The Culverhouse College of Commerce and Business by sanmelody

VIEWS: 27 PAGES: 273

									Partnership
 Taxation
  Thompson Dunavant PLC
Overview
           Partnerships are Hot!
•   Limited liability corporations (LLC’s)
•   No double taxation
•   Loss flow-through
•   No limitation on # of partners or types
•   No formal requirements to be met
•   Special allocations on K-1 possible
•   Debt included in basis

                                              3
          Types of Partnerships
• General K: owned solely by general partners;
  GP’s have unlimited liability for K debts, rights to
  participate in mgt, liability for SE taxes on K
  income.
• Limited K: one or more limited partners and one
  or more general partners. Limited partners have
  limited liability for K debts, NO participation in
  general management, and do not pay SE taxes on
  K income.
• (Older partnerships organized this way.)
                                                         4
           Types of Partnerships
• LLC: all members have limited liability. Combines
  corporate benefit of limited liability with benefits of
  partnership taxation. Like an LP with no GPs! All
  owners have legal right to participate in management
  of entity.
• Member-managed (most) vs. Manager-managed
  (when have passive inventory)
• LLP: partners have better liability protection than GP
  but more liability exposure than LP. LLP partner not
  liable personally for any malpractice/other tort of
  another partner (but liable for your own).

                                                            5
           Advantages of K over S
Unlike S corporations, partnerships:
1. Provide owners with the ability to contribute assets for an
    ownership interest tax-free, regardless of the contributing
    parties' percentage of ownership.
2. Do not usually recognize gain when appreciated assets are
    distributed to a partner, even if the partner has no basis in
    the partnership.
3. May have income, expenses, gains, losses, and credits
    specially allocated among owners.
4. May have the basis of their assets adjusted when an
    ownership interest is sold or when gain or loss is
    recognized by a partner as a result of partnership
    distributions.

                                                                6
            Advantages of K over S
Unlike S corporations, partnerships:
5. Allow owners to include their share of partnership
    liabilities in their basis.
6. Have no restrictions on who may be an owner or on the
    number of owners.
7. May not lose their elections to be treated as partnerships.
8. Are not subject to any built-in gains tax or passive
    investment income tax.
9. Are subject to distribution restrictions only for a donee
    partner, whereas S corporations are subject to rules
    requiring fair salaries, interest, etc. to all related parties.



                                                                  7
          Advantages of S over K
Unlike partners, S corporation shareholders:
1. Flow-through income of S corporation (other than
   salaries) is not subject to self-employment tax.
2. May be employees of their S corporation, with their
   salaries subject to FICA, and not subject to self-
   employment tax.
3. Typically have capital gain on the sale of an ownership
   interest or may qualify for § 1244 ordinary loss.
4. Are not subject to ordinary income when certain
   capital assets are sold to the S corporation, even if the
   seller owns more than 50% of the business.
                                                           8
      Check-the-Box Regulations
• Default Entity: A business that has at least two
  owners and that is not a corporation under state law
  (“per se corporation”) is taxed as a partnership.
• Election: Can elect to be taxed as a C corp by filing
  Form 8332. Then could elect to be S corp.
• Replaces historical resemblance test (more corporate
  characteristics than noncorporate).
• Default for business that has one owner =
  disregarded entity.
                                    Reg. §301.7701-1

                                                       9
     Entity vs. Aggregate Theory
• Entity Theory: K and partners treated as
  separate entities. Ex: partnership elections
• Aggregate Theory: K and partners are treated
  as “one”, like sole proprietorship. Ex: conduit
  of income and losses, character flow-through,
  debt allocation to partner’s basis, distributions
  generally not taxable.
• Subchapter K is mixture of both. This creates
  complexity!
                                                  10
Contributions
               Contributions
• §721 general rule
• Services not treated as property; §83 rule
  applies in its place.
• §707 disguised sale rules




                                               12
                Formation of K
• Draft of Partnership Agreement: usually written,
  specifies capital, profits, and loss ratios. Written by
  attorney, often reviewed by accountant.
• Accountant must have read and must constantly
  refer to the agreement!
• Capital interest: entitled to share of assets of K
  upon liquidation.
• Profits interest: entitled to share only in future
  profits of the K.

                                                        13
   §721 Contributions of Property
• §721(a): No gain or loss is recognized by a
  partnership or any of its partners if property is
  contributed to the partnership in exchange for an
  interest in the partnership.
• NONTAXABLE EVENT to both partners and
  partnership. Why? Continuity of interest
  principle
• How different than §351 for S and C
  corporations? No 80% control test.
• Property does not include services (like §351).
                                                  14
               §721 Deferral
• Like §351, provides for deferral, not exclusion
  of gain.
• Partner has substituted basis for partnership
  interest, or same as property transferred,
  under §722 (“outside basis”).
• Partnership has carryover basis for property
  transferred under §723 (“inside basis”).


                                                    15
                §721 Deferral
• Holding period of asset in partner’s hands carries
  over to partnership under §1223(2).
• Holding period of partner’s interest includes
  holding period of contributed asset, but only if
  asset is capital or §1231 asset per §1223(1). If
  contribute cash or ordinary assets, holding period
  begins anew.
• Fragmentation of holding period of interest if
  multiple assets contributed – FMV allocation
  under §1223 Regs.
                                                   16
      Book Capital vs. Tax Capital
• So begins book capital vs. tax capital
  discrepancies!
  Key to complexity of partnerships!
• Inside basis = tax basis of assets in K
  Outside basis = partner’s tax basis of K interest
• Book capital accounts = FMV of contributions.
  Tax capital accounts (outside basis) = tax basis
  of contributions.

                                                  17
            §721 Basic Example
Missy Misdemeanor contributes land with a fair
   market value of $25,000, basis of $15,500 and
   Fred Felony contributes $25,000 cash to the FM
   Partnership.
Missy: recognizes no gain, has outside basis in
   interest of $15,500 (tax capital account), has
   book capital account of $25,000.
Partnership: recognizes no gain, has inside basis in
   land (tax basis) of $15,500.
Initially, total outside basis and inside basis equal.
                                                         18
           §721 Basic Example
Missy’s holding period in interest = carryover to
  include period held asset contributed because
  land was §1231 asset.
Fred’s holding period in interest begins now.
Partnership’s holding period in land = carryover
  to include period Missy held asset.



                                                19
         Contribution of Services
• §721 does not apply. Services are not property.
• Rather, §83 applies! §83 applies to all receipts of
  “restricted property” in exchange for performance of
  or refraining from performance of services.
• Property = partnership interests, stock, stock options.
• Capital interest: FMV is ordinary income to service
  partner and subject to employment taxes upon receipt.
• Exception: If capital interest can be forfeited (lost),
  income to partner is deferred until this risk of forfeiture
  expires.

                                     Reg. §1.721-1(b)(1)
                                                           20
Contribution of Services Example 1




                                 21
Contribution of Services Example 2
• Assume that the partnership agreement
  stipulates that C must surrender her capital
  interest back to A and B if she fails to perform
  services exclusively for the partnership
  business during the next 3 years.
• No ordinary income to C until 3 years passes
  (until the restriction lapses).


                                                 22
  Contribution of Services: §83(b)
• Election is available to include value of interest in
  income now instead of waiting until risk of
  forfeiture lapses.
• Why would you do that? If you predict that the
  value of the partnership will triple in next 3
  years?
• Choice: Recognize income now when receive
  interest at current FMV or recognize when
  restriction lapses at then FMV, possibly higher.
• Also consider: time value of money, future tax
  rates.
                                                      23
  Contribution of Services: §83(b)
• Risk of election:
  1. If lose interest because of forfeiture, no
     deduction for income already included.
  2. Value could be same or lower in the future.




                                                   24
Contribution of Services Example 3




                                25
         Contribution of Services
• What if receive profits interest only? Very popular in
  last 10-15 years.
• Uneasy consensus that not income.
• Prop. Reg. §1.83-3(l): FMV of partnership interest
  received for services = “liquidation” value of interest.
• No income if receive only true “future profits”
  interest.
• But partnership must elect this safe harbor. Be
  careful to meet significant requirements of election.

                                                         26
Contribution of Services Example 4




                                 27
           Disguised Sale Rules
• §707(a)(2)(B): contribution of property by a
  partner can be recharacterized as a sale.
• When? If the contributing partner receives
  distributions that are, in substance, consideration
  for the contribution.
• §721 will not apply! IRS combines contribution
  and distribution into one taxable sale.
• Beware of direct or indirect transfers of property
  to the contributing partner!
                                                    28
              Disguised Sale Rules
• Disguised sale rules may apply if distribution would not
  otherwise have been made OR if distribution is made
  “simultaneously” with contribution or is not dependent
  on the entrepreneurial risks of partnership operations.
• Rebuttable presumptions made by IRS:
    1. Transfers within 2 years are presumed to be tainted
       unless facts show otherwise.
    2. Transfers more than 2 years apart are presumed not to
       be a sale unless facts show otherwise.
•   List of facts and circumstances in Regs.

                                     Reg. §1.707-3
                                                               29
           Disguised Sale Rules
• Contributing encumbered property to
  partnership can be viewed as a tainted
  distribution that triggers disguised sale rules.
• Why? Liability relief = cash received.
• Qualified (not tainted) and unqualified liabilities:
  Be careful about liabilities incurred within the 2
  year window and those incurred “in anticipation
  of the transfer to the partnership.”
                                    Reg. §1.707-5

                                                         30
Liabilities
                    Liabilities
• §752 general rule
• Allocation of recourse debt
• Allocation of nonrecourse debt




                                   32
§752 Liability Allocation




                            33
        §752: Effect of Liabilities
• §752(a): Any increase in partner’s share of
  liabilities of K = contribution of cash to K.
  Increases partner’s outside basis in interest.
• §752(b): Any decrease in partner’s share of
  liabilities of K = distribution of cash to partner.
  Decreases partner’s outside basis in interest.
• Partner’s economic investment (“basis”) in K
  includes cash, property, and share of K debt for
  which partner may ultimately be responsible.
                                    Reg. §1.752-2
                                                        34
           §752 Basic Example
• Fergie and Duchess are equal partners in the F&D
  Partnership, a GP. On January 1 of the current
  year, both have $25,000 outside basis, and K has
  no debt.
• K borrows $15,000 and uses funds to buy assets.
  On June 1, K repays $6,000 of debt.
• F’s outside basis on 6/1: 25,000 + 7,500 – 3,000 =
  $29,500
• $7,500 deemed contribution, $3,000 deemed
  distribution
                                                   35
       §752: Types of Liabilities
• Recourse debt: creditor can look to personal
  assets of general partner or other guarantor if
  K does not pay.
• Nonrecourse debt: creditor cannot look
  beyond assets of the K for repayment.
• LLC’s: normally all debt is nonrecourse.



                                                36
             §752 Recourse Debt
• Allocated to partner who has economic risk of loss (EROL).
• Generally, only GP’s have EROL.
• Constructive liquidation (“atom bomb”) scenario – who
  would end up paying the debts if worst case scenario – all
  liabilities of K become due but all K assets are completely
  worthless and K liquidates. (If profit/loss % = ratios of
  capital balances, same result if used loss % to allocate.)
• Reg. §1.752-2: After constructive liquidation, determine
  how the partners would be required to satisfy the
  remaining recourse liabilities out of their separate assets.


                                                             37
             §752 Recourse Debt
• Reg. §1.752-2(b)(1): “A partner bears the economic risk of
  loss for a partnership liability to the extent that, if the
  partnership constructively liquidated, the partner or related
  person would be obligated to make payment to any person (or
  a contribution to the partnership) because that liability
  becomes due and payable and the partner or related person
  would not be entitled to reimbursement from another
  partner or related person to another partner.”
• Amount partner would have to contribute to K (to restore
  negative capital account to zero) = share of recourse debt.
• No amount is usually allocated to LP because LP’s cannot have
  negative capital accounts.
                                                             38
Constructive Liquidation Example




                                   39
Constructive Liquidation Example




                                   40
Constructive Liquidation Example




                                   41
       §752 Recourse Example 1
• Partner contributes property with adjusted basis
  of $10,000, encumbered by recourse liability of
  $9,000, in exchange for 1/3 GP capital and profits
  interest. K assumes liability.
• Partner’s outside basis in interest =
  $10,000 substituted basis
  - $9,000 100% liability relief
  + 3,000 1/3 assumption
  = $4,000


                                                   42
       §752 Recourse Example 2
• Partner contributes property with adjusted basis
  of $50,000 in exchange for 25% general interest
  in capital, profits, and losses. K assumes $12,000
  of partner’s recourse debt. K has no other debt.
• Partner’s outside basis in interest =
  $50,000 substituted basis
  -$12,000 100% liability relief
  + 3,000 25% assumption
  = $41,000


                                                   43
§752 Recourse Example 3




                          44
§752 Recourse Example 3




                          45
§752 Recourse Example 3




                          46
               §752 Recourse Debt
• Reg. §1.752-2(b)(3): All statutory and contractual
  obligations relating to a partnership liability are taken into
  account.
• Includes guarantees, indemnifications, reimbursement
  agreements, and other obligations.
• Generally, if a partner guarantees a liability of the
  partnership, it generally will be allocated to the partner as a
  recourse liability. Who is ultimately liable?
• De minimis rule: Partner does not bear EROL for loan
  guaranteed if partner’s interest is 10% or less.
  Reg. §1.752-2(d)

                                                               47
             §752 Recourse Debt
• Reg. §1.752-2(h): Includes direct pledges and some indirect
  pledges.
• Reg. §1.752-2(b)(5): A partner’s obligation to make
  payment is reduced by his right to receive reimbursement
  from another partner or related person.




                                                           48
             §752 Recourse Debt
• Reg. §1.752-2(b)(6): It is assumed that all partners and
  related persons who have obligations actually perform,
  irrespective of their actual net worth.
• Exception in anti-abuse rule: unless the facts and
  circumstances indicate a plan to circumvent or avoid the
  obligation.




                                                             49
         §752 Recourse Example 4a
Reg. §1.752-2(f), Example 3
• E and F form a limited partnership. E, the general partner,
  contributes $2,000 and F, the limited partner, contributes $8,000 in
  cash to the partnership.
• The partnership agreement allocates losses 20% to E and 80% to F
  until F's capital account is reduced to zero, after which all losses are
  allocated to E.
• The partnership purchases depreciable property for $25,000 using
  its $10,000 cash and a $15,000 recourse loan from a bank. F
  guarantees payment of the $15,000 loan to the extent the loan
  remains unpaid after the bank has exhausted its remedies against
  the partnership.

                                                                         50
         §752 Recourse Example 4a
• In a constructive liquidation, E, as a general partner, would be
  obligated by operation of law to make a net contribution to the
  partnership of $15,000. Because E is assumed to satisfy that
  obligation, it is also assumed that F would not have to satisfy F's
  guarantee.
• The $15,000 mortgage is treated as a recourse liability because one
  or more partners bear the economic risk of loss. E's share of the
  liability is $15,000, and F's share is zero. This would be so even if E's
  net worth at the time of the determination is less than $15,000,
  unless the facts and circumstances indicate a plan to circumvent or
  avoid E's obligation to contribute to the partnership.



                                                                          51
        §752 Recourse Example 4b
Reg. §1.752-2(f), Example 5
• A partnership borrows $10,000, secured by a mortgage on real
  property. The mortgage note contains an exoneration clause which
  provides that in the event of default, the holder's only remedy is to
  foreclose on the property. The holder may not look to any other
  partnership asset or to any partner to pay the liability.
• However, to induce the lender to make the loan, a partner
  guarantees payment of $200 of the loan principal. The exoneration
  clause does not apply to the partner's guarantee. If the partner paid
  pursuant to the guarantee, the partner would be subrogated to the
  rights of the lender with respect to $200 of the mortgage debt, but
  the partner is not otherwise entitled to reimbursement from the
  partnership or any partner.
                                                                     52
        §752 Recourse Example 4b
• For purposes of §752, $200 of the $10,000 mortgage liability
  is treated as a recourse liability of the partnership and $9,800
  is treated as a nonrecourse liability of the partnership. The
  partner's share of the recourse liability of the partnership is
  $200.




                                                                 53
         §752 Recourse Example 5
Reg. §1.752-2(f), Example 4
• G, a limited partner in the GH partnership, guarantees a
  portion of a partnership liability. The liability is a general
  obligation of the partnership, i.e., no partner has been
  relieved from personal liability. If under state law G is
  subrogated to the rights of the lender, G would have the
  right to recover the amount G paid to the recourse
  lender from the general partner. Therefore, G does not
  bear the economic risk of loss for the partnership
  liability.

                                                                   54
         §752 Recourse Example 6
• Reg. §1.752-2(j)(4), Example of Anti-Abuse Rule:
   A and B form a general partnership. A, a corporation,
  contributes $20,000 and B contributes $80,000 to the
  partnership. A is obligated to restore any deficit in its
  partnership capital account. The partnership agreement
  allocates losses 20% to A and 80% to B until B's capital
  account is reduced to zero, after which all losses are allocated
  to A. The partnership purchases depreciable property for
  $250,000 using its $100,000 cash and a $150,000 recourse
  loan from a bank. B guarantees payment of the $150,000 loan
  to the extent the loan remains unpaid after the bank has
  exhausted its remedies against the partnership.

                                                                 55
         §752 Recourse Example 6
• Reg. §1.752-2(j)(4), Example of Anti-Abuse Rule continued:
   A is a subsidiary, formed by a parent of a consolidated group,
  with capital limited to $20,000 to allow the consolidated
  group to enjoy the tax losses generated by the property while
  at the same time limiting its monetary exposure for such
  losses. These facts, when considered together with B's
  guarantee, indicate a plan to circumvent or avoid A's
  obligation to contribute to the partnership. The rules of §752
  must be applied as if A's obligation to contribute did not exist.
  Accordingly, the $150,000 liability is a recourse liability that is
  allocated entirely to B.


                                                                    56
               §752 Recourse Debt
• Reg. §1.752-2(c): If a partner or related person holds a partnership
  liability, an otherwise nonrecourse debt can become a recourse
  debt. Holding partner has EROL.
• De minimis rule: Partner does not bear EROL for loan if partner’s
  interest is 10% or less. Reg. §1.752-2(d)
• When a partnership liability that is owed to a partner or person
  related to a partner includes an obligation owed to another
  unrelated person and is secured by the partnership property
  (wrapped indebtedness), the principal amount of the wrapped debt
  is treated as the unrelated person's risk. That is, the total debt
  (including the wrapped debt) is treated as two separate liabilities.



                                                                     57
         §752 Recourse Example 7
Reg. §1.752-2(f), Example 6: Wrapped Debt
• I purchases real estate from an unrelated seller for $10,000,
  paying $1,000 in cash and giving a $9,000 purchase mortgage
  note on which I has no personal liability and as to which the
  seller can look only to the property for satisfaction.
• At a time when the property is worth $15,000, I sells the
  property to a partnership in which I is a general partner. The
  partnership pays for the property with a partnership purchase
  money mortgage note of $15,000 on which neither the
  partnership nor any partner (or person related to a partner)
  has personal liability.


                                                               58
          §752 Recourse Example 7
• The $15,000 mortgage note is a wrapped debt that includes
  the $9,000 obligation to the original seller. The liability is a
  recourse liability to the extent of $6,000 because I is the
  creditor with respect to the loan and I bears the economic risk
  of loss for $6,000. I's share of the recourse liability is $6,000.
  The remaining $9,000 is treated as a partnership nonrecourse
  liability that is owed to the unrelated seller.




                                                                   59
                 §752 Recourse Debt
• Reg. §1.752-2(k): If a partner owns a partnership interest
  through a disregarded entity, the partner is treated as bearing
  the EROL for a partnership liability only to the extent of the “net
  value” of the disregarded entity’s assets on the allocation date.
• Reg. §1.752-2 (i): Tiered partnerships
  UTP’s liabilities include its share of LTP’s liabilities plus any of the
  LTP’s liabilities that are not allocated under the normal rules to
  the extent the partners of the UTP bear the EROL.




                                                                             60
        §752 Nonrecourse Debt
• No partner has EROL.
• Allocated to all partners based on their profit-
  sharing ratios. (debt only repaid through profits)
• Exception: if partner has contributed property to
  partnership that has built-in gain, contributing
  partner is allocated debt in amount of lower of
  1. the built-in gain (FMV – basis)
  2. NR debt over basis of property at contribution.
  Remainder then allocated in accordance with
  profits %.
                                                   61
         §752 Nonrecourse Debt
• Three-tier rule under Reg. §1.752-3:
  1. Share of §704(b) minimum gain
  2. Share of §704(c) minimum gain
  3. Share of excess nonrecourse debt
• §704(b) minimum gain = nonrecourse debt > §704(b)
  book value (FMV initially).
  Created as property is depreciated below debt.
• §704(c) minimum gain = gain that would be allocated if
  K distributed property in exchange for no consideration
  other than nonrecourse debt on property.
• Excess nonrecourse debt = any debt left.

                                                        62
          §752 Nonrecourse Debt
• Rationale: Lenders, not partners, bear the economic
  risk associated with nonrecourse liabilities. However,
  partners do indeed receive tax benefits (enhanced
  deductions such as depreciation or credits) as a result
  of nonrecourse debt.
• Thus, the debt is allocated based on future gain that is
  likely to occur upon satisfaction of the nonrecourse
  debt (Tier 1 & 2) or in the absence of such a direct link,
  based on the allocation of overall profits (Tier 3).
• The basis attributable to this debt should inure to
  partners in the same manner those partners will be
  allocated profits!

                                                           63
    §752 Nonrecourse Example 1
• Partner contributes property with adjusted basis
  of $6,000, encumbered by nonrecourse liability of
  $9,000, in exchange for 1/3 capital and profits
  interest. FMV = $10,000. K assumes liability.
• Partner’s outside basis in interest =
    $6,000 substituted basis
  - $9,000 100% liability relief
  +$3,000 Excess of liability over basis (9 - 6)
  + 2,000 1/3 assumption of remainder (6 x 1/3)
  = $2,000

                                                  64
     §752 Nonrecourse Example 2
• G and H are general partners, and I and J are limited
  partners in GHIJ Partnership. Partnership profits are
  allocated 10% to G, 20% to H, and 35% to each I and J.
  G contributed property with an adjusted basis of
  $80,000, a FMV of $120,000, and nonrecourse debt of
  $100,000, which GHIJ assumed.
• G’s share of debt =
  +$20,000 Excess of liability over basis (100-80)
  + 8,000 10% of remainder (80 x 10%)
  = $28,000
• H’s share = 80,000 x .20 = $16,000

                                                           65
§752 Nonrecourse Example 2




                             66
§752 Nonrecourse Example 3




                             67
 Beware! Relief of Liability > Basis
• Remember §752(b): decrease in share of
  partner’s liabilities = deemed cash distribution.
• §733: Cash distribution from K is nontaxable to
  partner and reduces outside basis.
• Gain if cash distribution > outside basis.
• This includes constructive or deemed cash
  distributions!
• Tax planning: have partner assume liability for
  some of debt.

                                                      68
 Liability Relief > Basis Example 1
• B contributes assets with FMV of $75,000 and
  adjusted basis of $30,000 to K in exchange for
  15% general interest in capital, profits, and
  losses. K assumes $45,000 of B’s recourse debt.
  K has no other debt.
• B’s outside basis =
  +$30,000 substituted basis
  - $45,000 100% liability relief
    + 6,750 15% assumption of liability(45 x .15)
  = ($8,250)
• $8,250 is GAIN!

                                                    69
Liability Relief > Basis Example 2

What if debt was nonrecourse?




                                     70
Liability Relief > Basis Example 2




                                     71
Outside Basis
     Outside Basis Computation
+   Original basis of contribution
+   Additional contributions
+   Increase in share of liabilities
+   Distributive share of taxable K income
+   Distributive share of tax-exempt K income
–   Distributions of cash and property
–   Decrease in share of liabilities
–   Distributive share of nondeductible expenses
–   Distributive share of losses
=   Partner’s outside basis for interest


                                                   73
        Outside Basis Computation
• §705: Basis is everything!
• Why do you want basis?
  Distributions are tax-free; losses are deductible; less gain/more loss
  on sale of interest
• Purpose: To keep tract of a partner’s “tax investment” in the
  partnership – to prevent double taxation or exclusion from taxation
  of income items upon ultimate disposition of the interest.
• If partner’s basis was not increased by his share of partnership
  income (whether taxable or tax-exempt), he would be taxed on
  income a second time upon sale of his interest. Conversely, losses
  (and nondeductible expenses) would benefit him a second time
  when interest was sold.

                                                                       74
      Outside Basis Computation
• §705(a) = positive and negative adjustments to basis.
• §705(b) alternative rule: Determine by reference to
  partner’s “proportionate share of adjusted basis of
  partnership property upon a termination of the
  partnership.”
• It may be difficult or impossible to reconstruct a
  partner’s basis if partnership has been around for many
  years. (not practical)
• Do not need consent of Commissioner to use alternative
  rule.

                                                        75
    Basis Computation Example 1
• J is a 50% partner of JS. At the beginning of
  the tax year, Janet’s partnership basis is
  $120,000. During the year JS borrowed
  $25,000, and it distributed $30,000 to both J
  and S. Schedule K shows:
     Ordinary income                   $80,000
     Capital gains (net)                 3,000
     Tax-exempt income                   5,000
     Nondeductible expenditures          5,000




                                                  76
     Basis Computation Example 1
    Beginning basis    $120,000
+   Ordinary income     $40,000    (50% x $80,000)
+   Capital gains          1,500   (50% x 3,000)
+   Tax-exempt income      2,500   (50% x $5,000)
+   New partnership debt 12,500    (50% x $25,000)
–   Cash distribution   (30,000)
–   Nondeductible exp    (2,500)     (50% x 5,000)
    Ending basis       $144,000

                                                     77
Basis Computation Example 2




                              78
Basis Computation Example 2




                              79
Operations
                 Operations
•   Flow-through approach
•   Separately stated vs. nonseparately stated
•   Taxable year and method
•   Transactions between partner and partnership
    Guaranteed payments
    Sales



                                               81
        Taxation of Partnerships
• Flow-through or conduit entity: partnership does
  not pay taxes, but partners pay taxes on their
  share of income.
• Distributions from partnership are generally not
  taxable (one level of tax, no double taxation).
• *Income of K is taxed to partners when earned by
  K, whether or not distributed in cash. Partner’s
  basis increases by allocation of income;
  distributions are tax-free to extent of basis.*
                                                 82
       Taxation of Partnerships
• Form 1065
• Schedule K: summarizes partnership’s
  income, gain, deductions, losses, credits
• Schedule K-1 for each partner: allocation of
  partner’s individual share of Schedule K items.
  Total of K-1’s = Schedule K.
• Individual partner reports income from K-1 on
  Schedule E.

                                                83
         Taxation of Partnerships
• §703(a): partnership income computed in same
  manner as individual, with some exceptions.
• Separately stated items: item that might have
  different tax consequence to partner depending
  on partner’s tax circumstances. (Ex: long-term
  capital gain, charitable contribution) §702(a)(1)-(7)
• Non-separately stated items (ordinary income):
  page 1 total. Generally trade or business income
  minus deductions that all partners treat the
  same. Item 1 on Schedule K. §702(a)(8)
                                                          84
        Taxation of Partnerships
• §702(b): Character (ordinary, capital) of
  income, loss, etc. flows through to partner as
  well. Character determined by reference to
  activities of partnership.
• Exception: Certain assets retain character in
  hands of partner for 5 years after contribution
  to K (inventory, capital asset sold at loss,
  unrealized receivables forever).

                                                85
Separately Stated Example




                            86
Separately Stated Example




                            87
Separately Stated Example




                            88
                 Taxable Year
• §706(a): Partner reports share of K income in
  partner’s taxable year within which or with which the
  K tax year ends.
• §706(b): Required tax year of K:
  1. Majority interest year
  2. Tax year of principal partners (5% or more)
  3. Least aggregate deferral of income year
   – Exception: Natural business year


                                                      89
           Method of Accounting
• §703(b): Cash method allowed unless:
  1. Inventory
  2. Large C corp is partner*
  3. Tax shelter
• Accrual method allowed.
• *Cash method permissible if partner is small C corp
  (average annual gross receipts < $5 million for last 3
  years) or qualified personal service corp.
• Tax shelter = K where > 35% of losses are allocable to LP’s
  or “limited entrepreneurs” – LLC members who do not
  actively participate in management.
                                                            90
          Guaranteed Payments
• §707(c): “Salary” paid to a partner for services
  performed.
• “Guaranteed” because paid regardless of partnership’s
  income.
• Guaranteed payment defined:
  1. Paid for the partner’s services or for the use of
  capital contributed to K.
  2. Partner is acting in his capacity as partner (not
  lender).
  3. Paid without regard to K income.
• Distinguished from a “draw” or “distribution”, which
  reduces partner’s capital account.

                                                      91
         Guaranteed Payments
• Don’t ask where the partner’s W-2 is. It’s on his
  K-1!
• Ordinary income to partner regardless of amount
  or character of K income.
• Timing: ordinary income in partner’s tax year
  that falls with the K’s tax year in which the K
  deducts it.
• Timing: But if K capitalizes the payment, included
  in year partner receives it (not in years K takes
  depreciation deductions).
                                                   92
      Guaranteed Pmt Example 1
Timing Example:
• Jerry, a cash basis taxpayer, is a partner in P. P
  uses accrual method and has a 12/31 year end.
  In Nov 2009, Jerry performs services for P and is
  paid $10,000 from P in January 2010. If the
  services performed are ordinary and necessary
  business expenses, P deducts the $10,000 in 2009
  and Jerry includes the $10,000 income in 2009
  (matching).
• If P is required to capitalize the $10,000, Jerry
  reports the $10,000 as income in 2010.

                                                   93
         Guaranteed Payments
• Not wages, but treated as self-employment
  income to all partners or members (LP’s, GP’s,
  LLC members). This applies to GP’s for
  services or for use of capital.
• Subject to self-employment tax, but no
  withholding.
• Partner must make estimated tax payments.


                                               94
Guaranteed Pmt Example 2




                           95
Guaranteed Pmt Example 3
                 2




                           96
     Guaranteed Pmts Example 4
Reg. §1.707-1(c), Example 1
Under the ABC partnership agreement, partner A is entitled
  to a fixed annual payment of $10,000 for services,
  without regard to the income of the partnership. His
  distributive share is 10 percent. After deducting the
  guaranteed payment, the partnership has $50,000
  ordinary income. A must include $15,000 as ordinary
  income for his taxable year within or with which the
  partnership taxable year ends ($10,000 guaranteed
  payment plus $5,000 distributive share).

                                                         97
      Guaranteed Pmts Example 5
Reg. §1.707-1(c), Example 2
Partner C in the CD partnership is to receive 30% of
  partnership income as determined before taking into
  account any guaranteed payments, but not less than
  $10,000. The income of the partnership is $60,000, and C
  is entitled to $18,000 (30% of $60,000) as his distributive
  share. No part of this amount is a guaranteed payment.
  However, if the partnership had income of $20,000
  instead of $60,000, $6,000 (30 percent of $20,000) would
  be partner C's distributive share, and the remaining
  $4,000 payable to C would be a guaranteed payment.
                                                           98
      Guaranteed Pmts Example 6
Reg. §1.707-1(c), Example 3
Partner X in the XY partnership is to receive a payment of
  $10,000 for services, plus 30 percent of the taxable
  income or loss of the partnership. After deducting the
  payment of $10,000 to partner X, the XY partnership has
  a loss of $9,000. Of this amount, $2,700 (30 percent of
  the loss) is X's distributive share of partnership loss and,
  subject to section 704(d), is to be taken into account by
  him in his return. In addition, he must report as ordinary
  income the guaranteed payment of $10,000 made to him
  by the partnership.
                                                             99
      Guaranteed Pmts Example 7
Reg. §1.707-1(c), Example 4
Assume the same facts as in last example except that,
  instead of a $9,000 loss, the partnership has $30,000 in
  capital gains and no other items of income or deduction
  except the $10,000 paid X as a guaranteed payment. The
  partnership has a $10,000 ordinary loss and $30,000 in
  capital gains. X's 30 percent distributive shares of these
  amounts are $3,000 ordinary loss and $9,000 capital
  gain. In addition, X has received a $10,000 guaranteed
  payment which is ordinary income to him.

                                                           100
          Guaranteed Payments
So why is it an M-1?
• Reported on page 1 as deduction of K.
• Reported on Schedule K as separately stated item
  and included in self-employment earnings.
• M-1 on left-hand side of Schedule M-1.




                                                     101
       Self-employment Income
§1402(a)
• GP’s: share of ordinary income plus guaranteed
  payments subject to SE tax.
• LP’s: guaranteed payments only.
• LLC members: depends on participation and type of
  LLC.
• Rare advantage of S over K.



                                                  102
       Self-employment Income
• Member-managed: all members participate in
  investment decisions.
• Manager-managed: members delegate the authority
  to manage the LLC to one or more persons (can be
  committee, board, group).
• Most states: default is member-managed. Can opt
  for centralized manager-managed.




                                                103
         Self-employment Income
Prop. Reg. §1.1402(a)-2
• All members of “member-managed” LLCs with only one class
   of interest are subject to SE tax on their share of LLC earnings.
• “Manager-managed” LLC’s with one class of interest:
    – Managing members’ share of LLC income is subject to SE
       tax.
    – Non-managing members’ share of LLC income is not
       subject to SE tax/is treated as a limited partner.
       Exception: Actively participating member (works for LLC
       more than 500 hours during the year) is not treated as a
       limited partner and is therefore subject to SE tax on share
       of income.
                                                                 104
         Self-employment Income
Prop. Reg. §1.1402(a)-2
• Non-managing member of manager-managed LLC who works
   more than 500 hours can still avoid SE tax by bifurcating
   interest into two pieces:
   1. Guaranteed payment received for services rendered
   (subject to SE tax)
   2. Distributive share on which no SE tax
• Conditions where bifurcation permitted:
   1. Partner not liable for K debt
   2. Partner does not have authority to contract on behalf of K.
   3. K has other partners who own substantial interest.
   4. Rights of that partner’s interest are identical to other LP’s.
                                                                  105
         Self-employment Income
Prop. Reg. §1.1402(a)-2
• But managing member of manager-managed LLC can
   bifurcate share of LLC income into 2 classes of interests too!
   1. Manager class
   2. Non-manager class
• Like one person having GP and LP interest in same K.




                                                                    106
        Self-employment Income
Prop. Reg. §1.1402(a)(h)(3): Example of Bifurcation
Doris, Edward and Fred form DEF, a manager-managed LLC that
   operates a nonservice trade or business. Fred is the only
   member-manager of DEF. Doris and Edward each own 10% in
   the non-manager (investment) class of interest. Fred owns the
   remaining 80% of the investment class of interest and 100% of
   the manager class of interest. Neither Doris nor Edward
   participates in the LLC’s trade or business for more than 500
   hours during the year. Doris and Edward are limited partners
   under the general rule of Proposed Reg. §1.1402(a)-(h)(2),
   and their share of LLC earnings is not subject to SE tax.


                                                             107
      Partners & Fringe Benefits
• Partners are not employees for fringe benefit
  purposes (so benefits are taxable
  compensation).
• Payments by partnership of insurance etc. are
  treated as guaranteed pmts, taxable to
  partner and deductible by K.
• Partner may deduct 100% of health insurance
  paid by partnership (ends up being a wash).

                                              108
      Sales Between Partner & K
• §707(a): Generally, transactions between partner
  and K are treated as if with non-partner.
• §707(b): Exceptions for related parties (partner
  owns > 50%, applying constructive ownership
  rules):
  1. Loss disallowed, deferred until subsequent
  sale
  2. Gain may be ordinary income if not capital
  asset to buyer.
                                                109
Sales Example 1




                  110
Distributive
  Shares
             Distributive Shares
•   §704(b) economic effect rules
•   §704(c) special allocations
•   §706 retroactive allocations
•   §704(d) loss limitations
•   §465 at-risk limitations
•   §469 passive loss limitations



                                    112
      Partner’s Distributive Share
• General rule of §704(b): Distributive share (what
  reported on K-1) as determined by partnership
  agreement is respected.
• Exception: If allocation in agreement lacks
  substantial economic effect under the rules of
  §704(b).
• Complex and detailed regulations!
• If allocation does not have SEE, IRS can reallocate
  items in accordance with “the partners’ interests in
  the partnership”.
                                                         113
                §704(b) Rules
Allocation per the partnership agreement is
  valid if meets one of 3 tests:
1. Has SUBSTANTIAL ECONOMIC EFFECT (safe
   harbor)
2. It is in accordance with partners’ interests in
   partnership as determined by facts and
   circumstances or
3. It is “deemed” to be in accordance with their
   interests.                    Reg. §1.704-1(b)(1)(i)

                                                      114
         §704(b) Rules: Rationale
• Allocations must affect dollar amount of partners’ shares of
  income or loss independently of the tax consequences.
• Allocation must follow economic benefit or burden. If
  partner benefits economically from an item of partnership
  income or gain (ex: receives a cash distribution), that item
  must be allocated to him so that he bears the correlative
  tax burden.
• If partner will suffer the economic burden of an item of
  partnership loss or deduction, he must be allocated the
  associated tax benefit.
• Tax allocation must affect the partner’s book capital
  accounts.
• TAX MUST FOLLOW BOOK.

                                                            115
         §704(b) Economic Effect
Reg. §1.704-1(b)(2)(ii)(b)
1. Capital accounts must be maintained. Allocation of
   items must be reflected in capital accounts.
2. Partnership must be liquidated according to capital
   accounts. Distributions must be made to partners in
   accordance with their positive capital account
   balances.
3. Deficit restoration agreement: partners with deficit
   balances in their capital account are unconditionally
   required to restore the deficit.
   Alternative: qualified income offset

                                                       116
         §704(b) Economic Effect
Reg. §1.704-1(b)(2)(ii)(d): Qualified income offset
• The absence of an unlimited deficit capital account
  makeup provision is not fatal! (Alternative #3)
• QIO: requires a member who unexpectedly receives an
  adjustment, allocation, or distribution that causes or
  increases a deficit balance in such member's capital
  account, to be allocated income and gain in an amount
  and manner sufficient to eliminate such deficit balance
  as quickly as possible.
• Most LLCs use QIO option because they do not require
  their members to restore negative capital account
  balances.

                                                       117
         §704(b) Economic Effect
Capital account maintenance rules:
• Very precise set of rules based on tax accounting
  concepts, not financial accounting.
• Usually will correspond to economic agreement among
  partners.
• Beware if you desire tax consequences that differ from
  the economic agreement!
• Increase/credit for: contributions (FMV property) and
  distributive share of income and tax-exempt income
• Decrease/debit for: distributions (FMV property),
  distributive share of expenses and losses and
  nondeductible expenditures.          Reg. §1.704-1(b)(2)(iv)

                                                            118
         §704(b) Economic Effect
Capital account maintenance rules – revaluation:
• Regulations permit capital accounts to be increased or
  decreased to reflect the revaluation of partnership
  property as a result of:
   – contribution or distribution of property as part of
     acquisition or relinquishment of interest in partnership or
   – generally accepted industry practices, if substantially all
     assets of K are publicly traded securities or
   – Grant of a K interest in consideration for services provided
     to the K.
• Includes goodwill and other intangible property.
                                        Reg. §1.704-1(b)(2)(iv)(f)
                                                                     119
        §704(b) Economic Effect
Capital account maintenance rules – revaluation:
• Must be made for substantial nontax business purpose.
• Generally advisable to “book up” partners’ capital
  accounts upon acquisition or relinquishment of
  partnership interest in order to avoid economic
  distortions.
• Regs warn that failure to restate or fix with special
  allocation could have adverse potential tax
  consequences.
• Book-ups of capital accounts are optional but very
  commonly elected.

                                                     120
          §704(b) Economic Effect
Capital account maintenance rules – revaluation:
• The book-up ensures partners that their capital accounts
  reflect appreciation in the property that occurred prior to the
  new partner's entry into the business.
• Revaluing when a new partner enters protects the economic
  interests of existing partners by revising the values on which
  distribution allocations are made, and in many cases
  determining the liquidation rights of the partners.
• A book-up may be controversial since the entering partner
  would have to agree on the booked-up value to be allocated
  to the existing partners.

                                                                121
           §704(b) Economic Effect
Revaluations will be respected if:
1. Adjustments are based on FMV. This can be based on arm’s
    length agreement among the partners, provided interests are
    sufficiently adverse. FMV cannot be less than nonrecourse debt
    on the property.
2. Corresponding adjustments are made to the partners' distributive
    shares to reflect unrealized income, gain, loss, or deduction
    inherent in the property. Assume a hypothetical sale for fair
    market value on the date of the revaluation and allocate the items
    of income, gain, loss, or deduction that would arise on the sale.
3. The partnership agreement allocates the partners' shares of
    depreciation, gain, or loss etc. as computed for tax purposes
    among the partners in a manner that takes account of the
    difference between the FMV of the property and its basis at the
    time it is revalued.
                                            Reg. §1.704-1(b)(2)(iv)(f)

                                                                         122
            §704(b) Economic Effect
3.   Reverse §704(c) built-in gain or loss
•    When a partner makes a contribution to the partnership in exchange for
     an interest, the property held by the partnership immediately before the
     contribution is increased or decreased to its fair market value on the
     partnership's books.
•    The original partners' capital accounts are adjusted so that their capital
     accounts equal their share of the FMV of the revalued property plus the
     FMV of the contributed property. If the revaluation increases the
     property's value, the inherent gain is also allocated to the original
     partners.
•    The new partner acquires an undivided interest in the revalued property
     and retains his proportionate share in the property that he contributes.
•    As if continuing partners contributed property to a new partnership!
     (Like a §743(b) adjustment to incoming partner, although no new basis
     created.)
                                                 Reg. §1.704-1(b)(2)(iv)(f)

                                                                              123
            Revaluation Example 1
Reg. §1.704-1(b)(5), Example 14(i)
• MC and RW form a partnership to which each contributes $10,000.
  The $20,000 is invested in securities of a non-publicly traded
  company.
• The securities appreciate in value to $50,000. At that time SK makes
  a $25,000 cash contribution to the partnership (acquiring a 1/3
  interest).
• The capital accounts of MC and RW are adjusted upward to $25,000
  each to reflect their shares of the unrealized appreciation in the
  securities.
• After the revaluation, the original partners each have a book capital
  account of $25,000 and a tax capital account of $10,000. The new
  partners’ book and tax capital accounts = $25,000.
• If the securities are sold for their $50,000 fair market value,
  resulting in taxable gain of $30,000, the gain must be allocated
  $15,000 to MC and $15,000 to RW.
                                                                     124
          Revaluation Example 2
Reg. §1.704-1(b)(5), Example 14(ii)
• Two years after new partner enters, the stock is sold
  for $74,000, resulting in tax gain of $54,000. The
  $30,000 is specially allocated to the original partners,
  $15,000 each. The remaining tax gain of $24,000 is
  split between the 3 partners 1/3 each ($8,000 each).
  Tax gain must be allocated 23,000-23,000-8,000.
• The book gain ($74,000-50,000) is allocated equally
  among the 3 partners.
• After these allocations, the book and tax capital
  accounts of all 3 partners are the same!

                                                             125
             Revaluation Example 2

                            Original P     Original P       New P
                          Tax     Book   Tax      Book   Tax     Book
Original contribution     10      10     10       10     25      25
Unrealized appreciation           15              15      0       0
Capital account           10      25     10       25     25      25
Special allocation        15      0      15       0      0       0
Remaining gain            8       8      8        8      8       8
Balance                   33      33     33       33     33      33




                                                                    126
          §704(b) Substantiality
• Economic effect must also be substantial.
• Major source of uncertainty and controversy.
• So follow mechanical safe harbor rules!
• Is there a reasonable possibility that the
  allocation will “affect substantially” the dollar
  amounts to be received by the partners from the
  partnership, irrespective of tax consequences?
• Prohibition against transitory allocations: offset
  by another allocation in a later year.
                               Reg. §1.704-1(b)(2)(iii),(3)(iii)

                                                                   127
           §704(b) Example 1
• DEF Partnership has 3 equal partners: D is a
  tax-exempt entity, and E and F are not.
• What would you do if you could?
• Give 100% of income allocation to D, 100% of
  loss allocation to E and F, and split cash
  distributions 1/3.
• §704(b) regulations obviously prohibit this!


                                             128
            §704(b) Example 2
• RST Partnership provides that taxable
  income/loss will be allocated 50% to R and 25%
  to each S and T. RST generated $48,000 of
  taxable income this year, $24,000 of which was
  reported as R’s distributive share on his K-1, and
  $12,000 of which was reported on each of S and
  T’s K-1’s. Each partner’s capital account was
  increased by $16,000.
• This lacks SEE under §704(b) because TAX DOES
  NOT FOLLOW BOOK.

                                                       129
            §704(b) Example 3
• ABC Partnership provides that taxable income will
  be allocated equally to A, B, and C. This
  allocation will also be reflected in the partners’
  capital accounts. When ABC liquidates, says the
  agreement, 40% of all liquidating distributions
  will go to A, and 30% to each B and C.
• This lacks SEE under §704(b) because liquidation
  not done in accordance with capital accounts.


                                                  130
§704(b) Example 4




                    131
§704(b) Example 4




                    132
§704(b) Example 4




                    133
                  §704(b) Example 5
Reg. §704-1(b)(5), Example 1
• A and B form a general partnership with cash contributions of $40,000
   each, which cash is used to purchase depreciable personal property.
• Per the partnership agreement, A and B will have equal shares of
   taxable income and loss and cash flow, except that that all depreciation
   deductions will be allocated to A. The partners' capital accounts will be
   maintained in accordance with the rules of §704(b), but that upon
   liquidation of the partnership, distributions will be made equally
   between the partners (regardless of capital account balances) and no
   partner will be required to restore a deficit capital account balance.
• In the partnership's first taxable year, it recognizes operating income
   equal to its operating expenses and has an additional $20,000 cost
   recovery deduction, which is allocated entirely to A.

                                                                          134
               §704(b) Example 5
• The allocation lacks economic effect and will be
  disregarded.
• The partners made equal contributions, share equally in
  other taxable income and loss and in cash flow, and will
  share equally in liquidation proceeds, indicating that their
  actual economic arrangement is to bear the risk imposed
  by the potential decrease in the value of the property
  equally.
• However, A is allocated the entire $20,000 deduction! This
  indicates that A will not bear the full risk of the economic
  loss corresponding to such deduction if such loss occurs.
• The cost recovery deduction will be reallocated equally
  between A and B.

                                                             135
§704(b) Minimum Gain Chargeback
• It gets even more complicated!
• Allocations of nonrecourse deductions (basically
  depreciation) cannot have substantial economic effect
  because the creditor alone bears any economic loss
  attributable to those deductions.
• Thus, nonrecourse deductions must be allocated in
  accordance with the members' interests in the LLC.
• For allocations of nonrecourse deductions to be
  respected, additional requirements must be met (past
  the 3 basic rules of §704(b)).
• Specifically, the agreement must have a minimum gain
  chargeback provision.              Reg. §1.704-2

                                                      136
§704(b) Minimum Gain Chargeback
• Minimum gain = amount of gain that would be
  realized if partnership disposed of property
  subject to nonrecourse debt in satisfaction of the
  debt only.
• Nonrecourse deductions are allowed every year
  to the extent of the net increase in a partner’s
  share of minimum gain.
• If the partner’s share of minimum gain decreases
  in a year, the minimum gain chargeback kicks in!
  Items of income or gain must be allocated to that
  partner to cover that net decrease.

                                                   137
      §704(c) Special Allocations
• Pre-contribution (“built-in”) gains and losses
  must be allocated to the partner making the
  contribution.
• Any difference between item for TAX purposes
  and for BOOK purposes at the time of the
  contribution must be allocated to the
  contributing partner when the partnership
  disposes of the asset.
• Remainder of the item is allocated normally.

                                              138
      §704(c) Special Allocations
• Each noncontributing partner’s share of
  income, loss, deduction, etc. with respect to
  the contributed property should be the SAME
  for both book and tax. (Beware: ceiling rule).
• TAX FOLLOWS BOOK for noncontributing
  partners. Leftovers to contributing partner.
• Rule allocates tax deductions on an annual
  basis, based on how partners share book
  deductions.
                                §704(c)(1)(A)

                                                139
             §704(c) Rationale
• Eliminates difference between contributing
  partner’s initial outside basis (tax capital) and
  his initial book capital account.
• Gives the two equal partners an equal outside
  basis in their interests.
• If no §704(c), allocation of gain to partners
  would have no substantial economic effect!


                                                  140
            §704(c) Example 1
• Partner A contributes land with FMV of $100,000
  and adjusted basis of $10,000 to Partnership for
  10% interest. Partnership sells land for $110,000.
• All $90,000 of built-in gain is allocated all to A
  (“special allocation”).
• Remaining gain of $10,000 is allocated in
  accordance with profit-sharing ratios (10% x
  $10,000 = $1,000).
• Total gain to A of $91,000.
                                                  141
           §704(c) Example 2
• O contributes land with FMV of $20,000 and
  adjusted basis of $14,000. P contributes cash
  of $20,000 to OPP Partnership, both in
  exchange for ½ interest.
• OPP sells the land for $24,000.
• Gain to O = $8,000. Gain to P = $2,000.



                                              142
            §704(c) Example 2
Consequences to O:
                   Outside Basis* Book Capital
  Initial          $14,000            $20,000
  Gain on sale $6,000
  Gain on sale $2,000                 $2,000
  Total            $22,000            $22,000
*Outside Basis = Tax Capital
  Initial: Book = FMV; Tax = carryover
  $6,000 initial difference is eliminated!

                                                 143
§704(c) Example 3




                    144
§704(c) Example 3




                    145
           §704(c) Depreciation
• What if asset is depreciable?
• Remember purpose of §704(c) – to eliminate
  difference between initial outside basis and initial
  capital account.
• Don’t wait until sale of depreciable property;
  instead, fix it as you depreciate!
• Rule: Tax depreciation first allocated to
  noncontributing partners = book depreciation.
  Remaining allocated to contributing partner.
                                                    146
           §704(c) Example 4
• D contributes a depreciable asset with FMV
  $60,000 and adjusted basis of $48,000. E
  contributes cash of $120,000 to DEF
  Partnership. D receives 1/3 interest; E
  receives 2/3 interest. Asset is depreciable
  over five years on the straight-line basis.
• Tax depreciation= $48,000 x 1/5 = $9,600
• Book depreciation = $60,000 x 1/5 = $12,000

                                                147
                    §704(c) Example 4
Consequences to D:
                        Outside Basis   Book Capital
   Initial              $48,000         $60,000
   Tax depr, yr 1       ($1,600)        ($4,000)
   Tax depr, yr 2        ($1,600)        ($4,000)
   Tax depr, yr 3        ($1,600)        ($4,000)
   Tax depr, yr 4        ($1,600)        ($4,000)
   Tax depr, yr 5        ($1,600)        ($4,000)
   Total                $40,000         $40,000

*Of total tax depreciation per year of $9,600, noncontributing partner
  E first gets his share of book (12,000 x 2/3 = $8000); remainder to D
  ($1,600).
*Of total book depreciation per year of $12,000, D gets 1/3, or $4,000.

                                                                     148
                    §704(c) Example 4
Consequences to E:
                        Outside Basis   Book Capital
   Initial              $120,000        $120,000
   Tax depr, yr 1       ($8,000)        ($8,000)
   Tax depr, yr 2        ($8,000)        ($8,000)
   Tax depr, yr 3        ($8,000)        ($8,000)
   Tax depr, yr 4        ($8,000)        ($8,000)
   Tax depr, yr 5        ($8,000)        ($8,000)
   Total                $80,000         $80,000

*Of total tax depreciation per year of $9,600, noncontributing partner
  E first gets his share of book (12,000 x 2/3 = $8000); remainder to D
  ($1,600).
*Of total book depreciation per year of $12,000, E gets 2/3, or $8,000.

                                                                     149
             §704(c) Ceiling Rule
• What if basis of D’s asset had been $36,000?
• Total tax depreciation per year would be $7,200
  ($36,000 x 1/5), but E is entitled to $8,000!
• This is an example of the ceiling rule. Only $7,200
  can be allocated to E.
• Allocation to partner is limited to actual amount
  realized for tax purposes by the K.
• If you have chosen the curative or remedial method,
  you can fix this!                    Reg. §1.704-3(b)(1)

                                                         150
           §704(c) Example 5
Reg. §1.704-3(b)(2), Example (1)(ii)
• A and B form partnership AB and agree that
  each will be allocated a 50% share of all
  partnership items and that AB will make
  allocations under §704(c) using the traditional
  method. A contributes depreciable property
  with an adjusted tax basis of $4,000 and a
  book value of $10,000, and B contributes
  $10,000 cash.

                                                151
             §704(c) Example 5
• The property is depreciated using the straight-line
  method over a 10-year recovery period. Because the
  property depreciates at an annual rate of 10 percent, B
  would have been entitled to a depreciation deduction
  of $500 per year for both book and tax purposes if the
  adjusted tax basis of the property equaled its fair
  market value at the time of contribution. Although
  each partner is allocated $500 of book depreciation per
  year, the partnership is allowed a tax depreciation
  deduction of only $400 per year (10 percent of $4,000).
• The partnership can allocate only $400 of tax
  depreciation under the ceiling rule of, and it must be
  allocated entirely to B.
                                                       152
§704(c) Depreciation Allocation Methods
•   A partnership must account for the difference between
    the basis and the value of contributed property by
    “using a reasonable method that is consistent with the
    purpose of §704(c).”
•   Reasonable means that the method prevents “the
    shifting of tax consequences among partners with
    respect to precontribution gain or loss.”
•   Applied on a property-by-property basis, and can use
    different “reasonable method” for each property.
•   Traditional method of §704(c) is “reasonable” unless
    ceiling rule comes into play and tax avoidance is afoot!

                                      Reg. §1.704-3(a)(1)

                                                            153
§704(c) Depreciation Allocation Methods
•   Anti-abuse rule in Reg. §1.704-3(a)(10):
    Allocation method chosen is not reasonable if the
    allocation of tax items with respect to contributed
    property are “made with a view to shifting the tax
    consequences of built-in gain or loss among the
    partners in a manner that substantially reduces the
    present value of the partners’ aggregate tax
    liability.”
•   In other words, you cannot design your method to
    take advantage of the ceiling rule.



                                                     154
§704(c) Depreciation Allocation Methods
                                          Reg. §1.704-3
1.  Traditional method with ceiling rule
2.  Traditional method with curative allocations:
    Reg. §1.704-3(c)
   • If ceiling rule limits amount that can be allocated to
       the noncontributing partner, allocate other items of
       income or loss of same character to cure shortage.
   • If insufficient curative items, can do next year.
3. Remedial method: Reg. §1.704-3(d)
   • If ceiling rule limits amount that should be allocated to
       the noncontributing partner, cure by allocating
       whatever is necessary to noncontributing partner and
       an offsetting allocation to contributing partners.
   • Create items if don’t have enough to cure!
                                                            155
       §704(c) Example 6: Curative
Reg. §1.704-3(c)(4), Example (1)
• E and F form partnership EF and agree that each will be allocated a
  50% share of all partnership items and that EF will make allocations
  under section 704(c) using the traditional method with curative
  allocations.
• E contributes equipment with an adjusted tax basis of $4,000 and a
  book value of $10,000. The equipment has 10 years remaining on
  its cost recovery schedule and is depreciable using the straight-line
  method. F contributes $10,000 of cash, which EF uses to buy
  inventory for resale.
• The equipment generates $1,000 of book depreciation and $400 of
  tax depreciation for each of 10 years. At the end of the first year, EF
  sells all the inventory for $10,700, recognizing $700 of income.



                                                                       156
     §704(c) Example 6: Curative
Reg. §1.704-3(c)(4), Example (1)
• Under the traditional method, E and F would
  each be allocated $350 of income from the sale
  of inventory for book and tax purposes and $500
  of depreciation for book purposes. The $400 of
  tax depreciation would all be allocated to F.
• Because the ceiling rule would cause a disparity
  of $100 between F's book and tax capital
  accounts, EF may properly allocate to E an
  additional $100 of income from the sale of
  inventory for tax purposes.

                                                 157
      §704(c) Example 7: Curative
Reg. §1.704-3(c)(4), Example (2)
• G and H form partnership GH and agree that each will be
  allocated a 50% share of all partnership items and that GH
  will make allocations under section 704(c) using the
  traditional method with curative allocations, but only to the
  extent that the partnership has sufficient tax depreciation
  deductions.
• G contributes property G1, with an adjusted tax basis of
  $3,000 and a fair market value of $10,000, and H
  contributes property H1, with an adjusted tax basis of
  $6,000 and a fair market value of $10,000. Both properties
  have 5 years remaining on their cost recovery schedules
  and are depreciable using the straight-line method.

                                                             158
      §704(c) Example 7: Curative
• G1 generates $600 of tax depreciation and $2,000 of book
  depreciation for each of five years.
• H1 generates $1,200 of tax depreciation and $2,000 of book
  depreciation for each of five years.
• G and H are each allocated $1,000 of book depreciation for each
  property. Under the traditional method, G would be allocated $0 of
  tax depreciation for G1 and $1,000 for H1, and H would be allocated
  $600 of tax depreciation for G1 and $200 for H1.
• Under the traditional method, G is allocated more depreciation
  deductions than H, even though H contributed property with a
  smaller disparity!
• GH makes curative allocations to H of an additional $400 of tax
  depreciation each year, which reduces the disparities between G
  and H's book and tax capital accounts ratably each year.


                                                                   159
     §704(c) Example 8: Remedial
Reg. §1.704-3(d)(7), Example (2)
• N and P form partnership NP and agree that each will be
  allocated a 50% share of all partnership items. The
  partnership agreement provides that NP will use the remedial
  allocation method.
• N contributes Blackacre (land) with an adjusted tax basis of
  $4,000 and a fair market value of $10,000. P contributes
  Whiteacre (land) with an adjusted tax basis and fair market
  value of $10,000.
• At the end of NP's first year, NP sells Blackacre to Q for $9,000
  and recognizes a tax gain (capital) of $5,000 and a book loss of
  $1,000. NP has no other items of income, gain, loss, etc.
                                                                 160
    §704(c) Example 8: Remedial
• If the ceiling rule were applied, N would be
  allocated the entire $5,000 of tax gain and N and
  P would each be allocated $500 of book loss.
• Because the ceiling rule would cause a disparity
  of $500 between P's allocation of book and tax
  loss, NP must make a remedial allocation of $500
  of capital loss to P and an offsetting remedial
  allocation to N of an additional $500 of capital
  gain.

                                                 161
              §704(c) Example 9
What if sell property after it has been depreciated?
Reg. §1.704-3(b)(2), Example (1)(iii)
• A and B form partnership AB and agree that each will
  be allocated a 50% share of all partnership items and
  that AB will make allocations under §704(c) using the
  traditional method. A contributes depreciable property
  with an adjusted tax basis of $4,000 and a book value
  of $10,000, and B contributes $10,000 cash. A has
  built-in gain of $6,000.
• Tax depreciation of $400 (10% of $4,000) is taken in the
  first year, so tax basis now = $3,600.

                                                        162
               §704(c) Example 9
• If AB sells the property at the beginning of AB's second year
  for $9,000, AB realizes tax gain of $5,400 ($9,000 less the
  adjusted tax basis of $3,600). The entire $5,400 gain must
  be allocated to A because the property A contributed has
  that much built-in gain remaining.
• If AB sells the property at the beginning of AB's second year
  for $10,000, AB realizes tax gain of $6,400 ($10,000 less the
  adjusted tax basis of $3,600). Only $5,400 of gain must be
  allocated to A to account for A's built-in gain. The remaining
  $1,000 of gain is allocated equally between A and B in
  accordance with the partnership agreement.
• If AB sells the property for less than the $9,000 book value,
  AB realizes tax gain of less than $5,400, and the entire gain
  must be allocated to A.
                                                              163
      §706 Retroactive Allocations
• In addition to §704(b) and §704(c):
• Determination of distributive share must take in account
  any change in partner’s interest in the partnership during
  the year.
• Varying interest rule: Enacted to prevent retroactive
  allocations of partnership items to new partners who were
  admitted after the items were recognized or incurred.
• In lieu of pro-ration, can elect interim closing of the books.
• If not specified in agreement, interim closing required.
• Make sure to specify in agreement which method applies
  on liquidation and on transfer of interest or specify which
  partner/member to decide or allow “any reasonable
  method”.

                                                              164
§706 Retroactive Allocations




         *Unless interim closing method elected.




                                                   165
         §704(d) Loss Limitation
• Partner’s share of loss is deductible only to extent
  of his outside basis in interest at end of year.
• Carry forward rest indefinitely.
• Apply §704(d) after allocation of other items,
  including distributions. Reg. 1.704-1(d)(2): apply
  all basis adjustments first other than losses.
• But don’t forget other limitations: §465 at-risk
  rules (any debt for which you are not personally
  liable is not at-risk amount) and §469 passive loss
  rules (can only deduct passive losses against
  passive income).
                                                    166
      Loss Limitation Rules       Deduction
                                  Allowed!

                      Passive
           At-Risk   Loss Rules
§ 704(d)    Rules
  Basis




                                        167
            §704(d) Example 1
• F is a partner in DEFG. AT the beginning of the
  year, F’s outside basis was $14,500. During the
  year, F received $3,000 cash distribution. For the
  year, her K-1 showed her distributive share of
  DEFG’s loss was $20,000. Her share of long-term
  capital gain was $4,700.
• F’s outside basis at end of year =
  $14,500 + 4,700 – 3,000 = $16,200
• Can only deduct $16,200 of loss this year.
  Carryover = $3,600.
                                                   168
§704(d) Example 2




                    169
          § 465 At-Risk Rules
• Loss from activity is deductible to extent taxpayer is AT
  RISK.
• Unused loss is suspended until AT RISK amount has
  increased.
• Do not apply at the partnership or corporate level; apply
   at partner or shareholder level.
• Apply on an activity by activity basis; activities may be
   aggregated.
• Apply after §704(d) and before the passive loss rules.


                                                         170
              § 465 At-Risk Rules
    Beginning at-risk balance
+   Contributions of cash & property (adjusted basis)
+   Increases in recourse debt (personally liable & lender no
    interest
+   Increases in debt (secured by property not used in activity)
+   Increases in qualified nonrecourse debt related to realty
+   Income (taxable and tax-exempt)
-   Cash or property withdrawals or distributions
-   Nondeductible expenses related to tax-exempt income
-   Decreases in qualified nonrecourse debt related to realty
-   Decreases in recourse debt (personally liable)
-   Losses
=   Amount at-risk

                                                                   171
           § 465 At-Risk Rules
• Application to real estate
• “Qualified nonrecourse financing" secured by real
  property used in the activity is included as an amount
  AT RISK
  – Must be borrowed from a qualified person or government
• Qualified person: party actively & regularly engaged in
  the business of lending money and is not
  – Related to the taxpayer under § 267(b) or § 707(b)
  – A person from whom the property was acquired
  – A person who receives a fee for the taxpayer's investment


                                                            172
§ 465 At-Risk Example 1




                          173
§ 465 At-Risk Example 2




                          174
 Passive Loss Rules – Quick Review
• §469: Income/loss is grouped into baskets: active
  (materially participate in activity), passive (do not
  materially participate or rental activity), portfolio
  (interest, dividends).
• Cannot deduct passive losses against active or portfolio
  income unless dispose of passive activity.
• Passive losses only offset passive income.
• Exception: $25,000 per year active participation in
  rental real estate (Phase-out if AGI >$100,000).
• Passive losses flow-through to individual level; retain
  their character.
                                                        175
   Passive Loss Rules – Example 1
Continue with at-risk example.




                                    176
Passive Loss Rules – Example 2




                                 177
Passive Loss Rules – Example 3




                                 178
Distributions
       Partnership Distributions
Types of Distributions
• Current – Cash
• Current – Property
• Liquidating – Cash
• Liquidating – Property
• §736 Payments
• §754 Adjustments (§734(b))
• Proportionate vs. Disproportionate
                                       180
       Partnership Distributions
• Aggregate theory of Subchapter K dominates!
• Theory says that partner is merely converting
  his indirect interest in the property into a
  direct interest via a distribution.
• Therefore, most distributions are
  NONTAXABLE.
• Also, tax basis is usually not affected.
• However, there are exceptions.
                                              181
   Current
Distributions
     Current Distributions - Cash
• Current = not in liquidation of partnership or of
  partnership interest.
• Can be actual cash distribution or constructive.
• §731(a): Partner does not recognize gain.
  Distribution is nontaxable return of capital to the
  extent of partner’s outside basis in his interest.
• §731(b): Partnership also does not recognize gain
  or loss.

                                                   183
     Current Distributions - Cash
• But basis of K interest cannot go below zero!
• If cash distribution received > partner’s
  outside basis, gain recognized by partner as if
  partner sold partnership interest. §731(a)(1)
• Most cash distributions (guaranteed payments
  and advances) are treated as occurring on last
  day of tax year.


                                               184
   Current Distribution Example 1
• At the beginning of the year, W’s outside basis in
  his 25% interest in WACK was $50,000, including
  his share of partnership debt of $60,000 (his
  share = 25%).
• On July 7, WACK made a $75,000 cash
  distribution to W.
• On the last day of the year, WACK’s debt was
  $80,000.
• WACK’s income for the year totaled $109,000
  ordinary income and $5,600 capital loss.
                                                   185
   Current Distribution Example 1
• Compute W’s outside basis in WACK:
  $50,000      Initial
  + 27,250     25% ordinary income
  + 5,000      25% increase in WACK debt
  - 75,000     Cash distribution
  - 1,400      25% of capital loss
  $5,850       Total

 Note that only loss comes after distribution -
 because of §704(d).


                                                  186
Current Distribution Example 1




                                 187
   Current Distribution - Property
• General rule: No gain or loss at either
  partnership or partner level.
• Partner takes carryover basis (inside basis of
  property to partnership) in property distributed.
• Partner reduces outside basis by same amount.
• Compare with S corporations (terrible rule of
  §311: gain but not loss).

                               §731(a)(1), §733


                                                      188
   Current Distribution Example 2
• Mini-me receives a current distribution of
  property from the Austin Powers Partnership. On
  that date, property had a FMV of $14,000;
  partnership had basis of $7,500 in asset. Prior to
  the distribution, Mini-me had outside basis of
  $12,000.
• Mini-me recognizes no gain despite that property
  is appreciated and takes $7,500 basis in asset.
  Mini-me’s outside basis is now $4,500.
• But, what if Mini-me’s basis had only been
  $6,000?

                                                  189
   Current Distribution - Property
• If the partner’s outside basis < inside basis of
  the asset distributed, the partner takes a
  substituted basis in the asset.
• In Example 2: Basis in asset to partner would
  be $6,000, because that is all that is left.
  Outside basis in interest is now zero.


                                 §731(a)(2)


                                                     190
    Current Distribution - Property
• If distributions consists of multiple assets and outside basis
  < inside basis of asset, outside basis is allocated first to any
  cash received and then to:
  Category 1 ordinary income assets (“hot”):
  unrealized receivables and inventory up to partnership’s
  inside basis.
  Category 2: any other assets.
• “Basis decrease” is allocated to Cat 1 and Cat 2 assets to
  the extent of the unrealized depreciation in each property.
• Rationale: Service does not want any increase to basis of
  hot assets as these generate the most revenue for them
  when sold.
                                             §732(c)


                                                                 191
   Current Distribution Example 3
• J receives a current distribution from the JKL
  Partnership consisting of:
                        Inside basis     FMV
  Cash                  $4,000           $4,000
  Accounts receivable$        0          $3,000
  Inventory             $2,000           $2,900
  Capital asset 1       $1,000           $1,500
  Capital asset 2       $3,000           $1,000
• J’s outside basis is $8,000. How is it “used”?

                                                   192
    Current Distribution Example 3
   $8,000                Total outside basis
   - $4,000              Cash
   $4,000                Remaining for Cat 1 & Cat 2
   - $0                  Unrealized receivables*
   - $2,000              Inventory*
   $2,000                Remaining for Cat 2
   - $1,000              Capital asset 1**
   - $1,000              Capital asset 2**
   $0

*Cat 1: take inside basis of partnership if sufficient outside basis.
**Cat 2: allocated based on unrealized depreciation.
  Capital asset 1: unrealized depreciation = 0 (appreciated)
  Capital asset 2: unrealized depreciation = $2,000
  Basis decrease allocated only to Capital asset 2!

                                                                        193
Current Distribution Example 4




                                 194
   Current Distribution Example 4




Or: Basis decrease allocation:
  Capital asset 1: 500/2,500 x 2,000 = 400
  Capital asset 2: 2,000/2,500 x 2,000 = 1,600
Then, apply basis decrease to carryover basis:
  Capital asset 1: 1,000 carryover - 400 = $600
  Capital asset 2: 3,000 carryover – 1,600 = $1,400
                                                      195
   Anti-Abuse Rule: §704(c)(1)(B)
• Do you remember §704(c)?
• There is another part to it: §704(c)(1)(B):
  If distributed property has been contributed
  to the partnership within 7 years of the
  distribution, and the property is distributed to
  a non-contributing partner, the contributing
  partner must recognize gain/loss he would
  have otherwise had to recognize under
  §704(c).

                                                 196
         §704(c)(1)(B) Example
• Three years ago, Yanni contributed an oboe (FMV
  $50,000, Basis $32,000) in exchange for a 50%
  interest in the YZ Partnership. YZ distributes the
  oboe to Z when the oboe is worth $61,000 and
  Z’s outside basis is $112,000.
• The $18,000 pre-contribution gain must be
  specially allocated to Yanni because that piece of
  gain “attaches” to Yanni.
• Z will take a basis in the oboe of $50,000, which
  was YZ’s basis in it, and reduce his outside basis
  by same.

                                                   197
        Anti-Abuse Rule: §737
• Assume the oboe stays in YZ Partnership, but
  instead YZ distributes a synthesizer to Yanni
  (FMV $40,000, inside basis $25,000).
• If the distribution is made within 7 years of
  the original contribution of the oboe by Yanni,
  Yanni must recognize the $18,000 pre-
  contribution gain in the oboe!
• Why? To prevent tax-free exchanges

                                                198
 Liquidating
Distributions
   Liquidating Distributions - Cash
• Liquidating = partner’s entire interest in
  partnership is extinguished.
• Partner has capital gain or loss =
  cash received – outside basis.
• Why? Final reckoning! Partner gone.
• Capital because partnership interest = capital
  asset.
                             §731(a)(1),(2)


                                                   200
Liquidating Distributions Example 1
• Akon receives a liquidating distribution of
  $20,000 cash from the ABC Partnership. This
  equals the value of Akon’s capital account. Akon
  is also relieved of $13,000 of ABC debt because
  he is no longer a partner. Akon’s outside basis
  prior to this is $24,500.
• Akon: $20,000 + $13,000 – 24,500 = $8,500
  capital gain
• What if his outside basis was $35,000? Akon
  would have a capital loss of $2,000.
                                                 201
Liquidating Distributions - Property
• See Current Distributions – Property rules.
  Same ordering rules of allocating outside basis
  apply (cash, Cat 1 up to inside basis, then Cat
  2).                           §732(c)

• Difference: Basis of Cat 2 assets are not
  limited to inside carryover basis. Only Cat 1
  assets are.
• Can recognize a loss if no Cat 2 assets received
  or not enough received!        §731(a)(2)


                                                202
Liquidating Distributions Example 2




                                  203
Liquidating Distributions Example 3
• R receives a liquidating distribution from the
  RUF Partnership consisting of:
                       Inside basis      FMV
  Cash                 $2,500            $2,500
  Accounts receivable$       0           $2,000
  Inventory            $3,000            $4,000
  Capital asset        $5,000            $9,000

• R’s outside basis is $12,000.

                                                   204
Liquidating Distributions Example 3
  $12,000             Total outside basis
  - $2,500            Cash
  $9,500              Remaining for Cat 1 & Cat 2
  - $0                Unrealized receivables*
  - $3,000            Inventory*
  $6,500              Remaining for Cat 2
  - $6,500            Capital asset**
  $0

*Cat 1: take inside basis of partnership if sufficient outside
  basis.
**Cat 2: all of rest of outside basis goes to only Cat 2 asset
  even though this is > inside basis to partnership!

                                                                 205
Liquidating Distributions Example 4




                                  206
Liquidating Distributions Example 4




                                  207
Liquidating Distributions Example 5




                                  208
Liquidating Distributions Example 6




                                  209
Liquidating Distributions Example 6




                                  210
                §736 Payments
• Partners may negotiate to receive more for their
  partnership interest than their proportionate interest
  in the partnership assets. This excess is called a
  §736(a) payment.
• What could this excess piece be? Recognition for long
  faithful service?
• If determined without reference to partnership income
  = GUARANTEED PMT (ordinary income)
• If determined with reference to partnership income =
  DISTRIBUTIVE SHARE
• Remainder treated under normal distribution rules.
                                                      211
§736(a) Payment Example




                          212
     §736(a) Payment Example 1
• R received $40,000 in cash plus $1,000 in debt
  relief, even though his book capital account
  balance was only $27,000.
• $41,000 – ($140,000 x .20) = $13,000 =
  §736(a) payment = guaranteed payment,
  ordinary income to R, deductible by RSTU.
• $28,000 cash received (his 20% share of value of
  assets) is treated under normal distribution rules.
  For example, if his outside basis was $23,000, R
  has capital gain of $5,000.
                                                   213
§736 Payment Example 2




                         214
§736 Payment Example 2




                         215
              §736(b) Payments
• Be cautious about liquidating payments made with
  respect to unrealized receivables or unspecified goodwill
  (agreement does not provide that withdrawing partner is
  paid for share of goodwill).
• Payments made for unrealized receivables (partnership is
  cash basis and has A/R) = §736(a) payment, not
  distribution.
• §736(b): Payments made with respect to unspecififed
  goodwill made to general partners in which capital is not
  material-income producing factor (professional services
  firm) = §736(a) payment, not distribution. §736(b)(3)
                                                         216
§736 Payment Example 3




                         217
§736 Payment Example 3




                         218
§736 Payment Example 3




 $3,500 = $2,400 10% receivables + $1,100 goodwill
 ($21,500 value received – 20,400 FMV specified assets)
                                                          219
     §754 Election: Distributions
• Recall that most distributions result in no gain/loss
  and carryover basis. This results in differences in
  inside basis and outside basis, which may cause
  problems.
• Way to correct this offered by Code: §754 election.
• Partnership may adjust the inside basis of the
  remaining partnership property if so chooses. This is
  the §734(b) adjustment.
           §754 election for distributions = §734(b) adjustment
           §754 election for sale of interest = §743(b) adjustment

                                                                     220
   §734(b) Adjustment Example 1
• Kayne North received a current distribution from
  NESW Partnership that consisted of $5,000 cash
  and inventory with an inside basis of $1,500. His
  outside basis was $3,600.
• Kayne recognizes $1,400 gain and takes zero basis
  in inventory. (ordering rule)
• *The partnership may increase the inside basis of
  its remaining assets by $2,900, the “lost” basis of
  $1,400 + $1,500, if it has §754 election in effect.*
• Everyone wants basis! No one wants to lose it.
                                                    221
   §734(b) Adjustment Example 2
• But, it works both ways!
• Assume Kayne North receives a liquidating
  distribution of $5,000 cash from NESW when his
  outside basis is $7,000. Kayne South receives a
  capital asset with inside basis of $10,000 when
  his outside basis is $14,500.
• Kayne North recognizes a $2,000 capital loss.
• Kayne South takes a $14,500 basis in the asset.
• NESW will have to decrease (!) the basis of its
  remaining assets by $6,500 if it has §754 election
  in effect.
                                                   222
   §734(b) Adjustment Example 2
Inside basis: $5,000 + $10,000 = $15,000
Outside basis: $7,000 + $14,500 = $21,500
Difference = $6,500

• This mechanism is available to correct the “screw-up”
  that occurs in these situations where inside basis and
  outside basis are different.
• Be cautious about when make §754 election!
• Must attach election to tax return for that year when
  filed. Applies for all subsequent years unless IRS grants
  revocation!

                                                         223
    §754 Adjustments: Allocation
• §755: optional basis adjustment is allocated to the
  same asset class in which the distributed property falls.
• Divide assets into: (1) capital and §1231 assets and (2)
  all other assets (ordinary income property).
• Allocate step-up or step-down between classes and
  then within classes. Based on relative
  appreciation/depreciation in assets.
• Allocations of increases in basis: first to properties
  with unrealized appreciation.
• Allocations of decreases in basis: first to properties
  with unrealized depreciation.
                                                         224
§755 Allocation Example
             1




                          225
§755 Allocation Example




                          226
§755 Allocation Example




                          227
 §754 Substantial Basis Reduction
• One final word of caution: These rules apply
  automatically even if §754 election not made
  if there is a “substantial basis reduction”.
• Substantial = sum of partner’s loss on
  distributions and basis increase is more than
  $250,000.
• Rules became effective in 2004.


                                                  228
§754 Substantial Basis Reduction




                                   229
§751(b) Disproportionate Distributions
• Another word of caution about distributions:
  when partnership has inventory or unrealized
  receivables (“hot” assets). These are called “hot”
  because they trigger ordinary income when sold.
• If partner getting a distribution does not get his
  share of these hot assets, partner still has to
  pretend like he did and recognize ordinary
  income on the distribution as if he had received
  them.
• Aggregate theory again: each partner owns his
  share of partnership’s hot assets.

                                                  230
§751(b) Disproportionate Distributions
• Unrealized receivables – A/R of cash basis
  company; assets with depreciation recapture
  potential.
• Inventory – if substantially appreciated (120%
  test)
• Partner is treated as indirectly disposing of a
  portion of his interest in partnership hot assets.
• Each partner must bear responsibility for his
  share of ordinary income potential in hot assets!
                                                  231
              §751(b) Example
• CDE Partnership makes distribution to C, who owns
  25% interest. CDE’s assets:
                   Inside basis FMV
  Inventory       $320,000      $400,000
  Capital asset   $600,000      $800,000

• C’s outside basis is $230,000.
• Distribution is of $300,000 in capital assets.
• Consequences to C: As if C exchanged part of capital
  assets for his share of inventory ($100,000).
• Fictional exchange triggers ordinary income of $20,000
  to C. ($400,000 – 320,000) x 25% = $20,000
                                                       232
Disposition
of Interest
      Sale of Partnership Interest
• Seller:
  Amount realized – outside basis = Gain/loss
• Character of gain is capital (entity theory), except
  for partner’s share of hot assets* (aggregate
  theory). Partner is allocated share of ordinary
  income that would result if hot assets had
  actually been sold by the partnership.
• Don’t forget effect of liabilities.
• Partnership tax year closes with respect to selling
  partner.
• * In this case, all inventory is hot asset!
                                                     234
   Sale of Interest Example: Seller
• K sells her 10% interest in Partnership KRUD for
  $45,000 cash. Her outside basis in her interest was
  $35,500. KRUD’s partial balance sheet:
                        Inside basis FMV
  Cash                  $40,000          $40,000
  Inventory             $90,000          $130,000
  1231 assets           $225,000         $300,000
  Debt                  $20,000          $20,000
• K recognizes gain of $11,500 ($45,000 + $2,000 share
  of liability relief - $35,500 basis).
• $4,000 ordinary income, $7,500 capital gain
• Ordinary income = (130,000 – 90,000) x .10

                                                         235
Sale of Interest Example: Seller




                                   236
Sale of Interest Example: Seller




                                   237
      Sale of Partnership Interest
• Buyer: takes cost basis as outside basis
• Partnership’s inside basis unless §754 election in
  effect to correct difference between outside and
  inside basis.
• *However, this time, step-up or step-down in
  basis goes to incoming partner only not to
  partnership.*
• New partner can step-up his share of partnership
  assets as if he bought the assets directly.
• Again, §754 election – this time called a §743(b)
  adjustment – equalizes inside and outside basis.
                                                   238
Sale of Interest Example: Buyer




                                  239
Sale of Interest Example: Buyer




                                  240
   §743(b) Adjustment Example 1
• Ren and Stimpy are equal partners in RS. RS
  owns one asset, land with FMV $100,000 and
  basis $40,000.
• Stimpy sells his interest to Jerry for $50,000.
• No §754: Jerry’s share in basis of land is $20,000
  (50% of 40,000). Sale of land for $100,000 results
  in gain to Jerry of $30,000 (50,000 – 20,000).
• §754 in effect: Jerry’s share of basis in land is
  stepped up to FMV of $50,000. Sale of land for
  $100,000 results in no gain to Jerry! But poor
  Ren still has gain of $30,000.
                                                   241
§743(b) Adjustment Example 2




                               242
§743(b) Adjustment Example 2




                               243
§743(b) Adjustment Example 2




                               244
§743(b) Adjustment Example 2




                               245
          §701 Anti-Abuse Rule
• Reg. §1.701-2: IRS can disregard the form of any
  partnership transaction if it believe the
  transaction (or series of) is abusive!
• Abusive if:
  1. Has principal purpose of substantially reducing
  the present value of the partners’ aggregate
  federal tax liability.
  2. Tax reduction is inconsistent with the intent of
  Subchapter K.
• IRS can recast to reflect the true “underlying
  economic arrangement.”

                                                   246
Terminations
       Partnership Termination
• §708(a): A partnership continues to exist until
  it is “terminated”.
• Two events that terminate a partnership for
  purposes of Subchapter K:
  §708(b)(1)(A): Discontinuation of Business
  §708(b)(1)(B): Technical Termination: There is
  sale or exchange of 50% or more of the total
  interest in capital and profits within a 12-
  month period.

                                               248
       Partnership Termination
• §708(b)(1)(A): NO PART of any business,
  financial operation, or venture of the
  partnership continues to be carried on by an
  of its partners.
• Even a nominal amount of continuing activity
  prevents termination (partnership holds notes
  and collects interest, makes minor purchases).
• Retention of any K business or investment
  asset may be sufficient to keep K alive.

                                               249
        Partnership Termination
• Technical Terminations:
  To prevent trafficking in partnerships with
  advantageous tax years (original purpose) and
  favorable ACRS recovery periods.
• Mechanical rules are easily avoided by planning.
• Was there a sale or exchange?
• Count transfers to other partners and transfers to
  outsiders, but only one sale of an interest is
  counted during the 12-month period.
  Reg. §1.708-1(b)(2).
                                                   250
         Partnership Termination
Sales or exchanges that do not count:
• *Liquidations of interests by partnership*
• Issuance of interest for contribution (§721)
• Conversion of GP interest into LP interest or vice versa
• Conversion of GP or LP into LLC
• Gift, bequest, inheritance, charitable contribution
  (unless bargain sale!)
• Transfer between spouses
• Transfer to and from trust or estate unless tax
  avoidance.

                                                         251
       Partnership Termination
Sales or exchanges that do count:
• Distributions of interests by corporations
• Contributions of interests to corporations.
• Transfers of interest in corporate
  reorganizations other than Type F if
  transferred from corporation merged out of
  existence. Do not count if interest considered
  held by same corporate entity.

                                               252
       Partnership Termination
• Termination only caused if 50% of both capital
  and profits exchanged. No termination if
  partner sells 30% capital interest and 60%
  profits interest (Reg. §1.708-1(b)(2)).




                                               253
Technical Termination Example




                                254
Technical Termination Example




                                255
         Partnership Termination
Planning to avoid:
• Have 50% partner retain de minimis portion for a year + 1
   day. (PLR)
• Dispose of portion of interest in transaction that is not a
   sale/exchange for §708.
• Do not sell 50% partner’s interest to remaining partners;
   have K liquidate the interest. Have K supply funds for
   liquidation, not partners to avoid recast.
• Combination sale/liquidation approach: part of departing
   partner’s interest is sold, remainder is liquidated.
• Delayed sale technique: sell portion and then grant option
   to purchase remaining %. Must be no contractual
   obligation or economic compulsion to exercise option.

                                                            256
        Partnership Termination
Tax Consequences if §708(b)(1)(A):
• Tax year closes with respect to all partners.
  Not usually an issue because of conformity
  rules regarding majority of partners and the K.
• All K assets treated as distributed to partners.




                                                257
         Partnership Termination
Tax Consequences if §708(b)(1)(B):
• Old K is terminated and a new K is formed.
• Reg. §1.708-1(b)(4):
  The K contributes all of its assets and liabilities to a
  new K in exchange for an interest in the new K; and
  immediately thereafter, the old K distributes interests
  in the new K to the purchasing partner and the other
  remaining partners in proportion to their respective
  interests in the old K in liquidation of the old K, either
  for the continuation of the business by the new K or for
  its dissolution and winding up.

                                                          258
           Partnership Termination
Tax Consequences if §708(b)(1)(B):
• Closing of K Tax Year: If tax year of K and some of
  partners are different, income bunching may
  result.
• Filing of two short-year returns: one for the Old
  K for the period ending on termination date and
  one for New K beginning thereafter.
• EIN # of Old K retained by New K. Reg. §301.6109-
  1(d)(2)(iii)
• Elections made by Old K expire. New K is free to
  make new elections. Example: §754 election.
                                                     259
         Partnership Termination
Tax Consequences if §708(b)(1)(B):
• No consequences under §704(b): book values of K
  assets and capital accounts of partners are not
  affected. Carryover to new K. Reg. §1.704-1(b)(2)(iv)(l)
• No consequences under §704(c): No new §704(c) gain
  or loss creates. Carryover to new K. Reg. §1.704-3(a)(3)(i)
• No §704(c)(1)(B) problem: (§704(c)(1)(B): contributed
  property distributed to a non-contributing partner
  within 7 years). Reg. §1.704-4(c)(3)
• No §737 problem (§737: distribution of other property
  to contributing partner within 7 years). Reg. §1.737-2(a)
                                                           260
         Partnership Termination
Tax Consequences if §708(b)(1)(B):
• No gain or loss under §731(a) (because only assets
  distributed were K interest, not cash).
• No deemed distributions of money or marketable
  securities.
• No deferred gain on installment obligations is
  triggered.
• Holding period and character of Old K assets carries
  over.
• No investment tax credit recapture.
• Suspended losses under §704(d), §465, §469 carryover.

                                                      261
          Partnership Termination
Tax Consequences if §708(b)(1)(B):
• Old K Basis in assets carries over to New K.
• Terminated K may make a §754 election to apply basis
   adjustment rules of §743(b) if one not in effect! Purchasing
   partner can get basis step-up even if new K does not make
   §754 election. Reg. §1.708-1(b)(5), Reg. §1.743-1(h)(1)
• New K can make §754 election: Distribution of interests in
   new K (hypothetical) is sale for §743 purposes. Reg. §1.761-
   1(e)
• Old §754 basis adjustments carryover to new K regardless of
   whether new K makes election. Reg. §1.743-1(h)(1)

                                                                  262
        Partnership Termination
Tax Consequences if §708(b)(1)(B):
• Termination of upper-tier K (UTP), UTP is treated
  as exchanging its entire interest in the capital and
  profits of the LTP. Thus, LTPs may terminate
  when UTP terminates.
• Qualified retirement plans should be unaffected
  (not terminated under §401) if continue in same
  fashion in new K.
• Old K can deduct unamortized organization costs
  on final return. Start-up expenses are uncertain.
                                                     263
        Partnership Termination
Tax Consequences if §708(b)(1)(B): Depreciation
• Deemed contribution of assets by old K to new K:
  governed by §721.
• §168(i)(7)(A): step-in-the shoes for MACRS or
  ACRS property transferred in §721.
• Exception in last sentence of §168(i)(7) for
  §708(b)(1)(B) terminations! Step-in-shoes rule is
  not applicable.
• MACRS and ACRS property is new property to
  new K: “newly placed in service”. RE-START
  DEPRECIATION!
                                                  264
        Partnership Termination
Tax Consequences if §708(b)(1)(B): Depreciation
• In addition, anti-churning rules of §168(f)(5)
  apply – cannot change depreciation method if
  overlapping ownership of old K and new K (90%).
  Rules not applicable if less than 10% overlapping
  ownership.
• MACRS stays MACRS.
• Cannot switch ACRS to MACRS if more generous
  method. Example: 5 year 150% under ACRS pre-
  1987; 5 year 200% under MACRS post-1986:
  cannot switch to 200%.
                                                  265
        Partnership Termination
Tax Consequences if §708(b)(1)(B): Depreciation
• Computation for year of termination –
  Use short-year rules for depreciation.
• Half year convention under MACRS: disposal in
  halfway point of year; results in significant loss of
  depreciation for terminated year.
• ACRS? Old rules were step-into-shoes, no short year –
  some uncertainty as no binding rules.
• Step-into-shoes rules for intangibles being amortized
  under §197. HR Rep. No. 213, 103d Cong.

                                                      266
         Partnership Termination
Tax Consequences if §708(b)(1)(B): Bonus Depreciation
• Additional first year allowance is to be claimed by the
  new partnership.
• It is to be claimed for the new partnership's tax year in
  which the eligible property was contributed by the
  terminated partnership to the new partnership.
• However, if the new partnership disposes of the property
  in the same year in which received, then no additional
  first year depreciation is allowable to either partnership.
  Reg. §1.168(k)-1(f)(1)(ii)


                                                           267
         Partnership Termination
Termination of 2-person K:
• Rev. Rul. 99-6:
  If deceased or retiring partner sells his interest:
  Purchasing partner is treated as having received a
  liquidating distribution of K assets attributable to his
  interest and then purchased assets attributable to
  interest of deceased/retiring partner.
• Why? So purchasing partner cannot tack K’s holding
  period in assets.
• For purposoes of determining purchasing partner’s
  holding period.


                                                             268
            Partnership Mergers
• §708(b)(2)(A): If two or more K’s merge or
  consolidate into one K, the resulting K is treated as a
  continuation of any merging K whose members own
  more than 50% of the capital and profits of the
  resulting K. All other K’s are terminated.
• If the members of more than one merging K own
  more than 50% of the resulting K, tie breaker =
  merging K which is credited with the contribution of
  assets having the greatest FMV, net of liabilities.
• If the members of none of merging K satisfy 50%
  test, all merging K’s terminate and new K is born. 269
              Partnership Mergers
• Assets-Over Form: Terminating K’s transfer assets to resulting
  K in exchange for interest in resulting K; interests then
  distributed to old partners in liquidation of their interests in
  old K. (“Sale within a merger”)
• Assets-Up Form: Terminating K’s distribute assets and
  liabilities to their partners in liquidation; partners contribute
  such assets and liabilities to resulting K in exchange for
  interests in resulting K.
• Default is Assets-Over if no form specified.
• Assets-Over usually better choice because basis of assets
  carries over (no basis changes as with Asset-Up) and no
  §704(c)(1)(B) or §737 problems.                Reg. §1.708-1(c)(3)
                                                                  270
           Partnership Divisions
§708(b)(2)(B); Reg. §1.708-1(d)(1):
• In the event of a division of a K into two or more K’s,
  any resulting K whose members had an interest of
  more than 50% in the capital and profit of the
  original K is deemed to be a continuation of the
  original K.
• Any other resulting K is a new K.
• If no resulting K treated as a continuation under 50%
  rule, original K terminates.

                                                        271
             Partnership Divisions
• Assets-Over Form: Existing K transfers some portion of its
  assets/liabilities to a new K and immediately thereafter
  distributes interest in the new K to some or all of its partners.
• Assets-Up Form: Existing K distributes assets and liabilities to
  its partners in liquidation; partners contribute such assets and
  liabilities to new K in exchange for interests in new K.
• Default is Assets-Over if no form specified.

Reg. §1.708-1(d)(3), (4)



                                                                 272
             Partnership Divisions
• Resulting K that is treated as a continuation files a return for
  the tax year of the K that has been divided and retains EIN of
  Prior K.
• Must disclose parties and facts in this return.
• All other resulting K’s that are treated as continuing are
  required to file separate returns using new EIN’s for each one,
  for tax year beginning on day after division.
• Resulting K treated as continuation is bound by old elections.
• Complexity and uncertainty involving §704(c) and §737 issues.



                                                                273

								
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