SMChap 020

Chapter 20 - Forming and Operating Partnerships
Chapter 20
Forming and Operating Partnerships
Solutions Manual
Discussion Questions:
1. [LO 1] What is a flow-through entity, and what effect does this designation have on how
business entities and their owners are taxed?
Flow-through entities are entities that are not taxed on the entity level; rather, these
entities are taxed on the owners level. These types of entities conduct a regular
business; however, the income earned and deductions allowed are passed to the owners
of these flow-through entities. The owners are then taxed on the amount allocated to
them. Thus, flow-through entities provide a way for income and deductions to be taxed
only once instead of twice.
2. [LO 1] What types of business entities are taxed as flow-through entities?
The two main business entities that are taxed as flow-through entities are partnerships
and S corporations. Partnerships are taxed under Subchapter K and consist of general
partnerships, limited partnerships, and limited liability companies (LLC). S
corporations are taxed under Subchapter S. Both these types of business entities are
treated as flow-through entities and are taxed accordingly.
3. [LO 1] Compare and contrast the aggregate and entity concepts for taxing partnerships
and their partners.
The aggregate concept treats partnerships more like a conglomeration of individual
owners. Each partnership is viewed as an aggregation of the partners separate interests
in the assets and liabilities of the partnership. For example, each partner, rather than
the partnership, pays tax on their individual share of partnership income.
The entity concept treats partnerships more like a corporation. Each partnership is an
entity separate from its partners. For example, the partnership decides on which tax
method to use and which tax elections to make rather than the individual partners.
4. [LO 2] What is a partnership interest, and what specific economic rights or entitlements
are included with it?
A partnership interest is an equity interest in a partnership. This interest is created
through a transfer or sale of cash, property, or services in exchange for an equity interest
in the partnership. A partnership interest gives each partner certain rights or
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entitlements. The two main economic rights are a capital interest and profit interest in
the partnership. A capital interest is the right for a partner to receive a share of the
partnership assets during liquidation. A profit interest is the right or obligation for a
partner to receive a share of the future income or losses of the partnership.
5. [LO 2] What is the rationale for requiring partners to defer most gains and all losses
when they contribute property to a partnership?
The rationale for requiring partners to defer most gains and losses when contributing
property to a partnership is twofold. First, the IRS desires that entrepreneurs have a way
to start their own business without having to pay any taxes upfront. Second, the partners
are considered still owning the property they have contributed to the partnership. While
they dont own the property outright, each partner has a small percentage of the property
contributed in her/his partnership interest she/he exchanged for. This second reasoning
helps further support the idea that partnerships follow the aggregate concept.
6. [LO 2] Under what circumstances is it possible for partners to recognize gain when
contributing property to partnerships?
Partners have the potential of recognizing gain on the contribution of property when the
property contributed is secured by debt. In determining whether gain must be
recognized, the partner must assess the cash deemed to have received from the
partnership distribution compared with the tax basis of the partners partnership interest
prior to the deemed distribution. This happens if the assumption of the partners
liabilities is in excess of the partners basis of the contributed property. If the cash
deemed to have received exceeds the tax basis immediately before the deemed
distribution, then a gain must be recognized. This circumstance occurs due to the
negative basis created for the partner, which is not allowed under partnership tax law.
7. [LO 2] What is inside basis and outside basis, and why are they relevant for taxing
partnerships and partners?
An inside basis, in relation to partnerships, is the basis the partnership takes in the assets
that the partnership holds. An outside basis, in relation to partnerships, is the tax basis
each partner has in the partnership. The inside basis is necessary to compute the
gain/loss recognized on all property sold by the partnership. The outside basis is
necessary to compute the gain/loss recognized on the partnership interest when sold.
For tax purposes, the inside basis is similar to the basis the partner had in the property
prior to contribution. On the other hand, the outside basis corresponds not only to the
contributed property, but also to the debt and income/losses of the partnership that have
been allocated to the individual partners.
8. [LO 2] What is recourse and nonrecourse debt, and how is each generally allocated to
partners?
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Recourse debt is debt for which partners are considered to have an economic risk of loss.
Partners are legally liable for recourse debt and must satisfy this type of debt personally
if the partnership cannot. An example of recourse debt is accounts payable.
Nonrecourse debt is debt for which no partners are considered to have an economic risk
of loss because nonrecourse debt is typically secured by real property. An example of
nonrecourse debt is a mortgage on a building.
In regards to a partnerships debt, recourse debt is allocated to those partners that have
the ultimate responsibility of paying the debt. The debt is allocated to the partners that
have an economic risk of loss. On the other hand, nonrecourse debt is generally
allocated to the partners according to their profit sharing ratios. Despite the partners
not being legally liable for some debt, all debt is allocated to adjust the outside basis of
the partners.
9. [LO 2] How does the amount of debt allocated to a partner affect the amount of gain a
partner recognizes when contributing property secured by debt?
A partner that contributes property secured by debt is not only contributing the property
to the partnership but also the debt. The partners tax basis in his or her partnership
interest would be increased by the basis of the assets contributed. Next, the propertys
debt is allocated to each partner according to who is ultimately responsible for it or by
each partners profit-sharing ratio. The basis of the contributed assets plus the
allocation of debt would represent the partners tax basis in the partnership immediately
before the deemed distribution of cash as a result of the relief of debt attached to the
contributed property. If the partner is not allocated enough debt, the partners outside
basis will become negative and a gain must be recognized. Thus, a partner can only
avoid gain by obtaining enough of the partnership debt to keep her/his basis at least
above zero.
10. [LO 2] What is a tax-basis capital account, and what type of tax-related information does
it provide?
A tax-basis capital account is an equity account that is created for each partner of the
partnership. This account is measured using the tax accounting rules. The account
reflects tax basis of any capital contributions (i.e., property and cash), capital
distributions, and future earnings and losses allocated to that partner. Additionally, a
tax-basis capital account can provides more tax-related information for each partner.
For instance, each partners share of inside basis of the partnerships assets can be
calculated by adding the partners share of debt to her/his capital account.
11. [LO 2] Distinguish between a capital interest and a profits interest, and explain how
partners and partnerships treat when exchanging them for services provided.
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A partnership interest can be broken down into two distinct rights: (1) capital interest
and (2) profits interest. To become a partner in a partnership, you will receive at least
one of these rights. A capital interest is the right to receive a share of the partnership
assets at liquidation. A profits interest is the right to share in the future earnings and
losses of the partnership. While these rights are given to most partners that contribute
cash or property, special rules exist when these rights are given to partners in exchange
for services.
When a partner receives a capital interest in exchange for services rendered to the
partnership, the partner must treat the liquidation value of the capital interest as
ordinary income. Further, the tax basis for the partner will be equivalent to the amount
of ordinary income recognized. The holding period for this tax basis will begin on the
date the capital interest is received. From the partnerships perspective, the partnership
can deduct or capitalize the value of the capital interest depending upon the type of
services rendered. This is determined on a fact and circumstance basis. Additionally, the
amount deducted by the partnership is allocated to the non-service partners as
consideration for effectively transferring a portion of their capital interest to the service
partner.
When a partner receives a profits interest in exchange for services rendered to the
partnership, the partner has no immediate tax impact because they have no liquidation
value at the time the interest is received. Thus, the non-service partners will not receive
any deductions for the additional partner to the partnership. As the partnership makes
future profits and losses, the service partner will be allocated her/his portion of these
losses according to the profit sharing ratios. The debt allocated to non-service partners
must also be redistributed with the additional service partner receiving her/his portion of
debt. Therefore, the tax basis of a service partner with only a profits interest will either
be zero or the portion of debt the partner is allocated.
12. [LO 2] How do partners who purchase a partnership interest determine the tax basis and
holding period of their partnership interests?
When a partner purchases a partnership interest, the initial tax basis for the partner is
determined by taking the cost basis of the interest the partner purchased and adding to
this basis any debt allocated to the partners interest. The holding period for this
purchased interest will begin on the date that the partner purchased the partnership
interest.
13. [LO 3] Why do you think partnerships, rather than the individual partners, are responsible
for making most of the tax elections related to the operation of the partnership?
The responsibility for the partnership, not the partners, to make the majority of tax
elections regarding the operation of the partnership is twofold. First, partnerships can
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consist of many different partners ranging from two to hundreds. The hassle to obtain
every partners approval on what elections to make would be very time consuming. The
costs would more than likely outweigh the benefits in performing this function. Second,
in many partnerships only a few partners are actively involved in the management of the
partnership. The limited partners have ownership to obtain a tax advantage on their
own personal returns. Thus, the entity concept would appear more reasonable when
dealing with the actual operations of the partnership.
14. [LO 3] If a partner with a taxable year-end of December 31 is in a partnership with a
March 31 taxable year-end, how many months of deferral will the partner receive? Why?
A partner with a calendar year end will receive nine months of deferral in her/his
partnership interest that has a March 31 year end. A partner must report the income or
loss of the partnership not at the partnerships year end but at the partners year end.
Thus, the first year of the partnership will be reported by the partner on her/his return
which includes the partnerships year end. This allows the partner to defer the reporting
of the first nine months of income or loss from the partnership into the succeeding tax
year when the partners income tax return is filed.
15. [LO 3] In what situation will there be a common year-end for the principal partners when
there is no majority interest taxable year?
The principal partner test states that the required tax year is the taxable year all the
principal partners have in common. A principal partner is a partner that owns at least 5
percent interest in the partnership profits and capital. For the principal partner test to
pass and not the majority interest test, the partnership must consists of numerous
partners that (1) own less than 5 percent profit and capital interest and (2) have a
variety of fiscal year ends. For example, if four partners with a calendar year end owned
10 percent each and 20 additional partners with differing fiscal year ends owned less
than 5 percent, then the majority test would not pass, but the principal partners test
would.
16. [LO 3] Explain the least aggregate deferral test for determining a partnerships year end
and discuss when it applies.
The least aggregate deferral test is the last resort test that a partnership must follow
when figuring out the partnership year end. The first test is the majority interest test.
The second test is the principal partners test. If these two tests dont apply, along with
the exception to elect an alternative year end, then the least aggregate deferral test goes
into effect.
The least aggregate deferral test selects the tax year which provides the partner group as
a whole the smallest amount of aggregate tax deferral. This is calculated by taking each
partners months of deferral under the potential tax year and weighting it with the
partners profit interest percentage. Then, each partners weighted totals are summed up
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to come up with an aggregate deferral number. The potential tax year that produces the
smallest aggregate deferral must be the one chosen by the partnership.
17. [LO 3] When are partnerships eligible to use the cash method of accounting?
Under the tax accounting rules, a partnership with a corporate partner must use the
accrual method of accounting unless the following exception applies. A partnership with
a corporate partner is eligible to use the cash method of accounting when the
partnership has average gross receipts over the past three taxable years less than or
equal to $5 million.
18. [LO 4] What is a partnerships ordinary business income (loss) and how is it calculated?
Through the course of business, partnerships create income or losses. Some of these
items are considered to affect a specific partner or groups of partners differently. Thus,
these separately-stated items must be reported on a partner-by-partner basis. Then, after
adjusting the partnerships business income (loss) for these separately-stated items, the
partnership reports the remaining amount of business income (loss) to ordinary business
income (loss). The total amount will be allocated to each partner according to the
special allocation rules agreed upon or else based upon the profit sharing ratios of the
partnership.
19. [LO 4] What are some common separately stated items, and why must they be separately
stated to the partners?
Separately-stated items must be taken out of ordinary income (loss) because these items
either (1) relate only to a specific partner in the partnership or (2) the item is taxed
differently for each partner depending upon the entity of the partner and the partners
current tax situation. The following is a partial list of items that are separately stated on
a partnership return.
1. Short-term capital gains (losses)
2. Long-term capital gains (losses)
3. Section 1231 gains (losses)
4. Charitable contributions
5. Dividends
6. Interest income
7. Guaranteed payments
8. Net earnings (losses) from self-employment
9. Tax-exempt income
10. Net rental real estate income (loss)
11. Investment interest expense
12. Section 179 deductions
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20. [LO 4] Is the character of partnership income/gains and expenses/losses determined at the
partnership or partner level? Why?
In keeping with the entity concept, the character of all income/gains and expenses/losses
is determined at the partnership level. Despite the chance that specific items would
change character depending upon the partner who holds them, the IRS has decided to
unify the character of all items by looking at the character from the partnerships
perspective. Thus, partnerships are required to file a 1065 return along with all
partners K-1s to help audit the amounts and character that show up on the individual
partners return.
21. [LO 4] What are guaranteed payments and how do partnerships and partners treat them
for income and self-employment tax purposes?
Guaranteed payments are similar to cash salary payments for services provided. The
idea behind a guaranteed payment is for a partner to receive a fixed amount of income
no matter the profit (loss) for the partnerships taxable year. Thus, on the partnership
level, they are treated like a salary payment to an unrelated party. The partnership
deducts the guaranteed payment in computing the partnerships ordinary business
income (loss).
On the partner level, the partner that receives a guaranteed payment must account for
the guaranteed payment as a separately-stated item that is taxed as ordinary income.
Further, the partner must include the amount of the guaranteed payment in computing
self-employment income for tax purposes. This amount is included no matter if the
partner is a general partner, limited partner, or LLC member.
22. [LO 4] How do general and limited partners treat their share of ordinary business income
for self-employment tax purposes?
In determining how different partners treat their share of ordinary business income, the
IRS assesses the involvement the partner has in the partnership. General partners are
considered to be actively involved in the management of the partnership. Thus, the
general partners share of ordinary business income is treated as trade or business
income and is subject to self-employment tax. Conversely, limited partners are generally
not actively involved with managing the partnership. The limited partners share of
ordinary business income is treated as investment income and not subject to selfemployment tax. Both types of partners must treat guaranteed payments as income
relating to self-employment; however, the ordinary business income depends on the type
of partner.
23. [LO 4] What challenges do LLCs face when deciding whether to treat their members
shares of ordinary business income as self-employment income?
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Due to the lack of authoritative ruling that exists for LLCs, members must decide on their
own whether to include ordinary business income as self-employment income or not. A
proposed regulation gave us clarity on this matter; however, the regulation was
withdrawn. Members of an LLC should still review this proposed regulation to
understand the stance the IRS is trying to take and whether they will take an aggressive
or conservative stance for their specific situation.
The proposed regulation helped clarify that if an LLC member is involved in the
operations of the LLC, the member should treat the ordinary business income as selfemployment income. The regulation listed the following three criteria that would
demonstrate active involvement in the LLC: (1) personally liable for the debt of the LLC
as an LLC member, (2) authority to contract on behalf of the LLC, or (3) participate in
more than 500 hours in the LLCs trade or business during the taxable year. If any one of
these requirements is met, then the LLC member would be more associated as a general
partner and should more than likely account for the ordinary business income as selfemployment income.
24. [LO 4] How much flexibility do partnerships have in allocating partnership items to
partners?
Partnerships have a great deal of flexibility in determining how to allocate partnership
items to partners, both separately-stated and non-separately stated items. The
determining factors must be (1) the partners agree upon the allocations and (2) the
allocations have substantial economic effect. The second factor is put into place to make
sure the allocations are being accomplished for a business objective and not just to
reduce or avoid taxes. While both of these items need to be met for a special allocation
of a partnership item, certain items have mandatory allocations to specific partners. For
example, contributed property built-in gain (loss) must be allocated to the partner who
contributed the property when the property is sold. Any additional gain (loss) will be
allocated according to the partnership agreement. Overall, if the partnership has no
mandatory allocations or does not specify and meet the requirements for special
allocations, the partnership will allocate according to the capital or profit interest.
25. [LO4] What are the basic tax-filing requirements imposed on partnerships?
While a partnership does not pay taxes, the IRS still requires all partnerships to file an
information return to the IRS Form 1065 (U.S. Return of Partnership Income). This
form must be filed by the 15th day of the 4th month of the partnerships year end. For
calendar year end partnerships, the form must be filed by April 15th. An extension is
available to file by the due date of the original return and provides the partnership an
additional five months to file Form 1065. The extension must be filed on Form 7004.
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The tax return that must be filed by all partnerships consists of a detailed calculation of
the partnerships ordinary business income (loss) on page 1 of Form 1065. On page 3 of
Form 1065, Schedule K must be filled out which lists the ordinary business income (loss)
along with any separately-stated items. This schedule is an aggregate of each partners
share of items both separately-stated and non-separately stated. In addition, each
partners proportion of the above items is reported on a Schedule K-1. A Schedule K-1
for every partner must be filed with Form 1065, and each individual partner will receive
her/his own Schedule K-1 from the partnership.
26. [LO 5] In what situations do partners need to know the tax basis in their partnership
interests?
Partners should always keep track of the tax basis in their partnership interest because
certain situations require partners to actually know their tax basis. These situations
occur when a partner sells her/his partnership interest or when a partner receives a
distribution from the partnership. Tracking the tax basis in the partnership interest helps
the partner determine the amount of gain or loss that must be reported on the partners
tax return.
27. [LO 5] Why does a partners tax basis in her partnership need to be adjusted annually?
A partners tax basis needs to be adjusted annually for the following three reasons. First,
a partner does not want to double count any income/gain from the partnership when
she/he sells her/his partnership interest or receive a distribution from the partnership.
Second, the IRS does not want partners to double count any expenses/losses from the
partnership in a similar situation from above. Last, partners want to make sure they
adjust for tax-exempt income and non-deductible expenses, so these items will not
ultimately be taxed or deducted at the time of selling a partnership interest or receiving a
distribution from the partnership.
28. [LO 5] What items will increase a partners basis in her partnership interest?
The following items will increase a partners basis and must be adjusted for on an annual
basis in the order given.
1. Actual and deemed cash contributions to the partnership
2. Partners share of ordinary business income
3. Partners share of separately-stated income/gain items and
4. Partners share of tax-exempt income
29. [LO 5] What items will decrease a partners basis in her partnership interest?
The following items will decrease a partners basis and must be adjusted for on an
annual basis in the order given. These items will be adjusted after all the increases to a
partners basis have been taken into effect.
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1.
2.
3.
4.
Actual and deemed cash distributions from the partnership

Partners share of non-deductible expenses (fines, penalties, etc.)
Partners share of ordinary business losses and
Partners share of separately-stated expenses/loss items
30. [LO 6] What hurdles (or limitations) must partners overcome before they can ultimately
deduct partnership losses on their tax returns?
While a partnership can create an ordinary business loss, the individual partners
potentially will not be able to deduct the entire amount in the year of the loss. The
partner must overcome three loss limitation rules before the deduction is available. If the
loss does not pass any of the limitations, then the loss is suspended indefinitely under that
specific hurdle. The three loss limitations are (1) the tax basis limitation, (2) the at-risk
loss limitation, and (3) the passive activity loss limitation.
First, a partner is not able to take any losses that exceed the tax basis of the partner, the
partners outside basis. This limitation prevents partners from taking losses beyond their
investment or basis in their partnership interests. Second, a partner cannot take any
losses that exceed the at-risk amount for the partner. The at-risk amount is generally the
same as the partners tax basis, except that it excludes the partners share of nonrecourse
debt. This limit still includes recourse debt and qualified nonrecourse debt. Finally, in
the case of a passive participant in a partnership, losses cannot be taken if the loss
exceeds the amount of passive income reported by the partner. Passive losses such as
losses from rental activities or losses allocated to a limited partner can only be offset
with passive gains.
31. [LO 6] What happens to partnership losses allocated to partners in excess of the tax basis
in their partnership interests?
Losses that are allocated to partners that exceed the partners tax basis cannot be used
during the current taxable year. The excess loss will be suspended and carried forward
indefinitely until the partner has sufficient basis to utilize the losses. A partner would be
able to increase her/his tax basis by (1) making a capital contribution, (2) guaranteeing
more partnership debt, or (3) helping the partnership become more profitable. Once the
partners tax basis is positive, the losses previously suspended can be used.
32. [LO 6] In what sense is the at-risk loss limitation rule more restrictive than the tax basis
loss limitation rule?
While the at-risk loss limitation and tax basis loss limitation are basically the same, one
difference exists between the two different hurdles a partner must overcome when faced
with losses. The at-risk loss limitation only accounts for those items that the partner is at
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risk for. The major item that is not included under the at-risk calculation but is included
in the tax basis is nonrecourse debt. As a note, qualified nonrecourse debt is still
considered to be part of the partners at-risk calculation.
33. [LO 6] How do partners measure the amount they have at risk in the partnership?
A partner will measure her/his partnership at-risk amount by looking at what items affect
the partners economic risk of loss. In most cases, items included in the at-risk amount
would include cash contributed, tax basis of property contributed, recourse debt,
qualified nonrecourse debt, and any other adjustments to the partners tax basis
excluding nonrecourse debt. Nonrecourse debt is considered a part of the tax basis but
not a part of the at-risk basis since the partner does not have an economic risk of loss for
this type of debt.
34. [LO 6] In what order are the loss limitation rules applied to limit partners losses from
partnerships?
The order of the hurdles a partner must pass for the loss limitation rules are (1) tax basis
loss limitation, (2) at-risk loss limitation, and (3) passive activity loss limitation. As the
losses exceed the limitation in each hurdle, the suspended losses will be carried forward
indefinitely within each group until enough basis or income is generated to cover these
losses. Once the loss has passed all three limitations, the partner can use the loss as a
deduction on her/his own personal return.
35. [LO 6] How do partners determine whether they are passive participants in partnerships
when applying the passive activity loss limitation rules?
According to the Code, a partner is considered to be a passive participant if the activity
conducted is a trade or business and the partner does not materially participate in the
activity. The IRS has made it clear that those participants in rental activities and limited
partners within a partnership are automatically considered to be passive participants.
Further, regulations help clarify whether a partner would be considered a material
participant. If the partner meets any of the conditions below, then the partner would be a
material participant and the activity would not be considered a passive activity to the
partner.
1. The individual participates in the activity more than 500 hours during the year.
2. The individuals activity constitutes substantially all of the participation in such
activity by individuals.
3. The individual participates more than 100 hours during the year and the
individuals participation is not less than any other individuals participation in the
activity.
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4. The activity qualifies as a significant participation activity (individual

participates for more than 100 hours during the year) and the aggregate of all other
significant participation activities is greater than 500 hours for the year.
5. The individual materially participated in the activity for any 5 of the preceding 10
taxable years.
6. The activity involves personal services in health, law, accounting, architecture, and
so on, and the individual materially participated for any three preceding years.
7. Taking into account all the facts and circumstances, the individual participates on a
regular, continuous, and substantial basis during the year.
36. [LO 6] Under what circumstances can partners with passive losses from partnerships
deduct their passive losses?
A partner may deduct the passive losses she/he has generated from a partnership under
three circumstances. First, a passive loss is not deductible until the taxpayer generates
current year passive income in the activity producing the loss. Second, a passive loss is
not deductible until the taxpayer generates current year passive income from another
passive activity the taxpayer is involved with. Last, a passive loss will not be deductible
unless the taxpayer sells the activity that has produced the passive loss. In this case, the
taxpayer will report a gain or loss on the sale and can use the passive loss to offset this
or any other source of income ( i.e., active income, portfolio income, or other passive
income).
Problems
37. [LO 2] Joseph contributed $22,000 in cash and equipment with a tax basis of $5,000 and
a fair market value of $11,000 to Berry Hill Partnership in exchange for a partnership
interest.
a. What is Josephs tax basis in his partnership interest?
b. What is Berry Hills basis in the equipment?
a. $27,000.
Josephs tax basis is considered to be his outside basis in the partnership. The tax
basis includes the $22,000 in cash and his original basis in the equipment, $5,000.
Josephs holding period for his outside basis would depend upon the holding period
of the assets contributed. If property contributed is a capital or Section 1231 asset,
the holding period for that portion of the partnership interest includes the holding
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period of the contributed property. Otherwise, the holding period of the partnership
interest begins on the date it is received.
b. $5,000.
Berry Hill Partnerships basis in the equipment is a carryover basis from the partner
who contributed the equipment. The basis in the equipment plus the basis in the cash
will give us Berry Hill Partnerships inside basis. The holding period for the
equipment carries over to the Berry Hill Partnership from Joseph.
38. [ LO 2] Lance contributed investment property worth $500,000, purchased three years
ago for $200,000 cash, to Cloud Peak LLC in exchange for an 85 percent profits and
capital interest in the LLC. Cloud Peak owes $300,000 to its suppliers but has no other
debts.
a. What is Lances tax basis in his LLC interest?
b. What is Lances holding period in his interest?
c. What is Cloud Peaks basis in the contributed property?
d. What is Cloud Peaks holding period in the contributed property?
a. $455,000.
Lances basis in his LLC interest is made up of the $200,000 basis of the investment
property he transferred to the LLC and his $255,000 share of the LLC debt (85% x
$300,000). Because LLC general debt obligations are treated as nonrecourse debt,
Lances profit sharing ratio is used to allocate a portion of the LLC debt to him.
b. Three years.
Because Lance contributed a capital asset, the holding period of the contributed
assets tacks onto his partnership interest.
c. $200,000.
The LLC takes a carryover basis in the contributed property.
d. Three years.
The LLC inherits Lances holding period in the contributed property.
39. [ LO 2] Laurel contributed equipment worth $200,000, purchased 10 months ago for
$250,000 cash and used in her sole proprietorship, to Sand Creek LLC in exchange for a
15 percent profits and capital interest in the LLC. Laurel agreed to guarantee all $15,000
of Sand Creeks accounts payable, but she did not guarantee any portion of the $100,000
nonrecourse mortgage securing Sand Creeks office building. Other than the accounts
payable and mortgage, Sand Creek does not owe any debts to other creditors.
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a. What is Laurels initial tax basis in her LLC interest?

b. What is Laurels holding period in her interest?
c. What is Sand Creeks initial basis in the contributed property?
d. What is Sand Creeks holding period in the contributed property?
a. $280,000.
Laurels basis in her LLC interest is made up of the $250,000 basis in the equipment
(no depreciation was taken on the equipment prior to the contribution because it was
acquired and contributed within the same calendar year) Laurel contributed, her
$15,000 share of accounts payable that she guaranteed, and her $15,000 share of the
nonrecourse mortgage securing Sand Creeks office building (15% x $100,000).
Laurels profits sharing ratio is used to allocate a portion of the mortgage to her
because it is nonrecourse debt.
b. Laurels holding period begins the day the LLC interest is acquired because the asset
she contributed is not a capital or Section 1231 asset. The equipment is not a Section
1231 asset because it was used in a trade or business for one year or less.
c. $250,000.
The LLC takes a carryover basis in the contributed property.
d. Ten months.
Laurels holding period is included in the LLCs holding period regardless of the
nature of the property Laurel contributed.
40. [LO 2] {Planning}Harry and Sally formed the Evergreen partnership by contributing the
following assets in exchange for a 50 percent capital and profits interest in the
partnership:
Harry:
Cash
Land
Totals
Basis Fair Market Value

$ 30,000
$ 30,000
100,000
120,000
$ 130,000
$ 150,000
Sally:
Equipment used in a business
Totals
200,000
$ 200,000
150,000
$ 150,000
20-14
a. How much gain or loss will Harry recognize on the contribution?

b. How much gain or loss will Sally recognize on the contribution?
c. How could the transaction be structured a different way to get a better result for Sally?
d. What is Harrys tax basis in his partnership interest?
e. What is Sallys tax basis in her partnership interest?
f. What is Evergreens tax basis in its assets?
g. Following the format in Exhibit 20-2, prepare a tax basis balance sheet for the
Evergreen partnership showing the tax capital accounts for the partners.
a. $0.
Generally, partners recognize gain on property contributed to a partnership only
when the cash they are deemed to receive from debt relief exceeds their basis in the
partnership prior to the deemed distribution. Harry did not have any debt relief.
b. $0.
Partners may never recognize loss when property is contributed to a partnership even
when they are relieved of debt.
c. Sally should consider selling the property to the partnership rather than contributing
it. By selling the property, she could recognize the $50,000 built-in loss on the
equipment.
d. $130,000.
Harrys basis in his partnership interest is simply the combined tax basis in the cash
and land he contributed to the partnership.
e. $200,000.
Sallys basis in her partnership interest equals $200,000 basis in the equipment she
contributed.
f. $330,000.
The partnerships basis in its assets equals the sum of the partners bases in the cash
($30,000), in the land ($100,000), and in the equipment ($200,000).
20-15
g. The partnerships tax basis balance sheet would appear as follows:

Evergreen Partnership
Tax Basis Balance Sheet
Tax Basis
Assets:
Cash
Equipment
Land
Totals
Capital:
Capital-Harry
Capital-Sally
Totals
$30,000
200,000
100,000
$330,000
$130,000
200,000
$330,000
41. [LO 2] Cosmo contributed land with a fair market value of $400,000 and a tax basis of
$90,000 to the Y Mountain partnership in exchange for a 25 percent profits and capital
interest in the partnership. The land is secured by $120,000 of nonrecourse debt. Other
than this nonrecourse debt, Y Mountain partnership does not have any debt.
a. How much gain will Cosmo recognize from the contribution?
b. What is Cosmos tax basis in his partnership interest?
a. $0.
As reflected in the table below, Cosmo does not recognize any gain because the
$120,000 of cash he is deemed to receive from debt relief does not exceed his basis in
Y Mountain prior to this deemed distribution.
20-16
Description
(1) Basis in contributed Land
(2) Nonrecourse mortgage in
Cosmo
$90,000
$30,000
Explanation
Nonrecourse
excess of basis in contributed
debt > basis is
land
allocated only
(3) Remaining nonrecourse
to Cosmo
25% x
$22,500
mortgage
Basis immediately prior to
[120,000 - (2)]
$142,500
debt relief
(4) Relief from mortgage debt
Cosmos initial tax basis in Y
($120,000)
$22,500
Mountain
(1) + (2) + (3)

+ (4)
b. $22,500 as indicated in the table above.

42. [LO2] When High Horizon LLC was formed, Maude contributed the following assets in
exchange for a 25 percent capital and profits interest in the LLC:
Maude:
Cash
Land*
Totals

$ 20,000
$ 20,000
100,000
360,000
$ 120,000
$ 380,000
*Nonrecourse debt secured by the land equals $160,000

James, Harold and Jenny each contributed $220,000 in cash for a 25% profits and capital
interest.
a. How much gain or loss will Maude and the other members recognize?
b. What is Maudes tax basis in her LLC interest?
c. What tax basis do James, Harold, and Jenny have in their LLC interests?
d. What is High Horizons tax basis in its assets?
20-17
e. Following the format in Exhibit 20-2, prepare a tax basis balance sheet for the High
Horizon LLC showing the tax capital accounts for the members.
a. $0.
None of the members recognize gain because their debt relief was not in excess of
their bases in their LLC interest prior to any debt relief. See table below:
Description
Maude
Other
Explanation
Members
(2) Cash contributed
$100,000
$20,000
$60,000
$220,000
Nonrecourse
debt > basis is
land
allocated only
$25,000
mortgage
$205,000
debt relief
Each members initial tax
$25,000
to Maude
25% x
[160,000 - (3)]
($160,000)
$45,000
basis in the LLC
$245,000
(1) + (2) + (3)

+ (4) + (5)
b. $45,000.
See table in part a. above.
c. $245,000 each.
d. $780,000.
High Horizon takes a $120,000 carryover basis in the assets Maude contributes and
a $660,000 basis in the total cash the other three members contributed.
20-18
e. High Horizons tax basis balance sheet would appear as follows:

High Horizons, LLC
Tax Basis
Assets:
Cash
Land
Totals
Liabilities and Capital:
Mortgage debt
Capital-Maude
Capital-James
Capital-Harold
Capital-Jenny
Totals
$680,000
100,000
$780,000
$160,000
(40,000)
220,000
220,000
220,000
$780,000
Note that the members tax capital accounts are equal to their bases in the LLC
interests less their individual shares of LLC debt.
43. [LO2] Kevan, Jerry, and Dave formed Albee LLC. Jerry and Dave each contributed
$245,000 in cash. Kevan contributed the following assets:
Kevan:
Cash
Land*
Totals

$ 15,000
$ 15,000
120,000
440,000
$ 135,000
$ 455,000
*Nonrecourse debt secured by the land equals $210,000

Each member received a one-third capital and profits interest in the LLC.
a. How much gain or loss will Jerry, Dave and Kevan recognize on the contributions?
b. What is Kevans tax basis in his LLC interest?
c. What tax basis do Jerry and Dave have in their LLC interests?
20-19
d. What is Albee LLCs tax basis in its assets?

e. Following the format in Exhibit 20-2, prepare a tax basis balance sheet for the Albee
LLC showing the tax capital accounts for the members. What is Kevans share of the
LLCs inside basis?
f. If the lender holding the nonrecourse debt secured by Kevans land required Kevan to
guarantee 33.33 percent of the debt and Jerry to guarantee the remaining 66.67 percent of
the debt when Albee LLC was formed, how much gain or loss will Kevan recognize?
g. If the lender holding the nonrecourse debt secured by Kevans land required Kevan to
guarantee 33.33 percent of the debt and Jerry to guarantee the remaining 66.67 percent of
the debt when Albee LLC was formed, what are the members tax bases in their LLC
interests?
a. $0.
None of the members recognize gain because their debt relief was not in excess of
their bases in their LLC interest prior to any debt relief. See table below:
Description
Kevan
Other
Explanation
Members
$120,000
$15,000
$90,000
$245,000
Nonrecourse
debt > basis is
land
allocated only
$40,000
$40,000
mortgage
to Kevan
33.3% x
[$210,000 (3)]

debt relief
Each members initial tax
$265,000
($210,000)
$55,000
basis in the LLC
$285,000
(1) + (2) + (3)

+ (4)+ (5)
b. $55,000.
20-20
c. $285,000 each.
d. $625,000.
Albee, LLC takes a $135,000 carryover basis in the assets Kevan contributes and a
$490,000 in the total cash the other two members contributed.
e. Albee, LLCs tax basis balance sheet would appear as follows:
Albee , LLC
Tax Basis
Assets:
Cash
Land
Totals
Liabilities and Capital:
Mortgage debt
Capital-Kevan
Capital-Jerry
Capital-Dave
Totals
$505,000
120,000
$625,000
$210,000
(75,000)
245,000
245,000
$625,000
Note that the members tax capital accounts are equal to their bases in the LLC
interests less their individual shares of LLC debt.
20-21
f. $5,000. See table below:

Description
Kevan
Jerry
Dave
Explanatio
n
(1) Basis in contributed

Land
(3) Mortgage
$120,000
$15,000
$70,000
$245,000
$140,000
$245,000
$0
Guarantee
33.33% x
$210,000
for Kevan
and 66.67%
x $210,000
(4) Basis immediately
$205,000
$385,000
$245,000
prior to debt relief

(5) Relief from
($210,000)
$0
$0
mortgage debt
(6) Gain Recognized
$5,000 (4)-
$0
$0
(5)
$0
$385,000
$245,000
Each members initial

tax basis in the LLC
for Jerry
1+2+3
(4)+(5)
( (4) + (5) +
(6)
g. Kevans basis is $0, Jerrys basis is $385,000, and Daves basis is $245,000. See the
table in part f. above.
44. [LO2] {Research} Jim has decided to contribute some equipment he previously used in
his sole proprietorship in exchange for a 10 percent profits and capital interest in Fast
Choppers LLC. Jim originally paid $200,000 cash for the equipment. Since then, the tax
basis in the equipment has been reduced to $100,000 because of tax depreciation, and the
fair market value of the equipment is now $150,000.
a. Must Jim recognize any of the potential 1245 recapture when he contributes the
machinery to Fast Choppers? {Hint: See 1245(b)(3).}
b. What cost recovery method will Fast Choppers use to depreciate the machinery?
{Hint: See 168(i)(7).}
20-22
c. If Fast Choppers were to immediately sell the equipment Jim contributed for $150,000,
how much gain would Jim recognize and what is its character? {Hint: See 1245 and
704(c).}
a. According to Section 1245(b)(3), recapture potential on property contributed to a
partnership is only recognized to the extent any gain is recognized from the
contribution of property. Because Jim was not relieved of any debt in the transaction,
he will not recognize gain from the contribution under Section 721. Therefore, Jim
does not recognize any of the Section 1245 recapture potential on the equipment at
the time of contribution.
b. According to Section 168(i)(7), a transferee partnership will step into the shoes of the
transferor partner for purposes of depreciating contributed equipment. In this
situation, Fast Choppers will continue to depreciate the equipment using the same
method instituted by Jim over the remaining useful life of the equipment. In other
words, the annual depreciation calculation will proceed as if the property were still
held by Jim.
c. Under Section 704(c), all $50,000 of gain recognized from the sale of the equipment
would be allocated to Jim because this gain was built-in at the time the equipment
was contributed. Moreover, the Section 1245 recapture potential remains with the
equipment after the contribution; as a result, all $50,000 of gain recognized (the
lesser of the $50,000 gain recognized or the $100,000 depreciation taken) must be
characterized as Section 1245 recapture income.
45. [LO2] {Research} Ansel purchased raw land three years ago for $200,000 to hold as an
investment. After watching the value of the land drop to $150,000, he decided to
contribute it to Mountainside Developers LLC in exchange for a 5 percent capital and
profits interest. Mountainside plans to develop the property and will treat it as inventory,
like all of the other real estate it holds.
a. If Mountainside sells the property for $150,000 after holding it for one year, how much
gain or loss does it recognize, and what is the character of its gain or loss? {Hint: See
724.}
b. If Mountainside sells the property for $125,000 after holding it for two years, how
much gain or loss does it recognize, and what is the character of the gain or loss?
c. If Mountainside sells the property for $150,000 after holding it six years, how much
gain or loss is recognized, and what is the character of the gain or loss?
20-23
a. According to Section 724(c), recognized losses on assets that were capital assets in
the hands of contributing partners are treated as capital losses up to the amount of
loss built into the assets at the time they were contributed if they are sold within a five
year period beginning on the date of contribution. Thus, Mountainside Developers
will recognize a $50,000 loss characterized as a capital rather than an ordinary loss.
b. In this instance, Mountainside Developers will recognize a $75,000 loss from the
sale of the land. The built-in loss at the time the land was contributed or $50,000
will be characterized as a capital loss, and the remaining $25,000 loss will be
characterized as an ordinary loss per Section 724(c).
c. Because Mountainside Developers held the land as inventory for more than five
years, it will recognize a $50,000 ordinary loss per Section 724(c).
46. [LO2] {Research} Claude purchased raw land three years ago for $1,500,000 to develop
into lots and sell to individuals planning to build their dream homes. Claude intended to
treat this property as inventory, like his other development properties. Before completing
the development of the property, however, he decided to contribute it to South Peak
Investors LLC when it was worth $2,500,000, in exchange for a 10 percent capital and
profits interest. South Peaks strategy is to hold land for investment purposes only and
then sell it later at a gain.
a. If South Peak sells the property for $3,000,000 four years after Claudes contribution,
how much gain or loss is recognized and what is its character? {Hint: See 724.}
b. If South Peak sells the property for $3,000,000 five and one-half years after Claudes
contribution, how much gain or loss is recognized and what is its character?
a. Under Section 724(b), any gain or loss on contributed property that was treated as
inventory by the contributing partner and sold by the partnership during the five year
period beginning on the date of contribution is treated as ordinary gain or loss.
Thus, the entire $1,500,000 gain from the sale of the land will be treated as ordinary
gain.
b. Section 724(b) only applies if contributed property is sold during the five year period
beginning on the date of contribution. Because South Peak sold the land after the
expiration of this time period and held the land as investment property, it should
recognize $1,500,000 of capital gain.
47. [LO2] {Research} Reggie contributed $10,000 in cash and a capital asset he had held for
three years with a fair market value of $20,000 and tax basis of $10,000 for a 5 percent
capital and profits interest in Green Valley LLC.
20-24
a. If Reggie sells his LLC interest thirteen months later for $30,000 when the tax basis in
his partnership interest is still $20,000, how much gain does he report and what is its
character?
b. If Reggie sells his LLC interest two months later for $30,000 when the tax basis in his
partnership interest is still $20,000, how much gain does he report and what is its
character? {Hint: See Reg. 1.1223-3}
a. Reggie sold his LLC interest, a capital asset, for $30,000 when he had a basis in the
LLC interest of $20,000. Thus, he will recognize a $10,000 capital gain. The capital
gain is treated as a long-term capital gain because he has held his LLC interest for
more than twelve months. In this situation, the holding period of his LLC interest at
the date he contributed property is irrelevant.
b. Under Reg. 1.1223-3(b)(1), the holding period of Reggies LLC interest is based on
the relative fair market value of the property he contributed. Since two-thirds of the
value of the property he contributed was a capital asset held for three years, twothirds of his LLC interest is treated as being held for three years and the remaining
one-third of his LLC interest has a holding period that begins on the date of
contribution. Under Reg. 1.1223-3(c)(1), two-thirds or $6,667 of the resulting
$10,000 capital gain from the sale will be treated as long-term capital gain and the
remaining one-third or $3,333 will be treated as short-term capital gain.
48. [LO2] Connie recently provided legal services to the Winterhaven LLC and received a 5
percent interest in the LLC as compensation. Winterhaven currently has $50,000 of
accounts payable and no other debt. The current fair market value of Winterhavens
capital is $200,000.
a. If Connie receives a 5 percent capital interest only, how much income must she report,
and what is her tax basis in the LLC interest?
b. If Connie receives a 5 percent profits interest only, how much income must she report,
and what is her tax basis in the LLC interest?
c. If Connie receives a 5 percent capital and profits interest, how much income must she
report, and what is her tax basis in the LLC interest?
a. Connie reports $10,000 of ordinary income or 5 percent of the LLCs capital of
$200,000. Her basis in the LLC interest is also $10,000.
b. Connie will not report any income but will have a basis in the LLC interest equal to
her share of the LLCs debt. Because the LLCs debt is a nonrecourse debt, it must
20-25
be allocated to her using Connies profits interest. Thus, her basis in the LLC equals
$2,500 or 5 percent of the LLCs $50,000 accounts payable.
c. Connie reports $10,000 of ordinary income or 5 percent of the LLCs capital of
$200,000. Her basis in the LLC is $12,500 consisting of the $10,000 of income she
recognizes for the receipt of her capital interest and her $2,500 share of the LLCs
nonrecourse accounts payable.
49. [LO2] Mary and Scott formed a partnership that maintains its records on a calendar-year
basis. The balance sheet of the MS Partnership at year-end is as follows:
Cash
Land
Inventory
Mary
Scott
Basis
$ 60
60
72
$192
$ 96
96
$192
Fair Market Value

$ 60
180
60
$300
$150
150
$300
At the end of the current year, Kari will receive a one-third capital interest only in
exchange for services rendered. Karis interest will not be subject to a substantial risk of
forfeiture and the costs for the type of services she provided are typically not capitalized
by the partnership. For the current year, the income and expenses from operations are
equal. Consequently, the only tax consequences for the year are those relating to the
admission of Kari to the partnership.
a. Compute and characterize any gain or loss Kari may have to recognize as a result of
her admission to the partnership.
b. Compute Karis basis in her partnership interest.
c. Prepare a balance sheet of the partnership immediately after Karis admission showing
the partners tax capital accounts and capital accounts stated at fair market value.
d. Calculate how much gain or loss Kari would have to recognize if, instead of a capital
interest, she only received a profits interest.
a. Kari will recognize one-third of the fair market value of the partnerships capital or
$100 as ordinary income.
b. Karis basis in her partnership interest will be equal to the amount of income she
reports or $100.
20-26
c. Immediately after Karis admission into the partnership the partnerships balance
sheet will appear as follows:
MS Partnership
Balance Sheet
Tax Basis
Assets:
Cash
Land
Inventory
Totals
Capital:
Capital-Mary
Capital-Scott
Capital-Kari
Totals
704(b)/FMV
$60
60
72
$192
60
180
60
300
46
46
100
$192
100
100
100
$300
Essentially, the tax capital and 704(b) capital accounts for both Scott and Mary are
reduced by their $50 share of the $100 compensation expense the partnership will
deduct for the capital interest Kari receives.
d. If Kari only receives a profits interest, she will not recognize any income until she
receives a profits allocation from the partnership.
20-27
50. [LO2] Dave LaCroix recently received a 10 percent capital and profits interest in Cirque
Capital LLC in exchange for consulting services he provided. If Cirque Capital had paid
an outsider to provide the advice, it would have deducted the payment as compensation
expense. Cirque Capitals balance sheet on the day Dave received his capital interest
appears below:
Assets:
Cash
Investments
Land
Totals
Basis
Fair Market Value
$ 150,000
$ 150,000
200,000
700,000
150,000
250,000
$ 500,000
$1,100,000
Liabilities and capital:

Nonrecourse Debt
Lance*
Robert*
Totals
100,000
200,000
200,000
$ 500,000
100,000
500,000
500,000
$ 1,100,000
*Assume that Lances basis and Roberts basis in their LLC interests equal their tax
basis capital accounts plus their respective shares of nonrecourse debt.
a. Compute and characterize any gain or loss Dave may have to recognize as a result of
his admission to Cirque Capital.
b. Compute each members tax basis in his LLC interest immediately after Daves receipt
of his interest.
c. Prepare a balance sheet for Cirque Capital immediately after Daves admission
showing the members tax capital accounts and their capital accounts stated at fair market
value.
d. Compute and characterize any gain or loss Dave may have to recognize as a result of
his admission to Cirque Capital if he receives only a profits interest.
e. Compute each members tax basis in his LLC interest immediately after Daves receipt
of his interest if Dave only receives a profits interest.
20-28
a. The tax consequences of giving Dave both a 10 percent capital and profits interest
are summarized in the following table:
Description
(1) Beginning
Dave
$0
Lance
$250,000
Robert
$250,000
Explanation
$200,000 tax basis capital
Basis in LLC
account + [.5 x $100,000
(2) Ordinary
nonrecourse debt]
Liquidation Value of Capital
$100,000
Income
Interest (.1 x $1,000,000 fair
(3) Ordinary
($50,000)
($50,000)
Deduction
(4) Increase in
Partners.
(2) x .5
[$100,000 nonrecourse debt x
$10,000
Debt Allocation
(5) Decrease in
Debt Allocation
(6) Ending
market value of LLC capital)

Capital Shift from Non-Service
$110,000
(5,000)
(5,000)
$195,000
$195,000
10% profit sharing ratio]

(4) x .5
(1) + (2) + (3) + (4) + (5)
Basis in LLC
As indicated in line (2) of the table above, Dave recognizes $100,000 of ordinary
income.
b. As indicated in line (6) of the table above, the members tax bases in the LLC
interests immediately after Dave is admitted are as follows: $110,000 for Dave and
$195,000 for Lance and Robert.
20-29
c. Immediately after Daves admission into the LLC, the LLCs balance sheet will
appear as follows:
Cirque, LLC
Balance Sheet
Tax Basis
Assets:
Cash
Land
Inventory
Totals
Capital:
Nonrecourse Debt
Capital-Lance
Capital-Robert
Capital-Dave
Totals
704(b/)FMV
$150,000
200,000
150,000
$500,000
$150,000
700,000
250,000
$1,100,000
$100,000
150,000
150,000
100,000
$500,000
100,000
450,000
450,000
100,000
$1,100,000
20-30
d. The tax consequences of giving Dave only a 10 percent profits interest are
summarized in the following table:
Description
(1)
Dave
$0
Lance
$250,000
Robert
$250,000
Beginning
Basis in LLC
(2) Ordinary
account + [.5 x $100,000

nonrecourse debt]
Dave does not recognize any
$0
Income
(3) Increase
Explanation
$200,000 tax basis capital
income because he only

receives a profits interest.
[$100,000 nonrecourse debt
$10,000
in Debt
x 10% profit sharing ratio]
Allocation
(4) Decrease
(5,000)
(5,000)
$245,000
$245,000
(3) x .5
in Debt
Allocation
(5) Ending
$10,000
(1) + (2) + (3) + (4)
Basis in LLC
Dave does not recognize any income because he only received a profits interest.
e. As reflected in line (5) of the table above, Daves basis is $10,000, Lances basis is
$245,000, and Roberts basis is $245,000.
51. [LO 2] Last December 31, Ramon sold the 10 percent interest in the Del Sol Partnership
that he had held for two years to Garrett for $400,000. Prior to selling his interest,
Ramons basis in Del Sol was $200,000 which included a $100,000 share of nonrecourse
debt allocated to him.
a. What is Garretts tax basis in his partnership interest?
b. If Garrett sells his partnership interests three months after receiving it and recognizes a
gain, what is the character of his gain?
20-31
a. Garretts basis in his partnership interest is equal to the $400,000 amount he paid for
it plus his $100,000 share of partnership debt or $500,000.
b. Because Garrett purchased his partnership interest, his holding period for the interest
begins on the date the interest was purchased. As a result, he only has a three month
holding period before the partnership interest is sold. This means his capital gain
from the sale of his partnership interest will be short-term capital gain.
52. [LO 3] Broken Rock LLC was recently formed with the following members:
Name
George Allen
Elanax Corp.
Ray Kirk
Tax Year End

December 31
June 30
December 31
Capital/Profits %
33.33%
33.33%
33.34%
What is the required taxable year-end for Broken Rock LLC?

George Allen and Ray Kirk together own more than 50 percent of the profits and capital
of Broken Rock. Because both George and Ray have a December 31 year end, December
31 is majority interest taxable year and is also the required year end for Broken Rock.
53. [LO 3] Granite Slab LLC was recently formed with the following members:
Name
Nelson Black
Brittany Jones
Lone Pine LLC
Red Spot Inc.
Pale Rock Inc.
Thunder Ridge LLC
Alpensee LLC
Lakewood Inc.
Streamside LLC
Burnt Fork Inc.
Snowy Ridge LP
Whitewater LP
Straw Hat LLC
Wildfire Inc.
Tax Year End

December 31
December 31
June 30
October 31
September 30
July 31
March 31
June 30
October 31
October 31
June 30
October 31
January 31
September 30
Capital/Profits %
22.0%
24.0%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
4.5%
What is the required taxable year-end for Granite Slab LLC?

Because none of the partners with the same year end together own more than 50 percent
of the capital and profits of Granite Slab, there is no majority interest taxable year.
However, Nelson Black and Brittany Jones are principal partners because they
individually own 5 percent or more of the profits and capital of Granite Slab. Moreover,
they both have a December 31 year end. Therefore, the required year end of the
20-32
partnership is the year end of the principal partners or December 31.

54. [LO 3] Tall Tree LLC was recently formed with the following members:
Name
Eddie Robinson
Pitcher Lenders LLC
Perry Homes Inc.
Tax Year End

December 31
June 30
October 31
Capital/Profits %
40%
25%
35%
What is the required taxable year-end for Tall Tree LLC?

Tall Tree does not have a majority interest taxable year because no partner or group of
partners with the same year end owns more than 50 percent of the profits and capital
interests in Tall Tree. Also, because all three principal partners in Tall Tree have
different year ends, the principal partner test is not met. As a result, Tall Tree must
decide which of three potential year ends, December 31, June 30, or October 31, will
provide its members the least aggregate deferral. The table below illustrates the required
computations:
Possible Year Ends
Members
12/31 Year End
Tax
Months
Year
% x MD
6/30 Year End
10/31 Year End
Months
%x
Months
%x
Deferral*
Deferral*
MD
Deferral*
MD
(MD)
6
2.4
(MD)
2
.8
Eddie
40%
12/31
(MD)
0
Robinson
Pitcher
25%
6/30
1.5
35%
10/31
10
3.5
5
1.4
3.8
0
2.8
Lenders
Perry Homes
Total
Aggregate
Deferral
*Months deferral equals number of months between proposed year end and members year end.
As the table above indicates, Tall Tree must use October 31 as its year end because it
provides the least amount of aggregate deferral to the members.
20-33
55. [LO 3] Rock Creek LLC was recently formed with the following members:
Name
Mark Banks
Highball
PropertiesLLC
Chavez BuildersInc.
Tax Year End

December 31
March 31
Capital/Profits %
35%
25%
November 30
40%
What is the required taxable year-end for Rock Creek LLC?

Rock Creek does not have a majority interest taxable year because no partner or group of
partners with the same year end owns more than 50 percent of the profits and capital
interests in Rock Creek. Also, because all three principal partners in Rock Creek have
different year ends, the principal partner test is not met. As a result, Rock Creek must
decide which of three potential year ends, December 31, March 31, or November 30, will
provide its members the least aggregate deferral. The table below illustrates the required
computations:
Possible Year Ends
Members
Mark Banks
Highball
12/31 Year End
Tax
Months
Year
Deferral*
35%
25%
12/31
3/31
(MD)
0
3
40%
11/30
11
% x MD
3/31 Year End
11/30 Year End
Months
%x
Months
%x
Deferral*
MD
Deferral*
MD
0
.75
(MD)
9
0
3.15
0
(MD)
1
4
.35
1
4.4
3.2
Properties,
LLC
Chavez
Builders,Inc.
Total
5.15
6.35
1.35
Aggregate
Deferral
*Months deferral equals number of members between proposed year end and partners year end.
As the table above indicates, Rock Creek must use November 30 as its year end because it
provides the least amount of aggregate deferral to the members.
20-34
56. [LO 3]{Research} Ryan, Dahir, and Bill have operated Broken Feather LLC for the last
four years using a calendar year-end. Each has a one-third interest. Since they began
operating, their busy season has run from June through August, with 35 percent of their
gross receipts coming in July and August. The members would like to change their tax
year-end and have asked you to address the following questions:
a. Can they change to an August 31 year-end and, if so, how do they make the change?
{Hint: See Rev. Proc. 2002-38, 2002-1 CB 1037.}
b. Can they change to a September 30 year-end and, if so, how do they make the change?
{Hint: See 444.}
a. If Broken Feather can establish that 25 percent of its gross receipts for the current
twelve month period ending on August 31 fell within the months of July and August,
and it can establish the same thing for the two preceding years ending on August 31,
then Broken Feather can change its year end to August 31 under Rev. Proc. 2002-38.
b. Under Section 444, Broken Feather can elect to have its year end fall up to three
months ahead of its normal required calendar year end. Thus, it may elect to have a
September 30, October 31, or November 30 year end under Section 444. However, if
it makes the Section 444 election, it must calculate and deposit a Section 7519
payment with the IRS to offset the deferral benefit the partners receive by having the
year end fall before December 31.
57. [LO 3] {Research}Ashlee, Hiroki, Kate, and Albee LLC each own a 25 percent interest in
Tally Industries LLC, which generates annual gross receipts of over $10 million. Ashlee,
Hiroki, and Kate manage the business, but Albee LLC is a nonmanaging member.
Although Tally Industries has historically been profitable, for the last three years losses
have been allocated to the members. Given these facts, the members want to know
whether Tally Industries can use the cash method of accounting. Why or why not?
{Hint: See 448(b)(3)}
Generally, partnerships without corporate partners may use the cash method of
accounting. However, partnerships that are tax shelters may not use the cash method of
accounting. According to Section 448(b)(3), partnerships defined as tax shelters are
ineligible to use the cash method. Section 461(i)(3)(B) includes syndicates among the
other categories of tax shelters. Section 1256(e)(3)(B) defines a syndicate as any
partnership that allocates more than 35 percent of its losses to either limited partners or
limited entrepreneurs. In addition to limited partnerships, this provision likely also
applies to LLCs because Section 464(e)(2) defines a limited entrepreneur as any person,
including LLC members, other than a limited partner, who does not actively participate
in the management of the enterprise. In summary, if more than 35 percent of losses in a
given year are allocated to either limited partners or to LLC members not actively
participating in the management of an LLC, the limited partnership or LLC will be not be
permitted to use the cash method. Because of these restrictions, a significant number of
20-35
limited partnerships and LLCs that would otherwise qualify are denied the use of the
cash method.
Because only 25 percent of Tally Industries loss for the year is allocated to a member
that does not actively participate in management and it does not have a corporate
member, Tally will be able to use the cash method.
58. [LO 4] Turtle Creek Partnership had the following revenues, expenses, gains, losses, and
distributions:
Sales revenue
Long-term capital gains
Cost of goods sold
Depreciation - MACRS
Amortization of organization costs
Guaranteed payments to partners for general management
Cash distributions to partners
$40,000
$2,000
($13,000)
($3,000)
($1,000)
($10,000)
($2,000)
Given these items, what is Turtle Creeks ordinary business income (loss) for the year?
Turtle Creeks ordinary business income is calculated in the table below:
Description
Sales revenue
Less:
Cost of goods sold
Amortization of organization costs
Guaranteed payments
Ordinary Business Income
Separately Stated Items on Schedule K-1:
Guaranteed payments
Cash distributions
Amount
$40,000
(13,000)
(3,000)
(1,000)
(10,000)
$13,000
$2,000
$10,000
$2,000
Note that guaranteed payments must be separately disclosed to the partners that receive
them, and cash distributions must be separately disclosed so that partners can reduce the
tax basis of their partnership interests by the amount of the distributions.
20-36
59. [LO 4] Georgio owns a 20 percent profits and capital interest in Rain Tree LLC. For the
current year, Rain Tree had the following revenues, expenses, gains, and losses:
Sales revenue
Gain on sale of land (1231)
Cost of goods sold
179 deduction*
Employee wages
Fines and penalties
Municipal bond interest
Short-term capital gains
Guaranteed payment to Sandra
$70,000
$11,000
($26,000)
($3,000)
($10,000)
($11,000)
($3,000)
$6,000
$4,000
($3,000)
*Assume the 179 property placed in service limitation does not apply.
a. How much ordinary business income (loss) is allocated to Georgio for the year?
b. What are Georgios separately stated items for the year?
a. Georgios allocation of ordinary business income is reflected in the table below:
Description
Total
20%
Amount
Allocated to
Georgio
Sales revenue
Less:
Cost of goods sold
Employee wages
Guaranteed payments
$70,000
(26,000)
(3,000)
(11,000)
(3,000)
$27,000
$5,400
20-37
b. Georgios separately stated items are calculated in the table below:

Description
Total
20%
Amount
Allocated to
Georgio
Separately Stated Items on Schedule K-1:

Section 1231 gains
Section 179 deduction
Municipal bond interest*
Fines and penalties*
$11,000
(10,000)
4,000
6,000
(3,000)
$2,200
(2,000)
800
1,200
(600)
*Although these amounts are not included in Georgios taxable income computation, they
must be separately disclosed because they affect Georgios tax basis in his LLC interest.
60. [LO4] {Research} Richard Meyer and two friends from law school recently formed
Meyer and Associates as a limited liability partnership (LLP). Income from the
partnership will be split equally among the partners. The partnership will generate fee
income primarily from representing clients in bankruptcy and foreclosure matters. While
some attorney friends have suggested that the partners earnings will be self-employment
income, other attorneys they know from their local bar association meetings claim just
the opposite. After examining relevant authority, explain how you would advise Meyer
and Associates on this matter. {Hint: See 1402(a)(13) and Renkemeyer, Campbell &
Weaver LLP v. Commissioner, 136 T.C. 137 (2011)}
Section 1402(a)(13) provides that a limited partners share of partnership ordinary
business income is not self-employment income, but the Code does not specifically
address the treatment of ordinary business income allocated to partners of limited
liability partnerships or LLPs. In attempting to address how the self-employment tax
rules should apply to LLC members, partners in LLPs, and other partners with limited
liability (other than limited partners in a limited partnership), Prop. Reg. 1.1402(a)2(h)(5) states that service partners in service partnerships such as law firms, accounting
firms, etc. may not be treated as limited partners for self-employment tax purposes.
Nonetheless, proposed regulations are not authoritative and taxpayers are not required to
follow them. However, the Tax Court, in Renkemeyer, Campbell & Weaver LLP v.
Commissioner, 136 TC 137(2011) decided to follow the approach in the proposed
regulations and treat law partners in a law firm organized as an LLP as subject to the
self-employment tax. Thus, to avoid controversy with the IRS, Richard and his partners
should treat their earnings as self-employment income. However, if they are willing to
litigate in a court other than the Tax Court (U.S. District Court or Federal Court of
20-38
Claims), they might consider taking a position that their earnings from the partnership
are not self-employment income.
61. [LO 4] The partnership agreement of the G&P general partnership states that Gary will
receive a guaranteed payment of $13,000, and that Gary and Prudence will share the
remaining profits or losses in a 45/55 ratio. For year 1, the G&P partnership reports the
following results:
Sales revenue
Gain on sale of land ( 1231)
Cost of goods sold
Employee wages
Cash charitable contributions
Other expenses
$70,000
$8,000
($38,000)
($9,000)
($14,000)
($3,000)
$2,000
($2,000)
a. Compute Garys share of ordinary income (loss) and separately stated items to be
reported on his year 1 Schedule K-1, including his self-employment income (loss).
b. Compute Garys share of self-employment income (loss) to be reported on his year 1
Schedule K-1, assuming G&P is a limited partnership and Gary is a limited partner.
c. What do you believe Garys share of self-employment income (loss) to be reported on
his year 1 Schedule K-1 should be, assuming G&P is an LLC and Gary spends 2,000
hours per year working there full time?
20-39
a. Garys ordinary business income, separately stated items, and self-employment

income are calculated in the table below:
Description
Sales revenue
Less:
Cost of goods sold
Employee wages
Other expenses
Guaranteed payments
Ordinary Business Loss
Total
Allocated to Gary
Explanation
Amount
$70,000
(38,000)
(9,000)
(14,000)
(2,000)
(13,000)
($6,000)
($2,700)
45% allocation to
Gary
Separately Stated Items

on Schedule K-1:
Section 1231 gains
$8,000
$3,600
Cash charitable
($3,000)
($1,350)
contributions
Guaranteed payment
$13,000
$13,000
Garys guaranteed
$900
payment
45% allocation to
$10,300
Gary
($2,700) ordinary

Self-employment income
$2,000
$7,000
[$13,000
45% allocation to
Gary
45% allocation to
Gary
business loss allocated
guaranteed
to Gary + $13,000
payment -
guaranteed payment
$6,000
ordinary
loss]
20-40
b. If Gary is a limited partner, then his self-employment income would equal the
$13,000 guaranteed payment he received.
c. Under Proposed Reg. 1.1402(a)-2, Garys $2,700 share of ordinary business loss will
reduce his $13,000 guaranteed payment leaving him with $10,300 of self-employment
income (because he spent more than 500 hours working in the trade or business of
the LLC). In this instance, the proposed regulations provide Gary with a favorable
interpretation of the law.
62. [LO 4] {Research} Hoki Poki, a cash-method general partnership, recorded the following
items for its current tax year:
Rental real estate income
Sales revenue
1245 recapture income
Interest income
Cost of goods sold
Supplies expense
Employee wages
Investment interest expense
Partners medical insurance premiums paid by Hoki Poki
$2,000
$70,000
$8,000
$2,000
($38,000)
($9,000)
($1,000)
($14,000)
($1,000)
($3,000)
As part of preparing Hoki Pokis current year return, identify the items that should be
included in computing its ordinary business income (loss) and those that should be
separately stated. {Hint: See Schedule K-1 and related preparers instructions at
www.irs.gov.}
Hoki Pokis ordinary business income is computed as follows:
Description
(1)Sales revenue
(2) Section 1245 recapture
income
(3)Cost of goods sold
(4)Depreciation - MACRS
(5)Supplies expense
(6)Employee wages
(7)Partners medical
insurance premiums
(8)Ordinary business
income
Total Amount
$70,000
8,000
(38,000)
(9,000)
(1,000)
(14,000)
(3,000)
$13,000
20-41
Hoki Pokis separately stated items are reflected in the table below:
Separately Stated Items
(1)$2,000 Rental real estate income
(2)$2,000 Interest income
(3)$1,000 Investment interest expense
(4)$3,000 Medical insurance premiums or
$3,000 Guaranteed Payments
$8,000 Self-Employment Income
Explanation
See line 2 of Schedule K-1
See line 5 of Schedule K-1
See instructions for line 13 of Schedule K-1,
Code H
See instructions for line 13 of Schedule K-1,
Code M (to provide partners with the
information needed to compute the for AGI
deduction for medical insurance)
According to Rev. Rul. 91-26, partners
medical insurance premiums paid by the
partnership are treated as guaranteed
payments by the partners.
Line (8) from the table above (general
partners treat ordinary business income as
self-employment income) + (4) (guaranteed
payments are always treated as selfemployment income) line (2) from table
above (Per 1402(a)(3)(C), gains from the
sale of property are not included in selfemployment income)
63. [LO 4] {Research} On the last day of its current tax year, Buy Rite LLC received
$300,000 when it sold a machine it had purchased for $200,000 three years ago to use in
its business. At the time of the sale, the basis in the equipment had been reduced to
$100,000 due to tax depreciation taken. How much did Buy Rites self-employment
earnings increase when the equipment was sold? {Hint: See 1402(a)(3).}
Buy Rites self-employment income does not increase due to the sale of the equipment.
According to 1402(a)(3)(C), gains from the sale of equipment are not included in Buy
Rites self-employment income. Thus, Buy Rite must insure that the $100,000 of ordinary
Section 1245 recapture is subtracted from its ordinary business income or loss when
calculating its self-employment income. Because the remaining $100,000 of Section
1231 gain is separately stated, it is not included in ordinary business income or loss and
therefore will not be included in self-employment income.
20-42
64. [LO 4] Jhumpa, Stewart, and Kelly are all one-third partners in the capital and profits of
Firewalker general partnership. In addition to their normal share of the partnerships
annual income, Jhumpa and Stewart receive an annual guaranteed payment of $10,000 to
compensate them for additional services they provide. Firewalkers income statement for
the current year reflects the following revenues and expenses:
Sales revenue
Interest income
Cost of goods sold
Employee wages
Depreciation expense
Guaranteed payments
Miscellaneous expenses
Overall net income
$340,000
3,300
1,200
(120,000)
(75,000)
(28,000)
(20,000)
(4,500)
$97,000
a. Given Firewalkers operating results, how much ordinary business income (loss) and
what separately stated items [including the partners self-employment earnings (loss)]
will it report on its return for the year?
b. How will it allocate these amounts to its partners?
c. How much self-employment tax will each partner pay assuming none have any other
source of income or loss?
a. The table below illustrates Firewalkers ordinary business income and separately
stated items. Note that the total self employment income for all partners consists of
Firewalkers $92,500 ordinary business income (because ordinary business income
from a general partnership is always treated as self-employment income by the
partners) plus the $20,000 in guaranteed payments made to Dave and Stewart.
20-43
b.
Description
Sales revenue
Less:
Cost of goods sold
Employee wages
Misc. expenses
Guaranteed payments
Separately Stated Items on
Schedule K-1:
Interest income
Guaranteed Payments
Self-employment income
Total
$340,000
Jhumpa
Stewart
Kelly
(120,000)
(75,000)
(28,000)
(4,500)
(20,000)
$92,500
$30,833
$30,833
$30,833
$3,300
$1,200
$20,000
$112,500
$1,100
$400
10,000
$40,833
$1,100
$400
10,000
$40,833
$1,100
$400
$30,833
c. The table above reflects the partners shares of ordinary business income and her/his
separately stated items. Note that each partners self employment income consists of
her/his individual shares of ordinary business income plus the guaranteed payment
she/he received, if any.
20-44
d. The table below reflects the partners self-employment tax liability:

Description
(1)Self-employment
Stewart
$40,833
Jhumpa
$40,833
Kelly
$30,833
income
(2) Percentage of self
92.35%
92.35%
92.35%
tax
(3) Earnings from self-
$37,709
$37,709
$28,474
employment
(4) Self employment tax
15.3%
15.3%
15.3%
rate
(5) Self-employment tax
$5,769
$5,769
$4,357
Explanation
employment income
subject to self-employment
(1) x (2)
(3) x (4)
liability
65. [LO 4] This year, Darrels distributive share from Alcove Partnership includes $6,000 of
interest income, $3,000 of dividend income, and $70,000 ordinary business income.
a. Assume that Darrel materially participates in the partnership. How much of his
distributive share from Alcove Partnership is potentially subject to the Medicare
contribution tax?
b. Assume that Darrel does not materially participate in the partnership. How much of
his distributive share from Alcove Partnership is potentially subject to the Medicare
contribution tax?
a. If Darrel materially participates in the business, the ordinary income is not passive to
him and should not be subject to the Medicare contribution tax. The $6,000 of
interest income and the $3,000 of dividend income are potentially subject to the
Medicare contribution tax.
b. If Darrel is not a material participant in the partnership, the $6,000 of interest
income, the $3,000 of dividend income, and the $70,000 of ordinary business income
are potentially subject to the Medicare contribution tax.
66. [LO 4] {Research} Lane and Cal each own 50 percent of the profits and capital of
HighYield LLC. HighYield owns a portfolio of taxable bonds and municipal bonds, and each
year the portfolio generates approximately $10,000 of taxable interest and $10,000 of
20-45
tax- exempt interest. Lanes marginal tax rate is 35 percent while Cals marginal tax rate is
15 percent. To take advantage of the difference in their marginal tax rates, Lane and Cal
want to modify their operating agreement to specially allocate all of the taxable interest to
Cal and all of the tax-exempt interest to Lane. Until now, Lane and Cal had been allocated
50 percent of each type of interest income.
a. Is HighYields proposed special allocation acceptable under current tax rules? Why or
why not? {Hint: See Reg. 1.704-1(b)(2)(iii)(b) and 1.704-1(b)(5) Example (5).}
b. If the IRS ultimately disagrees with HighYields special allocation, how will it likely
reallocate the taxable and tax-exempt interest among the members? {Hint: See Reg.
1.704-1(b)(5) Example (5)(ii).}
a. According to IRC 704 partnership allocations will be respected by the IRS unless
they do not have substantial economic effect. The facts provided are almost
identical to the general scenario described in Reg. 1.704-1(b)(2)(iii)(b) and to the
detailed facts described in 1.704-1(b)(5) Example (5) given that the special
allocation to Lane and Cal simply changes the character of the income allocated to
Lane and Cal but not the amount. Thus, this allocation is not appropriate because it
is not substantial.
b. As described in Reg. 1.704-1(b)(5) Example (5)(ii), the IRS will likely assert that 50
percent of both the taxable and tax-exempt bond interest should be allocated to Lane
and Cal.
67. [LO 5] Larrys tax basis in his partnership interest at the beginning of the year was
$10,000. If his share of the partnership debt increased by $10,000 during the year and his
share of partnership income for the year is $3,000, what is his tax basis in his partnership
interest at the end of the year?
$23,000 as computed in the table below:
Description
Beginning Tax Basis
Increase in Partners Share
of Debt
Partners Share of Income
Ending Tax Basis
Total Amount
$10,000
10,000
3,000
$23,000
68. [LO 5] Carmine was allocated the following items from the Piccolo LLC for last year:
Ordinary business loss
Nondeductible penalties
Tax-exempt interest income
20-46
Short-term capital gain

Cash distributions
Rank these items in terms of the order they should be applied to adjust Carmines tax
basis in Piccolo for the year (some items may be of equal rank).
Items that increase basis are applied first, then distributions, and then items that reduce
basis. Thus, the items above should be applied in the following order to adjust Carmines
tax basis:
Tax Exempt Income and Short Term Capital Gain (basis increasing items come first)
Cash Distribution (distributions come after basis increasing items)
Ordinary Business Loss and Non-Deductible Penalties (basis reducing items come last)
69. [LO 5] Oscar, Felix, and Marv are all one-third partners in the capital and profits of
Eastside general partnership. In addition to their normal share of the partnerships annual
income, Oscar and Felix receive annual guaranteed payments of $7,000 to compensate
them for additional services they provide. Eastsides income statement for the current
year reflects the following revenues and expenses:
Sales revenue
Dividend income
Cost of goods sold
Employee wages
Guaranteed payments
Overall net income
$ 420,000
5,700
2,800
(210,000)
(115,000)
(28,000)
(14,000)
(9,500)
$ 52,000
In addition, Eastside owed creditors $120,000 at the beginning of the year but managed to
pay down its debts to $90,000 by the end of the year. All partnership debt is allocated
equally among the partners. Finally, Oscar, Felix and Marv had a tax basis of $80,000 in
their interests at the beginning of the year.
a. What tax basis do the partners have in their partnership interests at the end of the year?
b. Assume the partners began the year with a tax basis of $10,000 and all the debt was
paid off on the last day of the year. How much gain will the partners recognize when the
debt is paid off? What tax basis do the partners have in their partnership interests at the
end of the year?
20-47
a. All of the partners have an ending tax basis of $87,333 as calculated in the table
below:
Description
(1)Beginning tax basis
(including partners
share of debt)
(2)Dividend income
(3)Short-term capital
gains
(4)Partners share of
ordinary business
income
Oscar
$80,000
Felix
$80,000
Marv
$80,000
$1,900
$933
$1,900
$933
$1,900
$933
$14,500
$14,500
$14,500
(5)Deemed
distribution from debt
repayment
(6)Guaranteed
payments received
($10,000)
($10,000)
($10,000)
$87,333
$87,333
(7)Ending tax basis
$87,333
Explanation
$5,700 x 33.33%
$2,800 x 33.33%
[$52,000 overall net
income - ($5,700
Dividend Income +
$2,800 Short-Term
Capital Gains)] x
33.3%
[$120,000 - $90,000]
x 33.33%
Partners dont
increase the basis of
their partnership
interests by the
amount of guaranteed
payments received
(1)+(2)+(3)+(4)+(5)
20-48
b. Each partner recognizes gain of $12,667 and has an ending basis of zero as
calculated in the table below:
Description
(1)Beginning tax Basis
(including partners
share of debt)
(2)Dividend income
(3)Short-term capital
gains
(4)Partners share of
ordinary business
income
Oscar
$10,000
Felix
$10,000
Marv
$10,000
Explanation
$1,900
$933
$1,900
$933
$1,900
$933
$5,700 x 33.33%
$2,800 x 33.33%
$14,500
$14,500
$14,500
(5)Deemed
distribution from debt
repayment
(6)Guaranteed
payments received
($40,000)
($40,000)
($40,000)

income - ($5,700
Dividend Income +
$2,800 Short-Term
Capital Gains)] x 33.3%
[$120,000 - $0] x
33.33%
(7)Gain recognized by
partners
(8)Ending tax basis
$12,667
$12,667
$12,667
Partners dont increase

the basis of their
partnership interests by
the amount of
guaranteed payments
received
-[(5)+(1)+(2)+(3)+(4)]
Generally
(1)+(2)+(3)+(4)+(5)
but may not go lower
than zero
20-49
70. [LO 5] Pam, Sergei, and Mercedes are all one-third partners in the capital and profits
of Oak Grove General Partnership. Partnership debt is allocated among the partners in
accordance with their capital and profits interests. In addition to their normal share of the
partnerships annual income, Pam and Sergei receive annual guaranteed payments of
$20,000 to compensate them for additional services they provide. Oak Groves income
statement for the current year reflects the following revenues and expenses:
Sales revenue
Dividend income
1231 losses
Cost of goods sold
Employee wages
Guaranteed payments
Overall net income
$476,700
6,600
(3,800)
(245,000)
(92,000)
(31,000)
(40,000)
(11,500)
$ 60,000
In addition, Oak Grove owed creditors $90,000 at the beginning and $150,000 at the end
of the year, and Pam, Sergei and Mercedes had a tax basis of $50,000 in their interests at
the beginning of the year. Also, Sergei and Mercedes agreed to increase Pams capital
and profits interest from 33.3 percent to 40 percent at the end of the tax year in exchange
for additional services she provided to the partnership. The liquidation value of the
additional capital interest Pam received at the end of the tax year is $40,000.
a. What tax basis do the partners have in their partnership interests at the end of the year?
b. If, in addition to the expenses listed above, the partnership donated $12,000 to a
political campaign, what tax basis do the partners have in their partnership interests at the
end of the year assuming the liquidation value of the additional capital interest Pam
receives at the end of the year remains at $40,000?
20-50
a. Pams basis is $140,000, Sergeis basis is $65,000, and Mercedess basis is $65,000
as computed in the table below:
Description
(1)Beginning tax basis (including
partners share of debt)
(2) Dividends income
(3)Partners share of ordinary
Pam
$50,000
Sergei
$50,000
Mercedes
$50,000
$2,200
$2,200
$2,200
$19,067
$19,067
$19,067
$30,000
$15,000
$15,000
business income
(4) Debt increase (deemed cash

contribution)
Explanation
Given
$6,600 x 33.33%
(Pams profits interest
doesnt increase until
the end of the year)
income - ($6,600
Dividend Income ($3,800) Section 1231
Losses)] x 33.3%
Pam :[( $150,000 x
40%) ($90,000 x
33.33%)]
Other Partners:
[($150,000 x 30%)
(5) Pams new 6.67% capital
$40,000
($20,000)
($20,000)
interest
($90,000 x 33.33%)]
Additional 6.67%
capital interest to Pam
is a guaranteed
payment to Pam and a
deduction allocated
equally to other
(6) Cash guaranteed payments

received
(7) Section 1231 losses

(8)Ending tax basis
($1,267)
$140,000
($1,267)
$65,000
($1,267)
$65,000
partners
Partners dont
increase the basis of
their partnership
interests by the amount
of cash guaranteed
payments received
($3,800) x 33.33%
Sum of (1) through (7)
20-51
b. Pams basis is $136,000, Sergeis basis is $61,000, and Mercedes basis is $61,000 as
computed in the table below:
Description
Ending tax basis given facts in part
Pam
$140,000
Sergei
$65,000
Mercedes
$65,000
a.
Campaign contribution
($4,000)
($4,000)
($4,000)
Explanation
See solution to part a.
above
($12,000) x 33.33%
Non-deductible
expenses must reduce
a partners tax basis
New ending basis given facts in part
$136,000
$61,000
$61,000
b.
71. [LO 6] {Research} Laura Davis is a member in a limited liability company that has
historically been profitable but is expecting to generate losses in the near future because
of a weak local economy. In addition to the hours she works as an employee of a local
business, she currently spends approximately 150 hours per year helping to manage the
LLC. Other LLC members each work approximately 175 hours per year in the LLC, and
the time Laura and other members spend managing the LLC has remained constant since
she joined the company three years ago. Lauras tax basis and amount at-risk are large
compared to her share of projected losses; however, she is concerned that her ability to
deduct her share of the projected losses will be limited by the passive activity loss rules.
a. As an LLC member, will Lauras share of losses be presumed to be passive as they are
for limited partners? Why or why not? {Hint: See 469(h)(2) and Garnett v.
Commissioner, 132 T.C. 368 (2009)}
b. Assuming Lauras losses are not presumed to be passive, is she devoting sufficient time
to the LLC to be considered a material participant? Why or why not?
c. What would you recommend to Laura to help her achieve a more favorable tax
outcome?
d. Section 469(h)(2) specifies that limited partners are presumed to be passive
participants. However, Laura is not a limited partner; rather she is a member in an
LLC. For a time, the IRS argued that LLC members should be treated as limited
partners in this context because of their limited liability. Nonetheless, the Tax Court
in Garnett v. Commissioner, 132 T.C. 368 (2009) and in subsequent memorandum
decisions determined that 469(h)(2) does not always apply to LLC members. In
response to the Garnett decision, the Treasury provided in Prop. Reg. 1.469-
20-52
5(e)(3)(i) that LLC members will not automatically be treated as limited partners as
long as they have management rights for some portion of the year. Thus, if Laura
can satisfy any one of the seven tests for material participation in Reg. 1.4695T(a), she may treat her losses as active.
e. In all likelihood, Laura is not spending enough time managing the LLC to be
considered a material participant. Given the facts provided, the only test for
material participation in Reg. 1.469-5T(a ) she might satisfy is the seventh test
which provides that an individual must participate on a regular, continuous, and
substantial basis during the year to be treated as a material participant. It is not
clear that she would satisfy this subjective test given her current level of
involvement.
f. Laura should be advised to increase her time spent managing the LLC from 150 to
175 hours per year. If she does this, she will clearly satisfy the test for material
participation found in Reg. 1.469-5T(a )(3) which provides that Laura will be a
material participant if she works more than 100 hours during the year in the LLC
and the number of hours she works is not less than the number of hours other
individual LLC members spend managing the LLC during the year.
72. [LO 6] Alfonso began the year with a tax basis in his partnership interest of $30,000.
His share of partnership debt at the beginning and end of the year consists of $4,000 of
recourse debt and $6,000 of nonrecourse debt. During the year, he was allocated $40,000
of partnership ordinary business loss. Alfonso does not materially participate in this
partnership and he has $1,000 of passive income from other sources.
a. How much of Alfonsos loss is limited by his tax basis?
b. How much of Alfonsos loss is limited by his at-risk amount?
c. How much of Alfonsos loss is limited by the passive activity loss rules?
a. Because Alfonsos basis before the loss allocation is $30,000, $10,000 of his $40,000
loss allocation is limited by his tax basis and will carryover to the following year.
b. Of the $30,000 loss not already limited by Alfonsos tax basis, $6,000 is limited
because Alfonsos at-risk amount is only $24,000 ($30,000 regular tax basis less the
$6,000 nonrecourse debt not allowed in calculating the at-risk amount). Thus,
$24,000 of loss remains after the tax basis and at-risk limitations, and Alfonso has a
$6,000 at-risk carryover.
c. Because Alfonso doesnt materially participate in the partnership, he may only deduct
the $24,000 loss remaining after the tax basis and at-risk limitations to the extent he
20-53
has passive income from other sources. Thus, he may deduct $1,000 of the $24,000
loss currently and will have a $23,000 passive activity loss carryover.
73. [LO 5, 6] {Research} Juan Diego began the year with a tax basis in his partnership
interest of $50,000. During the year, he was allocated $20,000 of partnership ordinary
business income, $70,000 of 1231 losses, $30,000 of short-term capital losses, and
received a cash distribution of $50,000.
a. What items related to these allocations does Juan Diego actually report on his tax
return for the year? {Hint: See Reg. 1.704-1(d)(2) and Rev. Rul. 66-94.}
b. If any deductions or losses are limited, what are the carryover amounts and what is
their character? {Hint: See Reg. 1.704-1(d).}
a. According to Rev. Rul. 66-94, 1966-1 CB 166 Juan Diego should increase his basis
first by his $20,000 share of ordinary business income and then reduce it by his
$50,000 cash distribution. At this point, his remaining basis of $20,000 will be
reduced to zero by the $70,000 Section 1231 losses and $30,000 short-term capital
losses allocated to him. Reg. 1.704-1(d)(2) describes how Juan Diegos $20,000
tax basis before considering the loss allocations should be allocated to the two types
of losses. The table below illustrates the required calculations:
Section 1231 losses

Short-term capital
losses
(1) Original
Loss
$70,000
$30,000
(2) Amount Deducted

Currently
$14,000
($20,000 x
$70,000/$100,000)
$6,000
($20,000 x
$30,000/$100,000)
(1) (2) Loss

Carryover
$56,000
$24,000
b. As indicated in the table above, Juan Diegos $80,000 loss carryover (due to his
$20,000 tax basis limitation) will be characterized as a $56,000 Section 1231 loss
and a $24,000 short-term capital loss.
74. [LO 6] Farell is a member of Sierra Vista LLC. Although Sierra Vista is involved in a
number of different business ventures, it is not currently involved in real estate either as
an investor or as a developer. On January 1, year 1, Farell has a $100,000 tax basis in his
LLC interest that includes his $90,000 share of Sierra Vistas general debt obligations.
By the end of the year, Farells share of Sierra Vistas general debt obligations has
increased to $100,000. Because of the time he spends in other endeavors, Farell does not
materially participate in Sierra Vista. His share of the Sierra Vista losses for year 1 is
$120,000. As a partner in the Riverwoods Partnership, he also has year 1 Schedule K-1
passive income of $5,000.
20-54
a. Determine how much of the Sierra Vista loss Farell will currently be able to deduct on
his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive
activity loss limitations.
b. Assuming Farrells Riverwoods K-1 indicates passive income of $30,000, determine
how much of the Sierra Vista loss he will ultimately be able to deduct on his tax return
for year 1 and list the losses suspended due to tax basis, at-risk, and passive activity loss
limitations.
c. Assuming Farrell is deemed to be an active participant in Sierra Vista, determine how
much of the Sierra Vista loss he will ultimately be able to deduct on his tax return for
year 1 and list the losses suspended due to tax basis, at-risk, and passive activity loss
limitations.
20-55
a. Farrell may only deduct $5,000 currently, and he will have a $10,000 loss suspended
by the tax basis limitation, a $100,000 loss suspended by the at-risk limitation, and a
$5,000 loss suspended under the passive activity limitation as illustrated in the table
below:
Description
Tax Basis
Limitation
At-risk
Limitation
(1) Beginning Tax

basis and At-risk
amount
$100,000
$10,000
(2) Increase in
nonrecourse debt
$10,000
$0
(3) Tax basis and

At-risk amount
before ordinary
business loss
(4) Ordinary
business loss
(5) Loss clearing
the Tax basis
hurdle
(6)Loss
suspended by Tax
basis hurdle
(7) Loss clearing
Tax basis hurdle
(8) Loss clearing
At-risk hurdle
(9) Loss
suspended by Atrisk hurdle
(10) Passive
activity loss
(11) Passive
income
(12) Loss used to
offset Passive
income
(13) Passive
activity loss
carryover
$110,000
$10,000
Passive
Activity
Limitation
Explanation
General debt
obligations of LLCs are
treated as nonrecourse
debt. Thus, Farrells
beginning at-risk
amount is $90,000 less
than his beginning tax
basis.
Non recourse debt
increases by $100,000 $90,000. Nonrecourse
debt not included in atrisk amount.
(1) + (2)
($120,000)
($110,000)
Loss limited to $110,000

tax basis
($10,000)
(4) - (5)
($110,000)
(5)
($10,000)

at-risk amount
(7) - (8)
($100,000)
($10,000)
$5,000
($5,000)
($5,000)
(8) Farrell is not a

material participant
From Riverwoods
Partnership
Loss only used to the
extent of passive income
(10) (12)
20-56
b. Farrell may only deduct $10,000 currently, and he will have a $10,000 loss
suspended by the tax basis limitation, and a $100,000 loss suspended by the at-risk
limitation as illustrated in the table below:
Description
Tax Basis
Limitation
At-risk
Limitation
(1) Beginning tax

basis and At risk
amount
$100,000
$10,000
(2) Increase in
nonrecourse debt
$10,000
$0
(3) Tax basis and

At-risk amount
before ordinary
business loss
(4) Ordinary
business loss
(5) Loss clearing
the Tax basis
hurdle
(6)Loss
suspended by Tax
basis hurdle
(7) Loss clearing
Tax basis hurdle
(8) Loss clearing
At-risk hurdle
(9) Loss
(10) Passive
activity loss
$110,000
$10,000
Passive
Activity
Limitation
Explanation
General debt
obligations of LLCs are
treated as nonrecourse
debt. Thus, Farrells
beginning at-risk
amount is $90,000 less
than his beginning tax
basis.
Non recourse debt
increases by $100,000 $90,000. Nonrecourse
debt not included in atrisk amount.
(1) + (2)
($120,000)
($110,000)

tax basis
($10,000)
(4) (5)
($110,000)
(5)
($10,000)

at-risk amount
(7) - (8)
($100,000)
(11) Passive
income
(12) Loss used to
offset Passive
income
(13) Passive
activity loss
carryover
($10,000)
(8) Farrell is not a

$30,000
From Riverwoods
Partnership
Loss used to the extent
of passive income
($10,000)
$0
(10) (12)
20-57
c. Farrell may only deduct $10,000 currently, and he will have a $10,000 loss
suspended by the tax basis limitation, and a $100,000 loss suspended by the at-risk
limitation as illustrated in the table below:
Description
Tax Basis
Limitation
$100,000
At-risk
Limitation
$10,000
(2) Increase in
nonrecourse debt
$10,000
$0
(3) Tax basis and

At-risk amount
before ordinary
business loss
$110,000
$10,000
(4) Ordinary
business loss
(5) Loss Clearing
the Tax basis
hurdle
(6) Loss
suspended by Tax
basis hurdle
(7) Loss clearing
Tax basis hurdle
(8) Loss clearing
At-risk hurdle and
deducted on tax
return
($120,000)
(1) Beginning Tax

basis and At-risk
amount
(9) Loss
Explanation
General debt obligations of
LLCs are treated as
nonrecourse debt. Thus,
Farrells beginning at-risk
amount is $90,000 less than
his beginning tax basis.
Nonrecourse debt increases by
$100,000 - $90,000.
Nonrecourse debt not included
in at-risk amount.
(1) + (2)
($110,000)
Loss limited to $110,000 tax

basis
($10,000)
(4) - (5)
($110,000)
(5)
($10,000)
Loss limited to $10,000 at-risk

amount on line (3). This
amount is deducted on
Farrells return because he is
an active participant.
(7) - (8)
($100,000)
20-58
20-59
75. [LO 6] {Research} Jenkins has a one-third capital and profits interest in the Maverick
General Partnership. On January 1, year 1, Maverick has $120,000 of general debt
obligations and Jenkins has a $50,000 tax basis (including his share of Mavericks debt)
in his partnership interest. During the year, Maverick incurred a $30,000 nonrecourse
debt that is not secured by real estate. Because Maverick is a rental real estate
partnership, Jenkins is deemed to be a passive participant in Maverick. His share of the
Maverick losses for year 1 is $75,000. Jenkins is not involved in any other passive
activities and this is the first year he has been allocated losses from Maverick.
a. Determine how much of the Maverick loss Jenkins will currently be able to deduct on
his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive
activity loss limitations.
b. If Jenkins sells his interest on January 1, year 2, what happens to his suspended losses
from year 1? {Hint: See Sennett v. Commissioner 80 TC 825 (1983) and Prop. Reg.
1.465-66(a).}
a. Jenkins may not deduct any losses currently, and he will have a $15,000 loss
suspended by the tax basis limitation, a $10,000 loss suspended by the at-risk
limitation, and a $50,000 loss suspended by the passive activity loss limitation as
illustrated in the table below:
20-60
Description
Tax Basis
Limitation
At-risk
Limitation
(1) Beginning Tax

basis and At-risk
amount
$50,000
$50,000
(2) Increase in
nonrecourse debt
$10,000
$0
(3) Tax basis and

At-risk amount
before ordinary
business loss
(4) Ordinary
business loss
(5) Loss clearing
the Tax basis
hurdle
(6)Loss
suspended by Tax
basis hurdle
(7) Loss clearing
Tax basis hurdle
(8) Loss clearing
At-risk hurdle
(9) Loss
(10) Passive
activity loss
(11) Passive
income
(12) Loss used to
offset Passive
income
(13) Passive
activity loss
carryover
$60,000
$50,000
Passive
Activity
Limitation
Explanation
General debt
obligations of general
partnerships are treated
as recourse debt. Thus,
Jenkins beginning atrisk amount is the same
as his beginning tax
basis.
Nonrecourse debt
generally not included
in at-risk amount.
(1) + (2)
($75,000)
($60,000)

tax basis
($15,000)
(4) - (5)
($60,000)
(5)
($50,000)

at-risk amount
(7) - (8)
($10,000)
($50,000)
$0
(8)Jenkins is not a
Given
$0
Loss only used to the

extent of passive income
($50,000)
(10) (12)
20-61
b. According to Sennett v. Commissioner 80 TC 825 (1983), a partner with losses

suspended by the tax basis limitation disappear when the partnership interest is sold.
Thus, Jenkins will lose the $15,000 loss suspended by the tax basis limitation. In
addition, Prop. Reg. 1.465-66(a) provides that Jenkins may utilize the $10,000 loss
suspended by the at-risk limitation to offset any gain he would otherwise report from
the disposition of his partnership interest. Finally, Jenkins may deduct the $50,000
passive activity loss carryover in the year of disposition.
76. [LO 6] {Planning} Suki and Steve own 50 percent capital and profits interests in
Lorinda LLC. Lorinda operates the local minor league baseball team and owns the
stadium where the team plays. Although the debt incurred to build the stadium was paid
off several years ago, Lorinda owes its general creditors $300,000 (at the beginning and
end of the year) that is not secured by firm property or guaranteed by any of the
members. At the beginning of the current year Suki and Steve had a tax basis of $170,000
in their LLC interests including their share of debt owed to the general creditors. Shortly
before the end of the year they each received a $10,000 cash distribution, even though
Lorindas ordinary business loss for the year was $400,000. Because of the time
commitment to operate a baseball team, both Suki and Steve spent more than 1,500 hours
during the year operating Lorinda.
a. Determine how much of the Lorinda loss Suki and Steve will each be able to deduct on
their current tax returns, and list their losses suspended by the tax basis, at-risk, and
passive activity loss limitations.
20-62
b. Assume that sometime before receiving the $10,000 cash distribution, Steve is advised
by his tax advisor that his marginal tax rate will be abnormally high during the current
year because of an unexpected windfall. To help Steve utilize more of the losses
allocated from Lorinda in the current year, his advisor recommends refusing the cash
distribution and personally guaranteeing $100,000 of Lorindas debt, without the right to
be reimbursed by Suki. If Steve follows his advisors recommendations, how much
additional Lorinda loss can he deduct on his current tax return? How does Steves
decision affect the amount of loss Suki can deduct on her current return and the amount
and type of her suspended losses?
a. The members (either Steve or Suki) may deduct $10,000 in losses currently, and they
will have a $40,000 loss suspended by the tax basis limitation, and a $150,000 loss
suspended by the at-risk limitation as illustrated in the table below:
20-63
Description
Tax Basis
Limitation
$170,000
At-risk
Limitation
$20,000
(2) Distribution
(3) Tax basis and
At-risk amount
before ordinary
business loss
($10,000)
$160,000
($10,000)
$10,000
(4) Ordinary
business loss
(5) Loss clearing
the Tax basis
hurdle
($200,000)
$400,000 x50%
($160,000)
Loss limited to $160,000 tax basis
(6)Loss
suspended by Tax
basis hurdle
(7) Loss clearing
Tax basis hurdle
($40,000)
(4) - (5)
(1) Beginning Tax

basis and At-risk
amount
Explanation
General debt obligations of LLCs are
treated as nonrecourse debt. Thus,
Suki or Steves beginning at-risk
amount is $150,000 less than their
beginning tax basis.
(1) + (2)
($160,000)
(5)
(8) Loss clearing

At-risk hurdle and
currently
deductible
($10,000)
(9) Loss
($150,000)
Loss limited to $10,000 at-risk

amount on line (3). This amount is
currently deductible because Steve
and Suki are active participants in the
activity.
(7) - (8)
20-64
20-65
b. Under these facts, Steve may deduct $120,000 in losses currently (a $110,000
increase over the loss he could deduct in part a.), and will have a $80,000 loss
suspended by the at-risk limitation as illustrated in the table below:
Description
Tax Basis
Limitation
$170,000
At-risk
Limitation
$20,000
(2) Increase in
debt allocation
$50,000
$100,000
(3) Tax basis and

At-risk amount
before ordinary
business loss
(4) Ordinary
business loss
(5) Loss clearing
the Tax basis
hurdle
(6)Loss
suspended by Tax
basis hurdle
(7) Loss clearing
Tax basis hurdle
(8) Loss clearing
At-risk hurdle and
currently
deductible
$220,000
$120,000
(1) Beginning Tax

basis and At-risk
amount
(9) Loss
Explanation
LLCs are treated as
Steves beginning at-risk
his beginning tax basis.
[(100,000 + 50% x
$200,000) - $150,000] for tax
basis and [100,000 0] for
at-risk amount because
guaranteeing the debt makes
it recourse debt
(1) + (2)
($200,000)
($200,000)
Loss is less than tax basis

limitation
$0
(4) - (5)
($200,000)
(5)
($120,000)
Loss is limited to at-risk

amount is currently
deductible because Steve is
an active participant in the
activity.
(7) - (8)
($80,000)
20-66
Suki may deduct $10,000 in losses currently (the same amount of loss as in part a.),
and she will have a $90,000 loss suspended by the tax basis limitation and a $100,000
loss suspended by the at-risk limitation as illustrated in the table below:
Description
(1) Beginning Tax
basis and At-risk
amount
(2) Distribution
(3) Decrease in
debt allocation
(4) Tax basis and
At-risk amount
before ordinary
business loss
(5) Ordinary
business loss
(6) Loss clearing
the Tax basis
hurdle
(6)Loss
suspended by Tax
basis hurdle
(7) Loss clearing
Tax basis hurdle
(8) Loss clearing
At-risk hurdle and
currently
deductible
(9) Loss
Tax Basis
Limitation
$170,000
At-risk
Limitation
$20,000
($10,000)
($50,000)
($10,000)
$0
$110,000
$10,000
Explanation
LLCs are treated as
Sukis beginning at-risk
her beginning tax basis.
[($200,000 x 50% )
($300,000 x 50%)]
(1) + (2)+ (3)
($200,000)
($110,000)
Loss is limited to the tax

basis
($90,000)
(5) - (6)
($110,000)
(6)
($10,000)
Loss is limited to at-risk

amount is currently
deductible because Suki is an
active participant in the
activity.
(7) - (8)
($100,000)
20-67
77. [LO 6]{Research} Ray and Chuck own 50 percent capital and profits interests in
Alpine Properties LLC. Alpine builds and manages rental real estate, and Ray and Chuck
each work full time (over 1000 hours per year) managing Alpine. Alpines debt (both at
the beginning and end of the year) consists of $1,500,000 in nonrecourse mortgages
obtained from an unrelated bank and secured by various rental properties. At the
beginning of the current year, Ray and Chuck each had a tax basis of $250,000 in his
LLC interest including his share of the nonrecourse mortgage debt. Alpines ordinary
business losses for the current year totaled $600,000 and neither member is involved in
other activities that generate passive income.
a. How much of each members loss is suspended because of the tax basis limitation?
b. How much of each members loss is suspended because of the at-risk limitation?
c. How much of each members loss is suspended because of the passive activity loss
limitation? {Hint: See 469(b)(7).}
a. Each member will have $50,000 of loss suspended because of the tax basis limitation
as reflected in the table below:
Description
Tax Basis
Limitation
At-risk
Limitation
(1) Beginning Tax

basis and At-risk
amount
$250,000
$250,000
(2) Ordinary
business loss
(3) Loss clearing
the Tax basis
hurdle
(4) Loss
suspended by Tax
basis hurdle
(5) Loss clearing
Tax basis hurdle
(6) Loss clearing
At-risk hurdle
($300,000)
(7) Loss
Passive
Activity
Limitation
Explanation
Because the LLCs
mortgage debt is
qualified nonrecourse
financing, it is included
in both the tax basis and
at-risk amount
50% x $600,000
($250,000)
Loss limited to
$250,000 tax basis
($50,000)
(2) - (3)
($250,000)
(3)
($250,000)
Loss limited to
$250,000 at-risk
amount
(5) - (6)
$0
20-68
20-69
b. As indicated in the table above, none of the members loss allocation will be
suspended because of the at-risk limitation.
c. Each members $250,000 loss remaining after the tax basis and at-risk limitations
(see table in part a.) is deductible currently. Although rental real estate ventures are
generally treated as passive activities under 469(c)(2), 469(b)(7) provides an
exception for taxpayers that work more than half of the time in real property trades
or businesses and work more than 750 hours in real property trades or businesses in
a given year. Given the facts in this problem, both members will be treated as active
participants and will therefore be able to immediately deduct $250,000.
Comprehensive Problems
78. [LO 2, 4, 5] Aaron, Deanne, and Keon formed the Blue Bell General Partnership at
the beginning of the current year. Aaron and Deanne each contributed $110,000 and
Keon transferred an acre of undeveloped land to the partnership. The land had a tax basis
of $70,000 and was appraised at $180,000. The land was also encumbered with a
$70,000 nonrecourse mortgage for which no one was personally liable. All three partners
agreed to split profits and losses equally. At the end of the first year Blue Bell made a
$7,000 principal payment on the mortgage. For the first year of operations, the
partnership records disclosed the following information:
Sales revenue
$470,000
Cost of goods sold
$410,000
Operating expenses
$70,000
$2,400
1231 gains
$900
Charitable contributions
$300
$300
Salary paid as a guaranteed payment to Deanne (not included in expenses) $3,000
a. Compute the adjusted basis of each partners interest in the partnership immediately
after the formation of the partnership.
b. List the separate items of partnership income, gains, losses, and deductions that the
partners must show on their individual income tax returns that include the results of the
partnerships first year of operations.
c. Using the information generated in answering parts a. and b., prepare Blue Bells page
1 and Schedule K to be included with its Form 1065 for its first year of operations along
with Schedule K-1 for Deanne.
d. What are the partners adjusted bases in their partnership interests at the end of the first
year of operations?
20-70
a. This initial adjusted basis for Keon is $23,333, for Aaron is $133,333, and for
Deanne is $133,333 as shown in the calculations with table below:
Description
land
(3) Debt allocated to
partners
(4) Relief from
nonrecourse mortgage
(5) Gain recognized
Keon
$70,000
$23,333
Aaron
Deanne
Explanation
$110,000
$23,333
$110,000
$23,333
$0
$0
($70,000)
$0
(4 )- [(1)+
(2)+ (3)] if
positive,
(6) Partners initial tax
$23,333
basis
$133,333
$133,333
otherwise 0
(1) + (2) +
(3)+ (4) +
(5)
b. The partners shares of ordinary business loss and separately stated items are
reflected in the table below:
20-71
Description
(1)
Partners
(11) Mortgageinitial
Tax basis (deemed
reduction
(2) Sales revenue
cash distribution)
Less:
(12) Self-employment
(3) Cost of goods
Loss
sold
(13) Guaranteed
(4) Operating
Payment
expenses
Partners ending tax
(5) Guaranteed
basis
payments
(6) Ordinary
Total
($7,000)
Keon
$23,333
($2,333)
Aaron
$133,333
($2,333)
Deanne
$133,333
($2,333)
($4,333)
($4,334)
($1,333)
Explanation
See
problem
($7,000)
x
33.33%
a. above
$470,000
($10,000)
(410,000)
3,000
(70,000)
(3,000)
Line 6 + 13
$17,767
127,767
127,767
(1) + (6)+
(7) through
(11)
[Sum of (2)
through (5)]
x 33.33%
($13,000)
($4,333)
($4,333)
($4,333)
$2,400
$800
$800
$800
gains
(8) Section 1231
$2,400 x
33.33%
$900
$300
$300
$300
gains
(9) Municipal bond
$900 x
33.33%
$300
$100
$100
$100
$300 x
33.33%
($300)
($100)
($100)
($100)
($300) x
33.33%
Business Loss
Separately Stated
Items on Schedule
K-1:
(7) Long-term capital
interest
(10) Charitable
contributions
c. Blue Bell Partnerships page 1 and Schedule K to be included with Form 1065 and
Deannes Schedule K-1 are shown below:
20-72
20-73
20-74
20-75
d. Keon has an ending basis of $17,767, Aaron has an ending basis of $127,767 and
Deanne has an ending basis of $127,767. These amounts are calculated in the table
included with the solution to part b. above.
79. [LO 4, 5, 6] The TimpRiders LP has operated a motorcycle dealership for a number of
years. Lance is the limited partner, Francesca is the general partner, and they share
capital and profits equally. Francesca works full-time managing the partnership. Both the
partnership and the partners report on a calendar-year basis. At the start of the current
year, Lance and Francesca had bases of $10,000 and $3,000 respectively, and the
partnership did not carry any debt. During the current year, the partnership reported the
following results from operations:
Net sales
Cost of goods sold
Operating expenses
Short-term capital loss
Tax-exempt interest
1231 gain
$650,000
$500,000
$160,000
$2,000
$2,000
$6,000
On the last day of the year, the partnership distributed $3,000 each to Lance and
Francesca.
a. What outside basis do Lance and Francesca have in their partnership interests at the
end of the year?
b. How much of their losses are currently not deductible by Lance and Francesca because
of the tax basis limitation?
c. To what extent does the passive activity loss limitation apply in restricting their
deductible losses for the year?
d. Using the information provided, prepare TimpRiders page 1 and Schedule K to be
included with its Form 1065 for the current year. Also, prepare a Schedule K-1 for
Lance and Francesca.
20-76
a. Lance has an ending basis of $5,000 and Francesca has an ending basis of $0 as
illustrated in the table below:
Description
Total
Lance
Francesc
(Limited
)
$10,000
(General)
$3,000
$3,000
$1,000
$3,000
$1,000
$6,000 x 50%
$2,000 x 50%
interest
(4) Basis Before
$14,000
$7,000
Distributions
(5) Cash
Sum of lines (1)

through (3)
($3,000)
($3,000)
distributions
(6) Basis Before
$11,000
$4,000
(1) Partners initial
Explanation
Given
Tax basis
Basis Increasing
Items:
(2) Section 1231 gain
(3) Tax-exempt
$6,000
$2,000
Given
(4) + (5)
Loss Allocations
(7) Sales revenue
Less:
(8) Cost of goods
(500,000)
sold
(9) Operating
(160,000)
expenses
(10) Ordinary
($10,000)
($5,000)
($5,000)
business loss
(11) Short-term
[Sum of (7) through

(9)] x 50%
($2,000)
($1,000)
($1,000)
($2,000) x 50%
$5,000
$0
capital loss
Partners ending tax
$650,000
basis
(6) + (10) + (11) or

limited to a basis of
zero. Thus, the tax
basis limitation
applies to
Francesca.
b. As indicated in the table in part a., Lance's loss allocations are not limited by his tax
basis; however, Francesca's has $2,000 of losses that are not deductible currently
because of the tax basis limitation.
c. Although Lances loss allocations are not limited because of his tax basis, his share of
the ordinary business loss is classified as a passive activity loss because he is a
20-77
limited partner. Thus, he must carryover his $5,000 ordinary business loss as a
passive activity loss until he either receives passive income or he sells his partnership
income. His $1,000 short-term capital loss is not limited because it is a portfolio
rather than a passive loss. The passive activity loss rules dont apply to Francesca
because she works full time managing the partnership and would be classified as a
material participant.
d. TimpRiders LPs page 1 and Schedule K to be included with Form 1065 and both
partners Schedule K-1 are shown below:
20-78
20-79
20-80
20-81
20-82
20-83
20-84
80. [LO 2, 4, 5] LeBron, Dennis, and Susan formed the Bar T LLC at the beginning of the
current year. LeBron and Dennis each contributed $200,000 and Susan transferred
several acres of agricultural land she had purchased two years earlier to the LLC. The
land had a tax basis of $50,000 and was appraised at $300,000. The land was also
encumbered with a $100,000 nonrecourse mortgage (i.e., qualified nonrecourse
financing) for which no one was personally liable. The members plan to use the land and
cash to begin a cattle-feeding operation. Susan will work full-time operating the
business, but LeBron and Dennis will devote less than two days per year to the operation.
All three members agree to split profits and losses equally. At the end of the first year,
Bar T had accumulated $40,000 of accounts payable jointly guaranteed by LeBron and
Dennis and had made a $9,000 principal payment on the mortgage. None of the members
have passive income from other sources.
For the first year of operations, the partnership records disclosed the following
information:
Sales revenue
Cost of goods sold
Operating expenses
Dividends
Salary paid as a guaranteed payment to Susan (not included in expenses)
Cash distributions split equally among the members at year-end
$620,000
$380,000
$670,000
$1,200
$300
$10,000
$3,000
a. Compute the adjusted basis of each members interest immediately after the formation
of the LLC.
b. When does each members holding period for his or her LLC interests begin?
c. What is Bar Ts tax basis and holding period in its land?
d. What is Bar Ts required tax year-end?
e. What overall methods of accounting were initially available to Bar T?
f. List the separate items of partnership income, gains, losses, deductions and other items
that will be included in each members Schedule K-1 for the first year of operations. Use
the proposed self-employment tax regulations to determine each members selfemployment income or loss.
g. What are the members adjusted bases in their LLC interests at the end of the first year
of operations?
h. What are the members at-risk amounts in their LLC interests at the end of the first
year of operations?
20-85
i. How much loss from Bar T, if any, will the members be able to deduct on their
individual returns from the first year of operations?
a. LeBrons adjusted basis is $216,667, Dennis adjusted basis is $216,667, and Susans
adjusted basis is $16,667 as calculated in the table below:
Description
land
LeBron
Dennis
$200,000
Susan
$50,000
Explanation
$50,000
Nonrecourse
$200,000
Susan only
debt >
Susans tax
basis in
contributed
$16,667
$16,667
$16,667
partners
property
[$100,000 $50,000] x
33.33%
(5) Relief from

nonrecourse mortgage
(6) Gain recognized
($100,000)
$0
$0
$0
(5 )- [(1)+
(2)+ (3)+
(4)] if
positive,
(7) Partners initial tax
$216,667
basis
$216,667
$16,667
otherwise 0
(1) + (2) +
(3) + (4)
+(5)
20-86
b. The holding period for LeBron and Dennis begins when they receive their LLC
interests because they only contributed cash. In contrast, Susans holding period
includes the holding period for the land he contributed since Susan held the land as
either a capital or Section 1231 asset.
c.
Bar T receives a $50,000 tax basis in the land and will include Susans holding
period as part of its holding period.
d. Bar T must adopt a calendar year end because all of its members have calendar year
ends.
e. Bar T may adopt either the cash or accrual method of accounting. It may generally
use the cash method because it does not have a corporate member. However, it must
use the accrual method in accounting for its inventory related transactions (i.e., the
hybrid method).
20-87
f. The members separately stated items are listed on lines (2), (3), (11), and (13) in the
table below. Note that LeBron and Dennis have self-employment income under the
proposed regulations because they are responsible for some of Bar Ts debt. Susan
clearly has self-employment income under the proposed regulations because she
works full time in the enterprise.
Description
(1) Members Initial Tax
Basis
(2) Dividends
(3) Municipal bond
interest
(4) Deemed cash
Total
LeBron
$216,667
Dennis
$216,667
Susan
$16,667
Explanation
See part a. above
$1,200
$300
$400
$100
$400
$100
$400
$100
$1,200 x 33.33%
$300 x 33.33%
$40,000
$20,000
$20,000
($3,000)
($1,000)
($1,000)
Accounts payable
are only allocated to
LeBron and Dennis
because they
guaranteed them
contribution from
accounts payable
(5) Cash distributions
(6) Deemed cash
($1,000)
($9,000)
distribution to Susan for

mortgage repayment
(7) Members Tax Basis

Before Loss Allocation
(8) Sales revenue
Less:
(9) Cost of goods sold
(10) Operating expenses
(11) Guaranteed payments
(12) Ordinary Business
Loss
(13) Self-employment loss
$236,167
$236,167
$7,167
(380,000)
(670,000)
(10,000)
($440,000)
($146,667
($146,667
($146,667
($430,000)
)
($146,667
)
($146,667
)
)
($136,667
$89,500
$0
$620,000
)
Members ending Tax
Because Susan was

originally allocated
the first $50,000 of
the nonrecourse
mortgage, the
repayment goes to
reduce her share of
the debt.
Sum of (1) through
(6)
$89,500
basis
[Sum of (8) through

(11)] x 33.33%
Line (12) + $10,000
guaranteed payment
for Susan only.
(7)+ (12) but not less
than zero. Susan
must carry over
$7,167 + ($146.667)
20-88
or ($139,500) of
ordinary loss.
g. As indicated in the table in part f. above, the ending basis for LeBron is $89,500, the
ending basis for Dennis is $89,500, and the ending basis for Susan is $0.
h. Generally, the members at-risk amounts will be less than the amount of their tax
bases to the extent they are allocated nonrecourse debt that is not qualified
nonrecourse financing. In this case, the members at-risk amounts are the same as
their tax bases in part g. because the nonrecourse mortgage is qualified nonrecourse
financing and the accounts payable are treated as recourse debt (i.e., they are
guaranteed by LeBron and Dennis).
i. As indicated in the table in part f. above, the $146,667 loss allocated to LeBron and
Dennis is not limited by their tax bases. However, given the facts provided, they
cannot deduct their losses currently, and each has a $146,667 passive activity loss
carryforward because they are not material participants in the enterprise. As for
Susan, her $146,667 loss is initially limited to her $7,167 tax basis leaving her with a
$139,500 loss carryforward. However, because she is a material participant in Bar
T, she may deduct the $7,167 currently.
20-89

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Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Actual and deemed cash distributions from the partnership

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

4. The activity qualifies as a significant participation activity (individual

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

a. What is Laurels initial tax basis in her LLC interest?

Basis Fair Market Value

Chapter 20 - Forming and Operating Partnerships

a. How much gain or loss will Harry recognize on the contribution?

Chapter 20 - Forming and Operating Partnerships

g. The partnerships tax basis balance sheet would appear as follows:

Chapter 20 - Forming and Operating Partnerships

excess of basis in contributed

debt > basis is

(3) Remaining nonrecourse

(1) + (2) + (3)

b. $22,500 as indicated in the table above.

Basis Fair Market Value

*Nonrecourse debt secured by the land equals $160,000

Chapter 20 - Forming and Operating Partnerships

excess of basis in contributed

debt > basis is

(4) Remaining nonrecourse

basis in the LLC

(1) + (2) + (3)

Chapter 20 - Forming and Operating Partnerships

e. High Horizons tax basis balance sheet would appear as follows:

Basis Fair Market Value

*Nonrecourse debt secured by the land equals $210,000

Chapter 20 - Forming and Operating Partnerships

d. What is Albee LLCs tax basis in its assets?

excess of basis in contributed

debt > basis is

(4) Remaining nonrecourse

Basis immediately prior to

basis in the LLC

(1) + (2) + (3)

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

f. $5,000. See table below:

(1) Basis in contributed

(4) Basis immediately

prior to debt relief

Each members initial

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Fair Market Value

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships