CHAPTER 21


                                   LECTURE NOTES


Gain or Loss on Contributions to the Partnership

13.   Formation of a partnership occurs through transactions between a partnership and each of
      its partners. Partners surrender assets and receive a partnership interest in exchange.

14.   Under § 721, the partnership and partners do not recognize gain or loss from the
      contribution of property in exchange for a partnership interest. The purpose of this
      provision, like its corporate counterpart (§ 351), is to allow taxpayers a tax-neutral choice
      in selecting a business form.

15.   Basis in a partnership interest acquired in by exchanging money and other property equals
      the cash exchanged plus the partner’s adjusted basis in the other property contributed.

      a.     This is termed “substituted” basis.

      b.     The partnership takes a “carryover basis” for the contributed assets.

      c.     If investment company gain is recognized under § 721(b) by the contributor of
             property for a partnership interest, such gain increases the basis of the interest.

16.   The nonrecognition provision of § 721 is a deferral rather than a tax reduction provision.
      Any built-in gain or loss is deferred until later disposal of the property or the eventual
      termination of the partnership.


17.    Neither the contributing partner’s tax basis in the partnership nor the partnership’s tax
       basis in the contributed property is determined by the value recorded on the partnership’s
       accounting (GAAP) books and records.

Exceptions to § 721

18.    Nonrecognition provisions of § 721 do not apply in the following situations.

       a.     If the property transferred to the partnership consists of appreciated stocks and
              securities, and the partnership is an investment partnership, gain is recognized by
              the contributing partner [§ 721(b)].

       b.     Transaction is essentially a taxable exchange of properties.

       c.     Contributions of assets to a partnership are followed by a distribution of assets to
              another partner. The partner receiving the distribution may be deemed to have
              made a disguised sale of the partnership interest to the contributing partner.

       d.     If a partnership interest is received for services, the nonrecognition rule of § 721
              does not apply. Instead, the partner generally is required under § 83 to recognize
              the fair market value of the interest as ordinary income (compensation for

24.    Under § 706(b)(1), a tax year of a partnership must be determined by systematic reference
       to certain tax years of the partners. The partnership’s tax year under § 706 is identified,
       in the following order, as

       a.     Tax year of the majority partners with the same tax year (i.e., partners with a more
              than 50% aggregate profit and capital interest).

       b.     Tax year of all principal partners (i.e., all partners with a 5% or greater profit or
              capital interest have the same year-end).

       c.     Year determined under the least aggregate deferral method. See Figure 21-2 and
              Example 19.

                               ETHICAL CONSIDERATIONS

A Preparer’s Responsibility for Partners’ Tax Returns (page 21-22). An individual may own an
interest in numerous partnerships, limited or general. Especially with limited partnership
interests sold over a wide geographical area, the partner’s accountant may have no access to
partnership records. The Schedule K-1 is the only source of the accountant’s information.
                                          Partnerships                                        21-3

This court case recognizes that in such situations, it would be unreasonable for the individual
partner’s return preparer to be responsible for partnership information. Responsibility is instead
attributed to the party providing the information—the partnership’s return preparer.

               Example. Peg is a 40% partner in the PDQ Partnership. Her basis is $10,000 at
               the beginning of the year. The partnership reports income for the year of $60,000,
               of which Peg’s share is $24,000. Assume Peg sells her interest in the partnership
               for $34,000 the first day of the next tax year. If a basis adjustment was not
               allowed, Peg’s share of partnership income would be subject to double taxation,
               as follows.

               Current year share of partnership income taxed to Peg               $24,000

               Gain on sale of partnership interest next year:
                   Selling price                                                   $34,000
                   Basis in partnership interest                                   (10,000)
               Gain on sale                                                        $24,000

               Peg would pay tax both in the current year, when it is earned by the partnership,
               and next year, when she sells the interest. However, since a basis adjustment is
               allowed, Peg’s share of partnership income is only taxed once:

               Current share of partnership income taxed to Peg                    $24,000

               Gain on sale of partnership interest next year:
               Selling price                                                       $34,000
               Basis in partnership interest:
                    Beginning basis                            $10,000
                    Basis increase for income                   24,000
               Ending basis                                                        (34,000)
               Gain on sale                                                       $     -0-

               The partnership income is taxed only in the year it is earned, not also in a later
               year when the interest is sold.

               Example: The Ellen-Glenn partnership is owned equally by partners Ellen and
               Glenn. At the beginning of the year, Ellen’s basis for her partnership interest is
               exactly $0. Her share of partnership income is $10,000 for the year, and she
               receives a $10,000 distribution from the partnership. Under the basis adjustment
               ordering rules, Ellen’s basis is first increased by the $10,000 of partnership
               income; then is decreased by her $10,000 distribution. She reports her $10,000
               share of partnership taxable income on her personal tax return and the $10,000

              distribution is a tax-free return of basis. Her adjusted basis at the end of the year
              is $0 ($0 + $10,000 income – $10,000 distribution).

              Although the above scenario is easy to follow, the ordering rules can sometimes
              produce some unusual results.

              Example: Assume the same facts, except that Ellen’s share of partnership
              operations results is a $10,000 loss instead of $10,000 income. She again receives
              a $10,000 distribution. Under the basis adjustment ordering rules, Ellen’s
              distribution is considered before the deductibility of the loss is evaluated. Ellen
              recognizes $10,000 gain on the distribution because she has no basis in her
              partnership interest. The gain effectively ensures that she still has a $0 basis after
              the distribution. The loss cannot be deducted under the loss limitation rule
              because Ellen has no basis in her partnership interest to “cover” the loss.

              There is a $20,000 difference in partnership earnings in the two examples
              ($10,000 income to $10,000 loss). However, Ellen reports $10,000 income (gain)
              in each case: ordinary income in the first example and probably a capital gain in
              the second example. She also has a $10,000 suspended loss in the second
              example. The results are not intuitive and require knowledge of the ordering

       By claiming that the note is not a partnership liability, Carter does not reduce the
       adjusted basis for his partnership interest, even though its fair market value is
       lowered to $1,500 ($4,000 – $2,500). If Carter then sells his partnership interest
       for $2,750 [$1,500 cash, plus the buyer’s assumption of $1,250 (50%) of the
       note], he may attempt to recognize a capital loss of $1,250 ($2,750 sales price –
       $4,000 adjusted basis).

              Partnership distributes $40,000 cash and accrual basis accounts receivable with a
              $20,000 basis and value. Bob reduces his basis in partnership to $0, has $40,000
              cash, and a $10,000 substituted basis in the receivables. He recognizes no gain or

              Partnership distributes $10,000 inventory with a $5,000 basis. Bob reduces his
              basis in the partnership to $45,000, has a $5,000 carryover basis in the inventory,
              and recognizes no loss since this is a nonliquidating distribution.

              Partnership distributes two parcels of land, each worth $30,000. Basis in parcel A
              is $40,000 and in parcel B is $20,000. Bob reduces his basis in his partnership to
              $0, assigns a $50,000 substituted basis to the two parcels, and recognizes no gain
              or loss. His $50,000 basis is allocated between the two parcels as follows.
                                   Partnerships                                          21-5

Examples. Assume partner Jill has a basis in her partnership interest of $50,000 in each of
the following independent situations. What gain or loss is recognized, and what is Jill’s
basis in the property received if the partnership makes the following proportionate
liquidating distributions and the partnership also liquidates? Compare the results of these
examples with the examples in 47. above.

a.     Partnership distributes $40,000 cash. Jill has $40,000 cash and recognizes a loss
       of $10,000, since she received only cash in the distribution.

b.     Partnership distributes $60,000 cash. Jill has $60,000 cash, and recognizes a gain
       of $10,000 on the excess distribution.

c.     Partnership distributes $40,000 cash and accrual basis accounts receivable with a
       $20,000 basis and value. Jill has $40,000 cash and a $10,000 substituted basis in
       the receivables. She recognizes no gain or loss.

d.     Partnership distributes $10,000 inventory with a $5,000 basis. Jill takes a $5,000
       carryover basis in the inventory, and reports a $45,000 loss on the liquidation,
       because she received only cash in the distribution.

e.     Partnership distributes two parcels of land, each worth $20,000. Basis in parcel A
       is $10,000 and in parcel B is $20,000. The land parcels are capital assets to both
       Jill and the partnership. Jill assigns $50,000 substituted basis of to the two parcels.
       Jill’s $50,000 basis is allocated between the two parcels as follows.

       (1)     First, the parcels are assigned carryover bases of $10,000 for parcel A and
               $20,000 for parcel B ($30,000 total).

       (2)     Next, the appreciation in parcel A is added to the basis of the parcel. This
               increases its basis from $10,000 to $20,000. The basis of parcel B is not
               adjusted above $20,000 because it is not an appreciated asset.

       (3)     Bases in the properties now total $40,000, but Jill must allocate $50,000 to
               them. The additional $10,000 basis is allocated according to the relative
               values of the property after adjustment in 2 above. The properties have
               equal allocations ($20,000). Therefore, the $10,000 is allocated equally
               ($5,000 to each parcel). Jill’s basis in each parcel, then, is $25,000.

       (4)     She recognizes no gain or loss. Note that Jill can “step-up” the basis in
               land (a capital asset), but she cannot “step-up” her basis in unrealized
               receivables or inventory (see c. above).

       Examples. Tim’s one-third interest in the equal TUV Partnership is sold to John for
       $75,000. On the sale date, the partnership’s cash basis balance sheet reflects unrealized
       receivables of $210,000. The receivables resulted from services rendered in the prior
       month and are expected to be collected at the end of the current month. Assuming that
       Tim’s basis in his partnership interest is $2,000, the sale results in a $73,000 gain.
       Without § 751(a), Tim’s $70,000 (1/3 of $210,000) share of forthcoming partnership
       ordinary income would be converted into capital gain. However, under § 751(a), Tim
       must report $70,000 of ordinary income and a $3,000 capital gain.

       The RST Partnership plans to sell all of its assets and discontinue operations. The
       partnership’s principal assets are shrimp boats which have been fully depreciated but are
       worth $400,000. Two days before the partnership sells its assets, Roy’s 25% partnership
       interest (basis $30,000) is sold for $120,000. Without § 751(a), Roy would avoid
       recognizing $100,000 (l/4 of $400,000) of depreciation recapture which results when the
       partnership sells the boats. Under § 751(a), Roy has $100,000 ordinary income and a
       $10,000 capital loss. There is no “ceiling” on the § 751(a) ordinary income.

       Example. The NOP Manufacturing Partnership has always operated at breakeven (i.e.,
       has never made a profit or suffered a loss). Partner Norma, a general partner who
       originally invested $1,000 in the partnership, sells her interest for $5,000 in cash and the
       assumption of her $10,000 share of partnership debt. If the balance in her capital account
       is $1,000 (her original investment), her gain on the sale is $4,000.

       Selling price:
           Cash                                                                     $ 5,000
           Assumption of debt share                                                  10,000
               Total                                                                $15,000
       Norma’s basis in interest (using capital account):
           Capital account                                     $ 1,000
           Debt share                                           10,000              (11,000)
               Gain on sale                                                         $ 4,000

       Any capital gain attributable to the seller’s share of the partnership unrealized gain on
       collectibles or unrecaptured § 1250 gain assets is taxed to the selling partner at 28%
       (collectibles) and 25% (unrecaptured § 1250 gain) rates and not at the general 15% capital
       gains rate.


The Red Robin Partnership, a general partnership, provides technical consulting services. The tax
return for the business is shown on the following pages. The discussion that follows presents the
fact pattern and walks you through the flow of information on the tax return.
                                           Partnerships                                   21-7

The cash basis Red Robin Partnership was formed January 1, 2004, to perform technical
consulting services in Madison, Alabama. The partnership’s business address is shown on the
tax return. The business code is 541600 and the EI number is 63-1235487. At the end of 2006,
assets totaled $400,000. Barney Pfister (SSN 444-33-2222) is a 40% general partner who lives in

Red Robin earns $80,000 from operations, reports $3,000 of interest income, paid a $200
charitable contribution, and has $1,000 of tax-exempt income. Guaranteed payments to partners
(already deducted in income from operations) were $100,000. Depreciation expense (already
deducted in income from operations) includes an adjustment for alternative minimum tax of
$2,000 for excess depreciation on property placed in service after 1986. The partnership
distributed cash of $50,000 to the partners. Partnership income is subject to self-employment
taxes by the partners. Barney receives 40% of the guaranteed payments.

Schedule K reflects the following items:

Line 1              Ordinary income                                                  $ 80,000
Line 4              Guaranteed payments                                               100,000
Line 5              Interest income                                                     3,000
Line 13a            Charitable contribution                                               200
Line 14a            Net earnings (loss) from self-employment                          180,000
Line 14c            Gross nonfarm income                                              325,000
Line 17a            Depreciation adjustment on property
                     placed in service after 1986                                        2,000
Line 18a            Tax-exempt interest income                                           1,000
Line 19a            Distributions of cash and marketable securities                     50,000
Line 20a            Investment income                                                    3,000

Barney’s K-1 reflects the following items, which are reported in the indicated location on his
Form 1040 (U.S. Individual Income Tax Return):

Line 1              Ordinary income                            $32,000             Schedule E
Line 4              Guaranteed payments                         40,000             Schedule E
Line 5              Interest income                              1,200             Schedule B
Line 13, Code A     Charitable contribution                         80             Schedule A
Line 14, Code A     Net earnings (loss) from
                     self-employment                            72,000            Schedule SE
Line 14, Code C     Gross non-farm income                      130,000            Schedule SE

Line 17, Code A     Depreciation adjustment on property
                     placed in service after 1986                     800          Form 6251
Line 18, Code A     Tax-exempt interest income                        400   Form 1040, Line 8b
Line 19, Code A     Distributions (typically not reported

                      as income)                                  20,000
Line 20, Code A     Investment income                              1,200               Form 4952
                                                          (Investment Interest Expense Deduction)

a.     Page 1 of Form 1065 is similar in appearance to a corporate tax return (Form 1120);
       however, this part of the return only includes trade or business income.

b.     Page 2 of Form 1065 accumulates information related to cost of goods sold, which is not
       relevant for Red Robin. Several questions must be answered at the bottom of this page
       regarding the overall operations of the partnership.

c.     Schedule K accumulates partnership taxable income and expense items, as well as other
       items which could be relevant to specific partners (such as information related to
       investment interest expense limitations, alternative minimum tax, self-employment tax,
       etc.). (Form 1065, p. 3)

d.     Income and deductions from Schedule K are accumulated in the Analysis of Net Income
       (Loss). This net income amount is reconciled to line 9 in Schedule M-1. (Form 1065, p. 4) Red
       Robin has $1,000 of tax-exempt interest income that is a book-tax difference.

e.     On Schedule M-2, partners’ capital account balances are reconciled with the “book
       income” amount, distributions, and the balance sheet capital balance (Schedule L). (Form
       1065, p. 4) Red Robin adjustments are for entity income and distributions to the partners.

f.     Each partner receives a Schedule K-1 from the partnership which reports the partner’s
       distributive share of all partnership items. The income and expense items from the
       Schedule K-1 are combined with the partner’s tax data from sources other than the
       partnership, and included in the partner’s personal tax return.

g.     Because Barney is a 40% partner with no special allocations, each of the items on
       Schedule K-1 represents exactly 40% of the amount on Schedule K.

h.     A partner will pay tax on partnership income per Schedule K-1, regardless of actual
       distributions received from the partnership.

i.     The K-1 reflects an allocation of partnership liabilities to the partner. This amount is
       important, since it is included in the partner’s basis in his partnership interest. This is an
       example of the aggregate concept. Red Robin’s debt is qualified nonrecourse debt related
       to the land and building.

j.     A partner will use the information from line 20 in determining any investment interest
       expense deduction he may be entitled to. The partner will use the self-employment
       information from line 14 in determining self-employment tax is due on the partnership
       income. The partner will use the preference amounts on line 17 in determining whether
       he is subject to alternative minimum tax.
                                        Partnerships                                        21-9

k.   The Schedule K-1 reflects the partner’s ownership interest in partnership capital and
     profits and provides a reconciliation of the partner’s capital account. The capital account
     balance plus the partner’s share of liabilities frequently approximates the partner’s basis
     in his partnership interest (assuming he acquired his interest for cash in the initial
     formation of the partnership), but this should always be verified. Ideally, the partner will
     maintain a separate schedule which tracks his or her outside basis in the partnership.

l.   Page 2 of Schedule K–1 includes references the partner will need for reporting the
     amounts from page 1. In addition, this page provides reference Codes for several items
     reported on the Schedule K–1. For example, on line 20, Code A represents investment
     income for the investment interest expense deduction limitation calculation.

Example: Red Robin Partnership
                                 Partnerships   21-11

Example: Red Robin Partnership

Example: Red Robin Partnership
                                 Partnerships   21-13

Example: Red Robin Partnership

Example: Red Robin Partnership
                                 Partnerships   21-15

Example: Red Robin Partnership

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