Professional Documents
Culture Documents
C10-6 a, b, c, e. p. C10-8.
C10-7 For Sec. 751 to come into play in a current distribution, the distributing partnership must
have both Sec. 751 assets (unrealized receivables and/or substantially appreciated inventory) and
non-Sec. 751 assets. In addition, the distributee partner must have given up some of his or her
interest in one of the two classes of assets in exchange for an increased interest in the other class
of assets. In other words, the distribution must be disproportionate. p. C10-9.
C10-8 A partner can recognize a loss on a distribution only if the distribution is a liquidating
distribution that consists only of money, unrealized receivables, and/or inventory. The partner
recognizes a loss if the amount of money and the carryover basis of the receivables and inventory
are less than the partner's predistribution basis in his or her partnership interest. p. C10-12.
C10-9 No. The basis of unrealized receivables and inventory received by a distributee partner in
a nonliquidating or liquidating distribution cannot be greater to the partner than to the partnership.
If the partner receives only money, unrealized receivables, and inventory as part of a liquidating
distribution, and the carryover basis of the receivables and inventory is less than the partner's
predistribution basis in the partnership interest (reduced by money received or deemed to have
been received in the distribution), the partner cannot step-up the basis in the receivables or
inventory but instead must recognize a loss.
Yes. If the partner's predistribution basis in the partnership interest is smaller than the sum of
money received and the carryover basis for the receivables and inventory, the basis of the
receivables and inventory to the distributee partner is reduced. The basis to be allocated between
the unrealized receivables and inventory equals the predistribution basis for the partnership
interest reduced by any money or deemed money received in the distribution. pp. C10-12 through
C10-14.
C10-10 Yes. In determining the character of gain and/or loss on the sale of a partnership interest,
the partnership is deemed to sell all its assets in a hypothetical sale for their FMV. The selling
partner is then allocated his or her share of the ordinary income or loss from the sale of Sec. 751
assets. The partners residual gain or loss on the sale is capital gain or loss. If the partnership
owns loss assets in addition to Sec. 751 assets, the allocable ordinary income could exceed the
partners total gain, in which case the residual amount would be a capital loss. This result occurs
in Example C10-20 in the text. pp. C10-16 through C10-19.
C10-11 a.
When Tyra's interest in the partnership terminates, she will be deemed to have
received a money distribution in the amount of her interest in partnership liabilities. Because she
has a zero basis, she must report gain equal to the money distribution. Any other property she
receives in the distribution will have a zero basis.
b.
The amount realized will equal the sum of the money received and any liabilities
assumed by the purchaser. Because her basis is zero she will report a large gain. pp. C10-12 and
C10-16 through C10-18.
C10-12 If the entire partnership terminates, the Sec. 736 provisions do not apply at all. Rather
each partner is taxed under the liquidating distribution rules. Section 736 applies if one or more
C10-2
partners (but fewer than all the partners) dies or retires. Accordingly, Sec. 736 applies to the
payments to Tom. pp. C10-19 and C10-20.
C10-13 Section 736 divides payments into two categories. Section 736(b) payments are for a
partner's interest in partnership property, and these payments are taxed under the rules for
liquidating distributions. The partner recognizes capital gain if she receives money exceeding
basis in her partnership interest, so Lucia will report a capital gain of $3,000 ($23,000 - $20,000)
on the payment she receives for partnership assets.
Section 736(a) payments will be taxed as a guaranteed payment (ordinary income) if the
distribution is not based on partnership income. If the payment is based on partnership income,
the partner will be taxed on a distributive share of partnership income with the character of the
income determined at the partnership level. Accordingly, Lucia will report her share of
partnership income as a distributive share. pp. C10-19 and C10-20.
C10-14 The advantages of terminating a partnership include the termination of tax accounting
elections, which also may be disadvantageous, and the possibility of an accelerated loss flow
through when the terminated partnerships year closes. The disadvantages of a termination may
include loss of a favorable tax year and the bunching of income for the partners. The advantage
or disadvantage of changed asset bases no longer exists under current Treasury Regulations. See
Reg. Sec. 1.708-1(b)(1)(iv). pp. C10-22 through C10-24.
C10-15 A publicly traded partnership (PTP) is defined as a partnership whose interests are either
traded on an established securities exchange or are traded in a secondary market or the equivalent
thereof. Two groups of PTPs are not taxed as corporations. A PTP that existed on December 17,
1987, and which has not added a substantial new line of business, was not taxed as a corporation
until tax years beginning after December 31, 1997. These partnerships, which were grandfathered
under the 1987 law for ten years, were granted a new election in the Taxpayer Relief Act of 1997
(TRA of 1997). The TRA of 1997 allows these PTPs to continue to be taxed as partnerships if
they elect to do so and agree to pay an annual tax of 3.5% of gross income from the partnerships
trade or business. Partnerships that have 90% or more of their gross income being "qualifying
income" (interest, dividends, real property rents, etc.) continue to be taxed as partnerships. pp.
C10-28 and C10-29.
C10-16 From a legal standpoint, all the owners of a limited liability company (LLC) have limited
liability for the firms debts. In a limited partnership, all general partners have significant liability
for firm debts. Under the check-the-box regulations, an LLC can choose whether to be treated as
a partnership or taxed as a corporation. If the LLC chooses partnership treatment, the LLC and
the limited partnership are treated similarly except the limited partnership must have at least one
general partner. p. C10-29.
C10-17 An electing large partnership is a partnership that is not a service partnership, is not
engaged in commodity trading, has at least 100 partners, and files an election to be taxed as an
electing large partnership. The primary advantage to the partnership of electing to be an electing
large partnership is that the reporting of income to the large number of partners is simplified.
Relatively few items are separately stated so that the reporting process is more difficult than for a
corporation but easier than for a non-electing partnership. pp. C10-30 through C10-33.
C10-3
Kayla recognizes no gain or loss on the distribution. Her basis for the equipment would
be a carryover basis from the partnership ($35,000) if that were possible, but it is limited to her
basis in her partnership interest prior to the distribution ($30,000). Kayla's holding period for the
office equipment includes the holding period the partnership had for the property. Her basis in the
partnership interest is zero following the distribution. The depreciation recapture potential is an
unrealized receivable that will generate ordinary income under Sec. 735 (a)(1) when Kayla sells
the property. pp. C10-2 through C10-7.
C10-19
The amount of the distribution includes both the cash and the relief from liabilities that
he received when his interest in the partnership changed from one-third to one-fourth. The
partnership probably has Sec. 751 assets because the partnership inventory is substantially
appreciated. Furthermore, the cash basis partnership probably has unrealized accounts receivable,
and the partnership may have recapture potential if it has any depreciable personality. Again, an
exchange of Sec. 751 assets for cash probably occurred because Joel received only cash and
probably gave up a portion of his interest (from one-third to one-fourth) in each Sec. 751 asset.
The amount of ordinary income is the difference between the amount of cash Joel is deemed to
have received for the Sec. 751 assets and the adjusted basis that Joel would have had in the Sec.
751 assets had the Sec. 751 assets been distributed to Joel immediately before the deemed Sec.
751 sale (usually a carryover from the partnership's basis in these Sec. 751 assets). Any cash or
deemed cash exceeding the amount deemed to be part of the Sec. 751 exchange is treated as a
current distribution. The current distribution will reduce his basis in his partnership interest. If
the current distribution is greater than his basis in the partnership interest, Joel will recognize gain
because he receives cash exceeding his basis. pp. C10-7 through C10-11.
C10-20
The partnership has no unrealized receivables, but the partnership does have inventory.
The results of the sale are determined as follows:
Application of step 1 yields the following gain on Scotts sale of his partnership interest:
Amount realized on sale
$43,000
Minus: Adjusted basis of partnership interest ( 33,000)
Total gain realized
$10,000
Application of step 2 yields the following allocation to Sec. 751 property:
Deemed Sale of
Assets
Partnership
Gain
Scotts Share
(1/3)
Inventory
$9,000
$3,000
Building
15,000a
5,000b
Land
6,000
2,000
a
$5,400 of which is Sec. 1250 gain.
b
$1,800 of which is Sec. 1250 gain.
Thus, on the sale of his partnership interest, Scott recognizes $3,000 of ordinary income
and $1,800 of Sec. 1250 gain.
Application of step 3 yields the following residual allocation to capital gain:
Total gain realized
Minus: Allocation to ordinary income and Sec. 1250 gain
Capital gain recognized
$10,000
( 4,800)
$ 5,200
In summary, on the sale of his partnership interest, Scott recognizes $3,000 of ordinary income,
$1,800 of Sec. 1250 gain, and a $5,200 capital gain.
If the partnership made a Sec. 754 election, Sallys optional basis adjustment would be calculated
as follows:
Cash purchase price
Minus: Sallys share of partnerships
basis in assets (1/3 x $99,000)
Optional basis adjustment
$43,000
( 33,000)
$10,000
The optional basis adjustment would be allocated $3,000 to the inventory, $5,000 to the building,
and $2,000 to the land.
pp. C10-16 through C10-18 and C10-26 through C10-29.
C10-21 Drew and Dana should consider the following:
C10-5
What will be the basis for each of the assets? Under current Treasury
Regulations, the termination will be deemed to result in the old partnership
contributing the property directly to the new partnership so that no
adjustment to asset bases is likely to occur.
Will income be bunched into a single tax year if the partnership terminates?
Termination of the partnership closes a tax year. If the partnership has the
same tax year-end as Drew and Dana, no bunching of income will occur. If
their tax years differ, however, some bunching will occur.
When the partnership terminates, all elections are lost. Are there
advantages or disadvantages from losing all existing elections? A few
advantageous tax year-ends for old partnerships were grand fathered when
Congress enacted the rules imposing required partnership tax year-ends.
The loss of this tax benefit would be a significant disadvantage.
Would liquidation by the partnership be more advantageous than a sale to the other
partners? Liquidation by the partnership does not terminate the partnership.
How much of his gain from the sale would be considered sale from his interest in
Sec. 751 assets and, therefore, taxed as ordinary income? His sale will result in
ordinary income to the extent of his share of ordinary income upon the
hypothetical sale of underlying Sec. 751 assets.
Will the sale cause a bunching of income from the partnership for David?
Because the sale of the entire partnership interest closes the partnership tax
year for the selling partner, the sale will cause bunching of income if David's tax
year-end is different from DDD's tax year-end.
The partnership terminates because only one partner remains. The partnership terminates
when the final Sec. 736 payment occurs. pp. C10-22 through C10-25.
C10-23
Is this gift going to make Haley a partner in the HotWheels LLC for tax purposes?
If Alex restructures the gift so that Haley has true control over the interest, how
will the LLC's income be allocated between Alex and Haley?
C10-6
Haley probably will not be a partner. For Haley to be considered a partner, she
must have control of the interest. For a minor, control includes the situation where the
interest is placed in trust for the benefit of the minor but only if the trustee is someone
who will act in the best interest of the trust beneficiary. It is not clear that Alex is giving
up any control over this interest since he will continue to control the 15% share he placed
into Haley's trust. Thus, Haley is unlikely to be considered a partner. A two-step
allocation process will be used to allocate partnership income. First, Alex must be
allocated a FMV salary. His current salary is described as small, and it may be too small
to be considered equal to the FMV of his services. Once Alex is allocated a FMV salary,
all other income allocated to Alex and Haley must be divided on a pro rata basis. Alex
must receive three-fourths and Haley must receive one-fourth. In effect, the family
partnership income allocation rules override the special allocation to Alex. pp. C9-30,
C9-31, and C10-29.
C10-24
How much will be kept in the business for growth, and how much will be
distributed to the owners each year? The larger the percentage of earnings
that will be distributed, the more advantageous a flow-through entity such
as a partnership can be.
What is the marginal tax rate for Jeff, Susan, and Richard? If Jeff, Susan,
and Richard have lower marginal tax rates than does Krypton, partnership
status has advantages.
How should Jeff's pay for operating the business be structured? If the business is
taxed as a corporation, a generous but reasonable salary will decrease the amount
of income subject to double taxation. However, given the 15% tax rate on
dividend income, double taxation is not as detrimental as when dividends were
taxed as ordinary income. If the business is structured as a partnership, the
partners need to decide whether to structure the payment as distributive share, as
an outright guaranteed payment, or whether to establish a guaranteed minimum
that may be some combination of the two. pp. C2-3 through C2-8 and C10-30.
C10-25 What method should XYZ Limited Partnership choose to use to operate under the
publicly traded partnership rules?
Pay the annual 3.5% of gross income tax and continue to be taxed as a publicly
traded partnership?
Buy back enough interests (or restrict opportunities for trading) so the partnership
is no longer publicly traded?
Incorporate the entity and be taxed as a regular C corporation?
If the XYZ Limited Partnership chooses to continue as a partnership, should it
elect to come under the electing large partnership rules?
The best alternative will be a function of the amount of gross income, amount of taxable
income, tax rates of the partners, amount of profits the firm wants to retain, and costs of buying
back partnership interests, and/or restricting trading, or incorporating.
C10-7
The election reduces the partnerships annual cost of providing information to partners
but will require some start-up cost to make the change. The election also has the advantage of
making it more difficult to accidentally terminate the partnership because of trades. However, the
election significantly reduces the partners reporting and audit options.
pp. C10-29 and C10-30.
Problems
C10-26 a.
$ 25,000
( 4,000)
( 14,000)
$ 7,000
C10-8
b.
$ 25,000
( 4,000)
$ 21,000
( 21,000)
$
-0-
Lisa recognizes no gain. Her basis in the land is limited to $21,000, which is the basis of
her partnership interest reduced by the cash distributed.
c.
$
$
-0-0-0-
Lisa recognizes a $3,000 gain, the amount by which cash distributed exceeds her
partnership basis before the cash distribution. Her basis in the land is limited to zero, which is the
basis of her partnership interest reduced by the cash distributed.
d.
$ 25,000
( 4,000)
$ 21,000
( 10,000)
$ 11,000
( 11,000)
Lisa recognizes no gain. Her basis in the receivables is zero, and her basis in the
inventory is $10,000. Her basis in the land is limited to $11,000, which is the basis of her
partnership interest reduced by the cash distributed and by the basis of receivables and inventory
distributed.
e.
$ 30,000
( 14,000)
$ 16,000
In addition, the corporation increases its E&P by the E&P gain (which also is $16,000),
decreases E&P by taxes on the tax gain, and decreases E&P by the $34,000 ($4,000 cash +
$30,000 FMV of land) dividend distribution to Lisa (Sec. 312).
Lisa recognizes a $34,000 ($4,000 cash + $30,000 FMV of land) dividend (Sec. 301(c)
and Sec. 316). Her basis in the land is its $30,000 FMV (Sec. 301(d)), and her basis in her
corporate stock remains at $25,000.
C10-9
f.
$ 30,000
( 14,000)
$ 16,000
$ 25,000
8,000
$ 33,000
( 33,000)
$
-0-
Lisa received a $34,000 ($4,000 cash + $30,000 FMV of land) distribution, which
exceeded her stock basis before the distribution. Thus, in addition to the $8,000 pass-through
gain, Lisa recognizes a $1,000 capital gain on the excess distribution (Sec. 1368(b)(2)). Her basis
in the land is its $30,000 FMV (Sec. 301(d)).
pp. C10-2 through C10-7, C4-2 through C4-11, and C11-24 through C11-28
C10-27
Partner's
a.
Gain/Loss
-0-
Postdistribution
basis
$7,000
b.
-0-
$4,000
c.
$9,000
-0-
d.
-0-
$14,000
C10-10
Property
Land
Machinery
Land
Inventory
Land - Parcel 1
Land - Parcel 2
Land - Parcel 1
Land - Parcel 2
Land - Parcel 3
Basis
to Partner
$4,000
3,000
6,000
7,000
-0-04,000
6,000
4,000
C10-28 a.
Because Mario does not receive cash exceeding his partnership basis, he
recognizes no gain under the current distribution rules of Sec. 731. However, Sec. 737 requires
an additional step when some precontribution gain remains unrecognized. Mario must recognize
gain equal to the lesser of:
1.
Remaining precontribution gain ($8,000 = $18,000 - $10,000) or
2.
The excess of the FMV of the property distributed over the adjusted basis of the
partnership interest immediately preceding the distribution ($3,000 = $23,000 $20,000 partnership basis).
Under Sec. 737, Mario must recognize a $3,000 gain, which takes its character from the land
Mario contributed to the partnership having the precontribution gain.
b.
Under Sec. 731, his basis in his partnership interest is reduced by the carryover
basis of the property distributed to him.
Mario's basis in partnership interest before
the distribution
Plus: Sec. 737 gain recognized on the distribution
Minus: Carryover basis of property distributed
Basis in partnership interest after the distribution
$20,000
3,000
(15,000)
$ 8,000
Because Mario recognized gain under Sec. 737, he must increase the basis of his
partnership interest by the $3,000 amount of the Sec. 737 gain. His basis is increased before
reducing the basis for the distribution.
c.
Because Mario recognizes $3,000 of gain under Sec. 737, the partnership must
increase its basis in the property related to the precontribution gain that Mario recognized. The
partnership's basis in the land is increased to $13,000 ($10,000 carryover basis from Mario at the
time of the contribution + $3,000 Sec. 737 gain recognized on this distribution).
Students may note that $5,000 of precontribution gain related to this land remains, which
could be recognized under Sec. 737 if Mario receives other distributions that trigger the
recognition of this gain within seven years of the original contribution of the land to the
partnership. pp. C10-2 through C10-7.
C10-29 a.
Andrew must recognize the gain that would have been allocated to him had the
partnership sold the land for its FMV instead of distributing it to Bob.
Amount deemed realized
Minus: Adjusted basis
Capital gain on deemed sale
$21,000
( 18,000)
$ 3,000
b. and c. All $3,000 of the gain would have been allocated to Andrew because his precontribution gain was $4,000, so Andrew must recognize a $3,000 gain. He increases his basis in
the partnership interest by the $3,000 gain he recognizes to $24,000. Bob's basis in his
partnership interest is not affected by the gain recognition. The partnership's basis in the land is
deemed increased by the $3,000 gain to $21,000 immediately before the land is distributed.
Accordingly, the basis of the land to Bob is $21,000, and Bob's basis in his partnership interest is
reduced to $9,000 ($30,000 - $21,000) by the distribution. Andrew's basis in his partnership
interest is not affected by the distribution. pp. C10-2 through C10-7.
C10-11
C10-30 First, Beth and Cathy must recognize precontribution gains on the distributed property.
1.
$10,000
( 4,000)
$ 6,000
The precontribution gain allocated to Beth on the deemed sale is $4,000 ($8,000 FMV - $4,000
basis at contribution). Beth's basis in her partnership interest after the deemed sale is $19,000
($15,000 + $4,000 gain recognized). The land's basis to the partnership immediately before the
distribution is $8,000 ($4,000 basis + $4,000 gain recognized).
2.
$10,000
( 1,000)
$ 9,000
The precontribution gain allocated to Cathy on the deemed sale is $3,000 ($4,000 FMV - $1,000
basis at contribution). Cathy's basis in the partnership interest after the deemed sale is $21,000
($18,000 + $3,000 gain recognized). The inventory's basis to the partnership immediately before
the distribution is $4,000 ($1,000 + $3,000 gain recognized).
Then, the current distributions must be analyzed using the normal rules.
Alonzo's distribution:
Basis in partnership interest before distribution
Minus: Carryover basis in land (see 1 above)
Basis in partnership interest after distribution
$19,000
( 8,000)
$11,000
Beth's distribution:
Basis in partnership interest before distribution
(see 1 above)
Minus: Carryover basis in inventory (see 2 above)
Basis in partnership interest after distribution
$19,000
( 4,000)
$15,000
Cathy's distribution:
Basis in partnership interest before distribution
(see 2 above)
Minus: Cash received in distribution
Basis in partnership interest after distribution
$21,000
( 10,000)
$11,000
(2)
Kay's Interest
C10-12
(3)
Fictional
(4)
(5)
Beginning
Partnership
Amount
Sec. 751 Assets:
Receivables
Inventory
Supplies
Recapture
Total
Other Assets:
Cash
Equipment
Land
Total
Before
Distribution
(1/3)
After
Distribution
(1/4)
Proportionate
Distribution
(3)=(1)-(2)
$16,000
52,000
6,500
1,500
$76,000
$ 5,333
17,333
2,167
500
$25,333
$ 4,000
13,000
1,625
375
$19,000
$ 1,333
4,333
542
125
$ 6,333
$ 30,000
9,000
65,000
$104,000
$10,000
3,000
21,667
$34,667
$ 2,500
2,250
16,250
$21,000
$ 7,500
750
5,417
$13,667
Kay's sale:
Amount realized
Minus: Adjusted basis
Recognized gain (ordinary income)
Kays basis in partnership interest:
Beginning basis
Minus: Sec. 751 transaction:
Inventory ($50,000/$52,000 x $4,333)
Supplies ($6,000/$6,500 x $542)
Basis after Sec. 751 transaction
Minus: Non-Sec. 751 distribution
Ending partnership interest basis
Actual
Distribution
Difference
(5)=(4)-(3)
$-0-0-0-0$-0-
($1,333)
( 4,333)
( 542)
( 125)
($6,333)
$20,000
-0-0$20,000
$12,500
( 750)
( 5,417)
$ 6,333
$ 6,333
( 4,666)a
$ 1,667
$33,750
( 4,166)
( 500)
$29,084
(13,667)b
$15,417
C10-13
c.
Beginning
Partnership
Amount
(1)
Jack's
Interest Before
Distribution
(1/4)
(2)
Jack's Interest
After
Distribution
(1/5)
(3)
Fictional
Proportionate
Distribution
(3)=(1)-(2)
$12,000
24,000
50,000
$86,000
$ 3,000
6,000
12,500
$21,500
$ 2,400
4,800
10,000
$17,200
$ 600
1,200
2,500
$4,300
$-0-0-0$-0-
($ 600)
( 1,200)
( 2,500)
($4,300)
$ 48,000
190,000
76,000
$314,000
$12,000
47,500
19,000
$78,500
$ 4,600
38,000
15,200
$57,800
$ 7,400
9,500
3,800
$20,700
$25,000
-0-0$25,000
$17,600
( 9,500)
( 3,800)
$ 4,300
Jack's sale:
Amount realized
Minus: Adjusted basis
Recognized gain (ordinary income)
Jack's basis in partnership interest:
Beginning basis
Minus: Sec. 751 transaction
Accounts receivable
Inventory ($21,000/$24,000 x $1,200)
Basis after Sec. 751 transaction
Minus: Non-Sec. 751 distribution
Ending basis
$600 receivables + $1,050 inventory + $0 recapture.
$25,000 total - $4,300 Sec. 751 exchange.
C10-14
(4)
(5)
Actual
Distribution
Difference
(5)=(4)-(3)
$ 4,300
( 1,650)a
$ 2,650
$76,875
( 600)
( 1,050)
$75,225
(20,700)b
$54,525
C10-33
Beginning
Partnership
Amount
Sec. 751 Assets:
Receivables
Inventory
Total
Other Assets:
Cash
$ 40,000
100,000
$140,000
$86,000
$ 20,000
(1)
Paulas
Interest Before
Distribution
(1/4)
(2)
Paula's Interest
After
Distribution
(1/5)
$10,000
25,000
$35,000
$ 8,000
18,000
$36,000
$ 5,000
$ 4,000
(3)
Fictional
Proportionate
Distribution
(3)=(1)-(2)
(4)
(5)
Actual
Distribution
Difference
(5)=(4)-(3)
$2,000
7,000
$9,000
$ -010,000
$10,000
$ 1,000
$1,000
$1,000
( 800)a
$ 200b
-0-
($2,000)
3,000
$1,000
($1,000)
($1,000)
Because the total basis for the inventory is $80,000 and the total FMV is $100,000, the
basis of this portion of the inventory is assumed to be 80% of its FMV.
b
The $200 gain is allocated one-third to each of the other three partners (Reg. Sec. 1.7511(b)(2)(ii)). Thus, each other partner recognizes $67 of ordinary income.
a
Beginning basis
Plus: Share of partnership income
Minus: Deemed distribution of cash
Distribution of remaining inventory
(adjusted basis = 0.80 x $9,000)
Ending basis
Paula
Partner Q
Partner R
Partner S
$25,000
$25,000
67
$25,000
67
$25,000
67
_______
$25,067
_______
$25,067
_______
$25,067
( 1,000)
( 7,200)
$16,800
C10-15
$1,000
7,200
$8,200
C10-34
Partner's
Postdistribution
Basis
None
a.
Gain/Loss
-0-
b.
-0-
None
c.
$9,000
None
d.
-0-
None
Predistribution basis
Less: Cash distribution
Basis to allocate
Basis
to Partner
$11,000a
3,000
10,000b
7,000
-0-c
-06,462d
10,769
10,769
Property
Land
Machinery
Land
Inventory
Land - 1
Land - 2
Land - 1
Land - 2
Land - 3
$20,000
( 6,000)
$14,000
Land
$ 4,000
7,000
$11,000
Predistribution basis
Less: Cash distribution
Basis to allocate
Less: Allocation to inventory
Allocation to land
$20,000
( 3,000)
$17,000
( 7,000)
$10,000
Predistribution basis
Less: Cash distribution
Basis to allocate (but not less than
zero)
$26,000
( 35,000)
$
-0-
Machinery
$ 3,000
-0$ 3,000
Predistribution basis
First allocate to property basis
Balance
Then allocate to property appreciation
Finally allocate based on relative FMV
Total
Land-1
Land-2
Land-3
$4,000
$ 6,000
$ 4,000
2,000
462
$6,462
4,000
769
$10,769
6,000
769
$10,769
Basis to
Allocate
$28,000
( 14,000)
$14,000
( 12,000)
$ 2,000
has no Sec. 751 assets. Marinda is deemed to have received $110,000 in cash or deemed cash
($100,000 cash + $10,000 release from liability). Accordingly, she must recognize capital gain of
$30,000 ($110,000 received - $80,000 basis). The partnership recognizes no gain. pp. C10-12
through C10-16.
C10-36
Basis before liability reduction
Minus: Liability reduction (deemed distribution)
Basis before distributions
Minus: Cash distributions
Basis to be allocated
Minus: Basis allocable to inventory
Basis allocable to receivables
Amount allocable to other property
Minus: Basis allocable to land
Basis allocable to building
Ending basis in partnership interest
C10-17
Alison
$110,000
( 50,000)
$ 60,000
( 20,000)
$ 40,000
( 32,195)a
( 7,805)a
$
-0(
-0-)
(
-0-)
$
-0-
Bob
$180,000
( 50,000)
$130,000
( 20,000)
$110,000
( 33,000)
( 10,000)
$ 67,000
( 15,000)b
( 52,000)b
$
-0-
Allisons allocation:
FMV of asset
Minus: Partnerships basis for the asset
Difference
Step 1: Give each asset the partnerships basis
for the asset
Minus: Allisons basis to be allocated
Decrease to allocate
Step 2: Asset basis after Step 1
Allocate the decrease first to assets
that have declined in value
Adjusted basis at this point in the
calculation
Step 3: Allocate $1,000 remaining decrease
based on relative adjusted basis at this
point in the calculation
Allisons basis in the assets
Inventory
Receivables
$ 35,000
( 33,000)
$ 2,000
$ 8,000
( 10,000)
( $2,000)
$43,000
(43,000)
$
-0-
$ 33,000
$10,000
$ 33,000
$10,000
$43,000
( 40,000)
$ 3,000
$43,000
( 2,000)
( 2,000)
$ 33,000
$ 8,000
$41,000
(
805)*
$ 32,195
( 195)
$ 7,805
( 1,000)
$40,000
-0-
Total
FMV of asset
Minus: Partnerships basis for the asset
Difference
Step 1: Give each asset the partnerships basis
for the asset
Minus: Bobs basis to be allocated
Increase to allocate
Step 2: Allocate the $12,000 increase first to
assets that have appreciated in value
Bobs basis in the asset
Land
Building
Total
$10,000
( 15,000)
($ 5,000)
$60,000
( 40,000)
$20,000
$70,000
( 55,000)
$15,000
$15,000
$40,000
$55,000
( 67,000)
$12,000
-0$15,000
12,000
$52,000
12,000
$67,000
The basis in each asset received is the number used to reduce the partners basis in the partnership
interest. Note that Alison's basis in the inventory and receivables is smaller than a carryover basis
from the partnership while Bob's basis in the building is larger than a carryover basis. Neither the
partners nor the partnership recognize any gain or loss. pp. C10-12 through C10-14.
C10-18
C10-37 a, b, and c.
Part a
$40,000
( 2,500)
$37,500
( 8,000)
$29,500
Part b
$46,500
( 2,500)
$44,000
( 8,000)
$36,000
Part c
$46,500
( 2,500)
$44,000
( 8,000)
$36,000
Inventory is not substantially appreciated. Therefore, Sec. 751 does not apply.
See Parts a c below for remaining allocations. Also see summary of bases after Part c.
a.
FMV of asset
Minus: Partnerships basis for the asset
Capital Asset 1
$15,000
( 10,000)
Capital Asset 2
$17,500
( 15,000)
$ 5,000
$ 2,500
$10,000
$15,000
$10,000
$15,000
$25,000
( 29,500
)
$ 4,500
$25,000
3,000
$13,000
1,500
$16,500
4,500
$29,500
Difference
Step 1: Give each asset the partnerships basis
for the asset
Minus: Larrys basis to be allocated
Increase to allocate
Step 2: Basis after Step 1
Allocate the $4,500 increase to assets
that have increased in value*
Larrys basis in the capital assets
Total
$32,500
( 25,000
)
$ 7,500
C10-19
b.
FMV of asset
Minus: Partnerships basis for the asset
Capital Asset 1
$15,000
( 10,000)
Capital Asset 2
$17,500
( 15,000)
$ 5,000
$ 2,500
$10,000
$15,000
$10,000
$15,000
$25,000
( 36,000
)
$11,000
$25,000
5,000
$15,000
2,500
$17,500
7,500
$32,500
1,615
$16,615
1,885
$19,385
3,500
$36,000
Difference
Step 1: Give each asset the partnerships basis
for the asset
Minus: Larrys basis to be allocated
Increase to allocate
Step 2: Basis after Step 1
Allocate the increase to assets
that have increased in valuea
Basis after Step 2
Step 3: Allocate the remaining $3,500
increaseb
Larrys basis in the capital assets
Total
$32,500
( 25,000
)
$ 7,500
c.
FMV of asset
Minus: Partnerships basis for the asset
Capital Asset 1
$15,000
( 10,000)
Difference
Step 1: Give each asset the partnerships basis
for the asset
Minus: Larrys basis to be allocated
Increase to allocate
Step 2: Basis after Step 1
Allocate the increase to assets
that have increased in valuea
Basis after Step 2
Step 3: Allocate the remaining $1,000
increaseb
Larrys basis in the capital assets
Capital Asset 2
$17,500
( 20,000)
$ 5,000
($ 2,500)
$10,000
$20,000
$10,000
$20,000
$30,000
( 36,000
)
$ 6,000
$30,000
5,000
$15,000
-0$20,000
5,000
$35,000
462
$15,462
538
$20,538
1,000
$36,000
C10-20
Total
$32,500
( 30,000
)
$ 2,500
Part a
$ 2,500
8,000
13,000
16,500
$40,000
Cash
Inventory
Capital Asset 1
Capital Asset 2
Total
Part b
$ 2,500
8,000
16,615
19,385
$46,500
Part c
$ 2,500
8,000
15,462
20,538
$46,500
b.
The partnership has inventory and Sec. 1250 property. Accordingly, the sales
transaction must be analyzed as follows:
Application of step 1 yields the following gain on Kellys sale of her partnership interest:
Amount realized on sale
($45,000 cash + $20,000 liabilities)
$65,000
Minus: Adjusted basis of partnership interest (42,000)
Total gain realized
$23,000
Application of step 2 yields the following allocation to Sec. 751 property:
Deemed Sale of Assets
Inventory
Building
Land
Partnership Gain
$60,000
4,000 (all Sec. 1250 gain)
5,000
$20,000
1,333
1,667
Thus, on the sale of her partnership interest, Kelly recognizes ordinary income of
$20,000 and a Sec. 1250 gain of $1,333.
Application of Step 3 yields the following residual allocation to capital gain:
Total gain realized
Minus: Allocation to ordinary income and Sec. 1250 gain
Capital gain recognized
$23,000
( 21,333)
$ 1,667
In summary, on the sale of her partnership interest, Kelly recognizes $20,000 of ordinary income,
$1,333 of Sec. 1250 gain, and a $1,667 capital gain.
c.
$65,000 = $45,000 cash paid + $20,000 share of partnership liabilities.
d.
Unchanged from the basic facts.
C10-21
interest:
Amount realized on sale
($75,000 cash + $15,000 liabilities)
Minus: Adjusted basis of partnership interest
($168,000 x 0.50)
Total gain realized
$90,000
( 84,000)
$ 6,000
Partnership
Gain (Loss)
$ 30,000
( 10,000)
$ 9,000
( 3,000)
Thus, on the sale of his partnership interest, Clay recognizes ordinary income of $9,000.
Application of step 3 yields the following residual allocation to capital loss:
Total gain realized
Minus: Allocation to ordinary income
Capital loss recognized
$ 6,000
( 9,000)
($ 3,000)
C10-40 a.
interest:
Amount realized on sale
($125,000 cash + $35,000 liabilities)
$160,000
Minus: Adjusted basis of partnership interest ( 110,000)
Total gain realized
$ 50,000
Application of step 2 yields the following allocation of Sec. 751 property:
Deemed Sale of Assets
Receivable
Inventory
Machinery
Building
Land
Investments
Partnership
Gain (Loss)
Alices
Share ()
$21,000
15,000
42,000a
45,000b
( 6,000)
33,000
$ 7,000
5,000
14,000a
15,000b
( 2,000)
11,000
Thus, on the sale of her partnership interest, Alice recognizes ordinary income of
$24,000 ($7,000 + $5,000 + $12,000 recapture). In addition, Alices Sec. 1250 gain is $10,000.
Application of step 3 yields the following residual allocation to capital gain:
Total gain realized
Minus: Allocation to ordinary income
and Sec. 1250 gain
Capital gain recognized
$50,000
(34,000)
$16,000
partnership income, it is a guaranteed payment. Thus, the $15,000 payment is ordinary income to
Suzanne.
b.
Suzanne's capital account will be removed because she is no longer a partner. The
partnership gets no deduction for the payments taxed as Sec. 736(b) payments, but the
partnership can deduct the guaranteed payment of $15,000. The remaining partners' bases in the
partnership must be increased to reflect the additional amount of liability each is allocated when
Suzanne is no longer a partner. pp. C10-19 and C10-20.
C10-42 a.
b.
$ 49,600
( 40,000)
$ 9,600
$58,000
( 49,600)
$ 8,400
$49,600
( 40,000)
$ 9,600
Brian is taxed on the Sec. 736(a) payment as a guaranteed payment, and the partnership
deducts the payment. pp. C10-19 and C10-20.
C10-24
C10-43 a.
$90,000
( 75,000)
$15,000
The character of the gain is capital because the partnership has no unrealized receivables
or substantially appreciated inventory.
b.
$ 90,000
( 75,000)
$ 15,000
The character of the gain is capital gain because the partnership has no Sec. 751 assets.
The Sec. 736(a) payment is treated as a guaranteed payment because it is determined without
reference to partnership income. It is ordinary income to Kim and deductible by the partnership.
pp. C10-19 and C10-20.
C10-44 a.
The FMV of Jerry's partnership interest is $160,000 (0.40 x $400,000) at the date
of his death. His estate will receive payments totaling $250,000 ($220,000 cash + $30,000
release from liabilities) during the two-year period following death. Up to the FMV of his share
of the assets ($160,000), the payments are Sec. 736(b) payments. The basis of his partnership
interest to his successor-in-interest is its FMV on the date of Jerry's death ($160,000).
Accordingly, the first $160,000 of payments is treated as liquidating distributions and will
generate no gain. The remaining payments ($90,000) are Sec. 736(a) payments, which are not
tied to partnership income and therefore are taxed as guaranteed payments to the successor-ininterest. These payments will be taxed as ordinary income to the successor-in-interest.
b.
The partnership gets no deduction for the Sec. 736(b) payments, but it can deduct
the Sec. 736(a) payments. Because this was a two-person partnership, the partnership will
continue only until the partnership makes the last payment to Jerry's successor-in-interest. At the
time the partnership makes the last payment, the partnership will terminate unless a new partner(s)
is admitted. pp. C10-19 and C10-20.
C10-45 a.
$150,000
(150,000)
Realized gain
-0-
b.
10% of partnership income is treated as Bruce's successor-in-interest's distributive
share in each of the next three years. It is not deductible by the partnership.
c.
When the partnership makes the final payment.
C10-25
$160,000
100,000
200,000
96,000
b.
John's distributions are Sec. 736(b) distributions. For distribution purposes, the
partnership holds no Sec. 751 assets. Thus, no Sec. 751 exchange occurs, and John will
recognize no gain or loss on the distribution. His basis in each asset is determined as follows:
Beginning basis in partnership interest
($261,600 + $72,000 share of liabilities)
Minus: Actual cash
C10-26
$333,600
( 24,000)
( 72,000)
( 60,000)
$177,600
(120,000)
( 57,600)
$
-0-
$ 24,000
60,000
120,000
57,600
$261,600
FMV
$ 24,000
60,000
180,000
108,000
$372,000
Notice that the built-in gain on these assets is $110,400 ($372,000 - $261,600). Thus, Johns
total gain is the same as in Part a except here the gain is deferred rather than recognized
immediately.
The partnership does not terminate and has the following postdistribution balance sheet:
Partnerships Basis
FMV
Assets:
Cash
Receivables
Building
Land
Total
$136,000
40,000
80,000
38,400
$294,400
$136,000
40,000
120,000
72,400
$368,000
$120,000
87,200
87,200
$294,400
$120,000
124,000
124,000
$368,000
Andrew and Stephen each will have an outside basis of $147,200 ($87,200 + $60,000 share of
liabilities).
pp. C10-12 and C10-18 and C10-22 through C10-24.
C10-47 a.
Sec. 736(b) property:
Cash
$ 60,000
Receivables
20,000
Land
100,000
$180,000
The amount realized equals $160,000 cash + $20,000 release from liabilities, which is
allocated all to the Sec. 736(b) property.
C10-27
$180,000
The character of the gain is capital gain because the partnership has no Sec. 751 assets or
Sec. 1250 property.
b.
Amount realized ($160,000 cash and $20,000 liabilities)
Minus: Adjusted basis of partnership interest
( 120,000)
Recognized gain or loss
$ 60,000
$180,000
The character of the gain is capital because the partnership has no Sec. 751 assets or Sec.
1250 property. Thus, in total, the results are the same as in Part a.
pp. C10-12 through C10-18.
C10-48 a.
A taxable transaction occurs.
determined as follows:
$60,000
(40,000)
$20,000
$60,000
(20,000)
$40,000
All or part of the gains might be Sec. 1250 gain if the underlying real property was subject to
depreciation.
b.
An exchange of a partner's general partnership interest for a limited partnership
interest in the same partnership is treated much like a corporate recapitalization and is likely to be
nontaxable. pp. C10-20 and C10-21.
C10-28
C10-49 a.
No. Only 40% is treated as having changed hands.
b.
No. Liquidating distributions do not terminate a partnership.
c.
Yes. Only one member of the partnership continues as owner.
d.
Yes. The partnership terminates on June 1 of the current year.
e.
The ABC Partnership terminates on December 30 of the current year. The WXY
Partnership is treated as having continued.
f.
The WXY Partnership terminates on January 1 of the current year.
pp. C10-22 through C10-26.
C10-50 a.
The KL Partnership continues while the MN Partnership terminates.
b.
The ABC Partnership continues while the CD Partnership terminates.
c.
The YZ and WX Partnerships both terminate.
d.
The DE Partnership is a continuation of the DEFG Partnership.
Partnership is a new partnership.
e.
The HIJK Partnership terminates.
The FG
$100,005a
(
-0-)
$100,005
b.
$100,000
( 80,000)
$ 20,000
c.
Pattys share of the gain is $20,000. However, she recognizes none of this gain
because of her $20,000 basis adjustment. pp. C10-26 through C10-29.
C10-29
C10-53 a.
The ABC Company (an LLC) will be treated as a partnership. Alex will report his
one-third share of each income item reported by the LLC.
Ordinary income
Short-term capital gain
Long-term capital loss
$10,000
4,000
( 2,000)
The distribution is not taxable because it does not exceed Alex's basis in his ABC
Company interest.
b.
Beginning basis
Plus: Share of ordinary income
Minus: Capital loss
Distribution
Ending basis
$40,000
14,000
( 2,000)
(12,000)
$40,000
p. C10-30.
C10-54 a.
Ordinary income:
Ordinary income before adjustments
Minus: Charitable contributions
Plus: Net short-term capital gain
Ordinary income
a
b.
$ 5,200,000
( 164,000)
390,300a
$5,426,300
$2,000,000
Ordinary income:
Ordinary income before adjustments
Minus: Net Sec. 1231 loss
Net loss
$ 700,000
( 107,800)a
$ 592,200
$ 27,000
( 134,800)
($107,800)
C10-30
b.
$3,000,000
437,600
43,000
Comprehensive Problems
C10-56 a.
Able, Baker, and Lifecycle Partnership recognize no gain or loss on the transfer of
land to the partnership. Lifecycle Partnership takes the following tax basis and book values in the
land:
Tax Basis
Book Value
Land A
Land B
$16,000
22,000
$30,000
20,000
The partnerships tax holding period for the land includes Ables and Bakers holding periods prior
to the transfers. Ables beginning basis in his partnership interest is $16,000, and Bakers
beginning basis is $22,000.
b.
Sales
Minus: Cost of goods sold
Gross profit
Minus:
Depreciation
Interest expense
Salary expense (guaranteed payment)
Operating expenses
Partnership ordinary income (loss)
Separately stated items:
Dividend income
STCG; LTCG
Tax-exempt interest
Charitable contribution
Qualified production activities income
reported to partners
C10-31
2006
2007
$964,000
(450,000)
$514,000
$990,000
(500,000)
$490,000
$500,000
(280,000)
$220,000
( 94,000)
(140,000)
-0( 30,000)
$250,000
(150,000)
(130,000)
( 12,000)
( 40,000)
$158,000
(115,000)
(125,000)
-0( 60,000)
($
80,000)
-0-0-0-0-
$250,000
2,000
1,000
1,500
500)
$158,000
-03,000
-0-0None
Able
Baker
$ 30,000
150,000
$180,000
94,800
600
1,200
900
(
300)
( 42,000)
$235,200
1,800
( 48,000)
$189,000
$ 20,000
100,000
$120,000
63,200
400
800
600
(
200)
( 28,000)
$156,800
1,200
( 32,000)
$126,000
Able
Baker
$ 16,000
1,200,000
150,000
$1,366,000
94,800
600
1,200
900
(
300)
( 42,000)
( 60,000)
$1,361,200
1,800
( 48,000)
( 18,000)
$1,297,000
$ 22,000
800,000
100,000
$922,000
63,200
400
800
600
(
200)
( 28,000)
( 40,000)
$918,800
1,200
( 32,000)
( 12,000)
$876,000
c.
Able
Baker
Selling price
Minus: Total book value
Book gain
$1,366,000
(1,191,000)
$ 175,000
$ 105,000
$70,000
Able
Baker
14,000
105,000
$ 119,000
($ 2,000)
70,000
$68,000
$1,366,000
(1,179,000)
$ 187,000
12,000
175,000
$ 187,000
$ 189,000
105,000
$ 294,000
Baker
$126,000
70,000
$196,000
Baker
$1,297,000
$876,000
14,000
105,000
(1,122,000)
$ 294,000
2,000)
70,000
(748,000)
$196,000
(4) Upon liquidation, Able receives $294,000, and Baker receives $196,000, which
are the amounts of their book capital accounts. Able, Baker, and Lifecycle Partnership recognize
no gain or loss on the liquidating distributions. The partners have no basis in the partnership
because it has terminated.
C10-33
C10-57
WARNING. Be aware that this problem is very complex because it combines a
number of concepts from within this chapter. Students are likely to need assistance in
completing it.
a. Annes tax results:
Cash payment
Liability relief
Total payment
$220,000
31,200
$251,200
$222,560
$ 28,640
$120,000
12,480
$107,520
$ 45,760
12,480
$ 33,280
$107,520
176,800
$ 69,280
Summary: Anne must recognize a guaranteed payment of $28,640, other ordinary income
of $33,280, and capital gain of $69,280.
Partnership tax results:
Deduct the guaranteed payment of $28,640 paid to Anne. (In addition, the partnership
would increase its basis in its accounts receivable to reflect the fact that some receivables were
deemed purchased from Anne for $33,280.)
C10-34
b.
interest:
Amount realized on sale
($220,000 cash + $31,200 liabilities)
Minus: Adjusted basis of partnership interest
Total gain realized
$251,200
( 120,000)
$131,200
$131,200
( 33,280)
$ 97,920
In summary, on the sale of her partnership interest, Anne recognizes $33,280 of ordinary income
and a $97,200 capital gain.
Partnership tax results:
ABC Partnership terminates because more than 50% of the capital and profits interest of
the partnership has been sold. The new partnership will elect a tax year and make all necessary
accounting elections. The assets of old ABC will be assumed contributed to new ABC.
Accordingly, the basis and holding period of the assets will be unchanged by the termination and
formation of a new partnership.
pp. C10-16 through C10-20 and C10-22 through C10-24.
C10-35
Beginning
Partnership
Amount
(1)
Daniels
Interest
Before
Distribution
(1/3)
(2)
Daniels
Interest
After
Distribution
(-0-)
(3)
(4)
(5)
Fictional
Proportionate
Distribution
(3)=(1)-(2)
Actual
Distribution
Difference
(5)=(4)-(3)
$ 60,000
$20,000
-0-
$20,000
$ 60,000
60,000
$120,000
$20,000
20,000
$40,000
-0-0-0-
$20,000
20,000
$40,000
-0-
($20,000)
$60,000
-0$60,000
$40,000
(20,000)
$20,000
Other Assets:
Cash
Land
Total
-0-
$20,000
(
-0-)
$20,000
$30,000
(
-0-)
(40,000)
$
-0-
Because the $40,000 remaining cash distribution exceeds Daniels partnership basis
($30,000), he recognizes a $10,000 capital gain.
Summary of results:
Current ordinary income
Current capital gain
$20,000
10,000
Basis
FMV
$20,000
-010,000
$30,000
$20,000
20,000
20,000
$60,000
Because Daniels partnership basis exceeds the amount of cash distributed, he recognizes no
gain on the distribution. His partnership basis is $10,000 after reduction for the cash distribution.
He takes a zero basis in the receivables and a $10,000 basis in Land A. Daniel recognizes gain or
income when he sells the assets.
Summary of results:
Deferred ordinary income
Deferred capital gain
$20,000
10,000
$60,000
( 30,000)
$30,000
$60,000
10,000
10,000
10,000
Thus, on the sale of his partnership interest, Daniel recognizes ordinary income of $20,000.
$30,000
( 20,000)
C10-37
$10,000
Summary of results:
Current ordinary of income
Current capital gain
$20,000
10,000
b.
Options 1 and 3 yield the same results: current gain recognition, a disadvantage, and
current receipt of cash, an advantage. Conversely, Option 2 defers gain recognition and cash
collection until Daniel collects on the receivables and sells the land. Thus, if Daniel has immediate
need for cash, he should select Option 1 or Option 3. If he does not have immediate cash needs, he
should consider Option 2.
( 300,000)
Because the sale is an installment sale, Mark would recognize his gain on an installment
basis. In the first year, he would recognize gain of $93,333, calculated as follows:
Gain realized
Contract price
x Installment
C10-38
$350,000
x $120,000 = $93,333
$450,000
At a 15% maximum rate, the gain would result in taxes of $14,000, leaving Mark $106,000
($120,000 - $14,000) of after-tax proceeds for the first year. In each of the following three years,
he would recognize gain of $85,556, calculated as follows:
Gain realized
Contract price
$350,000
$450,000
x $110,000 = $85,556
At a 15% maximum rate each year, the gain would result in taxes of $12,833, leaving Mark
$97,167 ($110,000 - $12,833) of after-tax proceeds each year. Total proceeds for Mark for the
four years are $450,000, and total taxes are $52,500 ($350,000 x 0.15). Thus, Marks total aftertax proceeds are $397,500 ($450,000 - $52,500).
Note that Michael is using after-tax dollars to pay Mark each year. Because this
transaction is an installment sale between related parties, Mark would have to recognize any
unrecognized gain if Michael later resold this partnership interest to another partner.
If no other partner is admitted to the partnership, the partnership will terminate when
Michael buys Mark's interest. Michael would receive all the partnership assets in a liquidating
distribution. The basis of the partnership assets would be changed as follows:
Michael's partnership interest basis
$ 300,000
Basis of partnership interest purchased from Mark ($450,000
installment sale + $200,000 share of liabilities)
650,000
Deemed cash contributed by Michael because
he assumes the partnership's liability
400,000
Balance before distributions
$1,350,000
Minus: Cash and deemed cash distributed
( 600,000)
Accounts receivable
( 90,000)
Remaining basis allocable to land
$ 660,000
Notice that this basis adjustment has greatly decreased the potential capital gain that Michael will
recognize on the subsequent sale of the land investment.
Option 2A: Retirement from the partnership for $150,000 plus 50% of partnership profits for
the next three years.
Assuming the brothers correctly project income to be approximately $200,000 for each of
the next three years, Mark will receive a total of $450,000 over the four years. His gain will be
$350,000, calculated as follows:
Amount realized
Minus: Adjusted basis
Realized gain
$650,000
(300,000)
$350,000
In the initial year, Mark will receive $150,000 cash that he will treat as a normal
partnership distribution that reduces his basis. In future years, he will be allocated a 50% share of
the partnership earnings (with the character they have at the partnership level), which will increase
C10-39
his basis. He also will receive a distribution from the partnership equal to the amount of income
he recognizes, and this distribution will reduce his basis by the same amount the income
recognition increases it. Accordingly, he will not be taxed on the distribution. After the final
payment, Mark no longer will be a partner, so his final payment will include the deemed cash from
the release of his liability share. Mark will report approximately $300,000 of income under this
method, and the character of the income is determined at the partnership level. Because the main
source of partnership income is the sale of investment land, most of the gain Mark will recognize
also will be capital gain.
Assuming all partnership income is capital gain for the three years, each year Mark will be
allocated $100,000 in capital gains and will pay taxes of $15,000 so that he has after-tax income
of $85,000. The first year's payment is tax-free so he has after-tax receipts of $150,000 for the
first year. Cash received over the four years is $450,000, and he will pay taxes of $45,000,
leaving after-tax receipts of $405,000 ($450,000 - $45,000).
Michael's share of income for the three years is reduced by the income allocated to Mark.
The partnership will continue in operation under this option until Mark receives his final payment
from the partnership.
Option 2B:
Retirement from the partnership for $150,000 cash plus $100,000 guaranteed
payment for three years.
In this option, as in the preceding one, Mark's first year payment is simply a distribution
from the partnership, which reduces his basis in the partnership interest. Likewise, in the final
year Mark will be deemed to receive cash equal to the share of liabilities that he no longer will be
liable for. Assuming the liabilities do not change, these two distributions will have the following
results:
Beginning basis
Minus: Year one cash
Basis after cash distribution
Minus: Year four liability release
Basis (but not less than zero)
$300,000
(150,000)
150,000
(200,000)
$
-0-
Mark will recognize a $50,000 long-term capital gain in year four. At a 15% maximum tax
rate, he will owe taxes of $7,500. Because this gain is caused by the deemed cash distribution
from the liability release, Mark is not receiving any cash to pay these taxes. The $100,000
guaranteed payment will be taxed as ordinary income in each of the next three years. Assuming
Marks ordinary tax rate is 35% each year, he will pay $35,000 in taxes for an after-tax amount of
$65,000. Over the four years, Mark will receive cash of $450,000 and will pay taxes of $112,500
[($35,000 x 3) + $7,500] for after-tax receipts of $337,500 ($450,000 - $112,500).
Option 3: Outside purchase of interest.
Under this option, Mark will report a $350,000 long-term capital gain determined as
follows:
Amount realized ($450,000 cash + $200,000 liabilities)
C10-40
$650,000
(300,000)
$350,000
At a 15% maximum tax rate, the gain would result in taxes of $52,500, leaving Mark
$397,500 ($450,000 cash - $52,500 taxes) of after-tax proceeds. (Mark receives the same aftertax benefits that he receives if Michael is the purchaser.)
Although this option technically terminates the partnership because of the 50% sale, the
partnership nevertheless continues as a new partnership. This results contrasts with Option 1,
where the partnership goes out of existence. If Michael wants to continue the partnership form of
conducting the investment, he should consider this option. Also, unless the partnership has made
a Sec. 754 election, no increased basis for the investment land occurs under this option.
Summary: Mark's after-tax receipts are highest for Option 2A -- the retirement from the
partnership for $150,000 cash plus a 50% distributive share for the next three years. The
memorandum should emphasize to Mark that this option is the only sales arrangement under
which uncertainty exists about what he will receive. If land sales are unusually slow for the threeyear payout period, Mark may receive little more than the $150,000 first year payment.
Accordingly, students may want to recommend the sale to John or the sale to Michael
depending on whether or not Michael wants to continue as a sole proprietor or as John Watson's
partner.
C10-60 Relevant facts:
Miguel wrote an opinion letter used in the prospectus of a tax shelter and prepared the
first year tax-return. The tax shelter has grossly overvalued assets, and other revenues and
expenses were falsified. The investors and the IRS do not know about the overvalued assets nor
about the falsified revenues and expenses.
The AICPA bylaws designate the Accounting and Review Services Committee as the
senior technical committee authorized to issue pronouncements in connection with the unaudited
financial statements or other unaudited financial information of a nonpublic entity. The
Committee promulgates Statements on Standards for Accounting and Review Services (SSARSs)
and is authorized to promulgate attestation standards in its area of responsibility. Miguel must
follow these standards in conducting the review for Mr. Azul. The information contained in the
financial statements must conform with Generally Accepted Accounting Principles (GAAP) or, if
applicable, with another comprehensive basis of accounting. The standard review report contains
three paragraphs. The report does not have a title and is usually addressed to the owner or party
who engaged the accountant.
The first paragraph of the review report states which financial statements have been
reviewed and that the review was conducted in accordance with SSARSs issued by the AICPA. It
also states that all information contained in the review report is the representation of management
or the owners of the company. The second paragraph of the review report describes what occurs
during a review. A review consists principally of inquiries of company personnel and analytical
procedures applied to financial data. It also states that a review is substantially less in scope than
C10-41
C10-42
Possible alternatives:
1.
2.
3.
4.
5.
1.
2.
3.
4.
5.
6.
7.
8.
What are the possible consequences to Miguel, to the investors, to the tax authorities, and
to Mr. Azul of each alternative?
Which alternative would provide the greatest benefit to the largest number of people?
Which alternative would be most fair to the investors? To the tax authorities? To Miguel?
Does Miguel have the right to report the tax shelter to the IRS?
Did Miguel meet his obligations under the AICPA's Statements on Standards for Tax
Services, No. 1 and No. 3?
Does Miguel have a potential problem with the IRS under the tax return preparer rules
(see Chapter C15).
Does Miguel have a potential problem with Treasury Department Circular 230 (see
Chapter C15).
Should the federal government be able to require tax preparers to investigate what their
clients tell them?
C10-43
Partnership Liquidation:
Partner
Arnie
Becky
$80,000
(33,333)
$46,667
$46,667
$120,000
( 33,333)
$ 86,667
$ 86,667
Clay
$160,000
( 33,334)
$126,666
$126,666
Total
$360,000
(100,000)
$260,000
Neither the partner nor the partnership recognizes gain or loss on the asset and liability transfer.
Financial Accounting Results:
First, the partnerships assets would be appraised and written up to reflect the current
FMV of each asset. All gains and losses would be recognized for financial accounting purposes
and allocated among the three partners according to their interest in gains and losses (equally).
Each partners capital account would be increased by his or her share of the $110,000 gain that
would result. See Reg. Sec. 1.704-1(b)(2)(iv)(f).
The entries on the partnerships financial accounting books to record the gains would be as
follows:
Inventory
50,000
Land
60,000
Arnies capital
36,667
Beckys capital
36,667
Clays capital
36,666
Recording the transfer of assets and liabilities to the new corporation in exchange for the stock of
the new corporation would require the following entries on the partnerships books (assuming the
corporation opens a new set of books instead of continuing to use the partnership books):
Investment in ABC Corp. stock
500,000
Liabilities
100,000
Cash
50,000
Accounts receivable
55,000
Inventory
200,000
Land
295,000
To distribute the stock and close the partnerships books would require the final entry:
Arnies capital
Beckys capital
Clays capital
Investment in ABC Corp. stock
C10-44
166,667
166,667
166,666
500,000
To establish the new ABC Corporation, the corporation would record the following entry:
Cash
Accounts receivable
Inventory
Land
Liabilities
Common stock
50,000
55,000
200,000
295,000
100,000
500,000
Assets would be recorded on the corporations books at their FMV, so the total basis of
the assets for financial accounting purposes would be $600,000 (APB 29).
C10-62
$16,667
10,000
16,667
33,333
13,333
7,000
$97,000
All payments based on partnership income also will be Sec. 736(a) payments taxed as distributive
shares.
Total fixed payments = $20,000 x 5 = $100,000
Sec. 736(b) payments as portion of fixed payments: $97,000/$100,000 = 97%
Allocation of payments for years 1-5:
$20,000 payment: Sec. 736(b) (97%)
Sec. 736(a) (3%)
$19,400a
C10-45
(14,000)
Taxation of the partnership is not affected by the payments made for Della's interest in
property. It takes no deduction and does not reduce the continuing partners' distributive share of
the payments made for the interest in property. The small guaranteed payment each year is
deductible by the partnership. The $5,000 distributive share results in a smaller distributive share
for each of the remaining partners.
C10-63 Transfer of an interest in a partnership by gift does not terminate the partnership tax year
for the donor. (Little authority exists to suggest how a part-sale, part-gift will be treated, but
most practitioners agree that it will be treated the same as a gift transfer for this purpose.)
However, the donor must recognize income from the partnership up to the date of the gift.
Because the partnership tax year does not close on the date of the gift, the income is included in
the partner's tax year that includes the normal partnership year-end (Reg. Sec. 1.706-1(c)(5)). On
his tax return for the tax year ending June 30 of the current year, Pedro will report partnership
income from the tax year that ended on December 31 of last year. He will report partnership
income earned between January 1 of the current year and his June 15 gift on his tax return for the
tax year that ends on the next June 30th. Juan and the American Red Cross must report all
partnership income earned after June 14 of the current year.
Transfer of a majority interest by gift does not constitute a sale or exchange that can
terminate a partnership (Reg. Sec. 1.708-1(b)(1)(ii)). Although part-sale, part-gift transactions
like this one are not clearly covered by the Treasury Regulation, the sale portion of the transaction
does not appear to be a majority interest.
The transfer to Juan is a part-sale and part-gift. See Victor P. Diedrich v. CIR, 47 AFTR
2d 81-977, 81-1 USTC 9249 (8th Cir., 1981). The 30% interest transferred to Juan is
considered sold to him because the liability is one-half of the FMV ($50,000 liability $100,000
FMV of partnership interest transferred). Pedro must recognize gain on the sale of a 15% interest
of $30,000 ($50,000 liabilities transferred - $20,000 basis). The remaining 15% interest is a gift
to Juan. Pedro must report the gift portion for gift tax purposes at its FMV of $50,000.
The transfer to the American Red Cross also is a part-sale and part-gift but the allocation
of basis to the sale and gift differ from the allocation above (Rev. Rul. 75-194, 1975-1 C.B. 80).
Only a pro rata portion of the basis is allocated to the sale transaction, so basis of $10,000
([$50,000 liability $100,000 FMV] x $20,000 basis) is allocated to the sale, and the remaining
$10,000 of basis is allocated to the gift portion of the transaction. On the sale transaction, Pedro
must recognize gain of $40,000 ($50,000 liability transferred - $10,000 basis allocated to sale
transaction). Pedro makes a charitable contribution of the remaining partnership interest, which
has a basis of $10,000 and FMV of $50,000. The contribution is eligible for a charitable
contribution deduction.
C10-45
C10-46