, but under the amended
allocation there would be only $160 subject to US tax.
* The allocation in this problem is not a suspect shifting allocation b/c the partners are gambling on
what is going to happen. To run afoul of the shifting tax consequences rule in Reg. 1.704-1(b)(2)(iii)
(b) there must be a strong likelihood at the time the allocation becomes part of the partnership
agreement that (1) there will not be a substantial change in the partners respective capital accounts as a
result of the allocation, and (2) that the total tax liability of the partners will be less as a result of the
51
allocation.
- However, if the partners changed the allocation after the close of the taxable year (or before but with
reasonable certainty of what was going to happen) and the two things listed in the regulation occurred,
then that would be tax planning with 20/20 hindsight and would violate the substantiality requirement.
* Point As long as there is uncertainty, an allocation of items where the items sort out by character
should stand up b/c there is not a strong likelihood at the time such allocations become part of the
partnership agreement that one partner will be better off and one will not be worse off after tax.
However, a retroactive allocation where there is no uncertainty will fail the substantiality test, unless the
allocation substantially affects the partners capital accounts. If the allocation substantially affects the
partners capital accounts, then it is not a prohibited shifting allocation.
(b) Assume the same facts as in (a) except that the partnership agreement provides that all
income or loss will be shared equally, but that Eddie will be allocated all income or loss derived
from Canadian operations as a part of his equal share of partnership income or loss, up to the
amount of that share. As a result of this allocation, the total tax liability of Eddie and Fran for
each year to which these allocations relate will be reduced. Do these allocations have substantial
economic effect?
-In the end, going to flunk b/c end position is always 50/50.
Thus, first part of test met
Issue: will 2
nd
* Suppose Canadian Income of $100k, and US Income of $50k
Special Allocation
E: $50k of Canadian and remaining $25k of US
F: $75k of US
PIP = 50/50
E: $25k C and $50k US
F: $25 C and $50k US
Issue: Is one better tax result than the other? Yes, b/c special allocation reducing tax; thus, lacks SEE
Special Allocation: E only taxed on $25k and F on $75k
PIP: E taxed on $50k, but F stays taxed on $75k
- This is a really bad allocation.
- Suppose Canadian income drops to $70, but US income increases to $130:
Original Amended
E (C) $50 $50 E (C) $70 $30 = $100
F (US) $50 $50 F (US) $0 $100 = $100
- Suppose Canadian income is $110 and US income is $90:
Original Amended
E (C) $50 $50 E (C) $100 $0 = $100
F (US) $50 $50 F (US) $10 $90 = $100
- This is a clear example of shifting b/c the capital account is not affect. Additionally, F has the same
tax consequences b/c being taxed by US on income of $100, but E is reducing the amount of his income
share subject to US tax. Thus, have one partner better off and no partner worse off after taxes.
- Remember that need to consider the consequences of the interaction of allocated items with items on
the partners individual tax returns.
Problem 3: Gail and Haley formed a partnership to develop and market computer software. Gail
contributed $10,000 in cash and Haley contributed $200,000. The partnership agreement
52
provides that all 174 deductions for research and experimental expenditures are to be allocated
to Haley. In addition, Haley will be allocated 90%, and Gail 10%, of all partnership income or
loss, excluding research and experimental expenditures, until Haley has received aggregate
allocations of income equal to the sum of such research and experimental expenditures and his
share of such taxable loss. Thereafter, Gail and Haley will share all taxable income and loss
equally. Operating cash flow will be distributed equally between Gail and Haley. The
partnership agreement also provides that Gails and Haleys capital accounts will be determined
and maintained in accordance with the 704(b) regulations, liquidating distributions will be
made in accordance with the partners capital account balances, and that upon liquidation
partners must restore deficit capital account balances? Do these allocations have substantial
economic effect?
Based on Reg. 1.704-1(b)(5) Ex. 3
G $10k cash GH Partnership
H $200k cash
Partnership Agreement:
(i) Pre-Flip:
- All 174 deductions to H
- All other income or loss 90% to H and 10% to G
Until H receives aggregate allocations of income equal to sum of research expenditures and
share of taxable loss
(ii) Post-Flip:
- 50/50
(a) Do these allocations have economic effect?
- Yes, the three requirements of the basic test are satisfied.
(b) Are the allocations substantial?
Luke says probably substantial main fact: dont know when all this is going to happen; dont know if
this flip is ever going to be reached
To be absolutely certain, need way more information
Allocations Attributable to Nonrecourse Debt
Problem 1: Charlie is the general partner and Denise and Ella are the limited partners of the
CDE limited partnership. Charlie contributed $10,000 and Denise and Ella each contributed
$45,000 in cash. The initial contribution was used to purchase a parcel of land for $100,000. The
partnership then borrowed $1,200,000 from an unrelated commercial lender on a nonrecourse
basis to construct an office building to be held for rental. The loan requires only interest
payments for 10 years, at the end of which time the full principal balance is due. The partnership
agreement allocates all income, gain, loss, and deductions 10% to C and 45% to each of D and E
until the partnership cumulatively has recognized items of income and gain that equal its
recognized items of deduction and loss. Thereafter, all partnership items will be allocated 20%
to C and 40% to each of D and E. The partnership agreement requires that capital accounts be
properly maintained and that the partnership will be liquidated according to capital account
balances. Only C, the general partner, is required to restore a capital account deficit, but the
partnership agreement contains a qualified income offset and a minimum gain chargeback
provision. Rental income from the property equals deductible cash flow operating expenses.
Assume that the property has a 30-year cost recovery period. Thus, annual taxable income is a
net operating loss of $40,000.
C (gp) -- $10k
D (lp) -- $45k CDE limited partnership
E (lp) -- $45k Land: $100k (equity)
Building: $1,200,000 (nonrecourse loan)
- Pre-flip Allocations: all items 10/45/45
- Post-flip Allocations: all items 20/40/40
53
- Income = Deductible Operating Expenses
$40k annual net operating loss due to depreciation.
(a) What is the significance of the qualified income offset and minimum gain chargeback
provisions?
- meet -2(e) safe harbor
- Where one or more partners do not have a DRO, PA is reqd to satisfy the alternative test of EE
under -1(b)(2)(ii)(d)
For purposes of the test, a partners share of minimum gain is treated as an obligation to
restore negative capital account in that amount -2(g)(1)
Thus, NRC deductions may be allocated to a partner even though they results in a partner
having a negative CA w/o violating requirements of alternative EE test
(b) How will the partnerships depreciation deductions be allocated among the partners for each
of the first four years of the partnership?
Book Basis Book
Land $100k $100k Debt (NR) $1.2m
Building $1.2m $1.2m C $10k
D $45k
_____ _____ E $45k
$1.3m $1.3m $1.3m
Balance Sheet After Year 1 ($40k depreciation deduction 4/18/18):
Land $100,000 $100,000 Debt (NR) $1,200,000
Building $1,160,000 $1,160,000 C $6,000
D $27,000
_________ _________ E $27,000
$1,260,000 $1,260,000 $1,260,000
Total PMG: $0
Land $100,000 $100,000 Debt (NR) $1,200,000
Building $1,120,000 $1,120,000 C $2,000
D $9,000
_________ _________ E $9,000
$1,220,000 $1,220,000 $1,220,000
Total PMG: $0
Thus, for the first two years of the partnerships existence we are allocating depreciation deductions
under the 1.704-1 regulations b/c there is no PMG and thus no NRC deductions (after two years debt
($1,200,000) does NOT exceeds basis of assets ($1,220,000)), the partners still have equity in their
pship interests. If the property were conveyed to the lender solely in satisfaction of the mortgage and
for no other consideration at this point, the pship would recognize a loss and not a gain (minimum
gain). These allocations have SEE b/c used all safe harbors.
- In the real world we would need to know exactly what property was secured by the nonrecourse
mortgage in order to determine if the partners had nonrecourse deductions in years 1 and 2. If the only
property actually secured by the mortgage were the building, then there would be nonrecourse
deductions from the beginning. Here, we are assuming both securing debt.
- Notwithstanding that there was no minimum gain in years 1 and 2, the PA still had to provide that: (1)
maintain capital accounts; (2) liquidate according to capital accounts; (3) alternative test dont take
capital accounts below amount obligated to restore plus a qualified income offset; and (4) minimum
gain chargeback (effective for at least the first year there is minimum gain).
54
(ii) Balance Sheet After Year 3 ($40k depreciation deduction 4/18/18):
- The year 3 depreciation deduction takes the basis of the assets down from $1,220,000 to $1,180,000,
which is $20,000 below the $1,200,000 nonrecourse debt. Thus, since debt (1.2m) exceeds basis
(1.18m), there is $20k of minimum gain in year 3. BUT, remember there must be a NET increase in
PMG. Here, in year 2 there was $0 PMG and in year 3 there was $20k PMG. Thus, NRC deduction =
net increase of $20k.
Where is this NRC deduction coming from? Treat some of already existing item as NRC
deduction (must use ordering rule to determine which already existing item used)
Ordering Rules: Reg. 1.704-2(j) pro rata portion
Cost recovery related to property securing NRC
Here, can tag $20 of $40 as being NRC deduction thus, dont have to look
around for other pship items
- Bifurcation mechanically only the $20k of deductions that reduced the basis of the assets below
$1,200,000 (the value of the debt) are NRC deductions. Thus, in year 3 we must bifurcate the $40k of
depreciation deductions into two groups: (i) the first $20k of deductions that did not reduce the value of
the assets below the amount of the loan are governed by the 1.704-1 regulations, and (ii) the last $20k
of deductions that did reduce the value of the assets below the amount of the loan (NRC deductions) are
governed by the 1.704-2 regulations.
1st $20k: 1.704-1 Use PA allocation, 10% to C and 45% to each D and E (their deduction
sharing ratio). Therefore, the first $20k of depreciation deductions will be allocated $2k to C
and $9k to each D and E.
2
nd
$20k: 1.704-2 will determine the allocation of the $20k in NRC deductions for year 3.
Reg. 1.704-2(b)(1) provides that NRC deductions must be allocated in accordance with the
PIP Reg. 1.704-2(e) safe harbor which provides that allocations are deemed to be in
accordance with the PIP only if the four listed requirements are met (note that all necessary
provisions are contained in the partnership agreement) Reg. 1.704-2(e)(3) requires
compliance with minimum gain chargeback requirements Reg. 1.704-2(g) which provides the
method of determining each partners share of partnership minimum gain.
Piggyback on allocation that has EE here, could do 10/45/45, 20/40/40 or anything
in between Reg. 1.704-2(m) Ex 1(ii)
So long as all meet SEE
Here, we chose 10/45/45
- Note also that the partners share of minimum gain is treated as a limited obligation to restore a
negative capital account (Reg. 1.704-2(g)(1)(flush language).
- Note that Reg. 1.704-2 does not deem allocations to have economic effect, but deems them to be in
accordance with the partnership interests.
Land $100,000 $100,000 Debt (NR) $1,200,000
Building $1,080,000 $1,080,000 C ($2,000)
D ($9,000)
_________ _________ E ($9,000)
$1,180,000 $1,180,000 $1,180,000
Total PMG: $20k
(iii) Balance Sheet After Year 4 ($40k depreciation deduction 4/18/18):
Land $100,000 $100,000 Debt (NR) $1,200,000
Building $1,040,000 $1,040,000 C ($6,000)
D ($27,000)
_________ _________ E ($27,000)
$1,140,000 $1,140,000 $1,140,000
Total PMG: $60K
Thus, our net increase in PMG = $40k ($20k in year 3 to $60k in year 4). Therefore, all $40k of
depreciation will be used to tag $40k NRC deductions. Already made selection as to which allocation
55
going to follow, so must use same: 10/45/45
* Class Notes (Week 6 at page 7):
- The partnership agreement in this problem provides for two different allocations. The allocation of all
items in the early years (prior to breaking even) is 10/45/45. The allocation of all items in the later
years (after breaking even) is 20/40/40. Thus, a flip occurs once the partnership cumulatively has
recognized items of income and gain that equal its recognized items of deduction and loss.
- Suppose the partnership has the following net income/loss from operations:
Year Net Income/Loss
1 ($40k)
2 ($40k)
3 ($40k) ($120k)
4 $20k
5 $20k
6 $30k
7 $50k $120k
- Thus, for the first 7 years the allocation is 10/45/45, but beginning in year 8 the allocation flips to
20/40/40.
- Recall the Reg. 1.704-2(e)(2) requirement that the partnership agreement provide for allocations of
nonrecourse deductions in a manner that is reasonably consistent with allocations that have substantial
economic effect of some other significant partnership item attributable to the property securing the
nonrecourse liabilities.
- How much minimum gain is there after year 7? $280k of depreciation deductions reduced the basis of
the land and building to $1,020,000. The amount of the debt is still $1,200,000. Therefore, the
partnership minimum gain is $180k (at very end of year 7 and very beginning of year 8).
- Now suppose the partnership sells the building for a profit of $300k on January 1 of year 8. How will
the partnership allocate that $300k of gain? The partnership has $180k of minimum gain prior to the
sale and $0 of minimum gain after the sale. Therefore, there is a $180k decrease in partnership
minimum gain that must be allocated to the partners b/c of the minimum gain chargeback requirement
that was required to be included in the partnership agreement (Reg. 1.704-2(f)), which means C is
allocated 10% ($18k), D is allocated 45% ($81k), and E is allocated 45% ($81k). The $120k of the
$300k that is left over after allocating the minimum gain is then allocated to the partners according to
the post-flip profit sharing ratio, which means C is allocated 20% ($24k), D is allocated 40% ($48k),
and E is allocated 40% ($48k).
- But didnt the partners really want to allocate the entire $300k gain 20/40/40? Is there some way to
achieve such an allocation? See Reg. 1.704-2(e)(4) which provides for a waiver of certain income
allocations that fail to meet the minimum gain chargeback requirement if the minimum gain chargeback
distorts the economic arrangement of the partners. Basically, the partners will be asking the IRS for
mercy, but must meet the requirements listed in the regulation to be eligible (get everyone back to $0
capital account and then can apply for a waiver).
(c) How would the partnerships depreciation deductions be allocated among the partners for
each of the first four years of the partnership if the partnership agreement provided that C
would be allocated 2% and D and E each would be allocated 49% of the partnerships
depreciation deductions, but all other items would be allocated as in the basic facts?
Book Basis Book
Land $100k $100k Debt (NR) $1.2m
Building $1.2m $1.2m C $10k
D $45k
_____ _____ E $45k
$1.3m $1.3m $1.3m
Balance Sheet After Year 1 ($40k depreciation deduction 800/19,600/19,600):
56
Land $100,000 $100,000 Debt (NR) $1,200,000
Building $1,160,000 $1,160,000 C $9,200
D $25,400
_________ _________ E $25,400
$1,260,000 $1,260,000 $1,260,000
Total PMG: $0
Balance Sheet After Year 2 ($40k depreciation deduction 800/19,600/19,600):
Land $100,000 $100,000 Debt (NR) $1,200,000
Building $1,120,000 $1,120,000 C $8,400
D $5,800
_________ _________ E $5,800
$1,220,000 $1,220,000 $1,220,000
Total PMG: $0
(ii) Balance Sheet After Year 3 ($40k depreciation deduction 4/18/18):
Land $100,000 $100,000 Debt (NR) $1,200,000
Building $1,080,000 $1,080,000 C ($2,000)
D ($9,000)
_________ _________ E ($9,000)
$1,180,000 $1,180,000 $1,180,000
Total PMG: $20k
Results in net increase of $20k; thus, NRC deductions are $20k
Ordering Rule: tag depreciation first - $20k tagged as NRC and $20k as 704-1 general allocations
1.704-1: D/E $20k x 49% = 9,800, but CA BV is only $5,800 if did this, would create
deficit in CA which cant be fixed by -2(g). Here, have SEE as to $5,800 each to D and E,
which leaves $8,000 that has to be allocated using PIP. All $8,000 will be allocated to C. Also,
C gets regular $20k x 2% = $400. Thus, C allocated total of $8,400. These allocations take C,
D, and E to $0.
$20k NRC deduction:
3 choices: 2/49/49; 10/45/45; 20/40/40
If first year of NRC, found out that 2/49/49 does not have EE since would create
deficit in CA for D/E. Thus, can only use 10/45/45, 20/40/40 or anything in b/t.
Here, we decided to use 10/45/45 $2/$9/$9
(iii) Balance Sheet After Year 4 ($40k depreciation deduction 4/18/18):
Land $100,000 $100,000 Debt (NR) $1,200,000
Building $1,040,000 $1,040,000 C ($6,000)
D ($27,000)
_________ _________ E ($27,000)
$1,140,000 $1,140,000 $1,140,000
Total PMG: $60k, which results in $40k net increase
(d) Assume that the partnership allocations are the same as in part (b). What are the tax
consequences if the partnership sells the land & building on January 1, Year 5 for $1.2 million
(i.e., the amount of the debt). Assume that the partnership incurs no new nonrecourse debt in
Year 5.
(i) Balance Sheet After Year 4 ($40k depreciation deduction 4/18/18):
Land $100,000 $100,000 Debt (NR) $1,200,000
Building $1,040,000 $1,040,000 C ($6,000)
57
D ($27,000)
_________ _________ E ($27,000)
$1,140,000 $1,140,000 $1,140,000
Each Partners Share of NRC Deduction
C: $6k
D/E: $27k
(ii) Sale of land/building in Jan 1, 2005 do not take further depreciation in Year 5
AR: $1,200,000
AB: $1,140,000
Gain: $60,000
Causes debt to disappear
Cash 1.2m Debt (NR) $0
C $0
D $0
_________ _________ E $0
$1.2m $1,200,000
Total PMG: $0; thus, net decrease of $60k
Thus, $60k minimum gain chargeback.
Each partners share of net decrease: 1) share of PMG at close of Year 4 (6/27/27) 2) determine ratio:
6/60 = 10%; 27/60 = 45%. Thus, C: 10% x 60k = $6k; D/E: 45% x 60k = 27k.
(j): tag gain from sale of property
(e) Assume that the partnership allocations are the same as in part (b). What are the tax
consequences if the partnership makes an $80,000 principal payment on the nonrecourse debt in
Year 5? Assume that the partnership incurs no additional nonrecourse debt in Year 5. The cash
with which to pay the $80,000 was generated in Year 5 through imposition of a penalty on a
tenant who terminated its lease early. The partnership was able to find a new tenant quickly,
and, as a result, in Year 5, gross income exceeded operating expenses by $80,000.
(i) Balance Sheet After Year 4 ($40k depreciation deduction 4/18/18):
Land $100,000 $100,000 Debt (NR) $1,200,000
Building $1,040,000 $1,040,000 C ($6,000)
D ($27,000)
_________ _________ E ($27,000)
$1,140,000 $1,140,000 $1,140,000
(ii) Balance Sheet After Year 5 ($40k depreciation deduction 4/18/18; $80k gain allocation; and $80k
principal payment):
Land $100,000 $100,000 Debt (NR) $1,120,000
Building $1,000,000 $1,000,000 C ($2,000)
D ($9,000)
_________ _________ E ($9,000)
$1,100,000 $1,100,000 $1,100,000
Making $80,000 principal payment reduces PMG from $60,000 to $20,000.
Allocation of GI: still use 10/45/45 b/c the partnership cumulatively has NOT recognized items of
income and gain that equal its recognized items of deduction and loss.
58

Year Net Income/Loss
1 ($40k)
2 ($40k)
3 ($40k)
4 ($40k) ($160k)
5 $80k
Thus, $8,000 to C and $36,000 each to D and E.
Problem 2: Amy, Bill, and Casey are forming a LLC (that will be taxed as a partnership) to
conduct a restaurant business in a leased building. Each of them will contribute $100,000 in cash
to purchase furniture and equipment and to provide start-up working capital. Each of them will
have an equal interest in the capital and profits of the LLC. Is it important that the LLC
agreement comply with the alternative test for substantial economic effect provided in Reg.
1.704-1(b)(2)(i)(d)?
* What is the peculiar problem presented by an LLC that we have been ducking thus far? The members
of an LLC have limited liability, thus no obligation to restore a deficit capital account.
* There is a second problem, however. Assuming that the partnership is an accrual method partnership,
would the partnerships telephone bill be a recourse debt or a nonrecourse debt?
- Reg. 1.704-2(b)(3) says a nonrecourse liability means a nonrecourse liability as defined in Reg.
1.752-1(a)(2), which provides that a partnership liability is a nonrecourse liability to the extent that no
partner or related person bears the economic risk of loss for that liability under Reg. 1.752-2. The
telephone bill will be a recourse debt under state law, but under tax law it may be a nonrecourse debt.
Thus, allocating the deduction attributable to the telephone bill may be a nonrecourse deduction.
* Cross-Collateralization Example:
- Suppose the partnership has two properties, Blackacre and Whiteacre, that both serve as security for
two mortgages, Mortgage 1 and Mortgage 2. This is called cross-collateralization.
Blackacre $1,000 Mortgage 1 $1,800
Whiteacre $2,000 Mortgage 2 $2,400
$3,000 $4,200
- Reg. 1.704-2(d)(2) Property Subject to More Than One Liability:
(i) In General If property is subject to more than one liability, only the portion of the propertys
adjusted tax basis that is allocated to a nonrecourse liability under paragraph (d)(2)(ii) of this section is
used to compute minimum gain with respect to that liability.
(ii) Allocating Liabilities If property is subject to two or more liabilities of equal priority, the
propertys adjusted tax basis is allocated among the liabilities in proportion to their outstanding
balances. If property is subject to two or more liabilities of unequal priority, the adjusted tax basis is
allocated first to the liability of the highest priority to the extent of its outstanding balance and then to
each liability in descending order of priority to the extent of its outstanding balance, until fully
allocated. See paragraph (m), Example (1)(v) and (vii) of this section.
* Suppose that the LLC in Problem 2 has the following:
Book Basis
Building $450 $450 Mortgage Building = $600
Equipment $150 $150 Unsecured Note = $300
$600 $600 $900
- Both debts are recourse vis--vis the LLC, but under debtor-creditor law one is secured (mortgage)
and the other is not (note). The mortgage on the building has priority in recourse against the building,
but the mortgage and note have equal priority against the equipment.
- The regulations tells us how to calculate minimum gain: Min gain = debt basis. Thus, there is a total
minimum gain of $300 ($900 - $600) $100 mortgage and $200 note.
- Missing rest of notes on how to apportion.
59
SECTION 3: ALLOCATION WITH RESPECT TO CONTRIBUTED PROPERTY (Book/Tax
Disparity)
Problem 1: Sean and Pat formed a general partnership to which Sean contributed $50,000 of
cash and Pat contributed depreciable property with a FMV of $50,000 and a basis of $30,000.
The property had a ten year cost recovery period, of which 5 years were remaining on the
contribution date; it is being depreciated under the straight-line method. The partnership
agreement provides that Sean and Pat will share profits and losses equally. Each year the
partnership recognized $12,000 of gross income and no deductions other than the depreciation
deductions on the contributed property.
Assets Capital Accounts
Book Tax Book Tax
Cash $50k $50k S $50k $50k
Property $50k $30k P $50k $30k
$100k $80k $100k $80k
(a) How much depreciation will be allocated to Sean and Pat respectively for book and tax
purposes?
* Depreciation Calculation (5 years remaining, straight line):
- (i) Book Depreciation: $50k / 5 years = $10k / year $5k/year to S and $5k/year to P
- (ii) Tax Depreciation: $30k / 5 years = $6k / year $5k/year to S and $1k/year to P
- Reg. 1.704-3(b)(1) - For 704(c) property subject to amortization, depletion, depreciation, or other
cost recovery, the allocation of deductions attributable to these items takes into account built-in gain or
loss on the property. For example, tax allocations to the noncontributing partners (S here) of cost
recovery deductions with respect to 704(c) property generally must, to the extent possible, equal book
allocations to those partners.
Thus, S gets $5k of book depreciation and must be allocated $5k of tax depreciation, to the extent
possible.
- Note that the above allocation is mandatory under the traditional method. **The ceiling rule only
kicks in when the noncontributing partner cannot receive a tax allocation that matches his book
allocation.
- Forcing depreciation away from contributing partner so that she will have a higher income closes the
book/tax disparity
Year 1 Books after 1 year of depreciation and allocation of $12k pship gross income:
Assets Capital Accounts
Book Tax Book Tax
Cash $62k $62k S $51k $51k (50-5+
6)
Property $40k $24k P $51k $35k (30-1+
6)
$102k $86k $102k $86k
(b)(1) If the property contributed by Pat is sold for $30,000 after it has been held by the
partnership for two years, how will the partnership allocate the gain for book and tax purposes?
-168(i)(7): pship must step into shoes for partner for depreciation
(i) Property after Depreciation: Book Tax
$50k $30k
($10k) ($6k) - Year 1 depreciation
$30k $18k
(ii) Sold Property for $30k:
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Book Tax
AR $30k $30k
AB ($30k) ($18k)
Gain $0 $12k
- 3
rd
step: excess assigned to contributing Since there is a tax gain and no book gain, it all goes to Pat
(iii) Allocation of Gain from Sale of Contributed Property:
S (1/2) P (1/2)
Book Tax Book Tax
Initial capital account: $50k $50k $50k $30k
Year 1 Depreciation: ($5k) ($5k) ($5k) ($1k)
Year 2 Depreciation: ($5k) ($5k) ($5k) ($1k)
Year 1 Allocation $12k $6k $6k $6k $6k
Year 2 Allocation $12K $6k $6k $6k $6k
$52k $52k $52k $40k
Allocation from Sale $ 0 $ 0 $ 0 $12k
$52k $52k $52k $52k
- Reg. 1.704-3(b)(2), Ex (1)(iii) provides that: (i) tax gain greater than book gain is allocated to the
contributing partner and (ii) tax gain equal to book gain is allocated to each partner according to the
Thus, book gain = $0 and tax gain = $12k. Therefore, the $12k tax gain is greater than the $0 book
gain, and the entire $12k of tax gain is allocated to the contributing partner P b/c the property P
contributed had that much built-in gain remaining.
Character: Entire $12k to P is OI b/c we assumed 1245 property
-Reg. 1.1245-1(e)(2)(i): GR look at depreciation partner assigned and gain
-Reg. 1.1245-1(e)(ii)(C)(1): partners share
B/f contributed, assume P took $30k depreciation
After contributed, P only got $1k per year of depreciation ($2k total) b/c of application of
704(c)
Lesser of gain allocated or partners share of depreciation
Here, partners share of depreciation includes b/f and after contribution
depreciation thus, $32k depreciation is more than $12k tax gain
partnership for two years, how will the partnership allocate the gain for book and tax purposes?
(i) Property: Book Tax
$50k $30k
$30k $18k
Book Tax
AR $60k $60k
AB ($30k) ($18k)
Gain $30k $42k
Book Tax Book Tax
S: $50k $50k P: $50k $30k
($5k) ($5k) ($5k) ($1k) Year 1 depreciation
$6k $6k $6k $6k Year 1 Allocation of $12k
$6k $6k $6k $6k Year 2 Allocation of $12k
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$15k $15k Allocation of Book
____ $15k ____ $27k Allocation of Tax
$67k $67k $67k $67k
- Reg. 1.704-3(b)(2), Ex (1)(iii) provides that: (i) tax gain greater than book gain is allocated to the
contributing partner and (ii) tax gain equal to book gain is allocated to each partner according to the
- What we are trying to figure out here is the built-in gain that must be allocated to P. Initially, there
was $20k of built-in gain ($50k FMV > $30k AB at time of contribution). The question then becomes
why was only $12k of gain allocated to P? B/c we are under the traditional method, with no ceiling rule
problem, Reg. 1.704-3(a)(3)(ii) tells us that the built-in gain is reduced by the decrease in the difference
between book and tax. Here, started with $20k of built-in gain. Then compare the difference between
book and tax on date of contribution ($50k - $30k = $20k) and on date of sale ($30k - $18k = $12k).
The reduction in the difference between book and tax from the time of contribution to the time of sale
was $20k to $12k, which is $8k. Thus, $20k of built-in gain reduced by the $8k reduction in the
difference, equals $12k (Reg. 1.704-3(a)(3)(ii)).
-P has $27k total of gain, and S has $15k total of gain
-Character: Entire $27k tax gain is OI b/c recapture even though P only got $10k of depreciation
Ps total depreciation $30k + $2k = $32
(iv) Ending Balance Sheet:
Book Tax Book Tax
Cash $134k $134k S $67k $67k
_____ _____ P $67k $67k
$134k $134k $134k $134k
partnership for five years and is fully depreciated, how will the partnership allocate the gain for
book and tax purposes?
(i) Property: Book Tax
$50k $30k
($50k) ($30k) - 5 Years of depreciation
$0 $0
Book Tax
AR $15k $15k
AB $0 $0
Gain $15k $15k
Book Tax Book Tax
S: $50k $50k P: $50k $30k
$30k $30k $30k $30k 5 years of $12k GI Allocation
$7.5k $7.5k Allocation of Book
____ $7.5k ____ $7.5k Allocation of Tax
$62.5k $62.5k $62.5k $62.5k
(iv) Ending Balance Sheet:
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Book Tax Book Tax
Cash $125k $125k S $62.5k $62.5k
_____ _____ P $62.5k $62.5k
$125k $125k $125k $125k
- Here, the $20k built-in gain is reduced to $0 by fully depreciating the property. Thus, there is no
difference between book and tax and all the gain is allocated pursuant to the partnership agreement
(50/50). Further, there is no option on how to allocate the gain b/c we have not run into the ceiling rule.
Thus, under the traditional method.
Character: 1231 b/c fully depreciated
Total recapture: $60k ($30 pre and $30 post-contribution)
Each partners share of gain is less than allocated depreciation so all $7.5k gain each is 1231
Problem 2: The basic facts of Problem 1 apply, but assume that Ps basis for the depreciable
property was only $20,000.
- Now getting in to the ceiling rule.
(a) How much depreciation will be allocated to S and P respectively for book and tax purposes if
the partnership applies the traditional method with the ceiling rule?
Book Tax Book Tax
Cash $50k $50k S $50k $50k
$100k $70k $100k $70k
- (i) Book Depreciation: $50k / 5 years = $10k / year $5k/year to S
$5k/year to P
- (ii) Tax Depreciation: $20k / 5 years = $4k / year $4k/year to S
$0k/year to P
Ceiling rule problem: $1k difference b/t book and tax allocated to non-contributing partner
* $12k GI Allocation: 50/50 - $6k to each
- S is going to be unhappy with this result b/c he is getting less depreciation ($4k instead of $5k).
- If the clients are both happy with this result or can both live with it, then this is the resulting allocation
under the traditional method with the ceiling rule.
- However, if this result is not acceptable, then partners can use the curative or remedial allocation
method to fix the distortion caused by the ceiling rule.
Ending Balance Sheet:
Book Tax Book Tax
Cash $62k $62k S $51k (50-5+6) $52k (50+6-4)
Property $40k $16k P $51k $26k (20+6-0)
$100k $70k $100k $70k
(b) How will the partnership allocate depreciation and partnership gross income, for both book
and tax purposes, if the partnership elects to use curative allocations?
- Under the curative method (Reg. 1.704-3(c)), actual partnership items are reallocated for tax
purposes, but not for book purposes, even though the 704(b) regulations say we cant do that (the
704(c) regulations trump the 704(b) regulations).
- Recall that under the facts of Problem 1 the partnership has $12k of gross income each year.
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- (i) Book Depreciation: $50k / 5 years = $10k / year $5k/year to S
$5k/year to P
- (ii) Tax Depreciation: $20k / 5 years = $4k / year $4k/year to S
$0k/year to P
- (iii) Curative Allocation: $5k of income to S and $7k of income to P
S P
Book Tax Book Tax
($4k) Depreciation ($5k) ($4k) ($5k) $0
$12k Income $6k $5k $6k $7k
$8k
- The distortion caused by the ceiling rule here was that S only got $4k of tax depreciation when he
would have gotten $5k without the ceiling rule. Therefore, under Reg. 1.704-3(c)(1) we may make a
curative allocation of a partnership item (here income) to reduce or eliminate the disparity between
book and tax items of the noncontributing partner. Thus, here we allocated $1k less of tax income to S
to make up for the $1k less tax depreciation deduction (distortion caused by ceiling rule).
- Note that under Reg. 1.704-3(c)(3)(i) a curative allocation can be made only to the extent necessary to
offset the effect of the ceiling rule.
- Note that Reg. 1.704-3(c)(3)(iii) requires matching of the character of the item limited by the ceiling
rule and the character of the item used to make the remedial allocation. Additionally, the curative
allocation must be expected to have to have substantially the same effect on each partners tax liability
as the tax item limited by the ceiling rule.
Income is ordinary and depreciation deduction is ordinary
Books after Curative Allocation:
Book Tax Book Tax
Cash $62k $62k S $51k (50+6-5) $51k (50-4+5)
Property $50k $16k P $51k $27k (20-0+7)
$102k $78k $102k $78k
After 5 years of depreciation (fully depreciated) shows how gap fully closed over time
Book Tax Book Tax
Cash $110k $110k S $55k (50+30-25) $55k (50+
25-20)
Property $0 $0 P $55k $55k (20+
35-0)
$110k $110k $110k $110k
(c) How will the partnership allocate depreciation and partnership gross income, for both book
and tax purposes, if the partnership elects to use remedial allocations?
* Reg. 1.704-3(d) Remedial Allocation Method:
- (1) Determine the amount of book items under paragraph (d)(2) and the partners distributive shares
of those items;
- (2) The partnership then allocates the corresponding tax items recognized by the partnership using the
traditional method;
- (3) If the ceiling rule causes the book allocation of an item to a noncontributing partner to differ from
the tax allocation of the same item to the noncontributing partner, the partnership creates a remedial
item of income, gain, loss, or deduction equal to the full amount of the difference and allocates it to the
noncontributing partner; and
- (4) The partnership simultaneously creates an offsetting remedial item in an identical amount and
allocates it to the contributing partner.
* Step 1: Determine Amount of Book Items Under Reg. 1.704-3(d)(2):
- (i) Book = Tax (match) $20k / 5 years = $4k/year
- (ii) Book > Tax (excess) $30k / 10 years = $3k/year
$7k/year total book for first 5 years.
$3k/year total book for years 6 10.
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Then determine partners distributive shares of those items under 704(b). 50/50 partnership here, so
each S and P allocated $3.5k per year for book purposes.
* Step 2: Allocate Tax Items Using Traditional Method:
- Tax Depreciation: $20k / 5 years = $4k / year
$3.5k/year to S (match: tax gain equal to book gain)
$0.5k/year to P (excess: tax gain greater than book gain)
- Recall that Reg. 1.704-3(b)(2), Ex (1)(iii) provides that: (i) tax gain greater than book gain is allocated
to the contributing partner and (ii) tax gain equal to book gain is allocated to each partner according to
the partnership agreement.
* Step 3: Create Remedial Item once the ceiling rule causes the book allocation
- Beginning Balance Sheet:
Book Tax Book Tax
Cash $50k $50k S $50k $50k
$100k $70k $100k $70k
S P
Year Book Tax Book Tax Book Tax
1 ($7k) ($4k) ($3.5k) ($3.5k) ($3.5k) ($500)
2 ($7k) ($4k) ($3.5k) ($3.5k) ($3.5k) ($500)
3 ($7k) ($4k) ($3.5k) ($3.5k) ($3.5k) ($500)
4 ($7k) ($4k) ($3.5k) ($3.5k) ($3.5k) ($500)
5 ($7k) ($4k) ($3.5k) ($3.5k) ($3.5k) ($500)
($35k) ($20k) ($17.5k) ($17.5k) ($17.5k) ($2.5k)
Note that no remedial allocations are actually being made for the first 5 years.
- Balance Sheet After 5 Years:
Book Tax Book Tax
Cash $110k $110k S $62.5k (50+30-17.5) $62.5k
Property $15k $0 P $62.5k $47.5k (20+
30-2.5)
$125k $110k $125k $110k
- Remedial allocations for years 6 10: S (noncontributing partner) receives a notional tax deduction of
$1.5k per year and P (contributing partner) receives an offsetting notional tax gain item of $1.5k per
year in order to close gap of remaining book depreciation of $3k for 5 years
- by slowing down deprecation, pushed back ceiling rule problem to year 6
S P
Year Book Tax Book Tax Book Tax
6 ($3k) ($0) ($1.5k) ($1.5k) ($1.5k) $1.5k
7 ($3k) ($0) ($1.5k) ($1.5k) ($1.5k) $1.5k
8 ($3k) ($0) ($1.5k) ($1.5k) ($1.5k) $1.5k
9 ($3k) ($0) ($1.5k) ($1.5k) ($1.5k) $1.5k
10 ($3k) ($0) ($1.5k) ($1.5k) ($1.5k) $1.5k
($15k) ($0) ($7.5k) ($7.5k)($7.5k) $7.5k
- Balance Sheet After Year 6:
Book Tax Book Tax
Cash $122k $122k S $67k (62.5+6-1.5) $67k (62.5+
6-1.5)
Property $12k $0 P $67k $55k (47.5+
6-1.5)
$144k $122k $144k $122k
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- Ending Balance Sheet After 10 Years:
Book Tax Book Tax
Cash $170k $170k S $85k $85k (50+60-25)
Property $0 $0 P $85k $85k (20+60-2.5+7.5)
$170k $170k $170k $170k
* Allocation of Income
Years 1-5: $6k each
Years 6-10: $6k to S and $7,500 to P
- Notice how in the out years (years 6 10) P picks up the amount. S gets the right amount of tax
depreciation over time and P ends up in essence recognizing the deferred gain b/c he either has less
depreciation or more income from the remedial allocations.
- (Personal Comments) Basically, in years 1 5, S took tax depreciation deductions of $1.5k less than
he would have taken if it wasnt for the ceiling rule. To make up for this, S was allocated a notional tax
deduction of an additional $1.5k in years 6 10. B/c of the notional items to S in years 6 10, P was
allocated an offsetting remedial allocation in those years.
* Between curative and remedial allocations, which is more advantageous to P? Assume S said he will
not deal with the traditional rule, so the partners must use either curative or remedial allocations. P will
prefer to use the remedial method b/c his tax liability is deferred. S (noncontributing partner) will
prefer the curative method b/c it allocates deductions to match book as quickly as possible. Thus, S
prefers the curative method b/c he gets the deductions faster but will have higher income in the out
years.
- Is there any reason S might agree to use the remedial rather than curative method? Curative
allocations work only if the partnership has other actual book items to allocate. Thus, the partnership
needs gross income or other deductions to use the curative method. If the partnership doesnt have
other actual items, then curative allocations cannot be made. However, note that S would be entitled to
catch-up allocations under the curative method. Say S were entitled to $5k of curative allocations, but
only got $2k this year, then the following year S would be entitled to $8k.
* What is so different about the remedial method? Under the remedial method there is certainty b/c
know what the tax consequences are going to be, but may not know with curatives (and certainty is the
tax lawyers best friend).
* Spectrum (if have a ceiling problem):
Best for contributing partner --------------------------------- Best for noncontributing partner
Traditional Remedial Curative
* Does the partnership have to use the same method for everything and everyone? No, the partnership
may use different methods as long as overall it is reasonable (not getting too tricky).
- Example of getting too tricky Week 7 page 10.
* What is the advantage of the traditional method? Certainty and lower transaction costs.
* What happens if a partner sells his interest in the partnership? The new partner succeeds to the old
partners capital account and must live with the already agreed upon form of allocations.
3/18 Problem 3: Todd and Ursula are partners in the TU Partnership which owns Greenacre, a
farm that is leased to tenant farmers. The FMV of Greenacre is $1,200,000, its basis and book
value to the partnership is $600,000. Todd and Ursula each have a $300,000 basis in their
partnership interests. Veronica joins the partnership by contributing Whiteacre, which has a
FMV of $600,000. Veronicas basis in Whiteacre is $700,000. Todd, Ursula, and Veronica will
share all profits and losses 1/3 each. On Veronicas admission to the partnership the partnership
will revalue its assets to FMV. What are the tax consequences to the partnership and the
partners from the sale of Whiteacre in each of the following circumstances?
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**Assume that Todd and Ursula initially contributed $300,000 of cash each, which was used to
purchase Greenacre. Assume for simplicity that Greenacre, including any associated buildings, is
entirely non-depreciable.
Book Tax Book Tax
Greenacre $600k $600k T $300k $300k
Whiteacre $600k $700k U $300k $300k
V $600k $700k
- When V joins, the partnership should book-up: (revaluation under Reg. 1.704-1(b)(2)(iv)(f))
Book Tax Book Tax
Greenacre $1.2m $600k T $600k $300k
_____ _____ V $600k $700k
$1.8m $1.3m $1.8m $1.3m
- After V joins, the partners are each 1/3 partners.
- Effect of Revaluation of Greenacre:
Creates book/tax disparity for T and U
Must allocate tax in the future
Creates book gain of $600k
Use 704(a) and (b) to make allocation of this gain SEE
Assume 50/50 b/f V joins
$300 each to T and U
NOT a realization event
- Contribution of Whiteacre
704(c)(1)(C): contribution of built-loss property
Literal application (least TP friendly): only person who can benefit from $100k BIL
is V (person who contributed property)
(a) One year after Veronica joins the partnership the TUV Partnership sells Whiteacre for
$540,000.
* What are the tax consequences to the partnership and the partners:
- Note that V has a $100k built-in loss in Whiteacre.
(i) Partnership: Sale for $540k:
Book Tax
AR $540k $540k
AB $600k $700k
Loss ($60k) ($160k)
(ii) Partners:
T U V
Book Tax Book Tax Book Tax
Beginning CA $600k $300k $600k $300k $600k $700k
Built-In Loss $100k ($100k)
Additional Loss $60k ($20k) ($20k) ($20k) ($20k) ($20k) ($20k)
$580k $280k $580k $280k $580k $580k
$60k book loss: follow PA $20K each (note: must test for SEE)
$160k tax loss: Under 704(c)(1)(C), built-in losses must be allocated only to the partner who
contributed the loss property.
Thus, $100k of tax loss is reserved exclusively for V.
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Analysis:
First, $60k (matching book loss) is allocated to all 3 partners to share.
Then, $100k excess allocated to contributing partner, V.
(iii) Ending Balance Sheet:
Book Tax Book Tax
Greenacre $1.2m $600k T $580k $280k
Cash $540k $540k U $580k $280k
_____ _____ V $580k $580k
$1.74m $1.14m $1.74m $1.14m
(b) One year after Veronica joins the partnership, the TUV Partnership sells Greenacre for
$1,200,000 and distributes $600,000 cash to Veronica who leaves the partnership. The $600,000
of partnership tax gain on the sale of Greenacre is properly allocated $300,000 each to Todd and
Ursula. Veronica recognizes a $100,000 loss on her liquidation distribution. In the next taxable
year the partnership sells Whiteacre for $540,000.
(i) Sale of Greenacre:
Book Tax
AR $1.2m $1.2m
AB $1.2m $600k
Gain $0 $600k
* Balance Sheet After Sale of Greenacre $300k tax gain allocated to each T and U:
Book Tax Book Tax
Cash $1.2m $1.2m T $600k $600k
_____ _____ V $600k $700k
$1.8m $1.9m $1.8m $1.9m
No book gain so no tax gain to match to book gain for allocating to noncontributing partner, V.
- Upon the contribution of Greenacre to the partnership, assume that book and basis were both $600k.
The property appreciated in value to $1.2m while only T and U were partners, therefore that $600k is
passed through $300k each to T and U upon subsequent sale. The theory here is that T and U should be
taxed on the gain that occurred while they were the only partners (before V joined). Treat T and U as
contributors of Greenacre.
(ii) What happens when the partnership takes $600k and distributes it to V, who then leaves the
partnership (liquidating distribution)?
-$600k distribution to V, which reduces her basis in her partnership interest to $100k. The distribution
is tax free to V b/c she had sufficient basis (only distribution in excess of basis is taxable). V then
recognizes a $100k loss on her liquidating distribution.
(iii) What happens the following year when the partnership sells the property contributed by V for
$540k? How do we allocate the loss?
Book Tax
AR $540k $540k
AB $600k $600k
Loss ($60k) ($60k)
- A $60k book and tax loss occurs when the pship sells the property and only T and U are partners
(50/50). Therefore, that loss is allocated $30k to each.
- Who gets the other $100k of built-in loss? V got the $100k loss when she left the partnership. The
partnership is disallowed that $100k loss b/c to allow it to the partnership also would be double
68
counting. Think about the pass through concept.
Add Problem 3(b): How would your answer change if, instead of contributing cash, Todd
contributed land for Greenacre at a time when it was worth $300,000 and when he had a basis in
it of $100,000? Assume that Ursulas $300,000 of cash was used to construct a farm building,
and that the land and building were each worth $600,000 at the time Veronica joined the
partnership.
Book Tax Book Tax
Farm/Bldg $300k $300k U $300k $300k
(ii) Balance Sheet after Revaluation:
Book Tax Book Tax
Bldg $600k $300k U $600k $300k
Revaluation creates $300k book gain from land and $300k book gain from building
Book gain ALWAYS allocated under PA
$300k each to T and U
(iii) Balance Sheet after Vs Admittance:
Book Tax Book Tax
Bldg $600k $300k U $600k $300k
Whiteacre $600k $700k V $600 $700k
(iv) Calculate Gain Realized/Recognized on Sale of Greenacre and Building:
Land Book Tax Building Book Tax
$600k $600k $600k $600k
$600k $100k $600k $300k
$0k $500k $0k $300k
Tax consequences governed by 704(c) no book gain to match tax gain for allocation to
noncontributing partner, V. Thus, all tax gain considered excess to allocate to T and U.
Land
Forward: $200k to T
Reverse: match up w/ prior book allocations
Building
Reverse: match up w/ prior book allocations
(v) Ending Balance Sheet:
Book Tax Book Tax
Cash $1.2m $1.2m T $600k $600k (100+500)
U $600k $600k (300+300)
Whiteacre $600k $700k V $600 $700k
**Lesson: Can have same asset be subject to forward 704(c) and reverse 704(c) allocations.
Problem 4: Kim and Lesley each contributed $150,000 to form a LLC that is taxed as a
partnership. They shared profits and losses equally. Using the initial contribution, the KL LLC
purchased an apartment building and began to renovate it for sale as condominiums. When Kim
and Lesley were unable to finish the project, Marion was admitted as a new member of the LLC
in consideration of a $250,000 cash contribution to fund completion of the project. At the time
Marion was admitted to membership in the LLC, the FMV of the building project, which was the
LLCs sole asset, was $500,000.
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- Initial Balance Sheet of KL LLC:
Book Tax Book Tax
Building $300k $300k K (1/2) $150k $150k
L (1/2) $150k $150k
- Balance Sheet After M Joins (KLM LLC) Without Booking-Up:
Note: Assumed put cash into building (capital expenditure so increase BV and Tax)
Book Tax Book Tax
Building $550k $550k K (1/3) $150k $150k
L (1/3) $150k $150k
_____ _____ M (1/3) $250k $250k
$550k $550k $550k $550k
(a) What would be the result if the capital account and allocation provisions of the LLC
agreement were not amended to reflect Marions admission as a member?
* This question is asking what the result is if the partnership does not book-up its assets upon the
admission of a new partner.
1.2m AR Book gain: $650k; Tax gain $650k
Book allocation
$216,667 to each probably has SEE (Luke: but something not quite right b/c of the shift a
lot of value earned b/f M joined)
1.704-1(b)(1)(iii): still subject to general principles (i.e., assignment of income, STD,
substance over form, etc)
Here, IRS could use assignment of income
706(d): must do allocations to account for varying interests BUT mostly aimed at
operating income/expenses and not a lot of guidance for how applies to BIG/L when
new partner admitted
Most practitioners would say doubt as SEE but can take position that it meets b/c
706 doesnt directly apply and AID has been codified by 704(c)(1)(A), which does
not cover this
Book Tax Book Tax
Building $1.2m $1.2m K (1/3) $366,666 366,666
L (1/3) $366,666 366,666
_____ _____ M (1/3) $466,667 $466,667
$1.2m $1.2m
Advise M to get revaluation b/c paying tax on income that was earned largely b/f she joined the LLC.
Should considered her tax bracket when making this decision.
- But nothing mandates the use of 704(c) principles if the partnership does not book up.
* If we do not book up upon the admission of M, what do K and L think of the result? They are not
happy. As a result of not booking up and not using 704(c) principles, but merely relying on 704(b),
they have transferred wealth to M. The FMV of the property at the time M was admitted was $500k (as
opposed to $300k when it was purchased). Therefore, there is $200k of appreciation that rightly
belongs to K and L ($100k each). However, as a result of not booking-up and increasing capital
accounts, the partners have in effect transferred 1/3 of that appreciation to M.
(b) How should the capital account and allocation provisions of the LLC agreement be amended
to reflect Marions admission as a member? Assume that after completion of the project using
Marions contribution, all of the condominium units were sold in the same year for an aggregate
price of $1,200,000, resulting in a taxable profit of $650,000.
* Now looking at what happens when the partnership elects to book-up:
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- Balance sheet after Revaluation:
Book Tax Book Tax
Building $500k $300k K (1/3) $250k $150k
L (1/3) $250k $150k
$200k book gain created by revaluation allocated $100k each to K and L. Assume SEE.
- Balance Sheet After Ms Admittance:
Book Tax Book Tax
Building $750k $550k K (1/3) $250k $150k
L (1/3) $250k $150k
_____ _____ M (1/3) $250k $250k
$750k $550k $750k $550k
- The partnership then sells the condos for $1,200,000:
Book Tax
AR $1,200,000 $1,200,000
AB $750,000 $550,000 Ms contributed $250k cash was used to improve the
Gain $450,000 $650,000 property (capitalized)
- Reverse 704(c) Gain Allocation Allocate to the noncontributing partner tax gain equal to (up to)
book gain, and then tax gain in excess of book gain is allocated to the contributing partners.
- Book gain ($450k) $150k to each K, L, and M
- Tax gain ($650k) $150k to each K, L, and M (match book gain)
$100k to each K and L (tax gain > book gain reverse allocation)
- Thus:
- Book gain $150k to each K, L, and M.
- Tax gain $250k to each K and L
$150k to M
Book Tax Book Tax
Cash $1.2m $1.2m K (1/3) $400k $400k
L (1/3) $400k $400k
_____ _____ M (1/3)$400k $400k
$1.2m $1.2m $1.2m $1.2m
- The rules of 704(b), (c), and (d) are attempting to make the tax return match the real deal.
- 704(b) says that book and tax must be done contemporaneously.
- 704(c) deals with resolving differences between tax items and book items. Just like 704(b), this
section is saying that tax items and book items must be the same (eventually). Over time there can
never be a tax item without a book item, but in a given year there can be (like when the book item has
already occurred). Thus, 704(c) is all about tax items trying to catch up with book items.
SECTION 5 Allocations Where Interests Vary During the Year
Problem 1: Prior to October 1, Nora and Oliver were equal partners in a general partnership.
As of October 1, Pat made a capital contribution to the partnership and the partnership
agreement was amended to make Nora, Oliver, and Pat equal partners. During the year, the
partnership recognized $180,000 of net income from business operations. Net operating income
of $90,000 was realized in January through September, and net operating income of $90,000 was
realized in October through December. In addition, in November, the partnership sold an item
of 1231 property and recognized a $60,000 loss. The partnership uses the accrual method and
is on the calendar year.
Jan. 1 Sept. 30 Oct. 1 Dec. 31
N: 50% N: 1/3
O: 50% O: 1/3
Net operating income = $90k P: 1/3
Net operating income = $90k
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1231 loss = $60k
* Note that the 706(d) rules apply any time an interest in a partnership is sold, a new partner enters
the partnership by making a contribution, etc.
- We have a choice in how to allocate the items between N, O, and P. We can use either the closing of
the books method (default) or the proration method.
(a) How much income and loss must each partner include under the closing of the books method?
(i) January 1 September 30: Segment 1
N: $45k income (follow PA assume SEE)
O: $45k income
P: $0
(ii) October 1 December 31: Segment 2
N: $30k income; $20k 1231 loss (cant net w/ gain b/c of character)
O: $30k income; $20k 1231 loss
P: $30k income; $20k 1231 loss
- NOTE: troubled by fact loss allocated equally to all partner even though loss probably accrued b/f pat
joined, yet assigned portion
* This results in:
N $75k ordinary income; $20k 1231 loss
O $75k ordinary income; $20k 1231 loss
P $30k ordinary income; $20k 1231 loss
(b) How much income and loss must each partner included under the proration method?
Partner
Profit/Loss
Percentages
Months
Held Computation
Partners
Share
Net
Income/Loss
Nora
Income 50% 9 .50 (x) 9/12 (x) $180k $67,500
Income 33.3% 3 .333 (x) 3/12 (x) $180k $15,000 $82,500
Loss 50% 9 .50 (x) 9/12 (x) $60k ($22,500)
Loss 33.3% 3 .333 (x) 3/12 (x) $60k ($5,000) ($27,500)
Oliver
Income 50% 9 .50 (x) 9/12 (x) $180k $67,500
Income 33.3% 3 .333 (x) 3/12 (x) $180k $15,000 $82,500
Loss 50% 9 .50 (x) 9/12 (x) $60k ($22,500)
Loss 33.3% 3 .333 (x) 3/12 (x) $60k ($5,000) ($27,500)
Pat
Income 0% 9 0 0
Income 33.3% 3 .333 (x) 3/12 (x) $90k $15,000 $15,000
Loss 0% 9 0 0
Loss 33.3% 3 .333 (x) 3/12 (x) $60k ($5,000) ($5,000)
- technically should use days, i.e., 270/365, not months
* This results in:
N $82.5k ordinary income; $27.5k 1231 loss
O $82.5k ordinary income; $27.5k 1231 loss
P $15k ordinary income; $5k 1231 loss
* So which method should the partners choose? Whichever results in the lowest amount of taxes.
- Here, N and O want to use proration method b/c results in higher loss of $27,500
BUT, would want to know what tax bracket they are in if high, might rather want closing of
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the books b/c results in lower income
- Note that proration must be elected into by agreement of the partners (closing of the books is the
default method).
* HYPO: What if sell 1231 property?
b/f entry:
Book Basis FMV Book Basis
1231 $160k $160k $100k
N $80k $80k
O $80k $80k
After entry:
Revaluation: Reg. 1.704-1(b)(2)(iv)(f) dont elect to revalue and then fail to make allocations as if
had revalued, might be subject to changes
Creates $60K book loss to assign on revaluation each to N and O
1231 $100k $160k
N $50k $80k
O $50k $80k
P $50k $50k
Sell 1231 for $100k creates $0 book/gain loss and $60k tax loss
$60k tax loss assigned $30k each to N and O 704(c)
*Special Allocation and 706(d)
Does 706(d) prevent us from giving special allocation of $60K to P (1/3 of $180k)?
Cant do special allocation in Segment 1 when P was not a partner
BUT nothing to prevent from making special allocation from Segment 2 where P is partner (as
long as SEE)
(c) When is it likely that the partners will decide whether to elect to use the proration method?
- The closing of the books method is more exact, but the proration method is simpler. Thus, there are
more transaction costs associated with the closing of the books method, which often leads to use of the
proration method.
- Any pship or LLC that has a lot of turnover in partners or members will use the proration method.
- Note that the proration method, however, has its own problems.
In deciding whether to use proration, each partner must consider the effect of its inaccuracies
on his tax liability for the year.
When a partnership interest is disposed of in its entirety, the selling partner must bear in mind
that if the proration method is used, events occurring after the sale can significantly and
unexpectedly affect his tax liability for the year of the sale. (CB 176)
Problem 2: Ursula and Vanessa were equal partners in a partnership that used the cash method
of accounting and calendar year. Last year the partnership reported no taxable income or loss;
however, it incurred a $90,000 expense item that was not paid, but would have been deductible if
it had been paid. On June 1 of this year, William made a capital contribution to become a 1/3
partner. This year the partnership earned net taxable income of $36,000, at the rate of $3,000
per month, and in August it paid the $90,000 expense item.
706(d)(2): Items attributable to Prior Year For purposes of determining partners distributive share,
706(d)(2)(C) requires the payment to be treated as paid on the 1
st
day of the taxable year. Then,
706(d)(2)(D) requires allocation among partners according to their interest in the prior year to which
the payment was attributable.
Allocable cash basis items: generally, only applies to expense items
(a) What is each partners distributive share of income or loss for this year using the closing of
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the books method?
(i) January 1 May 31: (5 months x 3k = $15k)
- Treat prior years expense as paid on Jan 1 even though actually paid Aug 1 when W was a partner.
U: $7,500 income; $45k loss
V: $7,500 income; $45k loss
W: $0
(ii) June 1 December 31: (7 months x 3K = 21k)
U: $7k income
V: $7k income
W: $7k income
* This results in:
N $14,500 ordinary income; $45k loss
O $14,500 ordinary income; $45k loss
P $7k ordinary income; $0 loss
(b) What is each partners distributive share of income or loss for this year using the proration
method?
Partner
Profit/Loss
Percentages
Months
Held Computation
Partners
Share
Net
Income/Loss
U
Income 50% 5 .50 (x) 5/12 (x) $36k $7,500
Income 33.3% 7 .333 (x) 7/12 (x) $36k $6,993 $14,493
Loss 50% 12 .50 (x) 12/12 (x) $90k ($45,000) ($45,000)
V
Income 50% 5 .50 (x) 5/12 (x) $36k $7,500
Income 33.3% 7 .333 (x) 7/12 (x) $36k $6,993 $14,493
Loss 50% 12 .50 (x) 12/12 (x) $90k ($45,000) ($45,000)
W
Income 0% 5 0 0
Income 33.3% 7 .333 (x) 7/12 (x) $36k $6,993 $6,993
Loss 0% Last year 0 0
Nothing changes w/ expense items deemed paid on Jan 1 of current year, but look to interests of prior
year to assign
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CHAPTER 5: Allocation of Partnership Liabilities
SECTION 1 Allocation of Recourse Liabilities
Problem 1: Sean and Pat formed a general partnership. Sean contributed $50,000 in cash and
Pat contributed $40,000 in cash. Sean and Pat agreed to split profits and losses equally. The
partnership borrowed $100,000 from Cottage Savings Bank on a recourse (not necessarily for
purposes of 752) basis. What is the basis of each of Sean and Pat in their partnership interests?
* This problem illustrates what happens when have capital contribution ratio different from loss sharing
ratio. Basically, the regulations result in shifting to avoid 704(d) limitation problem.
S (50%) $50k SP General Partnership
P (50%) $40k (borrowed $100k w/ recourse)
Liability b/c cash
(i) Initially, the assets and capital accounts of the partnership look as follows, but we cannot determine
how the recourse debt is allocated among the partners until we perform the Reg. 1.752-2(b)
constructive liquidation:
Assets (inside basis) Liabilities: $100k
Property$190k $190k S $50k
P $40k
- The partners share partnership liabilities jointly and severally. Thus, Cottage Savings Bank could sue
S or P, or both S and P. If the bank collects from P, then P is entitled to contribution for S. How do we
know the amount of the contribution? First, look to the partnership agreement, otherwise state law will
provide the default rules. However, the partnership agreement almost always provides the answer.
- Reg. 1.752-2 tells us how to allocate debt for which partners bear the ROL (recourse debt).
Ultimately, the ROL question boils down to who bears the ROL in the worst possible scenario. If we
can answer this question, then we know what each partners share of the debt is. Note that this
construct does not work for nonrecourse debt b/c ultimately it is the lender, and not the partners, that
bear the ultimate ROL.
* Reg. 1.752-2(b)(1)(i)-(v) provides a series of mechanical steps for determining risk of loss:
(i) Assume all liabilities are due;
(ii) Assume that all partnership assets are worthless (including cash);
(iii) Assume the partnership disposes of all its assets for $0 (with one exception);
(iv) Allocate all items of income, gain, loss and deduction for book purposes; and
(v) The partnership is liquidated.
Ultimately, the above steps will tell us the partners final capital accounts in the worst case scenario,
which tells us who bears the ROL.
(ii) Assume the assets of the partnership become worthless and sell for $0: $190 cash w/ FMV of $0;
sell cash for $0 AR creates $190k book and tax loss. How do we allocate that loss between S and P?
The deal was to split profits and losses 50/50, which results in each partner being allocated $95k of the
hypothetical loss in the constructive liquidation.
Assets (inside basis) Capital Accounts (outside basis)
Book Basis Book
Property$0 $0 Debt $100k
S $50k - $95k = ($45k)
P $40k - $95k = ($55k)
*would need to ask if substantial economic effect? Here, we are to assume that the partners have
unconditionally agreed to restore a deficit capital account balance at liquidation - SBEE
- Thus, the partnership agreement says that S is at risk (or owes) $45k on the debt and P is at risk for (or
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owes) $55k on the debt (those amounts are allocated to each partner as their share of the debt).
Therefore, if the bank sued S and got a judgment for the entire $100k, then S would be entitled to
recover $55k from P.
(iii) Increase in Share of Partnership Liabilities:
Property$190k $190k Debt $100k
S $50k $50k + $45k = $95k
P $40k $40k + $55k = $95k
$190k $190k
- Section 752(a) provides than any increase in a partners share of the liabilities of a partnership will be
considered as a contribution of money by such partner to the partnership.
- Section 722 provides for an increase in the basis of contributing partners interest when a partner
contributes property, including money, to the partnership.
Thus, S and P are treated as having contributed to the partnership money in an amount equal to their
respective shares of the partnership debt they assumed, which increased their basis in their respective
partnership interests.
-704-1(b)(2)(iv)(c): treatment of liabilities
* Note how S and P ended up with the same outside basis, even though S contributed $50k and P
contributed only $40k. The mechanics of Reg. 1.752-2 avoid the potential pitfall of running into the
704(d) limitation problem down the road by self-adjusting. Recall how under the special allocation of
depreciation deduction materials a partner allocated more depreciation would eventually run into
704(d) limitation problem. However, under these regulations it is very difficult to run into such a
problem.
Problem 2: David and Ruth formed a general partnership to which they each contributed
$50,000 in cash. They agreed to split profits equally, but losses were to be allocated 60% to
David and 40% to Ruth. The partnership borrowed $100,000 from Hillsboro National Bank on a
recourse basis. What is the basis of each of David and Ruth in their partnership interests?
D -- $50k DR Partnership (general) borrowed $100k (recourse)
R -- $50k Profits: 50/50
Losses: 60% to D and 40% to R.
D $50k $50k +?
R $50k $50k +?
* Here, the partners put in equal amounts and agreed to share profits equally, but they have different
allocation of losses.
(i) What is each partners respective share of the recourse debt?
Assume that all partnership assets are worthless (including cash);
Assume the partnership disposes of all its assets for $0 (with one exception);
$0 - $200 = ($200)
Allocate ($200) loss based on partnership agreement
The partnership is liquidated triggers deficit restoration obligations
D must put in $70k and R must put in $30k
Thus, those amounts increase tax basis
* Assume a constructive liquidation (Reg. 1.752-2(b)), which results in a loss of $200k that must be
allocated pursuant to the partners loss sharing ratio:
60% to D = $120k
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40% to R = $80k
(ii) Allocate Loss
Book Basis Book
D $50k - $120k = ($70k)
R $50k - $80k = ($30k)
(iii) Determine Partners respective bases in partnership interest:
D $50k $50k + $70k = $120k
____ ____ R $50k $50k + $30k = $80k
$200k $200k $200k $200k
- The effect of the above allocations is that there is zero possibility of running into the 704(d)
limitation.
* If D and R each sold their partnership interests immediately after assuming the debt they would be
relieved of $70k and $30k debt, respectively, and recover their $50k cash contributions.
D E
AR $120k $80k $50k cash + amount of debt relief
AB $120k $80k $50k cash + amount debt assumed
$0 $0 gain realized or recognized
* Would that fact that either D or R were insolvent affect our allocation of the debt? No, Reg.
1.752-2(b)(6) tells us that for purposes of determining the extent to which a partner or related person
has a payment obligation and the economic risk of loss, it is assumed that all partners and related
persons who have obligations to make payments actually perform those obligations, irrespective of their
actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the
obligation (see Reg. 1.752-2(j)).
- Thus, no need to inquire into net worth of partners and their ability to pay. But if D was insolvent, R
really would bear all the risk of loss since the bank could see R jointly and severally and obtain the
entire $100k from R and R could recover nothing from insolvent D. However, this possibility does not
affect the allocation of the debt.
* Is there anything else we need to pay attention to in Problems 1 and 2 (is there anything that could
throw off our allocations based on capital accounts)? Yes, we need to know if there are any contracts
between the partners that alter the risk of loss provided in the partnership agreement (see Reg.
1.752-2(b)(5)).
- Suppose that A, B, C, D and E are equal partners and agree to share profits and losses 1/5 each. If B
made a deal with A to cover any loss to A, the partnership debt would be allocated $0 to A (b/c A bears
no risk of loss), 2/5 to B, and 1/5 to C, D, and E.
- Point Remember to ask clients if there are any other documents or agreements outside of the
* Example: What happens when the partnership earns $10k of income and the partners pay down the
note $10k?
Asset $200k $200k Debt $100k
D $50k $120k
R $50k $80k
- First, $5k is added to each partners capital account. The debt then gets reduced down when the
77
partners pay the note. Remember that capital accounts are in essence each partners equity in the
partnership. Thus, if they use income to pay down debts, the total does not change.
- Finally, determine how this affects each partners basis:
D $55k $120k + 5 5 = $120k
R $55k $80 + 5 5 = $80k
$5k income allocated to each (+ $5k) and $5k reduction in share of debt which is a deemed distribution
to each (- $5k).
Capital Accounts
D R
$55k $55k Book
$120k $80k Tax Basis
($65k) ($25k) $90k debt
- D: share of the debt went from $70k to $65k, which is a reduction of $5k.
- R: share of the debt went from $30k to $25k, which is a reduction of $5k.
- Thus, basis remained unchanged at $120k and $80k.
- Remember to go through the hypothetical transaction (constructive liquidation) to determine what
went on and how to properly allocate the debt. Cannot say that if the partners pay down the debt, then
reduce their share 50/50 (be careful of short hand rules of thumb track the regulation).
- Constructive Liquidation: $200k loss allocated pursuant to loss sharing ratio:
60% to D = $120k
40% to R = $80k
Book Basis Book
D $55k - $120k = ($65k)
R $55k - $80k = ($25k)
D $55k $55k + $65k = $120k
R $55k $55k + $25k = $80k
* Example: What happens if in year 2 the partnership has $10k of cash ($10k of the asset is now cash)
and pays down the debt $10k?
(i) Before paying down debt:
Cash $10k $10k D $55k $120k
R $55k $80k
(ii) After paying down debt:
D $55k
R $55k
78
- Now we must figure out each partners share of the debt for this year.
(a) Constructive liquidation = $190k loss:
60% to D = $114k
40% to R = $76k
(b) Share of debt
Book Basis Book
D $55k - $114k = ($59k)
R $55k - $76k = ($21k)
(c) Partners Bases:
D $55k $55k + $59k = $114k
R $55k $55k + $21k = $76k
- Thus, of the $190k total basis:
Ds $114k = 60%
Rs $76k = 40%
Problem 3: Juan, Kimberly, and Maurice form a partnership to invest in commercial real estate.
Kimberly and Maurice each contribute $50,000 in cash to the partnership. Juan forms a LLC, in
which he is the sole member. The LLCs assets are limited to $90,000 of cash. The Juan LLC
contributes $50,000 of cash to the JKM Partnership. The partnership borrows $1 million with
full recourse to the partnership and purchases an office building for $1.15 million. The partners
share all partnership items equally, 1/3 each. The partnership agreement provides for properly
maintained capital accounts, liquidation in accord with capital accounts, and that each partner is
responsible for repayment of the partners capital account deficit, if any. What is each partners
basis in the partnership interest?
J -- $90k cash J LLC -- $50k cash
K -- $50k cash JKM Partnership
M -- $50k cash $1 million loan (recourse)
buys office $1.15 million
Building$1,150,000 $1,150,000 Debt $1 million
J LLC $50k $50k +
K $50k $50k +
M $50k $50k +
(ii) The partnership borrowed $1 million pursuant to recourse loan, so need to allocate that debt to the
partners (going from $0 debt to $1 million debt).
- The problem here is that under Prop. Reg. 1.752-2(k) the LLCs risk of loss is limited to the amount
of assets in the LLC ($40k). Thus, J LLC should not get 1/3 of the basis. The J LLC bears the risk of
loss for only $40k of the $1 million recourse loan, which leaves $960k of debt to allocate between K
and M ($480k each).
Building$1,150,000 $1,150,000 Debt $1 million
J LLC $50k $50k + $40k = $90k
K $50k $50k + $480 = $530k
M $50k $50k + $480 = $530k
$1.15m $1.15m
- Insertion of LLC screams plan to circumvent/avoid the obligation under Reg. 1.752-2(b)(6).
- Analyze under Reg. 1.752-2(k)
Max that can be used to increase basis but doesnt tell you how much
79
Must do constructive liquidation test
$1M debt due
Building worth $0
Partnership sells building generates Loss of $1.15M
Exception does not apply b/c applies to NRC debt (can only go after this
asset)
Allocate loss
What if tried to allocate according to agreement? 1/3 each ($383,33)
J would end up with negative capital account
Here, we allocate $50K and $40K to J (up to extent of net asset value inside
LLC: $90K)
NOTE: substantial economic effect Reg. 1.704-1(b)(2)(ii)(c)
If not expressly obligated
Treat them as having deficit restoration obligation to
extent responsible for repayment
Other partners allocated based on partners interest in partnership
Here, 50/50 ($529,999.50)
Subtract those amounts from BV
50-90= (40)
50-530=(480)
50-530=(480)
Liquidate: triggers partners obligation
J must pay $40
KM must each pay $480
Represents economic ROL, which tells us their share of liabilities
Increase in share of liabilities gives basis under 752(a) treat as
contribution of money
Add those amounts to each partners outside basis
SECTION 2 Allocation of Nonrecourse Debt
Problem 1: Art contributed $10,000, and Beverly, Chuck, and Darlene each contributed $30,000
to the ABCD partnership, which then borrowed $900,000 to purchase a building for $1 million.
The partners share all items of income and deduction in proportion to their respective capital
contributions.
* Reg. 1.752-3(a) provides three tiers for allocations of nonrecourse debt:
- (1) To each partner equal to that partners share of minimum gain (excess of loan over book when
book and tax differ);
- (2) To each partner equal to that partners 704(c) gain if the partnership conveyed the property to
the lender is satisfaction of the mortgage and for no other consideration; and
- (3) Excess nonrecourse liabilities (those not allocated under (1) and (2)) according to profit sharing
per the partnership agreement. However, if the partners desire to allocate differently than profit sharing
ratio, they may do so by (1) providing for a different allocation of excess nonrecourse liabilities in the
partnership agreement, (2) allocating per nonrecourse deductions, or (3) first allocating an excess
nonrecourse liability to a partner up to the amount of built-in gain that is allocable to that partner under
704(c).
- Note how there is no flexibility/choice in (1), but there is the possibility of flexibility in (2) and (3)
when drafting the partnership agreement.
- Example of (2): Partner contributed property with FMV $100, AB $20 ($80 built-in gain), and
nonrecourse debt $60. How much of the debt is allocated to the partner under the second component?
$60 is the default rule. Note that there is an alternative rule that would allow us to allocate all of the
704(c) gain ($80).
* Initial Balance Sheet:
80
Property $1 mil $1 mil Debt $900k
A $10k
B $30k
C $30k
_____ _____ D $30k
$1 mil $1 mil $1 mil
(a) The partnership is a general partnership and the loan is a recourse loan. What is each
partners basis in the partners partnership interest?
- We need to figure out (i) each partners share of the partnership debt and then (ii) determine each
partners tax basis.
- Here we have a recourse debt, so determine partners share of recourse liability under Reg. 1.752-2.
Reg. 1.752-2(b) says to determine using constructive liquidation, which means assume all the
partnership assets, including cash, become worthless.
(i) Constructive Liquidation:
- If assets become worthless, then partnership has $1 million loss which flows through to the partners:
10% to A = $100k loss
30% to B, C, and D = $300k loss each
Capital Account Share of Loss
A $10k ($100k) = ($90k)
B $30k ($300k) = ($270k)
C $30k ($300k) = ($270k)
D $30k ($300k) = ($270k)
(ii) Increase in Share of Partnership Liabilities:
Partners each bear economic risk of loss for this amount. Therefore, there tax basis is increased by the
amount of the debt for which they bear the economic risk of loss because they are treated as each
contributing cash in an amount equal to the increase in their share of the debt ( 752(a)).
A $10k $10k + $90k = $100k
B $30k $30k + $270k = $300k
C $30k $30k + $270k = $300k
_____ _____ D $30k $30k + $270k = $300k
$1 mil $1 mil $1 mil $1 mil
(b) The partnership is a limited partnership, Art is the general partner and the others are limited
partners, and the loan is a recourse loan. What is each partners basis in the partners
partnership interest?
- Again have recourse loan so under Reg. 1.752-2.
(i) Constructive Liquidation:
- If assets become worthless, then partnership has $1 million loss which flows through to the partners.
However, only A bears the economic risk of loss with respect to the loan because B, C, and D have no
obligation to restore a negative capital account (limited partners). Therefore, As capital account can
go to negative $900, while B, C, and Ds cannot go below $0.
Capital Account Share of Loss
A $10k ($910k) = ($900k)
B $30k ($30k) = $0
C $30k ($30k) = $0
D $30k ($30k) = $0
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Partners each bear economic risk of loss for this amount. Therefore, there tax basis is increased by the
amount of the debt for which they bear the economic risk of loss because they are treated as each
contributing cash in an amount equal to the increase in their share of the debt ( 752(a)).
A $10k $10k + $900k = $910k
B $30k $30k + $0k = $30k
C $30k $30k + $0k = $30k
_____ _____ D $30k $30k + $0k = $30k
- What does this do to the partners original plan to split profits and losses in proportion to their capital
contributions? B, C, and D will not get to take depreciation deductions or pass through losses beyond
the initial $30k they contributed because of 704(d) limitation on allowance of loss to adjusted basis of
partners interest in the partnership. Thus, from a planning perspective, their plan to share profits and
losses does not work under this arrangement if the partnership has losses.
(c) The partnership is a general partnership and the loan is a nonrecourse loan secured by the
building. What is each partners basis in the partners partnership interest?
- Here, there is a nonrecourse debt so under Reg. 1.752-3.
(i) Reg. 1.752-3(a): Partners Share of Nonrecourse Liabilities:
- 752(a) says treat increase in share of debt as a cash contribution. So what is each partners increase
in their share of partnership debt?
- (a)(1) Minimum Gain: No minimum gain here because loan is $900k, but property is booked in at $1
million.
- (a)(2) 704(c) gain: None because partnership purchased property, it was not contributed by a
partner.
- (a)(3) Excess Nonrecourse Liabilities Allocated According to Partners Share of Partnership Profits:
Excess Nonrecourse Liabilities = $900k
10% to A = $90k
30% to B = $270k
30% to C = $270k
30% to D = $270k
A $10k $10k + $90k = $100k
B $30k $30k + $270k = $300k
C $30k $30k + $270k = $300k
_____ _____ D $30k $30k + $270k = $300k
- Note that this is the same result as in Problem 1(a), but that none of A, B, C, or D is liable on the debt
(nonrecourse), but there is a non-tax disadvantage from Problem 1(b) because now B, C, and D are no
longer insulated from partnership liabilities because they are general partners.
(d) The partnership is a limited partnership, Art is the general partner and the others are limited
partners, and the loan is a nonrecourse loan secured by the building. What is each partners
basis in the partners partnership interest?
A $10k $10k + $90k = $100k
B $30k $30k + $270k = $300k
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C $30k $30k + $270k = $300k
_____ _____ D $30k $30k + $270k = $300k
- Exact same result as Problem 1(c). The only difference between this problem and the last one is that
here B, C, and D are limited partners insulated from the partnerships liabilities. Note how the type of
partnership is not affecting the share of debt distributions for nonrecourse liabilities as it did for
recourse liabilities.
- We could do even better by making the limited partnership an LLC and getting A limited liability
also.
(e) What is the result in (d) if the debt is nonrecourse but Art, the sole general partner,
personally guarantees the loan?
- Here, the debt is nonrecourse as to the entity, but A has personally guaranteed the debt. This takes the
debt out of Reg. 1.752-3 allocation of nonrecourse debt and puts it into Reg. 1.752-2 allocation of
recourse debt because A now bears the economic risk of loss with respect to the borrowed funds.
A $10k $10k + $900k = $910k
B $30k $30k + $0k = $30k
C $30k $30k + $0k = $30k
_____ _____ D $30k $30k + $0k = $30k
- Why isnt As guarantee offset by subrogation rights (the substitution of one party for another whose
debt the party pays, entitling the paying party to rights, remedies, or securities that would otherwise
belong to the debtor), as would happen if a limited partner guaranteed the partnership debt? Because A
is subrogated to the banks rights against the partnership. Subrogation means that the guarantor steps
into the original lenders shoes, and the original lenders rights were only to take the property, not sue
the partners. Thus, assuming the property becomes worthless, A can only take the property, not sue the
partners.
- As a result, we are running into the same potential 704(d) limitation if the partnership is running at a
loss because B, C, and D will only be allowed to take deductions and losses to extent of their $30k
basis in partnership interest. However, if the partnership is running at a profit, then no one cares how
the debt is allocated.
(f) What is the result in (d) if the debt is nonrecourse but Art, the sole general partner, personally
guarantees up to $500,000 of the nonrecourse debt.
- A personally guarantees $500k of the $900k nonrecourse debt. Therefore, that $500k becomes
recourse, as in the last problem, and is allocated pursuant to Reg. 1.752-2. The remaining $400k of the
loan remains nonrecourse and is allocated pursuant to Reg. 1.752-3. See Reg. 1.752-2(f), Ex. (5) for
authority to bifurcate the loan.
(i) $500k Recourse Reg. 1.752-2:
- A is allocated this $500k because A bears the risk of loss.
(ii) $400k Nonrecourse Reg. 1.752-3:
- (a)(1): No minimum gain
- (a)(2): No 704(c) built-in gain or reverse 704(c) revaluation.
- (a)(3): Excess nonrecourse liability = $400k, allocated pursuant to profit sharing.
10% to A = $40k
30% to B, C, and D = $120k to each.
(iii) Total Increase in Share of Partnership Liabilities:
Property $1 mil $1 mil Debt $900k R NR
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A $10k $10k + $500k + $40k = $550k
B $30k $30k + $0k + $120k = $150k
C $30k $30k + $0k + $120k = $150k
_____ _____ D $30k $30k + $0k + $120k = $150k
- Note that the partners have $100k of equity in the partnership (contributed $100k cash). Therefore,
the first $100k in depreciation deductions are not nonrecourse deductions under the 704(b)
regulations.
- However, after the basis of the property is reduced to $900k, the next deductions are nonrecourse
deductions because they are grounded in nonrecourse debt (attributable to basis in partnership interest
created by nonrecourse borrowing). But A guaranteed $500k of the nonrecourse loan and made $500k
of it recourse. Therefore, there are $500k of deductions to A that are not nonrecourse deductions.
- The question then becomes which deductions occur first, the recourse or nonrecourse deductions (the
answer to this question affects who gets the deductions A recourse; A, B, C, and D nonrecourse).
This is a question that should be answered by what is written in the contracts, but remember it only
becomes important when the partnership is expecting losses.
(g)(1) What is the result in (b) if Beverly, a limited partner, personally guarantees the recourse
debt?
- Now we have a limited partner personally guaranteeing the recourse loan. See Reg. 1.752-2(f), Ex.
(3), which provides that the recourse loan is shared pursuant to Reg. 1.752-2, because one or more
partners bears the economic risk of loss.
- The general partner, A, is assumed to satisfy the obligation, regardless of his actual financial situation,
and, therefore, it is also assumed that B will never have to satisfy his guarantee. Thus, the $900k loan
is allocated $900k to A and $0 to B, C, and D.
A $10k $10k + $900k = $910k
B $30k $30k + $0k = $30k
C $30k $30k + $0k = $30k
_____ _____ D $30k $30k + $0k = $30k
(g)(2) What is the result in (d) if Beverly, a limited partner, personally guarantees the
nonrecourse debt?
- Now we have B, a limited partner, personally guaranteeing a nonrecourse loan. Here, B receives
$900k of the debt allocation.
Property$1 mil $1 mil Debt $900k
A $10k $10k + $0k = $10k
B $30k $30k + $900k = $930k
C $30k $30k + $0k = $30k
_____ _____ D $30k $30k + $0k = $30k
(h) What is the result in (d) if each partner personally guarantees a proportionate share of the
nonrecourse debt?
- See Abramson v. Commr (TC 1986) Under prior regulations, limited partners who personally
guaranteed a pro rata part of partnership nonrecourse debt were allowed to increase their respective
bases in their partnership interests under 752(a) by the amount of debt which they guaranteed.
- Thus, A guarantees $90k and B, C, and D guarantee $270k:
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Property$1 mil $1 mil Debt $900k
A $10k $10k + $90k = $100k
B $30k $30k + $270k = $300k
C $30k $30k + $270k = $300k
_____ _____ D $30k $30k + $270k = $300k
- Note that each partner bears some economic risk of loss with regard to the nonrecourse debt.
Therefore, the debt is a recourse debt as defined by Reg. 1.752-1(a)(1) and is shared between the
partners pursuant to Reg. 1.752-2.
- A great compromise was reached between the partners and the bank in this situation. The bank is
certain that the debt will be repaid in full and each partner knows that his liability is no more than his
proportionate share. Thus, we are right back to the allocation in Problem 1(a), but each partner is not
on the hook to the bank for the entire amount of the debt.
- Note that generally speaking for limited partnerships and LLCs, getting basis is pyrrhic victory
because the members or limited partners have become at risk for the debt. Problem 1(h), however, gets
us around this problem to some extent because each partner is only liable for a portion of the debt.
Problem 2: Elvira and Fred formed a limited partnership in which Elvira is the general partner
and Fred is the limited partner. Elvira contributed $10,000 for a 20% interest in partnership
income and loss and Fred contributed $40,000 for an 80% interest in partnership income and
loss. The partnership borrowed $850,000 pursuant to a nonrecourse loan and constructed an
office building on leased land at a cost of $900,000. Interest on the loan is payable annually, but
the principal is not due for 30 years. Assume that the cost recovery period for the building is 30
years, the method is straight line. The partnership agreement contains all of the provisions
necessary for allocations of deductions based on nonrecourse debt to be respected. The
partnerships gross income exactly equals its deductible cash flow expenses, so each year the
partnership reports a loss of $30,000 attributable to depreciation deductions.
What are Elviras and Freds respective shares of the nonrecourse debt, and their respective
basis in their partnership interests
* The point of this problem is to show how Reg. 1.752-3(a)(1)-(3) works:
Building$900k $900k Debt $850k
E (1/5) $10k
F (4/5) $40k
(a) Immediately after the debt was incurred?
(i) What are partners respective shares of the nonrecourse debt?
* Reg. 1.752-3(a): Partners share of nonrecourse liabilities = sum of:
(1) partners share of minimum gain = $0
(2) partners share of taxable gain allocated under 704(c) = $0
(3) partners share of excess non-recourse liabilities determined in accordance with partners
share of partnership profits = $850k split 20/80
E allocated $170k of nonrecourse debt
F allocated $680k of nonrecourse debt
(ii) Partners respective basis in their partnership interests?
E (1/5) $10k $10k + $170k = $180k
_____ _____ F (4/5) $40k $40k + $680k = $720k
$900k $900k $900k $900k
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- Note that it doesnt really matter that one partner, F, is a limited partner and the other partner, E, is a
general partner because the debt is nonrecourse.
(b) At the end of the second year?
- (1) Share of Minimum Gain: After two years the property has been depreciated to $840k but the debt
is still $850k. Therefore, there is $10k of minimum gain to allocate between the partners:
E is allocated $2k of minimum gain
F is allocated $8k of minimum gain
- (2) Share of 704(c) = $0 (no property contributed or revalued)
- (3) Share of Excess Nonrecourse Liabilities: $850k of nonrecourse liabilities, but $10k allocated
under (a)(1). Thus, $840k of excess nonrecourse liabilities:
$168k allocated to E
$672k allocated to F
* Need to figure out each partners share of the debt to determine if there was any change in the share
of debt. Thus, Reg. 1.752-3(a) allocation:
E F
(a)(1) Minimum gain $2k $8k $10k total
(a)(2) 704(c) $0 $0 $0k total
(a)(3) Excess $168k $672k $840k total
$170k $680k 20%/80% split
Thus, no change in 20/80 debt sharing ratio here.
- Partners Capital Accounts:
Book Basis
E F E F
- Initial $10k $40k $180k $720k
- Depreciation ($12k) ($48k) ($12k) ($48k) $60k (20/80)
($2k) ($8k) $168k $672k
- Note that the ($2k) and ($8k) book is each partners share of the $10k minimum gain.
E (1/5) ($2k) $168k
_____ _____ F (4/5) ($8k) $672k
$840k $840k $840k $840k
(c) At the end of the third year?
- (1) Share of Minimum Gain: After three years the property has been depreciated to $810k but the debt
is still $850k. Therefore, there is $40k of minimum gain to allocate between the partners:
under (a)(1). Thus, $810k of excess nonrecourse liabilities:
$162k allocated to E
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$648k allocated to F
E F
(a)(2) 704(c) $0 $0 $0k total
$170k $680k 20%/80% split
Book Basis
E F E F
- Initial $10k $40k $180k $720k
- Depreciation ($18k) ($72k) ($18k) ($72k) $90k (20/80)
($8k) ($32k) $162k $648k
- Note that the ($8k) and ($32k) book is each partners share of the $40k minimum gain.
E (1/5) ($8k) $162k
_____ _____ F (4/5) ($32k) $648k
$810k $810k $810k $810k
(d) At the end of 30 years?
- (1) Share of Minimum Gain: After thirty years the property has been fully depreciated to $0k but the
debt is still $850k. Therefore, there is $850k of minimum gain to allocate between the partners:
under (a)(1). Thus, $0k of excess nonrecourse liabilities.
E F
(a)(2) 704(c) $0 $0 $0k total
$170k $680k 20%/80% split
- Note how holding the property over its entire depreciable life moves everything from the third tier to
the first tier.
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Book Basis
E F E F
- Initial $10k $40k $180k $720k
- Depreciation ($180k) ($720k) ($180k ($720k) $900k (20/80)
($170k) ($680k) $0k $0k
E (1/5) ($170k) $0k
_____ _____ F (4/5) ($680k) $0k
$0k $0k $0k $0k
Problem 3: Gloria and Hank are equal partners in the GH partnership. The partnership owns
Whiteacre, which has a basis of $90,000 and a FMV of $120,000. Whiteacre is subject to a
nonrecourse mortgage of $108,000. Ira contributed $12,000 to become a partner, and Glorias
and Hanks interests in profits and losses were reduced to . In connection with Iras admission
to the partnership, the partnership revalued its assets and capital accounts for book purposes.
What are the respective partners shares of the nonrecourse debt and their bases in their
partnership interests after Iras admission to the partnership?
(i) When story begins:
- Reg. 1.752-3(a):
(1) $18 min gain: $108 debt > $90 book value:
$9k to G (because equal partners)
$9k to H (because equal partners)
(2) $0 704(c) gain
(3) $90 Excess nonrecourse liabilities:
$45k to G
$45k to H
Whiteacre $90k $90k Mort $108k
G (1/2) ($9k) $45k
____ ____ H (1/2) ($9k) $45k
$90k $90k $90k $90k
(ii) Admit Ira: When Ira is admitted, the partnership revalued its assets and capital accounts for book
purposes.
Cash $12k $12k G (1/4) $6k $45k
H (1/4) $6k $45k
I (1/2) $12k $12k
- The revaluation created a book-tax disparity, which created reverse 704(c) gain. The book and tax
values of the property in the hands of the partnership were originally both $90k. Therefore, there was
no 704(c) gain. However, the property must have appreciated in value during the time the partnership
held the property. That appreciation in value prior to I joining the partnership (reverse 704(c) gain)
must be allocated between G and H in proportion to their interests prior to I joining the partnership
(50/50).
- Assign $30k book gain to G and H $15k each increase their book values
Tiers
* Before Ira was admitted the allocation of nonrecourse debt was as follows:
Reg. 1.752-3(a) G (1/2) H (1/2)
(1) Minimum Gain $9k $9k $18k
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(2) 704(c) $0k $0k $0k
(3) Excess $45k $45k $90k
$54k $54k $108k
* After Ira was admitted the allocation of nonrecourse debt was as follows:
Reg. 1.752-3(a) G (1/4) H (1/4) I (1/2)
(1) Minimum Gain $0 $0 $0 $0
(2) 704(c) $9k $9k $0 $18k
(3) Excess $22.5k $22.5k $45k $90k
$31.5k $31.5k $45k
- Minimum gain = $0: Book $120k > Debt $108k
Decrease in PMG due only to revaluation does NOT trigger gain chargeback
Instead, special rule 1.704-2(d)(4)
Start w/ decrease then add back amount arising solely from the revaluation
See also, 1.704-2(g)(1)
- Reverse 704(c) gain = $18k: If property were conveyed to lender in satisfaction of debt, the AR of
$108k but AB (tax basis) of only $90k, which means $18k of reverse 704(c) gain.
$9k to G
$9k to H
I gets nothing
- Excess nonrecourse liabilities = $90k: $108k NR liabilities - $0k allocated under (a)(1) - $18k
allocated under (a)(2).
$22.5k to G (1/4 profits interest)
$22.5k to H (1/4 profits interest)
$45k to I (1/2 profits interest)
NOTE: Tier 3 imagine sold at 120 instead of 108, which gives additional $12k reverse
704(c) to allocate equally to G and H; then, remaining excess 90-12 = 78 would go to I and
to each G and H. Reg. 1.752-3(a)(3)
- Note how when the partnership booked the property up, the $9k allocation in the first tier dropped to
the second tier.
- 752(b) deemed distribution/contribution Thus, Gs and Hs share of the nonrecourse debt
decreased $22.5k (from $54k to $31.5k), and is a deemed distribution under 752(b) which will
decrease their bases in their partnership interests, and Is share of the nonrecourse debt increased $45k
(from $0 to $45k), and is a deemed cash contribution which will increase his basis in his partnership
interest.
Cash $12k $12k G (1/4) ($9k) $45k $22.5k = $22.5k
H (1/4) ($9k) $45k $22.5k = $22.5k
I (1/2) $12k $12k + $45k = $57k
- The reverse 704(c) allocation in the second tier is important for G and H because it plays a critical
role in avoiding the immediate recognition of gain by the old partners when they bring in a new partner
with money to save the project. Basically, it is a deferral mechanism that causes G and H to avoid
immediately recognizing gain.
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Chapter 8 Sales of Partnership Interests by Partners
SECTION 1 Sellers Side of Transaction
Problem 1: Blake is general partner in BCD. Charlie and Dave are limited partners. Blakes
interest is 20%, basis is $200 and FMV is 300. C & Ds are 40% each, basis is 400 each, FMV
600. No debts and distributes taxable income currently.
(a) B buys of Cs LP interest for $300. What are the tax consequences to C?
AR: $300
AB: $200
Gain $100
Basis: apportioned selling of interest so use of basis (300/600 x 400 = 200)
Gain will be capital assuming not inventory/receivables, but cant tell if its ST or LT based on
facts
(b) B buys all of Cs LP interest for $600, follow which B sells all of the LP interest to D for $300.
What are the tax consequences to B?
(i) After Sale to B:
AR: $600
AB: $400
Gain: $200
(ii) Sale to D:
AR: $300
AB: $267
Gain: $33
Bs unitary basis in both interests = $800 assign by relative FMV
300/900 (value of GP interest/total value of all interest) x 800 (basis) = $267
Fractionated Holding Period: Reg. 1.1223-3
When buy asset w/ cash, dont get tacked holding period thus, for 2/3 of interest,
only held from point when bought assume ST
Assume 1/3 was LT
Gain would be divided the same way
2/3 ST: 22
1/3 LT: 11
(c) B buys all of Cs LP interest for $600, following which B sells all of the LP interest to E (new
partner) for $300. What are the tax consequences to B?
Unitary basis: $800
Reg. 1223-3 applies as purchasing interest fractioned rule for holding period
(a): acquired portions of interest at different times OR multiple property contributed at same
time but w/ different holding periods Here, applies b/c
(b)(1): FMV of portion of pship interest recd/FMV of entire pship interest determined
immediately after the transaction
Here, 600/900 = 2/3 treated as newly acquired; remaining 1/3 is long term
(b)(3): dont worry about deemed contributions and distributions dont recomputed holding
period
(c): use same holding period at time acquired interest when go to sell
(2)(ii): divided holding period use same fraction when sell
(d): same rules for distributions use same ratio
Thus, here holding periods
2/3: ST
1/3: LT
90
AR: $600
AB: $533 (600/900 x 800) determined by relative FMV at time of sale
Gain: $67
2/3 x 67 = 45 ST
1/3 x 67 = 22 LT
Problem 2: Ernesto and Fran are general partners in EF. Ernesto contributed 1K for 1/3
interest. Fran contributed 2K for 2/3 interest. Partnership borrowed 1.2K to invest in securities,
which it purchased for 4.2K. When assets appreciated to 4.8K, Ernesto sold of his general
partnership interest to Gary for $600 cash. Tax consequences to Ernesto?
Securities $4,200 $4,200 Debt $1,200
E (1/3) $1,400 $1,400
_____ _____ F (2/3) $2,800 $2,800
$4,200 4,200
NOTE: Sale/exchange of partnership interest is NOT listed as circumstance for revaluation
AR: When E sells partnership interest for $600, he also is discharged from debt of x $400=$200.
Total AR =$800.
Basis: E has 1K contribution basis, and F has 2K contribution basis. Debt is 1.2K, and $400 debt is
allocated to E and $800 to F. When the debt is assumed, 752 increases basis when a partner increases
their liabilities. Thus, Es basis with assumption of debt is $1,400.
Rev. Rul 84-53-situation #2 b/c share of debt ($400) does NOT exceed his AB ($1,400)
Step 1: remove debt from basis $1,400-$400 = $1K.
Step 2: apportion $1,000 basis $1,000 x interest being sold = $500.
Step 3: add in debt share tied to interest being sold $500 + $200 ( share of
liability) =$700.
Gain: $800 (AR) - $700 (AB) = $100
Character: CG, but dont know when acquired so cant tell, Luke says probably LT
Problem 3: Ken owns 1/3 interest in KLM partnership, which develops real estate. Partnership
both constructs real estate for sale to customers and holds real estate for rental purposes.
(a) KLM uses cash method. Tax consequences to Ken if on Jan. 1, Ken sells his partnership
interest to Niki for 180K in cash?
Identify Unrealized A/R and inventory A/R and Store building
AR: $180k
Constructive sale at FMV
A/R: $60,000 - $0 = $60,000
Store: $180,000 - $150,000 = $30,000
Total: $90,000
1/3 to K b/c 1/3 interest in pship $30,000
K must pay tax on $30k of OI
Compute gain from sale: $180,000 (AR) - $110,000 (AB) = $70,000 total gain
$70,000 - $30,000 = $40,000 CG
(b) Tax consequences if on Jan. Ken sells partnership interest to Niki for 180K?
Same $30K OI as above
Total Gain from sale: $180k - $190k = ($10k)
Reconcile: ($10k) - $30k = ($40k) CL
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(c) KLM uses accrual method. Tax consequences to Ken if he sells his partnership interest to
Niki for 180K?
Accounts receivable under accrual method is not unrealized, so no ordinary income on accounts
receivable.
Constructive Sale of Store at FMV: $180k - $150k = $30k x 1/3 = $10k K must pay tax on $10k OI
Compute gain from sale: $180k - $130k = $50k
Reconcile: $50k - $10k = $40k CG
Problem 4: O & P are equal partners. LLC has a concession to operate a marina on a lake in a
national park. Uses accrual method. Each member earns and withdraws over 100K annually.
Gain in rental boats is 1245 gain, none of gain inherent in marina is 1245. Pams basis is 200K.
Sold interest for 600K (AR). Extra $250 that she is getting outside of the assets. How much is
ordinary income under 751?
Unstated intangible on books value of $500,000
Classify intangible either goodwill, receivable or both
We would need to know formal terms pship using
In sales agreement, did P/Q allocate any of purchase price
Racetrack Case: In sale K, term 7 parties acknowledge no consideration
giving to goodwill (CB 288)
Cant disavow in most circuits
Also, need to look at concession K is a right to earn OI?
Turns on facts and circumstances
CB 286/7
Here, we are assuming all unrealized receivable and NOT goodwill
Constructive sale at FMV
Unstated: $500,000
Inventory: $10,000
Rental boats w/ 1245 recapture: $40,000
Total: $550k
Ps share: $550k x = $275k OI
Total gain from sale: $600k - $200k (AB) = $400k
Reconcile: $400k - $275k = $125k CG
Drafting tip: If you have a purchase and sale agreement, call it goodwill in the agreement to get capital
treatment not
SECTION 2 Purchasers Side of the Transaction: Basis Aspects
Problem 1: A & B are equal partners. ABs assets: Cash-10K basis & FMV. AR-20K and FMV
50K. Inventory-50K basis and 80K FMV. Equipment 80K basis and 130K FMV. Good will $0
basis and 60K FMV. AB owes bank 30K and 2K to trade creditors. Cliff purchases Alexs
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partnership interest for 150K.
$20k trade payables b/c CMTP do not qualify as 752 debt
List as (2k) under book and nothing under FMV
Cash $10k $10k
AR $20k $50k A $65k $80k
Inv. $50k $80k B $65k $80k
Equip. $80k $130k
Goodwill $0 $60k
Total $160k $330k
Payable ($2k) ---
Partner BV
160 (total aggregate asset BV) 30 (debt) = 130/2 (b/c 2 partners) = $65k BV
Partner Basis
(a) What is Cliffs basis in partnership interest?
742-person buying an interest in the partnership has a basis for her partnership interest equal to
its cost (includes amount paid + any liabilities under 752(d).
C basis = $150k + $15k (his share of debt = of $30k)
Cs BV: just takes over As BV
Book Basis
B $65k $80k
C $65k $165k
(b) Should Cliff request a 754 election be made? Why? Compare effects on C if election made and
not made.
Tell to elect b/c doesnt have to recognize gain
Would be taxed twice if didnt make election
Amount of Adjustment: Outside ($165k) share of inside ($80k) = adjustment of $85k
Share of inside: $160k/2 = $80k
Positive adjustment
Assign $85k Adjustment
b/t the classes Reg. 1.755-1(b)(2)(i)
$55k ordinary
Sell A/R, Inv, and Equipment for FMV then split in half
$30k + $30k + $50k = $110k/2 = $55k
Divide by 2 b/c only adjusting Cs basis
Includes equipment b/c 1245 recapture
$30L capital
Sell goodwill then split in half
$60/2 = $30
Dont do anything w/ cash in shorthand method!
Within the classes BIG and what is Cs share
Ordinary
$30k AR: $15k
$30k Inv: $15k
$50 Equipment: $25k
Capital
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$60k GW: $30k
HYPO Assume pship sells Inventory for $80k
Creates $30k of book gain and $30 of tax gain
Both go 50/50 for $15k each
Pship books
Cash increases from $10k to $90k
Inventory disappears
Partners books
BV: Increase both B and C BV by $15k to $80k
Basis
Increase B basis by $15k to $95k
Do NOT adjust Cs basis
Instead, C must subtract $15k adjustment from his $15k tax gain Reg.
1.743-1(j)(1)-(3)
Thus, C does not have to pay any tax
(c) Are there any reason why B might hesitate to agree to 754 election?
Yes, Bernie might be hesitant to agree to a 754 election because it is irrevocable once made and can
hurt the partnership in the future, it applies to a number of different situations and difficult to generalize
as to when its appropriate for a partnership. Also, will apply to future elections.
**NOTE: results in constructive termination, which we will be responsible for talking about in exam
Problem 3: Erin purchases Fritzs interest for 100K. Inventory-basis 110K and FMV 160K.
Capital assets basis 90K and FMV 40K. Treas. Reg. 1.755-1(b)(3) provides for the allocation of
743(b) adjustments to specific assets within a class of property.
Assume original E is not Erin
Inv $110k $160k
Capital $90k $40k F $100k $100k
E (not Erin) $100k $100k
Erin will take over Fs $100k BV
743 adjustment of $0: Outside basis $100 share of total inside $100 (200/2) = $0
Reg. 755-1(b)(1)(i)
Assign b/t classes
Ordinary: $25k
Inventory w/ $50 BIG divide by 2 b/c Erins share
Capital must get ($25k) b/c adjustment must equal $0
Captial assets w/ $50 BIL divide by 2 = ($25k)
Assume original E is Erin: becomes single member disregard entity
Real termination of pship
Inv $110k $160k
Capital $90k $40k Fritz $100k $100k
Erin $100k $100k
CB 310, 387-88 Mccauslen
Seller (F): governed by 741, 751(a) treat as sale of interest
Economic total gain of $0 b/c $100k basis and $100k AR
94
BUT hot assets inside pship
So if sale of inventory at FMV and assign him his share, he has OI of $25k under
751(a)
Have to reconizile w/ Capital so CL of ($25k) to get him to $0
Buyer (E): treat as purchase of of assets w/ continued holding of other half
Inventory: total basis $135k
FMV basis in = $80k
Continue her basis in other = $55k
Capital assets: $65 k
FMV basis in = $20k
Continue her basis in other = $45k
**NOTE: triggers constructive termination, which will be responsible for on exam
Problem 4: G and H are partners in the GH partnership, which owns a commercial office
building. The FMV of building is $600k, its basis is $1m. The building is subject to a mortgage of
$500k. H sells his pship interest to I for $50k. The pship does not make a 754 election. Does the
absence of the election make a difference?
743(d): substantial BIL
Tested as time of sale of interest tied to pship level
More than $250k BIL in the aggregate
Bldg $1m $600k Debt: $500k
G $250k $500k
H $250k $500k
After purchase for $50k:
Bldg $1m $600k Debt: $500k
G $250k $500k
I $250k $300k
743(b) Adjustment: -$200k
Outside ($300k = $50 purchase + debt share of $250k) share of inside ($500k = $1m/2)
95
CHAPTER 9: Partnership Distributions
SECTION 1 CURRENT DISTRIBUTIONS
Problem 1: Amy basis is her partnership interest is 3K and Blairs is 5K. On the last day of each
month, Amy and Blair each withdrew $600 out of current cash flow. Determined that each
partners distributive share of partnership profits was 4K. Tax consequences to Amy and Blair?
Under 705(a)(2) and 733, current distributions of cash reduce the basis of the partners interest;
BUT, does not result in gain or loss unless the amount of the distribution exceeds the partners basis in
the partnership interest. 731.
Treas. Reg. 1.731-1(a)(1)(ii) treats advances or drawings of money or property against a partners
distributive share of income as current distributions made on the last day of the partnership taxable
year. Thus, the $7,200 distribution is accounted for at the end of the year, even though it was every
month.
AB of partner in partnership interest:
First, partners share of pship income causes increase in basis. 705(a)(1). Thus, A and Bs
basis must be increased by $4K each, which results in Amys new basis of $7K and Blair new
basis of $9K.
This results in $200 gain to A ($7,200 - $7,000) under 731(a)(1)
Treated as being realized from s/e of pship interest, which is capital under
741
There is no gain to B b/c his outside basis ($9k) is greater than his distribution
($7,200).
Next, cash distribution causes decrease in basis. 705(a)(2). Thus, A and Bs basis must be
decreased by $7,200 each, which results in $0 basis for Amy b/c cant go below $0
(7000-7200=(200)), and $1,800 basis for B ($9k-$7,200).
Problem 2: CDE partnership. No taxable income. To reduce Es interest from 2/9 to 1/8,
partnership plans to distribute $100 worth of property to him on July 1. Tax consequences if:
(a) P distributes Whiteacre to Eddie.
731(a)(1): no g/l from distribution of property that isnt in liquidation of a partners interest.
Distributee takes basis in distributed asset equal to pships basis in that asset. 732(a). Distributee
reduces his basis in partnership interest by the amount of the basis assigned to the distributed property
under 733(2).
G/L: E does not have gain from receiving Whiteacre. 731.
Basis in Whiteacre: $20 732(a)(1) (basis of partner is same as partnerships basis in property).
AB of Es interest in pship: must reduce by basis of the property distributed ($25 -$20). 733(2); thus,
E has $5 basis in pship.
Capital Account: under Reg. 1.704-1(b)(2)(4)(e), property distributed must be revalued and pship and
partner CA must be adjusted to reflect book g/l that would have been realized if property were sold for
FMV.
96
First, the revaluation of Whiteacre to $100 created a book gain of $80 ($100-$20), which must
be allocated to partners according to PIP. Here, that would be $35 to C (4/9), $27 to D (3/9),
and $18 to Eddied (2/9).
Next, Es BV must be reduced by FMV of property distributed, $100. Reg. 1.704-1(b)(2)(iv)
(b)
NOTE: pship may also revalue all pship assets under Reg. 1.704-1(b)(2)(iv)(f)(5) b/c there is a
reduction in a partners pship interest
(b) P distributes Blackacre to Eddie. FMV $100 and basis $140.
G/L: E doesnt recognize gain upon receipt of property. 731
Basis in Blackacre: Generally, partner takes same basis that pship had in property, UNLESS exceeds
his basis in pship. 732(a)(2). Thus, E takes $25 basis in Blackacre.
AB of Es interest in pship: must be reduced by FMV of property distributed. 733(2). Thus, Es basis
is reduced by $25, which gives his a new basis of $0.
Capital Account
First, revalue Blackacre to $140, which creates $40 book loss that must be allocated to all
partners based on PIP, $18 to C (4/9), $13 to D (3/9) and $9 to E (2/9). -1(b)(2)(iv)(e)
Next, reduce Es BV by FMV of property distributed ($140). -1(b)(2)(iv)(b)
NOTE: like in part (a), pship may choose to revalue all pship assets since Es interest is pship is being
reduced. -1(b)(2)(iv)(f)
Pships basis in remaining assets: not adjusted unless 754 election is in effect.
(c) P distributes $20 cash and Greenacre to Eddie.
G/L: E does not recognize any g/l on this distribution b/c the $20 cash distribution does not exceed his
$25 basis. 731(a)(1)
Es Basis in Greenacre: Cash is treated as distributed first, then the property. Reg. 1.732-1(a), Ex. 1.
So Es basis in pship is first reduced by $20 to $5. 733(1). Thus, his basis in Greenacre is limited to
his $5 basis in pship interest since less than pships basis in Greenacre. 732(a)(2).
Es AB in Pship Interest: Cash is treated as distributed first, then the property. Reg. 1.732-1(a), Ex. 1.
So Es basis in pship is first reduced by $20 to $5. 733(1). Then reduced by FMV of property ($80),
which gives E a basis of $0. 733(2)
Capital Account
First, revalue Greenacre to $80, which creates $60 book gain that must be allocated to all
(d) P distributes $30 cash and Brownacre to Eddie.
G/L: E must recognize $5 gain on this distribution b/c the $30 cash distribution exceeds his $25 basis.
731(a)(1)
Es Basis in Brownacre: Cash is treated as distributed first, then the property. Reg. 1.732-1(a), Ex. 1.
So Es basis in pship is first reduced by $30 to $0. 733(1). Thus, his basis in Brownacre is limited to
his $0 basis in pship interest since less than pships basis in Brownacre. 732(a)(2).
Es AB in Pship Interest: Cash is treated as distributed first, then the property. Reg. 1.732-1(a), Ex. 1.
97
So Es basis in pship is first reduced by $30 to $0. 733(1).
Capital Account
First, revalue Brownacre to $70, which creates $60 book gain that must be allocated to all
Problem 3: Regans basis=9K. Pship distributes to each partner in proportion to the PIP,
undivided interests in Blackacre and Whiteacre. FMV of interest in Blackacre recd by R =
$7.5K and portion of Pshipss basis for interest in Blackacre recd by R = $12K. FMV of interest
in Whiteacre recd by R = $15K and portion of Pships basis for interest in Whiteacre recd by R
= $6K. What is Rs basis in Whiteacre and Blackacre if:
Problem deals w/ distribution of multiple assets governed by 723(c)
751 does NOT apply b/c distribution represents proportion interest in distributed property
(a) W was held for sale to customers in the ordinary course of business and B was held for
rental?
G/L: none under 731(a).
Basis in Distributed Property: since his basin in pship interest is less than aggregate basis of distributed
property, his basis in the properties equals his basis in ship interest $9k. 732(a)(2).
When basis of distributed property is limited to basis in pship interest, the available basis must
be allocated first to unrealized receivables and inventory to extent of pship basis in those
assets, and then to other property. 732(c)(1). Here, Whiteacre was held for sale to
customers in OCOB, so it is inventory. Thus, must allocate pships basis in portion of
Whiteacre distributed to R of $6K to Whiteacre. (c)(1)(A). Then, the remaining basis of $3K
($9k - $6k) is allocated to Blackacre. 732(c)(1)(b).
AB in pship interest: reduced by FMV of portion of Whiteacre and Blackacre ($9k - $6k - $3k) to $0.
733.
(b) B was held for sale to customers in the ordinary course of business and W was held for
rental?
Under 732(c)(1)(a)(i), all $9K of basis goes to Blackacre and Whiteacre isnt allocated anything, so
will have $0 basis.
(c)(1) Both properties were held for sale to customers in the ordinary course of business?
Must allocate the $9K reduction in basis b/t the assets per 723(c)(1)(A)(ii) and (c)(3) b/c both are
now inventory.
B/c Blackacre has $4,500 unrealized depreciation (i.e., basis is more than FMV), $4,500 of
$9k decrease is allocated first to Blackacre, which reduces basis to $7,500.
Then, remaining $4,500 decrease is allocated b/t Whiteacre and Blackacre in proportion to
their respective bases as previously adjusted. 732(c)(3)(B).
Formula: remaining reduction x (pships basis in that asset/pships total bases in
assets distributed)
Whiteacre: $4,500 x $6,000/$13,500 = $2,000
Subtract from basis: $6,000 - $2,000 = $4,000
Blackacre: $4,500 x $7,500/$13,500 = $2,500
98
Subtract from basis reduced above: $7,500-$2,500 = $5,000
(c)(2) Both were held for rental?
732(c)(3). Same answer.
If both are held for rental, i.e. 1231 assets, Rs basis is allocated under 732(c)(1)(B), first to each
property to the extent of pships basis in the interest distributed to R, then the decrease is allocated
among the interests under 732(c)(3).
Problem 4: G & H equal partners.
Book FMV Book Basis FMV
Cash $60k $60k B Debt $90k
Blackacre $30k $150k W Debt $60k
Whiteacre $80k $120k G $10k $85k $90k
$170k $330k H $10k $85k $90k
$315k $170k $170k $180k
Blackacre and Whiteacre are both 1231 property. To reduce Gs interest in pship to , the
pship distributed Whiteacre to G subject to the debt, which G assumed. Both G and H had $85k
basis in respective pship interests b/f the distribution. What are the tax consequences to G and
H?
G/L: none under 731(a)(1)
Basis in Whiteacre: $80k, same as pship since his basis in pship does not exceed 732(a)(1)
Basis in Pship Interest: must account for deemed contribution b/f reducing for distribution
Distribution of encumbered property changes partners share of pships liabilities, which
results in deemed distributions and contributions of cash under 752(a) and (b).
B/f distribution: split $150k total liability 50/50; thus, Gs share = $75k
After distribution: G is responsible for all $60k related to Whiteacre and of
Blackacre, $22,500, for total of $87,500
Only net change is taken into account Reg. 1.752-1(f)
Increased from $75,000 to $87,500; thus, deemed cash contribution of
$7,500, which increases Gs basis from $85k to $92,500 722
Next, reduce by basis of Whiteacre ($92,500 - $80k) to $12,500
Hs share of pship liabilities decreased, which results in deemed distribution
b/f: $75,000
after: of $90k = $67,500
Thus, results in $7,500 deemed distribution 752(b)
Reduces Hs basis in pship from $85k to $77,500 733(1)
Capital Accounts
First, revalue Whiteacre to $120, which creates $40 book gain that must be allocated to all
partners based on PIP (50/50), $20 to G and $20 to H. -1(b)(2)(iv)(e)
Next, reduce Gs BV by FMV of property distributed less the debt assumed ($120-$60). -1(b)
(2)(iv)(b)
Results in negative BV, which does not reflect PIP after distribution
Thus, pship would want to choose to revalue all pship assets since Gs interest is pship is being
reduced Necessary to reflect the economic interests of the partners. -1(b)(2)(iv)(f)
First, revalue all assets, which creates $160 book gain that must be allocated to all partners
based on PIP (50/50), $80 to G and $80 to H.
Next, reduce Gs BV by FMV of property distributed less the debt assumed ($120-$60). -1(b)
(2)(iv)(b)
Problem 5: The LMN Pships assets and partners CA are as follows:
Book FMV Book FMV
Cash $120k $120k
99
Inv. $75k $150k L $105k $150k
Blackacre $60k $75k M $105k $150k
Whiteacre $60k $105k N $105k $150k
$315k $450k $315k $450k
Blackacre and Whiteacre are both 1231 property.
Problem deals w/ application of 751(b)
(a) Pship distributes $75k of cash to L. As results of distribution, Ls interest is reduced from 1/3
to 1/5 interest in pship, worth $75k, after distribution. What are tax consequences to L and pship
as a result of the distribution?
(i) Revalue
Cash $120k $120k
Inv. $150k $75k L $150k $105k
Blackacre $75k $60k M $150k $105k
$315k $450k $315k $450k
Book gain of $135k split 3 ways
(ii) Does 751(b) apply?
Non-pro rata distribution hint 751(b) is going to apply
No receivables, so any substantially appreciated inventory?
Definition of substantially appreciated: FMV of pship inventory exceeds its AB by 120%
751(b)(3)(A)
Inventory Includes: Reg. 1.751-1(d)(2)
All assets that are not capital nor 1231
Reg. does not say what to do w/ recapture
Inventory in hands in distribute
Here, we have substantially appreciated b/c $150k exceeds 120% of $75k basis ($90k)
(iii) Exchange Table
Hot Asset Post-distribution + Actual
Distribution
- pre-distribution Net change
Inventory $30k (1/5 of $150k) $0 $50k (1/3 of $150k) ($20k)
Class change ($20k)
Cold Assets
Cash $9k (1/5 of $45k) $75k $40k (1/3 of $120k) $44k
Black $15k (1/5 of $75k) $0 $25k (1/3 of $75k) ($10k)
White $21k (1/5 of $105k) $0 $35k (1/3 of $105k) ($14k)
Class change $20k
B/c $75k distribution of cash, only $45k cash post-distribution
(iv) Deemed distribution taxed as current:
Here, deemed distribution of $20k hot assets b/c that is net class change of ($20k)
B/c inventory is only hot asset, this current distribution consists of inventory
Total basis x portion distributing
$75k x $20/$150k = $10k
Pships basis = $10k
L takes $10k basis in inventory
L must reduce outside basis from $105k to $95k
(v) Deemed Exchange of $20k inventory for equivalent value of what actually recd:
$20k inventory w/ $10k basis exchange w/ what actually got
Look for number in table w/ positive numbers
Here, only item w/ positive amount is cash
100
Thus, exchange $20k inventory for $20k cash Selling inventory for cash
L recognizes $10k (20-10) of gain which is OI b/c inventory
Pship has no g/l b/c transferring cash w/ AR equal to basis
(vi) $55k cash distribution under 731
$95k - $55k = $40k new basis in pship
Cash $45k $45k
Inv. $130k $65k L $75k $40k
Inv. 751(b) $20k $20k M $150k $105k
Blackacre $75k $60k N $150k $105k
Whiteacre $105k $60k
HYPO: Later sell inventory for $150k
No book gain b/c revalued already
Tax gain of $65k ($150k - $85k)
On revalue, $25k book gain to L (when he was 1/3 partner)
Think about L as already having recognized $10k
Thus, assign $25k to M, $25k to N and $15k to K
(b) Pship distributes Blackacre to L to reduce Ls interest to 1/5. What are the tax consequences
to L and pship as a result of the distribution?
(i) Revalue: same as above
(ii) does 751(b) apply: same as above
(iii) Exchange Table
Distribution
Inventory $30k (1/5 of $150k) $0 $50k (1/3 of $150k) ($20k)
Class change ($20k)
Cold Assets
Cash $24k (1/5 of $120k) $0 $40k (1/3 of $120k) ($16k)
Black $0 $75k $25k (1/3 of $75k) $50k
White $21k (1/5 of $105k) $0 $35k (1/3 of $105k) ($14k)
Class change $20k
(iv) deemed distribution: same as above
L takes $10k basis in inventory
L reduces outside basis from $105k to $95k
(v) deemed exchange
Here, only item w/ positive amount is Blackacre
Thus, exchange $20k inventory for $20k Blackacre
L recognizes $10k of gain which is OI b/c inventory
$20k basis in $20k of Blackacre acquired by purchase, which should start
holding period over
Pship recognizes $4k 1231 gain ($20k - $16k)
Basis: $60k x $20k/$75 = $16k
Allocate the tax gain $2k each to M and L given past revaluation
Regs. just says cant assign to distribute partner (L)
1.751-1(b)(2)(ii)
1.751-1(b)(3)(ii)
Pship has cost basis of $20k in $20k of inventory
(vi) Actual distribution of $55k worth of Blackacre
Pships basis in this portion: $60k x $55k/75k = $44k
L takes $44k basis in $55k of Blackacre governed by 735(b) so tacked holding period
Has outside basis of $95k decreased by $44k to $51k
101
Cash $120k $120k
Inv. $130k $65k L $75k $51k
Inv. 751(b) $20k $20k M $150k $107k
(c) The pship distributes interest of inventory to L to reduce Ls interest to 1/5. What are the
tax consequences to L and the pship as a result of the distribution?
(i) Revalue
(ii) Does 751(b) apply
(iii) Exchange table
Distribution
Inventory $15k (1/5 of $75k) $75k $50k (1/3 of $150k) $40k
Class change $40k
Cold Assets
Cash $24k (1/5 of $120k) $0 $40k (1/3 of $120k) ($16k)
Black $15k (1/5 of $75k) $0 $25k (1/3 of $75k) ($10k)
White $21k (1/5 of $105k) $0 $35k (1/3 of $105k) ($14k)
Class change ($40k)
Inventory post is $75k b/c made $75k distribution (150-75)
(iv) Deemed distribution of $40k worth of cold assets
need to figure out which
$16k deemed of cash
$10k deemed of black
$14k deemed of white
Cash: from $105k to $89k
Black: pship basis: $60k x $10/75k = $8k of inside basis in $10k of B
L takes $8k basis in B
White: $60k x $14k/$105k = $8k of inside basis in $14k of W
L takes $8k basis in W
Ls outside basis reduced from $89k - $16k = $73k
(v) Deemed Exchange
Transfer all 3 for $40k of inventory
L recognizes $0k gain on cash
L recognizes $2k gain on B
L recognizes $6k gain on W
Both 1231 gain
L gets $40k cost basis in inventory - 735 does not apply
Pship basis in $20k inventory = $75k x $40/$150k = $20k basis
Creates $20k tax gain of OI
Assign $10k each to M and N
(vi) Actual distribution of $55k worth of Blackacre
Pships basis in this portion: $75k x $35k/150k = $17,500
L takes $17,500k basis in $35k of inventory governed by 735(b) so tacked holding period
L has outside basis of $73k decreased by $17,500 to $55,500
Cash $120k $120k
Inv. $37.5k $75k L $75k $55,500
Blackacre $65k $52k
Blackacre $10k $10k
102
Whiteacre $91k $52k M $150k $115k
HYPO: sell Blackacre for $75k
Creates $13k tax gain
In revalue, $5k of book gain to L, M, and N L in effect already recognized $2k of tax gain on B in
deemed exchange
Assign $5k to M, $5k to N and $3k to L
103
CHAPTER 6 TRANSACTIONS B/T PARTNERS AND PARTNERSHIP
SECTION 1: Transactions involving Services, Rents, and Loans
Problem 1: Alice and Bob are general partners in a real estate business. Alice is a 2/3 partner
and Bob is a 1/3 partner. At the beginning of the year Alices basis for her partnership interest
was $10,000; Bobs basis for his partnership interest was $5,000. This year the AB partnership
recognized taxable income of $9,000 from transactions with non-partners. The partnership uses
the accrual method of accounting and the partners use the cash method.
Cash Method TPs
A (2/3) -- $10k AB AB general partnership (accrual method TP)
B (1/3) -- $5k AB $9k taxable income
- If the partnership were to pay an unrelated lawyer to perform the work for the partnership, then the
lawyer would have $6k of income and the partnership would have either a 162 deduction or 263
capitalization. Section 707 was designed to reach the correct tax answers when the person providing
services also happens to be a partner, by treating the partner the same as the unrelated service provider.
(a)(1) What are the tax consequences to Alice and Bob if Bob is a lawyer and the partnership
paid Bob $6,000 to defend a negligence suit against the partnership by a person who was injured
in a slip and fall in a building owned by the partnership?
* Classify: 731, 707(c), OR 707(a)(1)
(1) Payment as Distributive Share ( 704) without 707.
A B
Book Tax Book Tax
- $9k of income $6k $6k $3k $3k
- $6k distribution ($6k)
(2) Section 707 Payment:
Factors in favor of 707(a)(1)
Rev. Rul. (200)
Services same as render for 3
rd
parties
Under PA not prohibited from engaging
Thus, should be 707(a)(1) payment payment to someone who is not a partner
Not Partner
61: OI to independent contractor
No associated change to BV or basis
83: governs timing here, not going to apply b/c cash
Pship
$6k payment is deductible net w/ $9k taxable income for $3k net income to be allocated 1/3 to B and
2/3 to A
Thus, increase BV and basis?
- The partnership has $9k of ordinary income and $6k of ordinary deduction, which means the 702(a)
(8) bottom line is $3k $2k to A and $1k to B.
- B has $6k ordinary income under 61.
A B
Book Tax Book Tax
104
- $3k 702(a)(8) $3k $3k $1k $1k
* Note that the capital gains preference is the 800 lbs gorilla in the tax system. Suppose the partnership
had $9k of capital gain income and paid B $6k for services:
- The partnership has $9k of capital gain ( 702(a)(1) or (2)) and a $6k ordinary deduction under 162.
Because the partnership has no ordinary income, the 702(a)(8) bottom line is negative $6k (the
deduction).
- B has $6k of ordinary income.
A B
Book Tax Book Tax
- 702(a)(1): $9k cg $6k $6k $3k $3k
- 702(a)(8): ($6k) ($4k) ($4k) ($2k) ($2k)
$2k $2k $1k $1k
- Thus, 707 produces a dramatically different result than treating the payment as a distribution under
704.
(a)(2) What would be the tax consequences to Alice and Bob if Bob billed the partnership for the
services in the current year, but the partnership did not pay Bob until April of the next year, in
which the partnership again realized $9,000 of taxable income from transactions with unrelated
parties?
- In this problem, we have a cash method payee (B), who performed services for the partnership and
was entitled to receive payment in the last taxable year. However, the accrual method partnership
failed to make the payment until the taxable year after the services were performed.
- The proper year for inclusion and deduction of payments subject to 707(a) is determined under
normal tax accounting principles and depends on whether the partner in question and the partnership,
respectively, use the cash or the accrual method of accounting. Difficulties arise only where a payment
from an accrual method partnership to a cash method partner is deferred beyond the close of the year in
which the services are performed. In such a case, section 267(a)(2), which controls the timing of
deductions for amounts paid to related taxpayers, defers the payors deduction until the year in which
the item is properly includable by the payee. Section 267(e)(1) treats a partnership and each partner as
related for purposes of applying 267(a)(2), regardless of the percentage interest which the partner has
in the partnership.
Thus, the partnerships $6k deduction is deferred until the payment is made and included in Bs
income.
(b) Bob is a lawyer and the partnership paid Bob $6,000 to represent it in purchasing an
apartment building (e.g., conduct the title search, etc). What are the tax consequences to Alice
and Bob?
Need to know what PA says a/b what Bob going to do
Probably still 707(a)(1)
- This problem deals with a situation in which the payment is not deductible by the partnership under
162, but rather must be capitalized under 263.
- Therefore, partnership has $9k of ordinary income and no deductions, so the 702(a)(8) bottom line
is $9k, which flows through $6k to A and $3k to B. The partnership is required to capitalize the $6k it
paid to B, which means the inside basis of the apartment building is increased $6k and the outside basis
to the partners is increased by their distributive share ($4k to A and $2k to B)
* Point If 707 was not in the Code, the partnership could avoid the capitalization requirement by
paying a partner, rather than a non-partner, to perform the services.
(c) The partnership paid Bob $6,000 to serve as resident manager of one of its apartment
buildings; the amount was unconditionally due if he rendered the services. What are the tax
consequences to Alice and Bob?
105
Probably 707(c)
This is his job w/in the pship
Payment still under 61 OI to independent contractor
Prop. Regs.: receipt of
Prop. Reg. 1.707-1(c): except as otherwise provided 83 trumps for in-kind payment
707(c) also governed by 83
$3K net income: assigned $2k to A and $1k to B
Reg. 704-1(b)(2)(iv)(o): not change in CA BV as to $6k payment
* This problem deals with what happens when the partner providing the services is, in essence, paid a
salary.
- Note that the partnership could have elected to alter the percentage of distributive shares to provide
that B (the partner providing the services) would simply get a greater distributive share. However, this
method has a serious problem because the service partner is looking for a guaranteed amount of
payment, and simply increasing Bs distributive share carries the risk that B will either be under-
compensated or over-compensated, depending on how well the partnership does.
- Alternatively, the partnership could do what was done here, which is to hire B, and in exchange for
Bs services, pay B $6k per year (salary), regardless of what the profits of the partnership are
(guaranteed payment).
- Still another alternative would be to provide in the partnership agreement that B will receive the first
$6k of income, and then the partners would split whatever other profits there were in accordance with
their distributive shares. Note how this agreement is somewhat different than the other two because B
is guaranteed $6k only as long as the partnership makes a least $6k.
* How is this situation ( 707(c) guaranteed payment) taxed?
- The partnership has $9k of ordinary income and gets a $6k deduction pursuant to 162. Therefore,
the partnerships 702(a)(8) bottom line is $3k $2k to A and $1k to B.
* What if the $9k of income was capital gain?
- The partnership has $9k of 702(a)(1) or (2) capital gain (depending on whether long term or short
term), and has $6k ordinary deduction. Thus, the 702(a)(1) or (2) is $9k ($6k to A and $3k to B) and
the 702(a)(8) bottom line is a $6k loss ($4k to A and $2k to B).
- B still has $6k of ordinary income.
(d) Bob served as resident manager of one of the partnerships apartment buildings; the
partnership agreed to pay Bob $6,000, but the payment was not made until April of the following
year, in which the partnership again realized $9,000 of taxable income from transactions with
unrelated parties. What are the tax consequences to Alice and Bob?
Governed by 706 on timing even if Prop. Reg. finalized
706(a): AM pship treats as happening during prior year
Included by Bob in earlier year
* What difference does it make whether the payment is classified as 707(a) or 707(c)? Basically, it
is just a timing issue.
- The most important difference between 707(a) payments to a partner and 707(c) payments to a
partner is that 707(a) payments to a cash method partner are taken into account by both the
partnership and the partner in the year paid, while 707(c) payments always are taken into account by
both the partnership and the partner in the year to which the item relates under the partnerships method
of accounting.
- Here, the partnership used the accrual method of accounting so the $6k was deducted by the
partnership last year under the all events test. Therefore, even though B is a cash method TP and would
not have to recognize the income until the year received under his method of accounting, he will be
forced to recognize the income in the year the partnership takes the deduction. Thus, 707(c)
accelerates Bs recognition of the income under the facts of this problem.
* Why does the word resident matter?
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- Under Rev. Rul. 81-301, the fact that a service partner provides such services to others may cause the
payment to be classified as 707(a) rather than 707(c). Therefore, the fact that B is the resident
manager implies that B does not provide such services for anyone else, and the payment is a 707(c)
guaranteed payment.
* Note that there is very little authority in this area because the issue only arises with respect to timing.
Recall that timing is really what tax law is all about (when is it includible in income and when is it
deductible, because know that ultimately it will be includible and deductible).
(e) What are the tax consequences to Alice and Bob if the partnership paid Bob $6,000 to oversee
construction of a new apartment building being constructed for the partnership by an unrelated
contracting company? Does it matter whether Bob holds himself out to third parties as engaged
in a business providing the services that he provided to the partnership?
Capitalized
Thus, 9K income assigned : 6kto A and 3k to B
Increase BV/basis
Then add construction project to pship books $6k BV and $6k basis
* Assuming the $6k is timely paid and is a 707(c) payment, how is it treated?
- The $6k must be capitalized pursuant to 263. Therefore, the partnership has $9k of income and no
deduction. Therefore, A is passed through $6k and B is passed through $3k. The basis of the
apartment building will be increased by $6k and the partners will be allocated their distributive share of
that amount. Finally, B has $6k of ordinary income.
- Ultimately, we would need some more information to determine definitively whether the payment was
707(a) or (c).
* This fact patterns presents tremendous temptation to amend the partnership agreement for the year of
construction to say that distributive share comes in two groups. The first $6k of income is allocated to
B and any excess income is split pursuant to profit sharing ratio. If this were done, notice the differing
results:
707(c) 704
Capitalization Capitalization
A B A B
- 702(a)(8) $6k $3k $2k $1k
$6k OI ___ $6k special
$2k $7k
- Notice how the two deals are really different. Under 707(c), the partnership must pay B the $6k, but
under 704 the partnership is not required to pay B (only pay B when partnership has income if
partnership only had $5k of income, then B only gets $5k and there is $0 left to distribute).
* Section 707(a)(2)(A) will re-characterize the above tax avoidance scheme as a 707(a) payment
(interestingly not as a 707(c) payment but remember that only difference is possibly timing).
- Be aware that the Secretary has not issued regulations concerning the above re-characterization. This
creates an interesting issue whether 707(a)(2)(A) is self-executing or not self-executing. If it is not
self-executing, then the TPs above 704 classification will not be re-characterized, but if it is self-
executing then we will need to consider all of the facts and circumstances to determine whether the
classification will be re-characterized as a 707(a) payment. See Week 10 notes at p. 3 for more
discussion of whether a code provision is self-executing.
- Point legal and factual uncertainty exists about whether provision is self-executing or not.
* Assuming that the provision is self-executing, what are some of the critical factors in determining
whether we came move the payment to distributive share?
- A temporary flip or amendment of the partnership agreement to provide for altered distributive share
would be strong evidence of avoidance purpose.
- Additionally, we would want to know the likelihood that the partnership will have income to cover the
first $6k allocation to B. If there is risk that B may not receive the allocation, that is good evidence that
allocation is real and not for tax avoidance purpose. If, however, there is little risk that the partnership
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will not have at least $6k in income every year, then the allocation of distributive share is not really any
different then guaranteeing the $6k payment to B each year. For example, if the partnership had a lot of
working capital or already locked in a reliable tenant.
- See pages 226 227 of text for list of factors that are relevant in determining whether a partner is
receiving a putative allocation and distribution in his capacity as a partner.
Problem 2:
(a) Carla and Don are the members of a LLC that is taxed as a partnership and which operates a
funeral home. Although they are equal members, because Don has assumed sole responsibility
for responding to night time calls, the LLC provides Don with an apartment on the second floor
of the funeral home. The LLCs expenses allocable to the apartment are $5,000, and the fair
rental value of the apartment is $6,000. What are the tax consequences of this arrangement to
Carla and Don?
If it were a normal EE, would be 119 fringe benefit
Issue: does D get benefit of 119 and be able to exclude value of stay on property or do have to treat as
not being able to rely on 119 and analysis as in-kind receipt to benefit and share in any deduction?
Here, not clear Luke says probably NOT 707(a)(1) b/c this is a small pship
* This problem deals with whether 707 payments can be excludable fringe benefits (see pp. 219 220
of text).
- The issue here is whether a partner can be considered an employee of the partnership and thus be
eligible for the 119 exclusion from gross income of the value of meals and lodging provided to
employees.
- In Armstrong v. Phinney (5
th
Cir. 1968) The court held that the entity approach adopted in 707(a)
was also applicable for purposes of the 119 exclusion for meals and lodging provided to employees.
Thus, it would be possible as a matter of law for a partner to qualify as an employee entitled to the
exclusion.
- In Wilson v. U.S. (Ct. Cl. 1967) The court reached the opposite conclusion on the ground that a
partnership is not a legal entity separate and apart from the partners, and, accordingly, cannot be
regarded as the employer of a partner for the purposes of 119.
- In Rev. Rul. 91-26 the IRS adopted the position of the Wilson court that a partner is not an employee
and does not qualify for tax free fringe benefits.
Thus, partners probably cannot expect tax free fringe benefit treatment in most cases, which means that
D has $6k of ordinary income and the partnership gets a $5k deduction (which is passed through $2.5k
each to C and D). Note that this is the most likely answer, but it is not definite.
* Note, however, that various provisions in the 132 regulations treat partners who perform services
for the partnership as employees for purposes of the exclusion of miscellaneous fringe benefits under
132. See Reg. 1.132-1(b)(1) and 1(b)(2)(ii) where partners are treated as employees for purposes of
excluding no additional cost fringe benefits, qualified employee discounts, and working condition
fringe benefits.
This most likely done because otherwise associate in law firm using lap top computer provided by firm
would be taxable fringe benefit.
(b) Don and Carlas LLC paid all of the premiums for group health insurance benefits for its
three employees, as well as for Carla and Don. The premium attributable to each person was
$2,000. What are the tax results to Carla and Don?
- Rev. Rul. 91-26 Held that accident and health insurance premiums paid by a partnership for the
benefit of partners performing services for the partnership were to be treated as 707(c) guaranteed
payments, includible in the partners income and deductible by the partnership. The partners were not
allowed to exclude the premiums under 106, but were allowed to claim deductions for the premiums
to the extent allowed under 162(l).
Problem 3: Jackie and Kerry are general partners in an investment partnership. Jackie
contributed $450,000 and Kerry contributed $200,000. They agreed that until Jackie had
cumulatively withdrawn distributions totaling $250,000 more than Kerry had withdrawn, Jackie
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would receive annually, before dividing partnership profits, an amount equal to 6% of the excess
of Jackies capital account over Kerrys capital account. For the current year the partnership
has net ordinary income of $12,000 and $8,000 of long-term capital gain. Because Jackies
capital account exceeded Kerrys by $250,000, Jackie was paid $15,000 as a guaranteed return
on the excess capital contribution. What are the tax consequences to Jackie and Kerry?
Here, payment is a 707(c) Payment:
- J has $15k of ordinary income.
No basis/BV adjustment
-162 ordinary - $15k deduction: split 50/50 (assuming thats what PA says) $7,500 each
-$15k OI goes $7,500 each
162 deduction and 707(c) can be netted
$8k of LTCG goes $4k each
Increases J and K BV/basis by $4k
Reduce pship cash for $15k
Why is this not a disguised sale so that 707(a)(2) would recharacterize?
Reg. 1.707-4(a)(1)(i)-(ii): if GP for use of capital is R, then dont have to treat as disguised
transaction
3 requirements
Treat as GP
Determine w/o regard to pship
R
* This problem deals with loans and guaranteed payments for the use of capital (text pp. 227-229).
- Section 707(c) expressly contemplates guaranteed payments by the partnership for the use of a
partners capital. This is distinguishable from interest on a loan, which is subject to 707(a), in that
707(c) governs payments in the nature of a return paid with respect to contributed capital, even if
determined under an interest-like computation, while 707(a) governs interest payments on a bona fide
loan. A bona fide loan from a partner to the partnership exists only if there is an unconditional
obligation to pay a sum certain at a determinable date (Rev. Rul. 73-301). In contrast, a contribution
credited to a partners capital account, repayable only as a distribution from partnership capital under
the terms of the partnership agreement, is not a loan even though it may bear interest.
- Here, the amount is clearly not interest on a loan because no unconditional obligation to pay a sum
certain at a determinable date.
- On a cash flow basis, the partnership has $20k of income ($12k ordinary and $8k capital gain). Thus,
J gets the first $15k and J and K split the remaining $5k ($2.5k each), which results in J receiving
$17.5k and K receiving $2.5k.
- The partnership gets $15k deduction from ordinary income (which is only $12k), which means
partnership has 702(a)(8) bottom line of negative $3k, which is passed through $1.5k to each J and K.
- The partnership has $8k of capital gain, which is passed through $4k to each.
J K
- 702(a)(1) or (2) $4k $4k
- 702(a)(8) ($1.5k) ($1.5k)
- Thus, J still has $17.5k net ($15k ordinary income - $1.5k ordinary deduction + $4k capital) and K
still has $2.5k net ($1.5k ordinary deduction and $4k capital gain).
- However, K would prefer to be in (2) because has $4k of capital gain and $1.5k ordinary deduction
* Note that the big difference between a 707(c) guaranteed payment and 707(a) interest on a loan is
timing. If 707(c) payment is accrued but unpaid, then the payee must include amount in income in
year the partnership takes the deduction. If 707(a) interest, then the income is included in the payees
income in the year he receives it and the partnership gets the deduction in the year the payee includes
the amount in income.
* Additional notes on factors to consider when determining whether a loan or a guaranteed payment are
contained in Week 10 Class Notes at p. 5.
109
Problem 4: Alito has been admitted as a new partner in the law firm of Scalia, Thomas &
Roberts. Alito is entitled to 25% of the partnerships profits, but in the first year is guaranteed a
minimum cash draw out of profits of $50,000. What are the tax consequences to Alito and the
other partners if the partnerships profit in Alitos first year as a partner is $100,000? What if
partnership profits are $200,000?
25% of profits must be defined somehow
At least $50k payment
Depends on which provision gets triggered
If Pship earns $100k, then A gets $25k as his share handled under 704/ 731
Tax on distributive share 704(b) assuming SEE
Cash distribution: 731 taxable to extent no basis
If 25% , then 707(c)
Deduction
A gets of deduction: ($6250) (assuming PA says allocated loss)
* This is basically a math problem that points out a situation in which 707(c) may be invoked, but is
not necessarily invoked.
* (Guaranteed Minimum Payments: p. 225):
- Suppose that A and B are partners in the AB partnership, in which A is a 25% partner, but that the
partnership agreement provides that A is entitled to receive not less than $100 per year. If the
partnerships income for the year is $400 or more, no portion of As distributive share is a guaranteed
payment (see Reg. 1.707-1(c), Ex (2)).
- If, however, partnership profits were only $200, under the approach in Reg. 1.707-1(c), Ex (2), $50
(25% of $200) would be As distributive share, and $50 would be a guaranteed payment.
- See also Rev. Rul. 69-180.
Problem 5: Andy is a civil engineer. Yosemite Development Associates, a general partnership,
has offered Andy a 10% partnership interest, but with a zero opening capital account, if Andy
will become the managing partner of Yosemite for the next four years. The principal activity of
Yosemite during that time will be the development and construction of an amusement park,
which will be developed in several stages. In year 1 the expected profits will be $0; in year 2 the
expected profits will be $1,000,000; in year 3 the expected profits will be $3,000,000. At the end
of year 4 it is expected that Andy will receive a full distribution of the balance in Andys capital
account and Andy will cease to be a partner.
* This problem builds on 707(a)(2)(A) basically, can the capitalization requirement be side-stepped.
- (Text p. 225 226): Suppose A, B, and C are each 1/3 partners in the ABC Partnership and A
performs services for the partnership related to the acquisition of a new building. If A is paid a fixed
sum for performing those services under either 707(a) or (c), the partnership will be required to
capitalize the payment and A will be required currently to include the payment in income. On the other
hand, if the partnership makes a special income allocation to A, which is subsequently distributed, Bs
and Cs distributive shares will be reduced proportionally, if effect allowing the capital expenditure for
As services to be deducted by B and C. Section 707(a)(2)(A) authorizes regulations (which have not
been issued) treating as a 707(a)(1) transaction the performance of services for the contribution of
property to the partnership by a partner coupled with a related allocation and distribution to the partner
if, when viewed together, the two events are more properly characterized as a transaction occurring
between the partnership and a partner acting in his capacity other than as a partner.
- Section 707(a)(2)(A) may apply both to one-time transactions and to continuing arrangements.
- Six factors are relevant in determining whether a partner is receiving a putative allocation and
distribution in his capacity as a partner: (1) whether the amount of the payment is subject to appreciable
risk; (2) whether the partnership status of the recipient is transitory; (3) whether the allocation and
distribution are close in time to the performance of services for, or the transfer of property to, the
partnership; (4) whether considering all of the facts and circumstances it appears that the recipient
became a partner primarily to obtain for himself or the partnership benefits which would not have been
available if he had rendered services to the partnership in a third party capacity; (5) whether the value
of the recipients interest in general and in continuing partnership profits is small relative to the
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allocation in question; and (6) whether the requirements for maintaining capital accounts under
704(b) makes it unlikely that income allocations are disguised payments for capital because it is
economically unfeasible.
(a) How will the allocation of operating profits to Andy be treated under 704 and 707?
Y1:
Y2: $100k to A; others have to split $900k; if 707a or c, must split $1m
Y3: $200k to A; others have to split $1.8m; if 707a or c, must split $2m
Y4: $300k to A; others have to split $2.7m; if 707a or c, must split $3m
Trying to create deduction
LH: 6 factors
Luke says under current law, this would be respected since dont have regs.
- Didnt really cover this problem in class, just briefly discussed some of the factors listed above.
Namely, need to determine whether the amount of the payment to Andy is subject to appreciable risk
(factor 1), the fact that the allocation is transitory hurts Andy (factor 2), and the result of side-stepping
the capitalization requirement is a big red-flag (factor 4).
(b) Would your answer change if after year 4 Andys capital account balance, if any, were not
distributed, but Andys continuing interest in the partnership profits was reduced to 1%?
SECTION 2: SALES OF PROPERTY
Problem 2:
(a) Ed and Fran are equal partners in the EF LLC, which holds investment assets and cash
totaling $4,000,000. Eds and Frans bases in their partnership interests are $1,750,000 each. On
February 1, Ed contributed Whiteacre, which had a FMV of $2,000,000 and an adjusted basis of
$600,000, to the LLC, and Eds capital account was increased by $2,000,000. On July 1, the EF
LLC distributed $1,500,000 in cash to Ed. Eds capital account was reduced by $1,500,000. How
should these transactions be treated for tax purposes?
* This problem deals with Disguised Sales and Exchanges of Property cash payment
- Beginning Balance Sheet:
Assets $4m $4m E $1.75m
F $1.75m
- On 2/1, E contributed Whiteacre (FMV $2 million and AB $600k).
Assets $6m $4.6m E $2.35m
F $1.75m
- On 7/1, LLC distributed $1.5 million cash to E
Assets $4.5m $3.1m E $850k
F $1.75m
- The above is how the partners and the partnership want to treat the transactions. The question is
whether the transaction will be recharacterized under 707(a)(2)(B) as a disguised sale. Look to the
1.707-3 Regulations to determine whether transaction will be recharacterized.
- Under Reg. 1.707-3(c) a presumption of disguised sale arises if the partner transfers property to a
partnership and the partnership transfers money or other consideration to the partner within a two year
period. Under Reg. 1.707-3(d) a presumption arises that such transfers are not a disguised sale if they
111
occur more than 2 years apart. However, both presumptions can be rebutted under the facts and
circumstances described in Reg. 1.707-3(b)(i)-(x), if the parties to the transaction or the IRS can
clearly establish the contrary.
- In this problem, the transfers occurred only 5 months apart. Therefore, the presumption of disguised
sale arises under Reg. 1.707-3(c), and the transactions will be treated as a disguised sale unless it can be
clearly established under the facts and circumstances listed in Reg. 1.707-3(b)(i)-(x) that the
transactions are not a disguised sale.
(i) E sold $2 million worth of property to the partnership in exchange for $1.5 million in consideration.
Therefore, of the contribution of the property by E will be treated as a sale and will be treated as a
contribution.
- Sale:
AR = $1.5 million (3/4 of $2 million)
AB = $450k (3/4 of $600k basis)
$1,050,000 gain recognized by E under 1001.
- Contribution: $500k FMV and $150k basis, which results in a $500k increase in Es capital account
and a $150k increase in Es basis in his partnership interest. Note that Es capital account has increased
by $500k in both cases.
- The facts and circumstances listed in the regulations seem to doom this transaction to disguised sale
treatment. The partnership has $4 million in liquidate assets, thus not much chance E will not get his
money.
- Note that under the facts and circumstances, an obligation of the partnership to distribute money or
property (or a right to the distribution on the part of the partner) coupled with security will doom the
transaction to disguised sale treatment.
- Note the regulation provide a safe harbor for certain reasonable guaranteed payments for the use of
partnership capital, preferred returns, operating cash flow distributions, and reimbursement of pre-
formation expenditures (Reg. 1.707-4).
(b) How should the transactions be treated for tax purposes if the distribution was received by
Ed on August 1 three years later and was in the amount of $1,736,438?
- The distribution three years after the initial contribution puts us into the presumption under Reg.
1.707-3(d) that the transaction was not a disguised sale. However, that presumption can be overcome
by the same facts and circumstances listed in Reg. 1.707-3(b)(i)-(x).
- The $1,736,438 is 5% compounded annually discounted from $2 million. Thus, possibility that facts
and circumstances could treat this transaction as a loan.
- See notes from Week 10 at page 11 for more discussion of the treatment if this is recharacterized as a
disguised sale.
4/19
Problem 3:
(a) Gail and Harvey formed the GH Partnership (a general partnership). Gail contributed
$400,000 of cash and has a 1/3 interest in profits and loss. Harvey contributed Greenacre, which
had a FMV of $2,000,000 and was subject to a $1,200,000 mortgage. Harveys basis in
Greenacre was $500,000. Harvey has a 2/3 interest in profits and loss. Harvey incurred the debt
secured by the mortgage last year and used the proceeds to purchase publicly traded securities.
What are the tax consequences of the transfer of Greenacre to the partnership?
* This problem deals with Assumption of Liabilities:
G (1/3) -- $400k cash GH
H (2/3) Greenacre ($2m FMV; $500k AB; $1.2m debt) Partnership
- H incurred the debt last year and bought securities with the proceeds.
112
Cash $400k $400k Debt $1.2m
Greenacre $2m $500k G $400k $800k
H $800k $1.6m
- Assuming the mortgage was recourse, in the worst case scenario the partnership could lose $2.4
million, which would be allocated 1/3 to G ($800k) and 2/3 to H ($1.6m), which would take Gs capital
account to negative $400k and Hs capital account to negative $800k. Therefore, G bears the risk of
loss for $400k of loan and her basis in her partnership interest is increased $400k to $800k, and H bears
the risk of loss for $800k of the loan and his basis in his partnership is increased from $800k to $1.6
million.
* Under Reg. 1.707-5(a)(1) provides that if a partnership assumes or takes property subject to a
qualified liability of a partner, the partnership is treated as transferring consideration to the partner only
to the extent provided in (a)(5). By contrast, if the partnership assumes or takes property subject to a
liability of the partner other than a qualified liability, the partnership is treated as transferring
consideration to the partner to the extent that the amount of the liability exceeds the partners share of
that liability immediately after the partnership assumes or takes subject to the liability (as provided in
(a)(2), (3) and (4)).
- Thus, the first step is to determine whether the liability of the partner assumed or taken subject to by
the partnership is a qualified liability.
- Here, the debt was incurred within two years of the transfer, so it is clearly not a qualified liability as
defined in Reg. 1.707-5(a)(6)(i)(A). Also, loan was used to purchase unrelated securities. Therefore,
pursuant to Reg. 1.707-5(a)(7), such liability is presumed to have been incurred in anticipation of the
transfer. Consequently, this transaction must be recharacterized as a disguised sale, in which case we
have part sale and part contribution treatment.
- Part Sale: In determining the amount of the transaction that will be recharacterized as a sale look to
the amount of the liability that the partner was relieved from. Prior to contribution H was responsible
for the entire $1.2 million of the recourse debt. However, after contributing the property to the
partnership, H was relieved of $400k of the recourse debt (the amount that E bears the risk of loss for
under the allocation of recourse debt analysis done above). The $400k of debt that H was relieved of is
1/5 of the FMV of the property subject to the liability that was contributed to the partnership, which
means 1/5 of the transaction is recharacterized as a sale.
After
If RC: $800k (2/3)
If NRC: $800k
Thus, decrease of $400k (1.2-800) that is his AR
AR = $400k (decrease of share of debt)
AB = $100k (400k/1.2m x $500k AB of property)
$300k gain recognized by H on part sale.
- Part Contribution: The remainder of the transaction is treated as a contribution of property to the
partnership by H.
H: book = $800k; basis: $400k
Compare debt for portion contributed w/ share of debt after
- Note how the capital accounts end up the same regardless of which way we characterize the
transaction. However, the basis of the property in the partnerships hands is effected by how we
characterize the transaction. Under the part sale part contribution recharacterization, the partnership
has a 4/5 723 transferred basis of $400k in the property (4/5 of $500k basis) plus a 1/5 1012 cost
basis of $400k (1/5 of $2 million cost basis). Therefore, the basis of the property in the hands of the
partnership is now $800k.
(b) What would be the consequences if Harvey had incurred the loan a year and a half ago to pay
for environmental remediation costs (that were deductible under 162) with respect to
Greenacre?
* The question here is whether the environmental remediation costs are a qualified liability?
113
- Reg. 1.707-5(a)(6)(i)(D) provides that if it is incurred in the regular course of trade or business it is a
qualified liability, but only if all of the assets of the business are transferred.
- Thus, have a type of cost (repairs to property) that has fallen through the gaps of the statute and
regulations.
- No clear answer to this question.
(c) What would be the result if Harvey incurred the loan three years ago to purchase publicly
traded securities?
- The liability here is old and cold, incurred more than three years before being transferred to the
partnership. In such situation there is a very strong presumption that the liability is a qualified liability.
Hs basis of $100k (500-400)
Problem 4: Memorial Hospital, a tax exempt organization, owns a building suitable for use as a
medical laboratory. Memorial has formed an LLC with Ben and Casey, cash method individuals
who operate a medical laboratory. Memorial has contributed the building and Ben and Casey
have contributed a going medical laboratory business (previously conducted in leased premises)
and cash. Memorials capital account was credited with $1,000,000, but the FMV of the building
very likely was closer to $2,000,000. The LLC agreement allocates the first $200,000 of annual
profits equally between Ben and Casey; all remaining profits are allocated to Memorial until
Memorial has been allocated cumulative profits of $1,700,000. At that time, which the parties
expect to be in about three years, Memorial will receive a liquidating distribution of the balance
in Memorials capital account and Memorials LLC interest will terminate. How should this
transaction be treated under 704 and 707?
707(a)(2)(A) applies
Book at less than FMV thus, not maintaining CA like supposed to
bldg $400k $400k B $200k
C $200k
M $2.7m
114
CHAPTER 9 Partnership Distributions
SECTION 2: DISTRIBUTIONS IN LIQUIDATION OF PARTNERS INTEREST
Problem 1: ABC Partnership-retail lumber and hardware business. It has the following assets
and partners CA restated to reflect FMV:
Book FMV Book FMV
Cash $165k $165k
Lumber Inv. $150k $120k A $244k $235k
Harware Inv. $100k $114k B $244k $235k
Blackacre $120k $155k C $244k $235k
Whiteacre $197k $111k $732k $705k
Goodwill $0 $45k
$732k $705k
Partnership is planning on making a liquidating distribution to C and is considering several
alternatives. What are the tax consequences to each of the following:
(a) C receives Blackacre and $85k cash incomplete liquidation of Cs interest in pship.
Capital is material income producing factor thus, not service pship
Not substantial appreciate inventory so dont have to worry about 751(b)
Hes getting $235k, which is the value of his interest thus, not bonus or sweetener
Thus, under 736(b)
Revalue:
Book Basis Book FMV
Cash $165k $165k
Lumber Inv. $120k $150k A $235k $244k
Harware Inv. $114k $100k B $235k $244k
Whiteacre $111k $197k $732k $705k
Goodwill $45 $0k
$732k $705k
Net book loss assigned 1/3 each
731 applies to decide g/l to C
Does not have to recognize gain b/c C has plenty of basis to absorb cash distribution
Reduced outside: 244-85 = 159
Basis in blackacre: 732(b) $159k
Check 732(c) doesnt do anything here
Class answer: 150K +85K=235K (value of his partnership interest). 736(b) applies because capital is a
material income producing factor. 731(a)(1)-gain or loss-Cs basis in partnership interest=244K. No
taxable gain because the cash doesnt exceed his partnership interest. No gain under 731. Also have
to look at 751(b) for whether there is gain-is there an exchange for all or part of his interest? Yes. Any
unrealized receivables? No. Inventory items that have appreciated substantially in value? Hardware
has appreciated, but not under the definition of substantially-751(b)(3). So 751(b) doesnt apply, no
gain. Next have to know what basis he takes from Blackacre. 732(b)-basis: subtract cash that was
distributed: 244K-85K=159K. Cs basis in Blackacres =159K. Partnership then needs to recalculate
capital accounts. Requires that book gain is revalued at FMV. Difference between inside basis (assets)
and partners aggregate basis. Aggregate basis=488K and inside basis =527K. Point is that they can
take a 754 election to help this.
Capital is a material income producing factor for the partnership here (not for services), so payments to
115
withdrawing partner equal to the FMV of his interest will be treated under 736(b) as distributions. 731
and 732 applies.
(b) C receives Lumber Inventory and $115k cash incomplete liquidation of Cs interest in pship.
731-no gain because cash doesnt exceed basis. 751 doesnt apply for same reason as in part (a). then
look at 732(b). First reduce cash. 244K-115K=129K basis in Lumber Inventory. If partnership had
sold inventory, would have been ordinary income, so he takes the inventory as ordinary income. Under
735 he has to take it as ordinary income for 5 years. 1.704-1)(b)(1)(f)-decide whether to make 754
election.
Cash: plenty of basis to absorb reduces basis to 129 (244-115)
Inventory: 732(b) gives basis of $129k
Check 732(c): applies here b/c inventory but, still takes basis of $129k
Must treat as inventory for 5 years under 735(a)
NOTE: Inside and outside basis do NOT have to equal one another but BV does
(c) C receives Hardware Inventory and $121k cash incomplete liquidation of Cs interest in
pship.
731(a)-no gain because cash doesnt exceed partnership basis. Under 751 no gain because no AR or
inventory. Next 732(b)-244K-121K cash=123K BUT under 732(c)(1)(a)- adjusted basis for inventory
is 100K. Lose 23K-123K-100K=23K. 731(a)(2)-says that the 23K is capital loss
Loss defined: if by applying formula, get something left over 731(a)(2)
Problem 2: DEF is a retail clothing business. It has the following assets, liabilities, and members
CA:
Book/Basis FMV Book Basis FMV
Cash $255k $255k Loan $120k
Mens Inv. $15k $90k A $215k $215k $245k
Womens Inv. $90k $180k B $215k $215k $245k
Blackacre $150k $180k C $215k $215k $245k
Whiteacre $135k $105k $645k $645k $735k
Goodwill $0 $45k
$645k $855k
The pship is planning to make a liquidating distribution to F. Fs basis in his partnership interest
is 215K, What are the tax consequences to each of the following:
(a) F receives Mens Clothing Inventory and $155k cash.
Revalue
Cash $255k $255k Loan $120k
Mens Inv. $90k $15k A $245k $215k
Womens Inv. $180k $90k B $245k $215k
Whiteacre $105k $135k $855k $645k
Goodwill $45 $0k
$645k $855k
LLC so NRC debt b/c no partner guaratees
751(b): done on gross value thus, $270k and his share of 1/3 which is $90k
Hot: post + actual - pre = change
Men $0 $90k $30 $60
Women $0 $0 $60 ($60)
116
Net $0
Thus, 751(b) does not apply
Cash distribution: $115k
But there is debt, so also deemed distribution: $40k
Must figure his share of NRC debt
Tier 1: $0
Tier 2:
Since revalued at same time percentages are the same so doesnt matter if
tier 2 or 3
Tier 3: $40k
Thus, total cash of $195k
$215k - $195 = $20k outside basis
Mens inventory: Pship basis was $15k
732(b) gives $20, but (c) limits to $15k
Thus, $20k (outside basis) - $15k (inventory) = $5k CL to recognize under 731(a)(2)
735 applies for 5 years to mens inventory
Bc debt, D and E also change
Share of debt increases split 120k 2 ways instead of 3; thus, increase of $20k
(d) F receives Blackacre and $65k cash.
(i) Exchange table
Hot Asset Post-distribution + Actual Distribution - Pre-distribution Change
M $0 $0 $30 (1/3) ($30k)
W $0 $$0 $60 (2/3) ($60k)
Cold Assets Net change ($90k)
Cash $0 $105k * $85k $20k
Black $0 $180k $60k $120k
White $0 $0 $35k (1/3 of $105k) ($35k)
Goodwill $0 $0 $15k ($15k)
Net Change $90k
*cash must be adjusted for any 752 deemed cash (decrease in share of pship liability)
$65k + $40k = $105
(ii) deemed current distribution of his share of hot assets (even though in context of liquidating)
$30k mens and $60k womens
b/c treating as current, his basis is pships unless limitation of outside comes into play (not
here)
Pships basis:
Mens: 30/90 x 15 = $5k
Womens 60/180 x 90k = $30k
Adjust Outside basis: $215k - $35k = $180
(iii) Exchange $90k hot assets for cold assets
Can only pick among cold assets w/ positive number if dont choose would be relative FMV
Reg. 1.751-1(g), Ex. 3(c), 4(c), 5(c): suggest can pick
Want to take into account pship appreciated property
Here, we assume exchanged $90k of Blackacre
Purchasing blackacre for share of cold assets (treated as under 707(a)(1))
Partner
Mens: $30-$5k = $25
Womens: 60-$30k = $30k
Total OI of $55k
Pship
117
$90k - $75 = $15k 1231 gain (tax only NOT book b/c already revalued)
Basis in $90k of Blackacre: $90k/$180 (total value) x $150k (total basis) =
$75k
Assigned to non-distributee partners must be equally: $7,500 each to D and E
Partner gets $90k basis in Blackacre
(iv) Liquidating distribution of $90k Blackacre and $
732(b)
Outside basis of $180k - $105k cash = $75k
$75k basis in $90k of Blackacre
(v) Adjust D and Es Basis
Share of gain from sale of $90k blackacre
Increase each by $7,500
Change of liability
Deemed contributions b/c taking over Fs share of debt ($40k)
Thus, D and Es tax basis increases by $20k each
Total increase of $27,500 for end basis of $242,500
Adjust Pship assets split Ms and Ws
Book Tax
Mens 60 30
30 10
Women 120 60
60 60
(e) F receives Womens Clothing Inventory and $65k cash.
(i) Exchange table
Hot Asset Post-distribution + Actual Distribution - Pre-distribution Change
M $0 $0 $30 (1/3) ($30k)
W $0 $180k $60 (2/3) $120k
Cold Assets Net change $90k
Cash $0 $105k * $85k (1/3 of $255k) $20k
Black $0 $0k $60k ($60k)
White $0 $0 $35k ($35k)
Goodwill $0 $0 $15k ($15k)
Net Change ($90k)
*cash must be adjusted for any 752 deemed cash (decrease in share of pship liability)
$65k + $40k = $105
(ii) deemed current distribution of his share of COLD assets (even though in context of liquidating)
Here, getting more than his share of hot assets thus, still 751(b) problem
Can pick which assets going to use 3 to choose from (can cherry pick under Reg. above)
Best tax move: maximize the loss and draw from the other assets and think about matching up
1231 assets
$35k of W
Make up different w/ other 1231 asset: $55k of B
Fs basis in these assets = Pships basis (not limited to his basis in pship interest b/c plenty of basis)
W: $135k x 35/105 = $45k
B: $150k x 55/180 = $46k
Adjust Outside basis: $215k - $45k -$46k = $124k
(iii) exchange $35 of W and $55 of B for $90 of Womens
Treated under 707(a)(1)
Partner
W: $35-$45k = ($10) 1231 loss
B: 55k 46k = 9k 1231 gain
118
Net: ($k)
Pship
$90k - $45 = $45k OI gain (tax only NOT book b/c already revalued)
Basis in $90k of Womens : $90k/$180 (total value) x $90k (total basis) =
$45k
Assigned to non-distributee partners must be equally: $22,500 each to D and E
$90k of inventory w/ $90k basis
(iv) Liquidating distribution of $90k inventory
732(a)
Outside basis of $124k - $105k cash = $19k
$19k basis in $90k of Inventory 732(b)
(v) Adjust D and Es Basis
Share of gain from sale of $90k inventory
Increase each by $22,500
Change of liability
Deemed contributions b/c taking over Fs share of debt ($40k)
Thus, D and Es tax basis increases by $20k each
Total increase of $42,500 for end basis of $257,500
Pship books
Book Basis
Cash: $190k $190k
Womens: gone
White: $70k $90k
$30k $35k
Black: $125k $104k
$55k $55k
Problem 3: J owns interest in profits and capital of GHIL pship. The pship is CMTP and has
conducted travel agency business that the pship purchased 7 years ago. It has the following assets
and partners CA:
Book/AB FMV Book/AB FMV
Cash $36k $36k
A/R $0k $12k G $16k $27k
Equip. $20k $20k H $16k $27k
Goodwill $8 $40k I $16k $27k
$64k $108k J $16k $27k
$64k $108k
J is planning to retire. Her basis for pship interest is $16k. PA has no express provisions
regarding payments to retiring partner.
Service Pship so 736(a)
Revalue
Book AB Book/AB AB
Cash $36k $36k
A/R $12k $0k G $27k $16k
Equip. $20k $20k H $27k $16k
Goodwill $40k $8k I $27k $16k
$64k $108k J $27k $16k
(a) What are the tax consequences to J and to pship if pship distributes $27k in cash to J in
complete liquidation of her pship interest?
736(a) portion
A/R: of $12k = $3k
Treat payment as being made for $3k worth of A/R
Goodwill: can only use appreciation: $40-8 = $32 x 1/4 = $8k
119
Total: $11k treated as 707(c)(1) guaranteed payment b/c not tied to profits
Tax:
J has $11k OI
Remaining have $11k deduction But lack EE b/c not matched by Book
adjustment (see below)
Thus, follow PIP, which is 1/3 each: $3,886.67 each
Book:
$11k reduction for J
No change for G, H, and I
Reg. 1.704-1(b)(2)(iv)(o): adjust, but if do that create disparity so
solution is reduce Js BV and leave others alone
736(b) portion: $27 - $11k = $16k cash
Does 751(b) apply?
NO b/c special rule 736(a) share does not get handled under 751(b)
751(b)(2)(B): does not apply to payment in (a) to liquidating partner
Liquidating distribution: 732
$16k - $16k = $0
Reduce remaining partners BV by $3,886.67
(b)(1) Could the results in (a) be changed by amending PA in conjunction w/ Js retirement to
provide that a retiring partner would be paid for the partners share of the pship goodwill? If so,
is it more likely that K or continuing partners would suggest such amendment?
Yes, put in that $8k of $27k payment is for goodwill
A/R: of $12k = $3k
Tax:
J has $3k OI
Remaining have $3k deduction But lack EE b/c not matched by Book
adjustment (see below)
Thus, follow PIP, which is 1/3 each: $1,000 each
Book:
$3k reduction for J
No change for G, H, and I
solution is reduce Js BV and leave others alone
736(b) portion: $27 - $3k = $24k cash
Does 751(b) apply?
Basis: 16k-24k = $0 basis
$8k gain: CG
Reduce remaining by $1k to $15k
(2) What would the result be if PA is amended as provided in (b)(1), but J is paid $30k cash?
736(a)
A/R: of $12k = $3k
Sweetner: $3k
Tax:
J has $6k OI
120
Remaining have $6k deduction
But $3k lacks EE b/c not matched by Book adjustment (see below)
Thus, follow PIP, which is 1/3 each: $1,000 each
But other $3k has SEE so $1k each
Book:
J: $3k reduction for A/R
No change for G, H, and I for that $3k
solution is reduce Js BV and leave others alone dont want to
break (q)
$3k: reduction of $1k each
736(b) portion: $30 - $6k = $24k cash
Does 751(b) apply?
Basis: 16k-24k = $0 basis
$8k gain: CG
Reduce remaining partners basis by $2k each to $14k
Reduce remaining partners BV for $1k each b/c J cant reduce below $0 (sweetener payment)
121

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CHAPTER 1 TAXATION OF PARTNERS AND PARTNERSHIPS

SECTION 2(A): DEFINITION OF PARTNERSHIP

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