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Partnership Taxation Outline (Spring 2012)

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Law school course outline for upper level Partnership Taxation course

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									Partnership Tax I&II Outline

I) Intro
    A) Classification of Entities for Tax Purposes, 3 Questions
       1) Is it recognized for federal tax purposes?
           (a) If no business reason for creating an entity, or it exists only transitorily,
               won’t be recognized for tax purposes even if for state law purposes
       2) Is it a business entity?
           (a) Any entity recognized for tax purposes that is not a trust or otherwise subject
               to special treatment (nonprofits, real estate investment trusts)
           (b) Morrissey – “trust” was actually organized with business purpose, so it is an
               “association” which is an unincorporated entity taxed as a corporation
           (c) If not treated as a corporation, then it is an ‘eligible entity’
       3) How many members does the entity have?
           (a) Eligible entity with at least 2 members can elect to be treated as a
               corporation or a partnership, 1 member as a disregarded entity or a
               corporation
       4) Default: 2 or more members, then partnership; single owner is disregarded
           (a) Publically traded partnerships that receive predominantly passive income
               treated as corporations
       5) Check the box!
II) Contributions and Receiving an Interest
    A) Contributions - General
       1) Contributor – 721(a) – nonrecognition treatment for contributing partner on
           exchange of property for partnership interest
           (a) Takes substituted basis in the interest (basis of contributed property)
               (i) Accounts receivable constitute “property” for contribution purposes
           (b) Exception: 721(b) Nonrecognition does not apply to gain realized on a
               transfer of property to a partnership that would be treated as an investment
               company within the meaning of 351 if the partnership were incorporated:
               (i) Applies to gains realized (not losses)
               (ii) Investment company: more than 80% of assets held for investment and
                    are readily marketable stocks and securities
           (c) Basis:
               (i) Money + Adjusted Basis of Contributed Noncash Property + Any Gain
                    Recognized
               (ii) No Losses recognized even if within the investment company exception
       2) Partnership – 723 – Takes contributed assets with carryover basis
           (a) Basis
               (i) Generally carryover
               (ii) Increased by the amount of gain recognized by partner under 721(b)
       3) Holding Period
           (a) 1223(1) – Contributed assets are capital or 1231 assets
               (i) Partner tacks holding period of contributed assets into newly acquired
                    partnership interest
           (b) Capital Assets


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          (i) Property other than 1231 or assets in list:
                Unrealized receivables, property used in business (equipment),
                    inventory
          (ii) Tack as long as held for one year
      (c) 1223(2) – Partnership always tacks when we have carryover basis
B) Contributions of Encumbered Property
   1) Assuming debt allocated in accordance with distributive shares:
      (a) 752(b) – Contributing Partner: Relief of portion of liability (by reason of
          other partners assuming) treated as distribution of cash and reduces
          partner’s basis (also 733)
          (i) Once we run out of basis, gain triggered (731)
      (b) 752(a) – Noncontributing Partners: Assumption of debt treated as
          contribution of property and increases partners’ bases
   2) Nonrecourse Debt – Allocation Reg 1.752-3(a), 3 Levels:
      (a) Level 1: Minimum Gain
          (i) Amount of gain partner would recognize if the encumbered property
               were sold solely for relief from liability
      (b) Level 2: 704(c) Gain
          (i) Portion of 704(c) gain partner(s) would recognize if the property were
               sold for book value
      (c) Level 3: Share of Profits
          (i) Allocate remaining in accordance with share of profits
   3) Accounts Payable
      (a) Cash Method Tax Payers: Not treated as “liabilities” for 752, and their
          contribution thus does not trigger a debt relief event
          (i) But they do trigger 704(c) gain
                704(c) applies to the deductions when they arise
      (b) Accrual Method Tax Payers – Contribution and assumption by partnership of
          accounts payable is relief from liability
          (i) Because accrual method tax payers deduct them as they are incurred
               (and thus before contribution), contributions of accounts payable by
               accrual method tax payers are treated as relief from liability
          (ii) Correspondingly, other partners will increase their basis by the amount
               of liability deemed assumed on the accounts payable
          (iii) And, the partners will reduce their basis accordingly as the accounts
               are paid down
C) Contributions of Services
   1) Partner
      (a) 721 nonrecognition does not apply
   2) Partnership – 2 Approaches/Treatments
      (a) McDougal: Partnership distributes % of each of its assets to Partner in
          payment for services and then Partner contributes interest in those assets
          back to the partnership in exchange for partners hip interest
          (i) The payment in this method will also entitled the partnership to a
               deduction



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                  Remember, the deduction will reduce the historic partners’ outside
                   bases.
      (b) Cash Out Cash In: Treat has distributing cash to Partner in payment for
          services followed by contribution of same cash back in exchange for
          partnership interest
          (i) Payment to service (new) partner deductible to historic partner, reduces
               outside bases
   3) Problem where original cotenants of property are tenants in common and don’t
      yet have a partnership.
      (a) When they convey part of the interest in land to the service partner, there is
          recognition on both sides
      (b) Look at the cotenants respective bases in the land, and there will be a
          recognition event
   4) Stafford – nonenforcable obligation can still be property
   5) Forfeitable Interest for Services – Section 83
      (a) 83(a): Interest triggers income when risk of forfeiture lapses, at the FMV at
          the time of lapse, basis in interest is equal to FMV at the time of lapse because
          in exchange for services
      (b) 83(b) election: you can elect to take the interest into income immediately
          (i) Report income to extent of FMV of interest at that time
          (ii) After lapse of forfeiture possibility, gain remains built in
          (iii) If the interest is forfeited, no corresponding deduction allowed
      (c) 83(h) Partnership can take the deduction (as a payment for services) once
          the partner takes the income in
D) Capital v. Profits Interest
      (a) Capital: shows up in capital account, liquidation rights in that amount
      (b) Profits but not Capital: future income/loss credited proportionally to that
          partner, but only with respect to income or loss recognized by the
          partnership from that point on
          (i) Starting capital account of 0
          (ii) Sol Diamond – Partner has income where the interest has a readily
               calculable value, Rev Procs below determine whether susceptible to
               valuation
                E.g., fixed rate bods
          (iii) Rev Proc 93-27: IRS will not treat profits interest as taxable unless 1
               of following 3:
                Profits interst in substantially certain and predictable stream of
                   income (e.g., high quality debt securitys, high quality net lease)
                Profits interst is disposed of within 2 years
                Profits interest is a limited interest in a publically traded partnership
                   or one with passive type income
          (iv) Rev Proc 2001-43
                If certain conditions met, determination of whether the profits
                   interest is income will be made at the time of receipt, even if




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                        substantially nonvested within the meaning of 83. Thus, neither the
                        grand or subsequent vesting become taxable
                     2001-43 and 93-27 taken together in effect provide a workable way to
                        make sure profits only interests won’t be taxable
                         in effect modifies 83(a) – we won’t treat it as a taxable event if just
                            a profits interest
                (v) Proposed Reg 1.721-1(b)(i):
                     Both profits and capital intersts are subject to 83
                     Safe Harbor: if the requirements the interest will be valued at the
                        liquidation value – look at the capital accounts, if zero, value the
                        profits interest at zero
            (c) A true profits interst should always be valued at zero, but must make an
                83(b) election to ge the benefit of this rule
        2) THIS IS A SITUATION TO BOOK UP
III) Determining Partners’ Distributive Shares of Gains and Losses - Basics
     A) 704(a) General Rule
            (a) Partnership agreement determines partners’ distributive share
            (b) Partner’s Interest in the Partnership: Reg -1(b)(3)(i): signifies the manner in
                which the partners have agreed to share economic burdens/beneifits
                corresponding to income, loss, and credit that is allocated
            (c) 704(d)
                (i) Depreciation Deductions Treated as Losses
                     If deductions in excess of basis, then 704(d) loss suspension, and not
                        gain recognized.
     B) 704(c) and Contributed Property
        1) On disposition of contributed property;
        2) Which had a built in gain or loss at the time of contribution;
        3) The contributing partner must recognize that gain/loss to the extent recognized
        4) After, the loss or gain is recognized by the partners in accordance with
            distributive shares
     C) Distributive Share and Basis – 705
        1) Income to the partnership increases partners’ bases by distributive share
        2) Losses, distributions, and debt relief reduce the partners’ bases by distributive
            share
IV) Partners’ Share of Partnership Debt
     A) Determine amount of recourse/nonrecourse debt through constructive liquidation
        test (nonrecourse/recourse business designations not determative);
     B) Following events deemed to occur simultaneously
        1) All liabilities become payable in full;
        2) All partnership’s assets including cash become worthless;
        3) Partnership disposes of all property in a fully taxable transaction for no
            consideration, except for relief from liabilities
        4) Income/loss allocated to partners
        5) Partnership Liquidates




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      (a) Each partner will have to kick in money based on extent to which they have
          negative capital account balance after
          (i) May require looking to nontax state law to determine who must kick in
              what and for treatment of negative account balances
      (b) Partner deemed to bear economic risk of loss of he or a related person bears
          the ultimate risk of loss
C) Nonrecourse
   1) Defined: nonrecourse to extent that no partner/RP bears the economic risk of
      loss for that liability
      (a) Always start with the constructive liquidation, figure out whether any
          partner bears the risk of loss. If so, the debt is recourse and allocated
          corresponding to that for basis purposes.
          (i) If partner(s) only bear part of risk of total debt, then the leftover is
              nonrecourse
   2) Partners’ Share of Nonrecourse Debt; Equals the sum of:
      (a) Partner’s share of partnership minimum gain; plus
          (i) Look at book basis because minimum gain chargeback provisions allow
              us that capital accounts can go negative but will be restored on
              liquidation
      (b) 704(c) Gain; plus
          (i) Amount of taxable gain that would be allocated to partner under 704(c) if
              partnership disposed of all partnership property in exchange for debt
              relief
      (c) Partner’s share of excess (not yet allocated) nonrecourse liabilities as
          determined by partners’ share of partnership profits
          (i) Game: Have rules in partnership agreement specially allocating
              nonrecourse debt under third step in a way that tracks our special
              allocation of nonrecourse deductions. If we have this, should have
              sufficient basis to avoid 704(d) loss suspension
               E.g., Limited pship borrows on nonrecourse basis. Specially allocate
                  the deductiosn to the limited partners, which is allowed under
                  minimum gain chargeback rules that allow us to specially allocate
                  nonrecourse deductiosn in a manner that tracks recourse deductions.
                  Provide in the agreement that “nonrecourse debt in step 3 will be
                  allocated in a manner consistent with recourse deductions.”
                   This is only true if agreement addresses the issue; default is “in
                      accordance with share of profits”
D) Deductions with respect to property and debt
   1) Depreciation Deductions
      (a) Reduce partners’ basis in accordance with allocation
      (b) Allocations must have Substantial Economic Effect
   2) Recourse Deductions
   3) Nonrecourse Deductions
      (a) Include in pship agreement ‘minimum gain chargeback’ provision:




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       (i) Allocate the minimum gain among the partners in the same way we
            allocate the depreciation deductions that produced the minimum gain
   (b) Nonrecourse Liability Allocation Rules
       (i) Cannot have economic effect because the creditor alone bears any
            economic burden on those allocations; thus
       (ii) Must be allocated in accordance with partners’ interests; Test:
       (iii) Allocations Deemed in Accordance if meet all 4:
             1) Throughout full life of partnership, requirements 1 and 2 of
                economic effects test are met (magic language), and either
                     Magic Language: requires that if there is a net decrease in
                        pship minimum gain for a taxable year, each partner must be
                        allocated items for that year equal to that partner’s share of the
                        net decrease in partnership minimum gain
                     Net decrease in pship minimum gain: depreciation increased
                        minimum gain, but paying down the principal decreases
                        minimum gain
                 1)a) requirement 3 of economic effect basic test; or
                 1)b) requirement 3 of alternative test
                     (full restoration requirement or qualified income offset)
             2)Beginning in first taxable year in which there are nonrecourse
                deductiosn and thereafter, pship agreement provides for allocation of
                deductions in a manner that is reasonably consistent with deductions
                that do have substantial economic effect; and
             3) Beginning in first taxable year “ “ “, include minimum gain
                chargeback language in pship agreement
             4) All other allocations have economic effect or are otherwise
                respected
4) Ceiling Rule Problems – Regs permit 3 different methods to deal with ceiling rule
   (a) Traditional Method
       (i) requires that when partnership has income/loss on 704 property, must
            make appropriate allocations to avoid shifting consequences of gain/loss
       (ii) The allocations of deductions attributable to 704(c) items that takes in
            built in gain on the property
             Noncontributing partner: must to the extent possible equal book
                allocations to the same partner(s)
             Essential hold the noncontributing partner harmless
       (iii) Total income/gain/loss/deduction for a year cannot exceed the total
            income/gain/deduction for that property for the taxable year
             Same way of saying “you can’t allocate what you don’t have” – Ceiling
                Rules
       (iv) Steps:
             Determine depreciation amount if Book equaled Tax on the property
             For tax purposes, we must allocate as much tax depreciation to the
                noncontributing partner as he would if book equaled tax, to the extent
                possible


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                     E.g., A and P. P contributed Property B 30 and FMV 50, 10k/yr
                      depreciation.
                       If book equaled tax, each would get 5k/yr deduction. But it only
                          throws off 6k per year worth of tax depreciation.
                       Thus, we must allocate to A 5, the amount of depreciation
                          allocated to him on the book side, and P is allocated 1k of the tax
                          depreciation
         (b) Traditional Method with Curative Allocations
             (i) Corrects distortions created by Traditional Method
             (ii) May take reasonable curative allocations to reduce or eliminate
                  disparities
                   i.e., make a tax allocation that differs from book allocation for same
                      item
             (iii) Reasonableness Limite
                   Unreasonable if it exceeds amount necessary to offset effect created
                      by ceiling rule
         (c) Remedial Allocations Method (1.704-3(d))
             (i) Creates remedial items and allocates to partners
             (ii) First, determine amount of book items and partners’ distributive share
                  under 704(b)
             (iii) Recognize tax items using traditional method
             (iv) If ceiling rule causes book allocation of item from tax item to
                  noncontributing partner, the partnership creates a remedial item and
                  contributes it to the noncontributing partner
             (v) Then create an equal and opposite allocation in an identical amount and
                  allocate it to the contributing partner
             (vi) Effects:
                   Do not affect pship’s computation of taxable income or partnership’s
                      tax basis in property because they offset each other, create a wash
                   On Partners: they are fictional tax items solely for tax purposes and do
                      not affect the partners’ book capital accounts, operate solely for tax
             (vii) For both book and tax purposes, for remedial allocation method only,
                  we take the contributed asset and break it into two parts. First is an asset
                  with an initial book bases equal to the asset’s tax basis at the time of
                  contribution. The second is a new asset with the book bases equal to the
                  difference between book and tax bases at the time of contribution, and a
                  tax basis of zero
                   First asset is depreciated using the contributed partners’ method and
                      remaining useful life
                   Second asset is depreciated as a new asset, which is to say with a new
                      useful life, and any permitted method
V) Determining Partnership and Partner Taxable Income
   A) Partnership computes income at entity level, allocates to partners, and partners
      report their shares on personal tax returns
      1) Capital gains/losses and 1231 gains/losses computed at partnership level


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B) Character of items determined at partnership level
   1) Whether capital or not
   2) Elections with respect to depreciation
   3) Ordinary Business Income/Loss is what is left
C) Items then allocated among the partners, retaining partnership level
   characterization
D) Each partner takes into account his distributive share of:
   1) Gains/losses on long/short term capital assets
   2) Gains/Losses from 1231 Property
   3) Charitable contributions
   4) Tax exempt income
      (a) Still gives basis credit to partners
   5) Dividends under 1(h)(11)
   6) Others as provided by regs
      (a) Catchall: If treated differently at partner level, separately state
      (b) Tax free income
          (i) Increases partners’ outside basis by allocated amount (705(a)(1)(B))
      (c) Brokers expenses
      (d) Lobbying expenses
          (i) Outside basis goes down by distributive share of legal fees to lobby
               congress, though not deductible
      (e) 469 passive activity items
   7) Foreign taxes
   8) Income/loss exclusive of separately state items (ordinary income, including
      1235 income)
E) 453:
   1) If partnership elects 453 on a sale of an asset for installment treatment on. E.g., a
      note, can the partner elect out of it?
      (a) I.e., is this made at partner or partnership level?
      (b) Partnership level I believe, but confirm
F) Exception (we didn’t study)
   1) Partnerships with 100+ partners may elect a different set of reporting rules
      under 771-775
G) Determining Taxable Year
   1) 706(d)(1)(B) and Reg 1.706-1(b)(2) 3 Tiered Test
      (a) Majority Interest Taxable Year
          (i) If one or more partners having aggregate profit and capital interest more
               than 50%
          (ii) And have the same taxable year
          (iii) Then the taxable year of that partner(s)
      (b) Taxable year of all partners with 5+% interest in profits or capital
          (i) Must all have same taxable year
      (c) If not first two, then taxable year of one of the partners that results in the
          least aggregate deferral of income (ask prof about tier 3)
          (i) Regs inconsistent with statute her



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               (ii) Alternative test 706(b)(1)(C): allows partnership to select a year that is
                    justified by a business purpose
               (iii) Least Deferral:
                     For each possible taxable year;
                     Multiply:
                         Partner’s % Interest; by
                         Months of Deferral Using the Hypothetically Chosen Year
                     Then add:
                         The number gotten in the previous multiplication equation for
                            each partner together
                     Do this for each possible taxable year. The one that ends with the
                        lowest number is the appropriate taxable year.
                         If two possibilities are equal in creating the least deferral, then
                            either is appropriate
                     (Number of months of deferral) * (% Interest) for each partner
                     Add up calculations, winner is taxable year with lowest sum
VI) Distributive Shares
    A) Partner’s distributive share determined by partnership agreement and 704 Regs
    B) 704 Regs – 3 Ways to Allocations in Partnership Agreement will be respected, if the
       allocation
       1) has Substantial Economic Effect – 2 Part Analysis
               (i) Stops TPs from gaming the system:
                     Time value of money: allocate losses now, income later, net effect is to
                    
								
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