Docstoc

tax_chapter_20_no_homework

Document Sample
tax_chapter_20_no_homework Powered By Docstoc
					Chapter 20 - Forming and Operating Partnerships



                                                                                Chapter 20
                                                         Forming and Operating Partnerships

                                     SOLUTIONS MANUAL

Discussion Questions


    1. [LO 1] What is a flow-through entity, and what effect does this designation have on how
        business entities and their owners are taxed?
        Flow-through entities are entities that are not taxed on the entity level; rather, these
        entities are taxed on the owner’s level. These types of entities conduct a regular
        business; however, the income earned and deductions allowed are passed to the owners
        of these flow-through entities, and the owners are taxed on the amount allocated to them.
        Thus, flow-through entities provide a way for income and deductions to be taxed only
        once instead of twice.

    2. [LO 1] What types of business entities are taxed as flow-through entities?
        The two main business entities that are taxed as flow-through entities are partnerships
        and S corporations. Partnerships are taxed under Subchapter K and consist of general
        partnerships, limited partnerships, and limited liability companies (LLC). S corporations
        are taxed under Subchapter S. Both these types of business entities are treated as flow-
        through entities and are taxed accordingly.

    3. [LO 1] Compare and contrast the aggregate and entity concepts for taxing partnerships
        and their partners.
        The aggregate concept treats partnerships more align with an individual. Each
        partnership is viewed as an aggregation of each partner’s separate interest in the assets
        and liabilities of the partnership. For example, each partner is proportioned and taxed
        on a certain amount of income the partnership creates. The partnership, as a whole, is
        never taxed.

        The entity concept treats partnerships more align with a corporation. Each partnership
        is an entity separate from its partners. For example, the partnership decides on which
        tax method to use and which tax elections to make, not the partners individually.

    4. [LO 2] What is a partnership interest, and what specific economic rights or entitlements
        are included with it?




                                                  20-1
Chapter 20 - Forming and Operating Partnerships


        A partnership interest is an equity interest in a partnership. This interest is created
        through a transfer or sale of cash, property, or services in exchange for an equity interest
        in the partnership. A partnership interest gives each partner certain rights or
        entitlements. The two main economic rights are a capital interest and profit interest in
        the partnership. A capital interest is the right for a partner to receive a share of the
        partnership assets during liquidation. A profit interest is the right or obligation for a
        partner to receive a share of the future income or losses of the partnership.

    5. [LO 2] What is the rationale for requiring partners to defer most gains and all losses
        when they contribute property to a partnership?
        The rationale for requiring partners to defer most gains and losses when contributing
        property to a partnership is twofold. First, the IRS desires that entrepreneurs have a way
        to start their own business without having to pay any taxes upfront. Second, the partners
        are considered still owning the property they have contributed to the partnership. While
        they don’t own the property outright, each partner has a small percentage of the property
        contributed in her/his partnership interest she/he exchanged for. This second reasoning
        helps further support the idea that partnerships follow the aggregate concept.

    6. [LO 2] Under what circumstances is it possible for partners to recognize gain when
        contributing property to partnerships?
        Partners have the potential of recognizing gain on the contribution of property when the
        property contributed is secured by debt. In determining whether gain must be
        recognized, the partner must assess the cash deemed to have received from the
        partnership distribution compared with the tax basis of the partner’s partnership interest
        prior to the deemed distribution. If the cash deemed to have received exceeds the tax
        basis, then a gain must be recognized. This circumstance occurs due to the negative
        basis created for the partner, which is not allowed under partnership tax law.

    7. [LO 2] What are inside basis and outside basis, and why are they relevant for taxing
        partnerships and partners?
        An inside basis, in relation to partnerships, is the basis the partnership takes in the assets
        that the partnership holds. An outside basis, in relation to partnerships, is the tax basis
        each partner has in the partnership. The inside basis is necessary to compute the
        gain/loss recognized on all property sold by the partnership. The outside basis is
        necessary to compute the gain/loss recognized on the partnership interest when sold. For
        tax purposes, the inside basis is similar to the basis the partner had in the property prior
        to contribution. On the other hand, the outside basis corresponds not only to the
        contributed property, but also to the debt and income/losses of the partnership.




                                                  20-2
Chapter 20 - Forming and Operating Partnerships


    8. [LO 2] What is recourse and nonrecourse debt, and how is each generally allocated to
        partners?
        Recourse debt is debt for which partners are considered to have an economic risk of loss.
        This type of debt partners are legally liable for and must satisfy personally if the
        partnership cannot. An example of recourse debt is accounts payable. Nonrecourse debt
        is debt for which no partners are considered to have an economic risk of loss in. This is
        a debt for which partners are not legally liable for. An example of nonrecourse debt is a
        mortgage.

         In regards to a partnership’s debt, recourse debt is allocated to those partners that have
        the ultimate responsibility of paying the debt. The debt is allocated to the partners that
        have an economic risk of loss. On the other hand, nonrecourse debt is allocated to all
        the partners according to the profit sharing ratios. Despite the partners not being legally
        liable for this debt, the debt is allocated proportionately to adjust the outside basis of
        each partner.

    9. [LO 2] How does the amount of debt allocated to a partner affect the amount of gain a
        partner recognizes when contributing property secured by debt?
        A partner that contributes property secured by debt is not only contributing the property
        to the partnership but also the debt. In calculating the outside basis of the partner, the
        partner must take her/his tax basis in the property and decrease her/his basis by the
        amount of the property’s debt. Next, the property’s debt is allocated to each partner
        according to who is ultimately responsible for it or by each partner’s profit-sharing ratio.
        If the partner is not allocated enough debt, the partner’s outside basis will become
        negative and a gain must be recognized. Thus, a partner can only avoid gain by
        obtaining enough of the partnership debt to keep her/his basis at least above zero.

    10. [LO 2] What is a tax-basis capital account, and what type of tax-related information does
        it provide?
        A tax-basis capital account is an equity account that is created for each partner of the
        partnership. This account is measured using the tax accounting rules. The account
        reflects tax basis of any capital contributions (i.e., property and cash), capital
        distributions, and future earnings and losses allocated to that partner. Additionally, a
        tax-basis capital account can provide more tax-related information for each partner.
        For instance, each partner’s share of inside basis of the partnership’s assets can be
        calculated by adding the partner’s share of debt to her/his capital account. Furthermore,
        if a partner acquires her/his interests by contributing property tax-free, then the
        partner’s outside basis will be equal to that partner’s share of partnership inside basis.




                                                  20-3
Chapter 20 - Forming and Operating Partnerships


    11. [LO 2] Distinguish between a capital interest and a profits interest, and explain how
        partners and partnerships treat when exchanging them for services provided.
        A partnership interest can be broken down into two distinct rights: (1) capital interest
        and (2) profits interest. To become a partner in a partnership, you will receive at least
        one of these rights. A capital interest is the right to receive a share of the partnership
        assets at liquidation. A profits interest is the right to share in the future earnings and
        losses of the partnership. While these rights are given to most partners that contribute
        cash or property, special rules exist when these rights are given to partners in exchange
        for services.

        When a partner receives a capital interest in exchange for services rendered to the
        partnership, the partner must treat the liquidation value of the capital interest as
        ordinary income. Further, the tax basis for the partner will be equivalent to the amount
        of ordinary income recognized. The holding period for this tax basis will begin on the
        date the capital interest is received. From the partnership’s perspective, the partnership
        can deduct or capitalize the value of the capital interest depending upon the type of
        services rendered. This is determined on a fact and circumstance basis. Additionally,
        the amount deducted by the partnership is allocated to the non-service partners as
        consideration for effectively transferring a portion of their capital interest to the service
        partner.

        When a partner receives a profit interest in exchange for services rendered to the
        partnership, the partner has no immediate tax impact because they have no liquidation
        value at the time they are received. Thus, the non-service partners will not receive any
        deductions for the additional partner to the partnership. As the partnership makes future
        profits and losses, the service partner will be allocated her/his portion of these losses
        according to the profit sharing ratios. The debt allocated to non-service partners must
        also be redistributed with the additional service partner receiving her/his portion of debt.
        Therefore, the tax basis of a service partner with only a profit interest will either be zero
        or the portion of debt the partner is allocated.

    12. [LO 2] How do partners who purchase a partnership interest determine the tax basis and
        holding period of their partnership interests?
        When a partner purchases a partnership interest, the initial tax basis for the partner is a
        determined by taking the cost basis of the interest the partner purchased and adding to
        this basis any debt allocated to the partner’s interest. The holding period for this
        purchased interest will begin on the date that the partner purchased the partnership
        interest.




                                                  20-4
Chapter 20 - Forming and Operating Partnerships


    13. [LO 3] Why do you think partnerships, rather than the individual partners, are responsible
        for making most of the tax elections related to the operation of the partnership?
        The responsibility for the partnership, not the partners, to make the majority of tax
        elections regarding the operation of the partnership is twofold. First, partnerships can
        consist of many different partners ranging from two to hundreds. The hassle to obtain
        every partner’s approval on what elections to make would be very time consuming. The
        costs would more than likely outweigh the benefits in performing this function. Second,
        in many partnerships only a few partners are actively involved in the management of the
        partnership. The limited partners have ownership to obtain a tax advantage on their own
        personal returns. Thus, the entity concept would appear more reasonable when dealing
        with the actual operations of the partnership.

    14. [LO 3] If a partner with a taxable year-end of December 31 is in a partnership with a
        March 31 taxable year-end, how many months of deferral will the partner receive? Why?
        A partner with a calendar year end will receive nine months of deferral in her/his
        partnership interest that has a March 31 year end. A partner must report the income or
        loss of the partnership not at the partner’s year end but at the partnership’s year end.
        Thus, the first year of the partnership will be reported by the partner on her/his second
        return which includes the partnership’s year end.

    15. [LO 3] In what situation will there be a common year-end for the principal partners when
        there is no majority interest taxable year?
        The principal partner test states that the required tax year is the taxable year all the
        principal partners have in common. A principal partner is a partner that owns at least 5
        percent interest in the partnership profits and capital. For the principal partner test to
        pass and not the majority interest test, the partnership must consists of numerous
        partners that (1) own less than 5 percent profit and capital interest and (2) have a
        variety of fiscal year ends. For example, if four partners with a calendar year end owned
        10 percent and 20 additional partners with differing fiscal year ends owned less than 5
        percent, then the majority test would not pass, but the principal partners test would.

    16. [LO 3] Explain the least aggregate deferral test for determining a partnership’s year end
        and discuss when it applies.
        The least aggregate deferral test is the last resort test that a partnership must follow
        when figuring out the partnership year end. The first test is the majority interest test.
        The second test is the principal partners test. If these two tests don’t apply, along with
        the exception to elect an alternative year end, then the least aggregate deferral test goes
        into effect.




                                                  20-5
Chapter 20 - Forming and Operating Partnerships


        The least aggregate deferral test selects the tax year which provides the partner group as
        a whole the smallest amount of aggregate tax deferral. This is calculated by taking each
        partner’s months of deferral under the potential tax year and weighting it with the
        partner’s profit interest percentage. Then, each partner’s weighted totals are summed up
        to come up with an aggregate deferral number. The potential tax year that produces the
        smallest aggregate deferral must be the one chosen by the partnership.

    17. [LO 3] When are partnerships eligible to use the cash method of accounting?
        A partnership is eligible to use the cash method of accounting unless the partnership has
        average gross receipts over the past three taxable years greater than $5 million and has
        a corporate partner. Under the tax accounting laws, a partnership must use the accrual
        method of accounting with a corporate partner, unless the above exception applies.

    18. [LO 4] What is a partnership’s ordinary business income (loss) and how is it calculated?
        Through the course of business, partnerships create income or losses. Some of these
        items are considered to affect a specific partner or groups of partners differently. Thus,
        these separately-stated items must be reported on a partner-by-partner basis. Then, after
        adjusting the partnership’s business income (loss) for these separately-stated items, the
        partnership reports the remaining amount of business income (loss) to ordinary business
        income (loss). The total amount will be allocated to each partner according to the
        special allocation rules agreed upon or else based upon the profit sharing ratios of the
        partnership.

    19. [LO 4] What are some common separately stated items, and why must they be separately
        stated to the partners?
        Separately-stated items must be taken out of ordinary income (loss) because these items
        either (1) relate only to a specific partner in the partnership or (2) the item is taxed
        differently for each partner depending upon the entity of the partner and the partner’s
        current tax situation. The following is a list of items that are considered to be separately
        stated on a partnership return.

            1. Short-term capital gains (losses)
            2. Long-term capital gains (losses)
            3. Section 1231 gains (losses)
            4. Charitable contributions
            5. Dividends
            6. Interest income
            7. Guaranteed payments
            8. Net earnings (losses) from self-employment
            9. Tax-exempt income
            10. Net rental real estate income (loss)
            11. Investment interest expense
            12. Section 179 deductions




                                                  20-6
Chapter 20 - Forming and Operating Partnerships


    20. [LO 4] Is the character of partnership income/gains and expenses/losses determined at the
        partnership or partner level? Why?
        In keeping with the entity concept, the character of all income/gains and expenses/losses
        is determined at the partnership level. Despite the chance that specific items would
        change character depending upon the partner who holds them, the IRS has decided to
        unify the character of all items by looking at the character from the partnership’s
        perspective. Thus, partnerships are required to file a 1065 return along with all
        partners’ K-1s to help audit the amounts and character that show up on the individual
        partner’s return.

    21. [LO 4] What are guaranteed payments and how do partnerships and partners treat them
        for income and self-employment tax purposes?
        Guaranteed payments are similar to cash salary payments for services provided. The
        idea behind a guaranteed payment is for a partner to receive a fixed amount of income no
        matter the profit (loss) for the partnership’s taxable year. Thus, on the partnership level,
        they are treated like a salary payment to an unrelated party. The partnership deducts the
        guaranteed payment in computing the partnership’s ordinary business income (loss).

        On the partner level, the partner that receives a guaranteed payment must account for
        the guaranteed payment as a separately-stated item that is taxed as ordinary income.
        Further, the partner must include the amount of the guaranteed payment in computing
        self-employment income for tax purposes. This amount is included no matter if the
        partner is a general partner, limited partner, or LLC member.

    22. [LO 4] How do general and limited partners treat their share of ordinary business income
        for self-employment tax purposes?
        In determining how different partners treat their share of ordinary business income, the
        IRS assesses the involvement the partner has in the partnership. General partners are
        considered to be actively involved in the management of the partnership. Thus, the
        general partner’s share of ordinary business income is treated as trade or business
        income and is subject to self-employment tax. Conversely, limited partners are generally
        not actively involved with managing the partnership. The limited partner’s share of
        ordinary business income is treated as investment income and not subject to self-
        employment tax. Both types of partners must treat guaranteed payments as income
        relating to self-employment; however, the ordinary business income depends on the type
        of partner.

    23. [LO 4] What challenges do LLCs face when deciding whether to treat their members’
        shares of ordinary business income as self-employment income?




                                                  20-7
Chapter 20 - Forming and Operating Partnerships


        Due to the lack of authoritative ruling that exists for LLCs, members must decide on their
        own whether to include ordinary business income as self-employment income or not. A
        proposed regulation gave us clarity on this matter; however, the regulation was
        withdrawn. Members of an LLC should still review this proposed regulation to
        understand the stance the IRS is trying to take and whether they will take an aggressive
        or conservative stance for their specific situation.

        The proposed regulation helped clarify that if an LLC member is involved in the
        operations of the LLC, the member should treat the ordinary business income as self-
        employment income. The regulation listed the following three criteria that would
        demonstrate active involvement in the LLC: (1) personally liable for the debt of the LLC
        as an LLC member, (2) authority to contract on behalf of the LLC, or (3) participate in
        more than 500 hours in the LLC’s trade or business during the taxable year. If any one
        of these requirements is met, then the LLC member would be more associated as a
        general partner and should more than likely account for the ordinary business income as
        self-employment income.

    24. [LO 4] How much flexibility do partnerships have in allocating partnership items to
        partners?
        Partnerships have a great deal of flexibility in determining how to allocate partnership
        items to partners, both separately-stated and non-separately stated items. The
        determining factors must be (1) the partners agree upon the allocations and (2) the
        allocations have substantial economic effect. The second factor is put into place to make
        sure the allocations are being accomplished for a business objective and not just to
        reduce or avoid taxes. While both of these items need to be met for a special allocation
        of a partnership item, certain items have mandatory allocations to specific partners. For
        example, contributed property built-in gain (loss) must be allocated to the partner who
        contributed the property when the property is sold. Any additional gain (loss) will be
        allocated according to the partnership agreement. Overall, if the partnership has no
        mandatory allocations or does not specify and meet the requirements for special
        allocations, the partnership will allocate according to the capital or profit interest.

    25. [LO4] What are the basic tax-filing requirements imposed on partnerships?
        While a partnership does not pay taxes, the IRS still requires all partnerships to file an
        information return to the IRS – Form 1065 (U.S. Return of Partnership Income). This
        form must be filed by the 15th day of the 4th month of the partnership’s year end. For
        calendar year end partnerships, the form must be filed by April 15th. An extension is
        available to file by the due date of the original return and provides the partnership an
        additional five months to file Form 1065. The extension must be filed on Form 7004.




                                                  20-8
Chapter 20 - Forming and Operating Partnerships


        The tax return that must be filed by all partnerships consists of a detailed calculation of
        the partnerships ordinary business income (loss) on page 1 of Form 1065. On page 3 of
        Form 1065, Schedule K must be filled out which lists the ordinary business income (loss)
        along with any separately-stated items. This schedule is an aggregate of each partner’s
        share of items both separately-stated and non-separately stated. In addition, each
        partner’s proportion of the above items is reported on a Schedule K-1. A Schedule K-1
        for every partner must be filed with Form 1065, and each individual partner will receive
        her/his own Schedule K-1 from the partnership.

    26. [LO 5] In what situations do partners need to know the tax basis in their partnership
        interests?
        Partners should always keep track of the tax basis in their partnership interest; however,
        certain situations require partners to actually know their tax basis. These situations
        include when a partner sells her/his partnership interest or when a partner receives a
        distribution from the partnership. The main reasoning is to help the partner figure out
        the amount of gain which s/he most report on her/his current tax return.

    27. [LO 5] Why does a partner’s tax basis in her partnership need to be adjusted annually?
        A partner’s tax basis needs to be adjusted annually for the following three reasons.
        First, a partner does not want to double count any income/gain from the partnership
        when she/he sells her/his partnership interest or receive a distribution from the
        partnership. Second, the IRS does not want partners to double count any expenses/losses
        from the partnership in a similar situation from above. Last, partners want to make sure
        they adjust for tax-exempt income and non-deductible expenses, so these items will not
        ultimately be taxed or deducted at the time of selling a partnership interest or receiving a
        distribution from the partnership.

    28. [LO 5] What items will increase a partner’s basis in her partnership interest?
        The following items will increase a partner’s basis and must be adjusted for on an annual
        basis in the order given.
                1. Actual and deemed cash contributions to the partnership
                2. Partner’s share of ordinary business income
                3. Partner’s share of separately-stated income/gain items and
                4. Partner’s share of tax-exempt income

    29. [LO 5] What items will decrease a partner’s basis in her partnership interest?
        The following items will decrease a partner’s basis and must be adjusted for on an
        annual basis in the order given. These items will be adjusted after all the increases to a
        partner’s basis have been taken into effect.
                1. Actual and deemed cash distributions from the partnership
                2. Partner’s share of non-deductible expenses (fines, penalties, etc.)
                3. Partner’s share of ordinary business losses and
                4. Partner’s share of separately-stated expenses/loss items



                                                  20-9
Chapter 20 - Forming and Operating Partnerships


    30. [LO 6] What hurdles (or limitations) must partners overcome before they can ultimately
        deduct partnership losses on their tax returns?
        While a partnership can create an ordinary business loss, the individual partners
        potentially will not be able to deduct the entire amount in the year of the loss. The
        partner must overcome three loss limitation rules before the deduction is available. If the
        loss does not pass any of the limitations, then the loss is suspended indefinitely under that
        specific hurdle. The three loss limitations are (1) assessing the tax basis of the partner,
        (2) evaluating the at-risk loss limitation, and (3) the passive activity loss limitation.

        First, a partner is not able to take any losses that exceed the tax basis of the partner, the
        partner’s outside basis. This limitation prevents partners from taking losses beyond their
        investment or basis in their partnership interests. Second, a partner cannot take any
        losses that exceed the at-risk limit for the partner. The at-risk limit is generally the same
        as the partner’s tax basis, except for the share of nonrecourse debt attributable to the
        partner. This limit still includes recourse debt and qualified nonrecourse debt. Finally,
        losses cannot be taken if the loss exceeds the amount of passive income reported by the
        partner. Passive losses, losses from rental activities or limited partnerships, can only be
        offset with passive gains.

    31. [LO 6] What happens to partnership losses allocated to partners in excess of the tax basis
        in their partnership interests?
        Losses that are allocated to partners that exceed the partner’s tax basis cannot be used
        during the current taxable year. The excess loss will be suspended and carried forward
        indefinitely until the partner has sufficient basis to utilize the losses. A partner would be
        able to increase her/his tax basis by (1) making a capital contribution, (2) guaranteeing
        more partnership debt, or (3) helping the partnership become more profitable. Once the
        partner’s tax basis is positive, the losses previously suspended can be used.

    32. [LO 6] In what sense is the at-risk loss limitation rule more restrictive than the tax basis
        loss limitation rule?
        While the at-risk loss limitation and tax basis loss limitation are basically the same, one
        difference exists between the two different hurdles a partner must overcome when faced
        with losses. The at-risk loss limitation only accounts for those items that the partner is at
        risk for. The major item that is not included under the at-risk calculation but is included
        in the tax basis is nonrecourse debt. As a note, qualified nonrecourse debt is still
        considered to be part of the partner’s at-risk calculation.




                                                  20-10
Chapter 20 - Forming and Operating Partnerships


    33. [LO 6] How do partners measure the amount they have at risk in the partnership?
        A partner will measure her/his partnership at-risk amount by looking at what items affect
        the partner’s economic risk of loss. In most cases, items included in the at-risk amount
        would include cash contributed, tax basis of property contributed, recourse debt,
        qualified nonrecourse debt, and any other adjustments to the partner’s tax basis
        excluding nonrecourse debt. Nonrecourse debt is considered a part of the tax basis but
        not a part of the at-risk basis since the partner does not have an economic risk of loss for
        this type of debt.

    34. [LO 6] In what order are the loss limitation rules applied to limit partner’s losses from
        partnerships?
        The order of the hurdles a partner must pass for the loss limitation rules are (1) tax basis
        loss limitation, (2) at-risk loss limitation, and (3) passive activity loss limitation. As the
        losses exceed the limitation in each hurdle, the suspended losses will be carried forward
        indefinitely within each group until enough basis or income is generated to cover these
        losses. Once the loss has passed all three limitations, the partner can use the loss as a
        deduction on her/his own personal return.

    35. [LO 6] How do partners determine whether they are passive participants in partnerships
        when applying the passive activity loss limitation rules?
        According to the Code, a partner is considered to be a passive participant if the activity
        conducted is a trade or business and the partner does not materially participate in the
        activity. The IRS has made it clear that those participants in rental activities and limited
        partners within a partnership are automatically considered to be passive participants.

        Further, regulations help clarify whether a partner would be considered a material
        participant. If the partner meets any of the conditions below, then the partner would be a
        material participant and the activity would not be considered a passive activity to the
        partner.

           1. The individual participates in the activity more than 500 hours during the year.
           2. The individual’s activity constitutes substantially all of the participation in such
           activity by individuals.
           3. The individual participates more than 100 hours during the year and the
           individual’s participation is not less than any other individual’s participation in the
           activity.
           4. The activity qualifies as a ―significant participation activity‖ (individual
           participates for more than 100 hours during the year) and the aggregate of all other
           ―significant participation activities‖ is greater than 500 hours for the year.



                                                  20-11
Chapter 20 - Forming and Operating Partnerships




           5. The individual materially participated in the activity for any 5 of the preceding 10
           taxable years.
           6. The activity involves personal services in health, law, accounting, architecture, and
           so on, and the individual materially participated for any three preceding years.
           7. Taking into account all the facts and circumstances, the individual participates on a
           regular, continuous, and substantial basis during the year.

    36. [LO 6] Under what circumstances can partners with passive losses from partnerships
        deduct their passive losses?
        A partner may deduct the passive losses she/he has generated from a partnership under
        three circumstances. First, a passive loss is not deductible until the taxpayer generates
        current year passive income in the activity producing the loss. Second, a passive loss is
        not deductible until the taxpayer generates current year passive income from another
        passive activity the taxpayer is involved with. Last, a passive loss will not be deductible
        unless the taxpayer sells the activity that has produced the passive loss. In this case, the
        taxpayer will report a gain or loss on the sale and can use the passive loss to offset this
        or any other source of income ( i.e., active income, portfolio income, or other passive
        income).




                                                  20-12
Chapter 20 - Forming and Operating Partnerships



    Problems
    37. [LO 2] Joseph contributed $22,000 in cash and equipment with a tax basis of $5,000 and
        a fair market value of $11,000 to Berry Hill Partnership in exchange for a partnership
        interest.
        a. What is Joseph’s tax basis in his partnership interest?
        b. What is Berry Hill’s basis in the equipment?


        a. $27,000.
           Joseph’s tax basis is considered to be his outside basis in the partnership. The tax
           basis includes the $22,000 in cash and his original basis in the equipment, $5,000.
           Joseph’s holding period for his outside basis would depend upon the holding period
           of the assets contributed. All capital or Section 1231 assets tacks onto the
           partnership interest. All other property has a holding period from the date the
           partnership interest is acquired.

        b. $5,000.
           Berry Hill Partnership’s basis in the equipment is a carryover basis from the partner
           who contributed the equipment. The basis in the equipment plus the basis in the cash
           will give us Berry Hill Partnership’s inside basis. The holding period for the
           equipment carries over to the Berry Hill Partnership from Joseph.

    38. [ LO 2] Lance contributed investment property worth $500,000, purchased three years
        ago for $200,000 cash, to Cloud Peak LLC in exchange for an 85 percent profits and
        capital interest in the LLC. Cloud Peak owes $300,000 to its suppliers but has no other
        debts.

        a. What is Lance’s tax basis in his LLC interest?

        b. What is Lance’s holding period in his interest?

        c. What is Cloud Peak’s basis in the contributed property?

        d. What is Cloud Peak’s holding period in the contributed property?


        a. $455,000.
           Lance’s basis in his LLC interest is made up of the $200,000 basis of the investment
           property he transferred to the LLC and his $255,000 share of the LLC debt (85% x
           $300,000). Because LLC general debt obligations are treated as nonrecourse debt,
           Lance’s profit sharing ratio is used to allocate a portion of the LLC debt to him.

        b. Three years.


                                                  20-13
Chapter 20 - Forming and Operating Partnerships


            Because Lance contributed a capital asset, the holding period of the contributed
            assets ―tacks onto‖ his partnership interest.

        c. $200,000.
           The LLC takes a carryover basis in the contributed property.

        d. Three years.
           The LLC inherits Lance’s holding period in the contributed property.

    39. [ LO 2] Laurel contributed equipment worth $200,000, purchased 10 months ago
       (acquired on January 31st) for $250,000 cash and used in her sole proprietorship, to Sand
       Creek LLC in exchange for a 15 percent profits and capital interest in the LLC. Laurel
       agreed to guarantee all $15,000 of Sand Creek’s accounts payable but she did not
       guarantee any portion of the $100,000 nonrecourse mortgage securing Sand Creek’s
       office building. Other than the accounts payable and mortgage, Sand Creek does not owe
       any debts to other creditors.

        a. What is Laurel’s initial tax basis in her LLC interest?

        b. What is Laurel’s holding period in her interest?

        c. What is Sand Creek’s initial basis in the contributed property?

        d. What is Sand Creek’s holding period in the contributed property?



    40. [LO 2] {Planning}Harry and Sally formed the Evergreen partnership by contributing the
        following assets in exchange for a 50 percent capital and profits interest in the
        partnership:

        Harry:                                    Basis Fair Market Value
        Cash                                   $ 30,000     $ 30,000
        Land                                    100,000      120,000
         Totals                               $ 130,000    $ 150,000

        Sally:
        Equipment used in a business            200,000     150,000
         Totals                               $ 200,000   $ 150,000

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

        b. How much gain or loss will Sally recognize on the contribution?

        c. How could the transaction be structured a different way to get a better result for Sally?




                                                  20-14
Chapter 20 - Forming and Operating Partnerships


        d. What is Harry’s tax basis in his partnership interest?

        e. What is Sally’s tax basis in her partnership interest?

        f. What is Evergreen’s tax basis in its assets?

        g. Prepare a tax basis balance sheet for the Evergreen partnership showing the tax capital
        accounts for the partners.

        a. $0.
           Generally, partners recognize gain on property contributed to a partnership only
           when the cash they are deemed to receive from debt relief exceeds their basis in the
           partnership prior to the deemed distribution. Harry did not have any debt relief.

        b. $0.
           Partners may never recognize loss when property is contributed to a partnership even
           when they are relieved of debt.

        c. Sally should consider selling the property to the partnership rather than contributing
           it. By selling the property, she could recognize the $50,000 built-in loss on the
           equipment.

        d. $130,000.
           Harry’s basis in his partnership interest is simply the combined tax basis in the cash
           and land he contributed to the partnership.




                                                  20-15
Chapter 20 - Forming and Operating Partnerships


        e. $200,000.
           Sally’s basis in her partnership interest equals $200,000 basis in the equipment she
           contributed.

        f. $330,000.
           The partnership’s basis in its assets equals the sum of the partners’ bases in the cash
           ($30,000), in the land ($100,000), and in the equipment ($200,000).

        g. The partnership’s tax basis balance sheet would appear as follows:

                                          Evergreen Partnership
                                        Tax Basis Balance Sheet
                                                            Tax Basis
                            Assets:
                            Cash                                     $30,000
                            Equipment                                200,000
                            Land                                     100,000
                            Totals                                $330,000
                            Capital:
                            Capital-Harry                            130,000
                            Capital-Sally                            200,000
                            Totals                                $330,000



    41. [LO 2] Cosmo contributed land with a fair market value of $400,000 and a tax basis of
        $90,000 to the Y Mountain partnership in exchange for a 25 percent profits and capital
        interest in the partnership. The land is secured by $120,000 of nonrecourse debt. Other
        than this nonrecourse debt, Y Mountain partnership does not have any debt.

         a. How much gain will Cosmo recognize from the contribution?

         b. What is Cosmo’s tax basis in his partnership interest?


        a. $0.
           As reflected in the table below, Cosmo does not recognize any gain because the
           $120,000 of cash he is deemed to receive from debt relief does not exceed his basis in
           Y Mountain prior to this deemed distribution.




                                                  20-16
Chapter 20 - Forming and Operating Partnerships




                            Description                   Cosmo         Explanation
                 (1) Basis in contributed Land              $90,000
                 (2) Nonrecourse mortgage in                $30,000 Nonrecourse
                 excess of basis in contributed                        debt > basis is
                 land                                                  allocated only
                                                                       to Cosmo
                 (3) Remaining nonrecourse                  $22,500 25% x
                 mortgage                                              [120,000 - (2)]
                 (4) Relief from mortgage debt            ($120,000)
                 Cosmo’s initial tax basis in Y             $22,500 (1) + (2) + (3)
                 Mountain                                              + (4)

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

    42. [LO2] Maude, James, Harold and Jenny formed the High Horizon LLC by contributing
        the following assets in exchange for 25 percent capital and profits interests in the LLC:

        Maude:                                    Basis Fair Market Value
        Cash                                   $ 20,000     $ 20,000
        Land*                                   100,000      200,000
         Totals                               $ 120,000    $ 220,000

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

        James, Harold and Jenny each contributed $220,000 in cash.

        a. How much gain or loss will Maude and the other members recognize?

        b. What is Maude’s tax basis in her LLC interest?

        c. What tax basis do James, Harold, and Jenny have in their LLC interests?

        d. What is High Horizon’s tax basis in its assets?

        e. Prepare a tax basis balance sheet for the High Horizon LLC showing the tax capital
        accounts for the members.

        a. $0.
           None of the partners recognize gain because their debt relief was not in excess of
           their bases in their partnership interest prior to any debt relief. See table below:


                                                  20-17
Chapter 20 - Forming and Operating Partnerships




                   Description                    Maude           Other        Explanation
                                                                Members
        (1) Basis in contributed Land              $100,000
        (2) Cash contributed                        $20,000     $220,000
        (3) Nonrecourse mortgage in                 $60,000                   Nonrecourse
        excess of basis in contributed                                        debt > basis is
        land                                                                  allocated only
                                                                              to Maude
        (4) Remaining nonrecourse                   $25,000      $25,000      25% x
        mortgage                                                              [160,000 - (3)]
        (5) Relief from mortgage debt             ($160,000)
        Each member’s initial tax                   $45,000     $245,000      (1) + (2) + (3)
        basis in the LLC                                                      + (4) + (5)

        b. $45,000.
           See table in part a. above.

        c. $245,000 each.
           See table in part a. above.

        d. $780,000.
           High Horizon takes a $120,000 carryover basis in the assets Maude contributes and a
           $660,000 in the total cash the other three members contributed.

        e. High Horizon’s tax basis balance sheet would appear as follows:

                                           High Horizons, LLC
                                        Tax Basis Balance Sheet
                                                               Tax Basis
                            Assets:
                            Cash                                   $680,000
                            Land                                    100,000
                            Totals                                  780,000




                                                   20-18
Chapter 20 - Forming and Operating Partnerships




                            Liabilities and Capital:
                            Mortgage debt                        160,000
                            Capital-Maude                        (40,000)
                            Capital-James                        220,000
                            Capital-Harold                       220,000
                            Capital-Jenny                        220,000
                            Totals                               780,000

            Note that the members’ tax capital accounts are equal to their bases in the LLC
            interests less their individual shares of LLC debt.

    43. [LO2] Kevan, Jerry, and Dave formed Albee LLC. Jerry and Dave each contributed
        $245,000 in cash. Kevan contributed the following assets:

        Kevan:                                    Basis Fair Market Value
        Cash                                   $ 15,000      $ 15,000
        Land*                                   120,000       230,000
         Totals                               $ 135,000    $ 245,000

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

        Each member received a one-third capital and profits interest in the LLC.

        a. How much gain or loss will Jerry, Dave and Kevan recognize on the contributions?

        b. What is Kevan’s tax basis in his LLC interest?

        c. What tax basis do Jerry and Dave have in their LLC interests?

        d. What is Albee LLC’s tax basis in its assets?

        e. Prepare a tax basis balance sheet for the Albee LLC showing the tax capital accounts
        for the members. What is Kevan’s share of the LLC’s inside basis?

        f. If the lender holding the nonrecourse debt secured by Kevan’s land required Kevan to
        guarantee 33.33 percent of the debt and Jerry to guarantee the remaining 66.67 percent of
        the debt when Albee LLC was formed, how much gain or loss will Kevan recognize?

        g. If the lender holding the nonrecourse debt secured by Kevan’s land required Kevan to
        guarantee 33.33 percent of the debt and Jerry to guarantee the remaining 66.67 percent of
        the debt when Albee LLC was formed, what are the members’ tax bases in their LLC
        interests?


                                                  20-19
Chapter 20 - Forming and Operating Partnerships




        a. $0.
           None of the partners recognize gain because their debt relief was not in excess of
           their bases in their partnership interest prior to any debt relief. See table below:

                   Description                    Kevan         Other        Explanation
                                                               Members
        (1) Basis in contributed Land              $120,000
        (2) Cash contributed                        $15,000    $245,000
        (3) Nonrecourse mortgage in                 $90,000                 Nonrecourse
        excess of basis in contributed                                      debt > basis is
        land                                                                allocated only
                                                                            to Kevan
        (4) Remaining nonrecourse                   $40,000    $40,000      33.3% x
        mortgage                                                            [$210,000 -
                                                                            (3)]
        (5) Relief from mortgage debt             ($210,000)
        Each member’s initial tax                   $55,000    $285,000     (1) + (2) + (3)
        basis in the LLC                                                    + (4)+ (5)

        b. $55,000.
           See table in part a. above.

        c. $285,000 each.
           See table in part a. above.

        d. $625,000.
           Albee, LLC takes a $135,000 carryover basis in the assets Kevan contributes and a
           $490,000 in the total cash the other two members contributed.




                                                   20-20
Chapter 20 - Forming and Operating Partnerships


        e. Albee, LLC’s tax basis balance sheet would appear as follows:

                                                  Albee , LLC
                                        Tax Basis Balance Sheet
                                                                     Tax Basis
                            Assets:
                            Cash                                         $505,000
                            Land                                          120,000
                            Totals                                        625,000
                            Liabilities and Capital:
                            Mortgage debt                                 210,000
                            Capital-Kevan                                 (75,000)
                            Capital-Jerry                                 245,000
                            Capital-Dave                                  245,000
                            Totals                                        625,000

            Note that the members’ tax capital accounts are equal to their bases in the LLC
            interests less their individual shares of LLC debt.

        f. $5,000. See table below:

              Description                Kevan               Jerry           Dave       Explanation
       (1) Basis in contributed           $120,000
       Land
       (2) Cash contributed                $15,000           $245,000       $245,000
       (3) Mortgage                        $70,000           $140,000                $0 33.33% x
       Guarantee                                                                        $210,000
                                                                                        for Kevan
                                                                                        and 66.67%
                                                                                        x $210,000
                                                                                        for Jerry
       (4) Relief from                  ($210,000)
       mortgage debt



                                                     20-21
Chapter 20 - Forming and Operating Partnerships




       (5) Gain Recognized                   $5,000             $0          $0 [(1)+ (2)+
                                                                                (3) + (4)]
       Each member’s initial                      $0       $385,000   $245,000 (1) + (2) +
       tax basis in the LLC                                                     (3)+ (4) +
                                                                                (5)

        g. Kevan’s basis is $0, Jerry’s basis is $385,000, and Dave’s basis is $245,000. See the
           table in part f. above.

    44. [LO2] {Research} Jim has decided to contribute some equipment he previously used in
        his sole proprietorship in exchange for a 10 percent profits and capital interest in Fast
        Choppers LLC. Jim originally paid $200,000 cash for the equipment. Since then, the tax
        basis in the equipment has been reduced to $100,000 because of tax depreciation, and the
        fair market value of the equipment is now $150,000.

        a. Must Jim recognize any of the potential § 1245 recapture when he contributes the
        machinery to Fast Choppers? {Hint: See § 1245(b)(3).}

        b. What cost recovery method will Fast Choppers use to depreciate the machinery?
        {Hint: See § 168(i)(7).}

        c. If Fast Choppers were to immediately sell the equipment Jim contributed for $150,000,
        how much gain would Jim recognize and what is its character? {Hint: See § 1245 and
        704(c).}

        a. According to Section 1245(b)(3), recapture potential on property contributed to a
           partnership is only recognized to the extent any gain is recognized from the
           contribution of property. Because Jim was not relieved of any debt in the transaction,
           he will not recognize gain from the contribution under Section 721. Therefore, Jim
           does not recognize any of the Section 1245 recapture potential on the equipment at
           the time of contribution.

        b. According to Section 168(i)(7), a transferee partnership will step into the shoes of the
           transferor partner for purposes of depreciating contributed equipment. In this
           situation, Fast Choppers will continue to depreciate the equipment using the same
           method instituted by Jim over the remaining useful life of the equipment. In other
           words, the annual depreciation calculation will proceed as if the property were still
           held by Jim.




                                                   20-22
Chapter 20 - Forming and Operating Partnerships


        c. Under Section 704(c), all $50,000 of gain recognized from the sale of the equipment
           would be allocated to Jim because this gain was built-in at the time the equipment
           was contributed. Moreover, the Section 1245 recapture potential remains with the
           equipment after the contribution; as a result, all $50,000 of gain recognized (the
           lesser of the $50,000 gain recognized or the $100,000 depreciation taken) must be
           characterized as Section 1245 recapture income.

    45. [LO2] {Research} Ansel purchased raw land three years ago for $200,000 to hold as an
        investment. After watching the value of the land drop to $150,000, he decided to
        contribute it to Mountainside Developers LLC in exchange for a 5 percent capital and
        profits interest. Mountainside plans to develop the property and will treat it as inventory,
        like all of the other real estate it holds.

        a. If Mountainside sells the property for $150,000 after holding it for one year, how much
        gain or loss does it recognize and what is the character of its gain or loss? {Hint: See
        §724.}

        b. If Mountainside sells the property for $125,000 after holding it for two years, how
        much gain or loss does it recognize and what is the character of the gain or loss?

        c. If Mountainside sells the property for $150,000 after holding it six years, how much
        gain or loss is recognized and what is the character of the gain or loss?

        a. According to Section 724(c), recognized losses on assets that were capital assets in
           the hands of contributing partners are treated as capital losses up to the amount of
           loss built into the assets at the time they were contributed if they are sold within a five
           year period beginning on the date of contribution. Thus, Mountainside Developers
           will recognize a $50,000 loss characterized as a capital rather than an ordinary loss.

        b. In this instance, Mountainside Developers will recognize a $75,000 loss from the sale
           of the land. The built-in loss at the time the land was contributed or $50,000 will be
           characterized as a capital loss, and the remaining $25,000 loss will be characterized
           as an ordinary loss per Section 724(c).

        c. Because Mountainside Developers held the land as inventory for more than five
           years, it will recognize a $50,000 ordinary loss per Section 724(c).

    46. [LO2] {Research} Claude purchased raw land three years ago for $1,500,000 to develop
        into lots and sell to individuals planning to build their dream homes. Claude intended to
        treat this property as inventory, like his other development properties. Before completing
        the development of the property, however, he decided to contribute it to South Peak
        Investors LLC when it was worth $2,500,000, in exchange for a 10 percent capital and
        profits interest. South Peak’s strategy is to hold land for investment purposes only and
        then sell it later at a gain.




                                                  20-23
Chapter 20 - Forming and Operating Partnerships


        a. If South Peak sells the property for $3,000,000 four years after Claude’s contribution,
        how much gain or loss is recognized and what is its character? {Hint: See § 724.}

        b. If South Peak sells the property for $3,000,000 five and one-half years after Claude’s
        contribution, how much gain or loss is recognized and what is its character?

        a. Under Section 724(b), any gain or loss on contributed property that was treated as
           inventory by the contributing partner and sold by the partnership during the five year
           period beginning on the date of contribution is treated as ordinary gain or loss.
           Thus, the entire $1,500,000 gain from the sale of the land will be treated as ordinary
           gain.

        b. Section 724(b) only applies if contributed property is sold during the five year period
           beginning on the date of contribution. Because South Peak sold the land after the
           expiration of this time period and held the land as investment property, it should
           recognize $1,500,000 of capital gain.

    47. [LO2] {Research} Reggie contributed $10,000 in cash and a capital asset he had held for
        three years with a fair market value of $20,000 and tax basis of $10,000 for a 5 percent
        capital and profits interest in Green Valley LLC.

        a. If Reggie sells his LLC interest thirteen months later for $30,000 when the tax basis in
        his partnership interest is still $20,000, how much gain does he report and what is its
        character?

        b. If Reggie sells his LLC interest two months later for $30,000 when the tax basis in his
        partnership interest is still $20,000, how much gain does he report and what is its
        character? {Hint: See Reg. §1.1223-3}




                                                  20-24
Chapter 20 - Forming and Operating Partnerships


    48. [LO2] Connie recently provided legal services to the Winterhaven LLC and received a 5
        percent interest in the LLC as compensation. Winterhaven currently has $50,000 of
        accounts payable and no other debt. The current fair market value of Winterhaven’s
        capital is $200,000.

        a. If Connie receives a 5 percent capital interest only, how much income must she report
        and what is her tax basis in the LLC interest?

        b. If Connie receives a 5 percent profits interest only, how much income must she report
        and what is her tax basis in the LLC interest?

        c. If Connie receives a 5 percent capital and profits interest, how much income must she
        report and what is her tax basis in the LLC interest?

        a. Connie reports $10,000 of ordinary income or 5 percent of the LLC’s capital of
           $200,000. Her basis in the LLC interest is also $10,000.

        b. Connie will not report any income but will have a basis in the LLC interest equal to
           her share of the LLC’s debt. Because the LLC’s debt is a nonrecourse debt, it must
           be allocated to her using Connie’s profits interest. Thus, her basis in the LLC equals
           $2,500 or 5 percent of the LLC’s $50,000 accounts payable.

        c. Connie reports $10,000 of ordinary income or 5 percent of the LLC’s capital of
           $200,000. Her basis in the LLC is $12,500 consisting of the $10,000 of income she
           recognizes for the receipt of her capital interest and her $2,500 share of the LLC’s
           nonrecourse accounts payable.

    49. [LO2] Mary and Scott formed a partnership that maintains its records on a calendar-year
        basis. The balance sheet of the MS Partnership at year-end is as follows:

                                                  Basis             Fair Market Value
        Cash                                      $ 60                      $ 60
        Land                                        60                       180
        Inventory                                   72                        60
                                                  $192                     $300

        Mary                                      $ 96                       $150
        Scott                                       96                        150
                                                  $192                       $300

        At the end of the current year, Kari will receive a one-third capital interest only in
        exchange for services rendered. Kari’s interest will not be subject to a substantial risk of
        forfeiture and the costs for the type of services she provided are typically not capitalized
        by the partnership. For the current year, the income and expenses from operations are
        equal. Consequently, the only tax consequences for the year are those relating to the
        admission of Kari to the partnership.



                                                   20-25
Chapter 20 - Forming and Operating Partnerships




        a. Compute and characterize any gain or loss Kari may have to recognize as a result of
        her admission to the partnership.

        b. Compute Kari’s basis in her partnership interest.

        c. Prepare a balance sheet of the partnership immediately after Kari’s admission showing
        the partners’ tax capital accounts and capital accounts stated at fair market value.

        d. Calculate how much gain or loss Kari would have to recognize if, instead of a capital
        interest, she only received a profits interest.

        a. Kari will recognize one-third of the fair market value of the partnership’s capital or
           $100 as ordinary income.

        b. Kari’s basis in her partnership interest will be equal to the amount of income she
           reports or $100.

        c. Immediately after Kari’s admission into the partnership the partnership’s balance
           sheet will appear as follows:



                                              MS Partnership
                                                  Balance Sheet
                                                       Tax Basis          704(b)/FMV
                Assets:
                Cash                                               $60                  60
                Land                                                60                 180
                Inventory                                           72                  60
                Totals                                             $192                300
                Capital:
                Capital-Mary                                        46                 100
                Capital-Scott                                       46                 100
                Capital-Kari                                       100                 100
                Totals                                             $192            $300


            Essentially, the tax capital and 704(b) capital accounts for both Scott and Mary are
            reduced by their $50 share of the $100 compensation expense the partnership will
            deduct for the capital interest Kari receives.




                                                      20-26
Chapter 20 - Forming and Operating Partnerships


        d. If Kari only receives a profits interest, she will not recognize any income until she
           receives a profits allocation from the partnership.

    50. [LO2] Dave LaCroix recently received a 10 percent capital and profits interest in Cirque
        Capital LLC in exchange for consulting services he provided. If Cirque Capital had paid
        an outsider to provide the advice, it would have deducted the payment as compensation
        expense. Cirque Capital’s balance sheet on the day Dave received his capital interest
        appears below:

        Assets:                                 Basis   Fair Market Value
          Cash                                $ 150,000    $ 150,000
          Investments                           200,000      700,000
          Land                                  150,000      250,000
             Totals                           $ 500,000   $1,100,000

        Liabilities and capital:
          Nonrecourse Debt                      100,000       100,000
          Lance*                                200,000       500,000
          Robert*                               200,000       500,000
           Totals                             $ 500,000   $ 1,100,000

           *Assume that Lance’s basis and Robert’s basis in their LLC interests equal their tax
           basis capital accounts.

        a. Compute and characterize any gain or loss Dave may have to recognize as a result of
        his admission to Cirque Capital.

        b. Compute each member’s tax basis in his LLC interest immediately after Dave’s receipt
        of his interest.

        c. Prepare a balance sheet for Cirque Capital immediately after Dave’s admission
        showing the members’ tax capital accounts and their capital accounts stated at fair market
        value.

        d. Compute and characterize any gain or loss Dave may have to recognize as a result of
        his admission to Cirque Capital if he receives only a profits interest.

        e. Compute each member’s tax basis in his LLC interest immediately after Dave’s receipt
        of his interest if Dave only receives a profits interest.

        a. The tax consequences of giving Dave both a 10 percent capital and profits interest
           are summarized in the following table:




                                                  20-27
Chapter 20 - Forming and Operating Partnerships




            Description         Dave         Lance            Robert                    Explanation
         (1) Beginning               $0     $250,000          $250,000 $200,000 tax basis capital
         Basis in LLC                                                       account + [.5 x $100,000
                                                                            nonrecourse debt]
         (2) Ordinary         $100,000                                      Liquidation Value of Capital
         Income                                                             Interest (.1 x $1,000,000 fair
                                                                            market value of LLC capital)
         (3) Ordinary                       ($50,000)         ($50,000) Capital Shift from Non-Service
         Deduction                                                          Partners.
                                                                            (2) x .5
         (4) Increase in       $10,000                                      [$100,000 nonrecourse debt x
         Debt Allocation                                                    10% profit sharing ratio]
         (5) Decrease in                      (5,000)             (5,000)                 (4) x .5
         Debt Allocation
         (6) Ending           $110,000      $195,000          $195,000         (1) + (2) + (3) + (4) + (5)
         Basis in LLC


            As indicated in line (2) of the table above, Dave recognizes $100,000 of ordinary
            income.

        b. As indicated in line (6) of the table above, the member’s tax bases in the LLC
           interests immediately after Dave is admitted are as follows: $110,000 for Dave and
           $195,000 for Lance and Robert.

        c. Immediately after Dave’s admission into the LLC, the LLC’s balance sheet will
           appear as follows:

                                                  Cirque, LLC
                                                  Balance Sheet
                                                        Tax Basis              704(b/)FMV
                Assets:
                Cash                                          $150,000                  $150,000
                Land                                           200,000                   700,000
                Inventory                                      150,000                   250,000
                Totals                                        $500,000                 $1,100,000




                                                      20-28
Chapter 20 - Forming and Operating Partnerships




                Capital:
                Nonrecourse Debt                          $100,000         100,000
                Capital-Lance                              150,000         450,000
                Capital-Robert                             150,000         450,000
                Capital-Dave                               100,000         100,000
                Totals                                    $500,000      $1,100,000


        d. The tax consequences of giving Dave only a 10 percent profits interest are
           summarized in the following table:




                                                  20-29
Chapter 20 - Forming and Operating Partnerships




          Description        Dave         Lance         Robert                  Explanation
          (1)                     $0     $250,000        $250,000 $200,000 tax basis capital
          Beginning                                                    account + [.5 x $100,000
          Basis in LLC                                                 nonrecourse debt]
          (2) Ordinary            $0                                   Dave does not recognize any
          Income                                                       income because he only
                                                                       receives a profits interest.
          (3) Increase      $10,000                                    [$100,000 nonrecourse debt
          in Debt                                                      x 10% profit sharing ratio]
          Allocation
          (4) Decrease                     (5,000)           (5,000)               (3) x .5
          in Debt
          Allocation
          (5) Ending        $10,000      $245,000        $245,000           (1) + (2) + (3) + (4)
          Basis in LLC


            Dave does not recognize any income because he only received a profits interest.

        e. As reflected in line (5) of the table above, Dave’s basis is $10,000, Lance’s basis is
           $245,000, and Robert’s basis is $245,000.

    51. [LO 2] Last December 31, Ramon sold the 10 percent interest in the Del Sol Partnership
        that he had held for two years to Garrett for $400,000. Prior to selling his interest,
        Ramon’s basis in Del Sol was $200,000 which included a $100,000 share of nonrecourse
        debt allocated to him.

        a. What is Garrett’s tax basis in his partnership interest?

        b. If Garrett sells his partnership interests three months after receiving it and recognizes a
        gain, what is the character of his gain?




                                                     20-30
Chapter 20 - Forming and Operating Partnerships


        a. Garrett’s basis in his partnership interest is equal to the $400,000 amount he paid for
           it plus his $100,000 share of partnership debt or $500,000.

        b. Because Garrett purchased his partnership interest, his holding period for the
           interest begins on the date the interest was purchased. As a result, he only has a
           three month holding period before the partnership interest is sold. This means his
           capital gain from the sale of his partnership interest will be short-term capital gain.

    52. [LO 3] Broken Rock LLC was recently formed with the following members:

                      Name                  Tax Year End     Capital/Profits %
               George Allen                  December 31          33.3%
               Elanax Corp.                    June 30            33.3%
               Ray Kirk                      December 31          33.3%

        What is the required taxable year-end for Broken Rock LLC?

        George Allen and Ray Kirk together own more than 50 percent of the profits and capital
        of Broken Rock. Because both George and Ray have a December 31 year end, December
        31 is majority interest taxable year and is also the required year end for Broken Rock.

    53. [LO 3] Granite Slab LLC was recently formed with the following members:

                       Name                 Tax Year End     Capital/Profits %
               Nelson Black                  December 31          22.0%
               Brittany Jones                December 31          24.0%
               Lone Pine, LLC                   June 30            4.5%
               Red Spot, Inc.                 October 31           4.5%
               Pale Rock, Inc.              September 30           4.5%
               Thunder Ridge, LLC               July 31            4.5%
               Alpensee, LLC                   March 31            4.5%
               Lakewood, Inc.                   June 30            4.5%
               Streamside, LLC                October 31           4.5%
               Burnt Fork, Inc.               October 31           4.5%
               Snowy Ridge, LP                  June 30            4.5%
               Whitewater, LP                 October 31           4.5%
               Straw Hat, LLC                 January 31           4.5%
               Wildfire, Inc.               September 30           4.5%

        What is the required taxable year-end for Granite Slab LLC?

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


                                                  20-31
Chapter 20 - Forming and Operating Partnerships




    54. [LO 3] Tall Tree LLC was recently formed with the following members:

                        Name                Tax Year End       Capital/Profits %
                Eddie Robinson               December 31             40%
                Pitcher Lenders, LLC           June 30               25%
                Perry Homes, Inc.             October 31             35%

          What is the required taxable year-end for Tall Tree LLC?

    55. [LO 3] Rock Creek LLC was recently formed with the following members:

                       Name                 Tax Year End       Capital/Profits %
                Mark Banks                   December 31             35%
                Highball Properties,          March 31               25%
                LLC
                Chavez Builders, Inc.        November 30                40%

          What is the required taxable year-end for Rock Creek LLC?

          Rock Creek does not have a majority interest taxable year because no partner or group
          of partners with the same year end owns more than 50 percent of the profits and capital
          interests in Rock Creek. Also, because all three principal partners in Rock Creek have
          different year ends, the principal partner test is not met. As a result, Rock Creek must
          decide which of three potential year ends, December 31, March 31, or November 30, will
          provide its members the least aggregate deferral. The table below illustrates the
          required computations:

           Possible Year Ends              12/31 Year End       3/31 Year End        11/30 Year End


     Members           %        Tax      Months      % x MD    Months         %x      Months     %x
                                Year    Deferral*             Deferral*       MD     Deferral*   MD
                                          (MD)                 (MD)                   (MD)
  Mark Banks         35%        12/31       0           0        9            3.15      1        .35
  Highball           25%        3/31        3          .75       0             0        4         1
  Properties,
  LLC
  Chavez             40%        11/30       11         4.4       8            3.2       0         0
  Builders,Inc.
  Total                                                5.15                   6.35               1.35
  Aggregate




                                                    20-32
Chapter 20 - Forming and Operating Partnerships


  Deferral
  *Months deferral equals number of members between proposed year end and partner’s year end.


    As the table above indicates, Rock Creek must use November 30 as its year end because it
    provides the least amount of aggregate deferral to the members.




                                                  20-33
Chapter 20 - Forming and Operating Partnerships


    56. [LO 3]{Research} Ryan, Dahir, and Bill have operated Broken Feather LLC for the last
        four years using a calendar year-end. Each has a one-third interest. Since they began
        operating, their busy season has run from June through August, with 35 percent of their
        gross receipts coming in July and August. The members would like to change their tax
        year-end and have asked you to address the following questions:

        a. Can they change to an August 31 year-end and, if so, how do they make the change?
        {Hint: See Rev. Proc. 2002-38.}
        b. Can they change to a September 30 year-end and, if so, how do they make the change?
        {Hint: See § 444.}

        a. If Broken Feather can establish that 25 percent of its gross receipts for the current
           twelve month period ending on August 31 fell within the months of July and August,
           and it can establish the same thing for the two preceding years ending on August 31,
           then Broken Feather can change its year end to August 31 under Rev. Proc. 2002-38.

        b. Under Section 444, Broken Feather can elect to have its year end fall up to three
           months ahead of its normal required calendar year end. Thus, it may elect to have a
           September 30, October 31, or November 30 year end under Section 444. However, if
           it makes the Section 444 election, it must calculate and deposit a Section 7519
           payment with the IRS to offset the deferral benefit the partners receive by having the
           year end fall before December 31.

    57. [LO 3] {Research}Ashlee, Hiroki, Kate, and Albee LLC each own a 25 percent interest
        in Tally Industries LLC, which generates annual gross receipts of over $10 million.
        Ashlee, Hiroki, and Kate manage the business, but Albee LLC is a nonmanaging
        member. Although Tally Industries has historically been profitable, for the last three
        years losses have been allocated to the members. Given these facts, the members want to
        know whether Tally Industries can use the cash method of accounting. Why or why not?
        {Hint: See § 448(b)(3)}

        Generally, partnerships without corporate partners may use the cash method of
        accounting. However, partnerships that are tax shelters may not use the cash method of
        accounting. According to Section 448(b)(3), partnerships defined as ―tax shelters‖ are
        ineligible to use the cash method. Section 461(i)(3)(B) includes ―syndicates‖ among the
        other categories of ―tax shelters‖. Section 1256(e)(3)(B) defines a syndicate as any
        partnership that allocates more than 35 percent of its losses to either limited partners or
        ―limited entrepreneurs‖. In addition to limited partnerships, this provision likely also
        applies to LLCs because Section 464(e)(2) defines a limited entrepreneur as any person,
        including LLC members, other than a limited partner, who does not actively participate
        in the management of the enterprise. In summary, if more than 35 percent of losses in a
        given year are allocated to either limited partners or to LLC members not actively
        participating in the management of an LLC, the limited partnership or LLC will be not be
        permitted to use the cash method. Because of these restrictions, a significant number of
        limited partnerships and LLCs that would otherwise qualify are denied the use of the
        cash method.



                                                  20-34
Chapter 20 - Forming and Operating Partnerships


        Because only 25 percent of Tally Industries’ loss for the year is allocated to a member
        that does not actively participate in management and it does not have a corporate
        member, Tally will be able to use the cash method.

    58. [LO 4] Turtle Creek Partnership had the following revenues, expenses, gains, losses, and
        distributions:

        Sales revenue                                                        $40,000
        Long-term capital gains                                               $2,000
        Cost of goods sold                                                  ($13,000)
        Depreciation - MACRS                                                 ($3,000)
        Amortization of organization costs                                   ($1,000)
        Guaranteed payments to partners for general management              ($10,000)
        Cash distributions to partners                                       ($2,000)

        Given these items, what is Turtle Creek’s ordinary business income (loss) for the year?

        Turtle Creek’s ordinary business income is calculated in the table below:

                                          Description                Amount
                     Sales revenue                                      $40,000
                     Less:
                     Cost of good sold                                 (13,000)
                     Depreciation - MACRS                                (3,000)
                     Amortization of organization costs                  (1,000)
                     Guaranteed payments                               (10,000)
                     Ordinary Business Income                           $13,000
                     Separately Stated Items on Schedule K-1:
                     Long-term capital gains                             $2,000
                     Guaranteed payments                                $10,000
                     Cash distributions                                  $2,000



        Note that guaranteed payments must be separately disclosed to the partners that receive
        them, and cash distributions must be separately disclosed so that partners can reduce the
        tax basis of their partnership interests by the amount of the distributions.




                                                    20-35
Chapter 20 - Forming and Operating Partnerships


    59. [LO 4] Georgio owns a 20 percent profits and capital interest in Rain Tree LLC. For the
        current year, Rain Tree had the following revenues, expenses, gains, and losses:

        Sales revenue                                                       $70,000
        Gain on sale of land (§1231)                                        $11,000
        Cost of goods sold                                                 ($26,000)
        Depreciation - MACRS                                                ($3,000)
        Section 179 deduction*                                             ($10,000)
        Employee wages                                                     ($11,000)
        Fines and penalties                                                 ($3,000)
        Municipal bond interest                                               $6,000
        Short-term capital gains                                             $4,000
        Guaranteed payment to Sandra                                        ($3,000)

        *Assume the §179 property placed in service limitation does not apply.

        a. How much ordinary business income (loss) is allocated to Georgio for the year?

        b. What are Georgio’s separately stated items for the year?

        a. Georgio’s allocation of ordinary business income is reflected in the table below:



                                Description                    Total          20%
                                                             Amount        Allocated to
                                                                            Georgio
            Sales revenue                                       $70,000
            Less:
            Cost of good sold                                   (26,000)
            Depreciation - MACRS                                 (3,000)
            Employee wages                                      (11,000)
            Guaranteed payments                                  (3,000)
            Ordinary Business Income                            $27,000           $5,400



        b. Georgio’s separately stated items are calculated in the table below:




                                                  20-36
Chapter 20 - Forming and Operating Partnerships




                                Description                    Total           20%
                                                              Amount       Allocated to
                                                                             Georgio
            Separately Stated Items on Schedule K-1:
            Section 1231 gains                                   $11,000         $2,200
            Section 179 deduction                               (10,000)         (2,000)
            Short-term capital gains                               4,000             800
            Municipal bond interest*                               6,000          1,200
            Fines and penalties*                                 (3,000)          (600)


        *Although these amounts are not included in Georgio’s taxable income computation, they
        must be separately disclosed because they affect Georgio’s tax basis in his LLC interest.

    60. [LO 4] The partnership agreement of the G&P general partnership states that Gary will
        receive a guaranteed payment of $13,000, and that Gary and Prudence will share the
        remaining profits or losses in a 45/55 ratio. For year 1, the G&P partnership reports the
        following results:

        Sales revenue                                                        $70,000
        Gain on sale of land (§ 1231)                                         $8,000
        Cost of goods sold                                                  ($38,000)
        Depreciation - MACRS                                                 ($9,000)
        Employee wages                                                      ($14,000)
        Cash charitable contributions                                        ($3,000)
        Municipal bond interest                                               $2,000
        Other expenses                                                       ($2,000)

        a. Compute Gary’s share of ordinary income (loss) and separately stated items to be
        reported on his year 1 Schedule K-1, including his self-employment income (loss).

        b. Compute Gary’s share of self-employment income (loss) to be reported on his year 1
        Schedule K-1, assuming G&P is a limited partnership and Gary is a limited partner.

        c. What do you believe Gary’s share of self-employment income (loss) to be reported on
        his year 1 Schedule K-1 should be, assuming G&P is an LLC and Gary spends 2,000
        hours per year working there full time?




                                                  20-37
Chapter 20 - Forming and Operating Partnerships


        a. Gary’s ordinary business income, separately stated items, and self-employment
           income are calculated in the table below:

               Description                 Total          Allocated to Gary        Explanation
                                         Amount
       Sales revenue                         $70,000
       Less:
       Cost of good sold                    (38,000)
       Depreciation - MACRS                  (9,000)
       Employee wages                       (14,000)
       Other expenses                        (2,000)
       Guaranteed payments                  (13,000)
       Ordinary Business Loss               ($6,000)               ($2,700)     45% allocation to
                                                                                      Gary
       Separately Stated Items on
       Schedule K-1:
       Section 1231 gains                     $8,000                 $3,600     45% allocation to
                                                                                     Gary
       Cash charitable                      ($3,000)               ($1,350)     45% allocation to
                                                                                     Gary
       contributions
       Guaranteed payment                    $13,000               $13,000     Gary’s guaranteed
                                                                                     payment
       Municipal bond interest                $2,000                  $900      45% allocation to
                                                                                      Gary
       Self-employment income                 $7,000               $10,300      ($2,700) ordinary
                                           [$13,000                           business loss allocated
                                         guaranteed                             to Gary + $13,000
                                           payment -                           guaranteed payment
                                              $6,000
                                            ordinary
                                                  loss]




                                                      20-38
Chapter 20 - Forming and Operating Partnerships


        b. If Gary is a limited partner, then his self-employment income would equal the
           $13,000 guaranteed payment he received.

        c. Under Proposed Reg. §1.1402(a)-2, Gary’s $2,700 share of ordinary business loss
           will reduce his $13,000 guaranteed payment leaving him with $10,300 of self-
           employment income (because he spent more than 500 hours working in the trade or
           business of the LLC). In this instance, the proposed regulations provide Gary with a
           favorable interpretation of the law.

    61. [LO 4] {Research} Hoki Poki, a cash-method general partnership, recorded the following
        items for its current tax year:

        Rental real estate income                                              $2,000
        Sales revenue                                                        $70,000
        Section 1245 recapture income                                          $8,000
        Interest income                                                        $2,000
        Cost of goods sold                                                   ($38,000)
        Depreciation - MACRS                                                  ($9,000)
        Supplies expense                                                      ($1,000)
        Employee wages                                                      ($14,000)
        Investment interest expense                                           ($1,000)
        Partner’s medical insurance premiums paid by Hoki Poki                ($3,000)

        As part of preparing Hoki Poki’s current year return, identify the items that should be
        included in computing its ordinary business income (loss) and those that should be
        separately stated. {Hint: See Schedule K-1 and related preparer’s instructions at
        www.irs.gov.}




                                                  20-39
Chapter 20 - Forming and Operating Partnerships




    62. [LO 4] {Research} On the last day of its current tax year, Buy Rite LLC received
        $300,000 when it sold a machine it had purchased for $200,000 three years ago to use in
        its business. At the time of the sale, the basis in the equipment had been reduced to
        $100,000 due to tax depreciation taken. How much did Buy Rite’s self-employment
        earnings increase when the equipment was sold? {Hint: See §1402(a)(3).}

        Buy Rite’s self-employment income does not increase due to the sale of the equipment.
        According to §1402(a)(3)(C), gains from the sale of equipment are not included in Buy
        Rite’s self-employment income. Thus, Buy Rite must insure that the $100,000 of ordinary
        Section 1245 recapture is subtracted from its ordinary business income or loss when
        calculating its self-employment income. Because the remaining $100,000 of Section
        1231 gain is separately stated, it is not included in ordinary business income or loss and
        therefore will not be included in self-employment income.

    63. [LO 4] Jhumpa, Stewart, and Kelly are all one-third partners in the capital and profits of
       Firewalker general partnership. In addition to their normal share of the partnership’s
       annual income, Jhumpa and Stewart receive an annual guaranteed payment of $10,000 to
       compensate them for additional services they provide. Firewalker’s income statement for
       the current year reflects the following revenues and expenses:




                                                  20-40
Chapter 20 - Forming and Operating Partnerships


                 Sales revenue                            $340,000
                 Interest income                              3,300
                 Long-term capital gains                      1,200
                 Cost of good sold                        (120,000)
                 Employee wages                            (75,000)
                 Depreciation expense                      (28,000)
                 Guaranteed payments                        (20,000)
                 Miscellaneous expenses                      (4,500)
                 Overall net income                        $97,000

        a. Given Firewalker’s operating results, how much ordinary business income (loss) and
        what separately stated items [including the partners’ self-employment earnings (loss)]
        will it report on its return for the year?

        b. How will it allocate these amounts to its partners?

        c. How much self-employment tax will each partner pay assuming none have any other
        source of income or loss?




                                                  20-41
Chapter 20 - Forming and Operating Partnerships


        a. The table below illustrates Firewalker’s ordinary business income and separately
           stated items. Note that the total self employment income for all partners consists of
           Firewalker’s $92,500 ordinary business income (because ordinary business income
           from a general partnership is always treated as self-employment income by the
           partners) plus the $20,000 in guaranteed payments made to Dave and Stewart.

                    Description                   Total       Jhumpa    Stewart    Kelly
           Sales revenue                          $340,000
           Less:
           Cost of good sold                      (120,000)
           Employee wages                          (75,000)
           Depreciation expense                    (28,000)
           Misc. expenses                           (4,500)
           Guaranteed payments                     (20,000)
           Ordinary Business Income                $92,500    $30,833    $30,833   $30,833
           Separately Stated Items on
           Schedule K-1:
           Interest income                          $3,300     $1,100     $1,100    $1,100
           Long-term capital gains                  $1,200      $400        $400      $400
           Self-employment income                 $112,500    $40,833    $40,833   $30,833

        b. The table above reflects the partner’s shares of ordinary business income and her/his
           separately stated items. Note that each partner’s self employment income consists of
           her/his individual shares of ordinary business income plus the guaranteed payment
           she/he received, if any.




                                                     20-42
Chapter 20 - Forming and Operating Partnerships


        c. The table below reflects the partner’s self-employment tax liability:

                       Description         Stewart        Jhumpa        Kelly        Explanation
           (1)Self-employment              $40,833            $40,833     $30,833
           income
           (2) Percentage of self           92.35%            92.35%      92.35%
           employment income
           subject to self-employment
           tax
           (3) Earnings from self-         $37,709            $37,709     $28,474      (1) x (2)
           employment
           (4) Self employment tax           15.3%             15.3%       15.3%
           rate
           (7) Self-employment tax           $5,769            $5,769      $4,357      (3) x (4)
           liability



    64. [LO 4] {Research} Lane and Cal each own 50 percent of the profits and capital of
        HighYield LLC. HighYield owns a portfolio of taxable and municipal bonds, and each
        year the portfolio generates approximately $10,000 of taxable interest and $10,000 of tax-
        exempt interest. Lane’s marginal tax rate is 35 percent while Cal’s marginal tax rate is
        15 percent. To take advantage of the difference in their marginal tax rates, Lane and Cal
        want to modify their operating agreement to specially allocate all of the taxable interest to
        Cal and all of the tax-exempt interest to Lane. Until now, Lane and Cal had been
        allocated 50 percent of each type of interest income.

        a. Is HighYield’s proposed special allocation acceptable under current tax rules? Why or
        why not? {Hint: See Reg. §1.704-1(b)(2)(iii)(b) and §1.704-1(b)(5) Example (5).}

        b. If the IRS ultimately disagrees with HighYield’s special allocation, how will it likely
        reallocate the taxable and tax-exempt interest among the members? {Hint: See Reg.
        §1.704-1(b)(5) Example (5)(ii).}

        a. According to IRC §704 partnership allocations will be respected by the IRS unless
           they do not have ―substantial economic effect.‖ The facts provided are almost
           identical to the general scenario described in Reg. §1.704-1(b)(2)(iii)(b) and to the
           detailed facts described in §1.704-1(b)(5) Example (5) given that the special
           allocation to Lane and Cal simply changes the character of the income allocated to
           Lane and Cal but not the amount. Thus, this allocation is not appropriate because it
           is not substantial.




                                                      20-43
Chapter 20 - Forming and Operating Partnerships


        b. As described in Reg. §1.704-1(b)(5) Example (5)(ii), the IRS will likely assert that 50
           percent of both the taxable and tax-exempt bond interest should be allocated to Lane
           and Cal.

    65. [LO 5] Larry’s tax basis in his partnership interest at the beginning of the year was
        $10,000. If his share of the partnership debt increased by $10,000 during the year and his
        share of partnership income for the year is $3,000, what is his tax basis in his partnership
        interest at the end of the year?

        $23,000 as computed in the table below:

                  Description                     Total Amount
         Beginning Tax Basis                                  $10,000
         Increase in Partner’s Share                           10,000
         of Debt
         Partner’s Share of Income                              3,000
         Ending Tax Basis                                     $23,000


    66. [LO 5] Carmine was allocated the following items from the Piccolo LLC for last year:

        Ordinary business loss
        Nondeductible penalties
        Tax-exempt interest income
        Short-term capital gain
        Cash distributions

        Rank these items in terms of the order they should be applied to adjust Carmine’s tax
        basis in Piccolo for the year.

        Items that increase basis are applied first, then distributions, and then items that reduce
        basis. Thus, the items above should be applied in the following order to adjust
        Carmine’s tax basis:

        Tax Exempt Income and Short Term Capital Gain (basis increasing items come first)
        Cash Distribution (distributions come after basis increasing items)
        Ordinary Business Loss and Non-Deductible Penalties (basis reducing items come last)

    67. [LO 5] Oscar, Felix, and Marv are all one-third partners in the capital and profits of
       Eastside general partnership. In addition to their normal share of the partnership’s annual
       income, Oscar and Felix receive annual guaranteed payments of $7,000 to compensate
       them for additional services they provide. Eastside’s income statement for the current
       year reflects the following revenues and expenses:




                                                      20-44
Chapter 20 - Forming and Operating Partnerships


                 Sales revenue                            $ 420,000
                 Dividend income                               5,700
                 Short-term capital gains                      2,800
                 Cost of good sold                         (210,000)
                 Employee wages                            (115,000)
                 Depreciation expense                        (28,000)
                 Guaranteed payments                         (14,000)
                 Miscellaneous expenses                       (9,500)
                 Overall net income                         $ 52,000

        In addition, Eastside owed creditors $120,000 at the beginning of the year but managed to
        pay down its debts to $90,000 by the end of the year. All partnership debt is allocated
        equally among the partners. Finally, Oscar, Felix and Marv had a tax basis of $80,000 in
        their interests at the beginning of the year.

        a. What tax basis do the partners have in their partnership interests at the end of the year?

        b. Assume the partners began the year with a tax basis of $10,000 and all the debt was
        paid off on the last day of the year. How much gain will the partners recognize when the
        debt is paid off? What tax basis do the partners have in their partnership interests at the
        end of the year?




                                                  20-45
Chapter 20 - Forming and Operating Partnerships


        a. All of the partners have an ending tax basis of $87,333 as calculated in the table
           below:

               Description               Oscar                Felix        Marv          Explanation
         (1)Beginning tax basis             $80,000            $80,000     $80,000
         (including partners’
         share of debt)
         (2)Dividend income                  $1,900             $1,900      $1,900        $5,700 x 33.33%
         (3)Short-term capital                 $933               $933        $933        $2,800 x 33.33%
         gains
         (4)Partner’s share of              $14,500            $14,500     $14,500   [$52,000 overall net
         ordinary business                                                             income - ($5,700
         income                                                                       Dividend Income +
                                                                                      $2,800 Short-Term
                                                                                       Capital Gains)] x
                                                                                            33.3%
         (5)Deemed                        ($10,000)           ($10,000)   ($10,000) [$120,000 - $90,000] x
         distribution from debt                                                            33.33%
         repayment
         (6)Guaranteed                            0                   0                 Partners don’t
         payments received                                                           increase the basis of
                                                                                       their partnership
                                                                                   interests by the amount
                                                                                         of guaranteed
                                                                                      payments received
         (7)Ending tax basis                $87,333            $87,333     $87,333    (1)+(2)+(3)+(4)+(5)




                                                      20-46
Chapter 20 - Forming and Operating Partnerships


        b. Each partner recognizes gain of $12,667 and has an ending basis of zero as
           calculated in the table below:

               Description               Oscar                Felix         Marv            Explanation
         (1)Beginning tax Basis             $10,000            $10,000      $10,000
         (including partners’
         share of debt)
         (2)Dividend income                  $1,900             $1,900       $1,900           $5,700 x 33.33%
         (3)Short-term capital                 $933               $933         $933           $2,800 x 33.33%
         gains
         (4)Partner’s share of              $14,500            $14,500      $14,500     [$52,000 overall net
         ordinary business                                                                income - ($5,700
         income                                                                          Dividend Income +
                                                                                         $2,800 Short-Term
                                                                                       Capital Gains)] x 33.3%
         (5)Deemed                        ($40,000)           ($40,000)    ($40,000)      [$120,000 - $0] x
         distribution from debt                                                                33.33%
         repayment
         (6)Guaranteed                            0                   0                Partners don’t increase
         payments received                                                                 the basis of their
                                                                                       partnership interests by
                                                                                             the amount of
                                                                                        guaranteed payments
                                                                                                received
         (7)Gain recognized by              $12,667            $12,667      $12,667    -[(5)+(1)+(2)+(3)+(4)]
         partners
         (8)Ending tax basis                      0                   0            0          Generally
                                                                                       (1)+(2)+(3)+(4)+(5) but
                                                                                        may not go lower than
                                                                                                zero


    68. [LO 5] Pam, Sergei, and Mercedes are all one-third partners in the capital and profits of
        Oak Grove General Partnership. Partnership debt is allocated among the partners in
        accordance with their capital and profits interests. In addition to their normal share of the
        partnership’s annual income, Pam and Sergei receive annual guaranteed payments of
        $20,000 to compensate them for additional services they provide. Oak Grove’s income
        statement for the current year reflects the following revenues and expenses:

                 Sales revenue                                 $476,700
                 Dividend income                                   6,600
                 Section 1231 losses                             (3,800)
                 Cost of good sold                            (245,000)
                 Employee wages                                 (92,000)
                 Depreciation expense                           (31,000)
                 Guaranteed payments                            (40,000)
                 Miscellaneous expenses                         (11,500)
                 Overall net income                            $ 60,000


                                                      20-47
Chapter 20 - Forming and Operating Partnerships




        In addition, Oak Grove owed creditors $90,000 at the beginning and $150,000 at the end
        of the year, and Pam, Sergei and Mercedes had a tax basis of $50,000 in their interests at
        the beginning of the year. Also, Sergei and Mercedes agreed to increase Pam’s capital
        and profits interest from 33.3 percent to 40 percent at the end of the tax year in exchange
        for additional services she provided to the partnership. The liquidation value of the
        additional capital interest Pam received at the end of the tax year is $40,000.

        a. What tax basis do the partners have in their partnership interests at the end of the year?

        b. If, in addition to the expenses listed above, the partnership donated $12,000 to a
        political campaign, what tax basis do the partners have in their partnership interests at the
        end of the year assuming the liquidation value of the additional capital interest Pam
        receives at the end of the year remains at $40,000?

        a. Pam’s basis is $140,000, Sergei’s basis is $65,000, and Mercedes’s basis is $65,000
           as computed in the table below:

                    Description                   Pam       Sergei     Mercedes         Explanation
       (1)Beginning tax basis (including          $50,000   $50,000      $50,000           Given
       partners’ share of debt)
       (2) Dividends income                        $2,200    $2,200       $2,200      $6,600 x 33.33%
                                                                                   (Pam’s profits interest
                                                                                    doesn’t increase until
                                                                                     the end of the year)
       (3)Partner’s share of ordinary             $19,067   $19,067      $19,067    [$60,000 overall net
                                                                                      income - ($6,600
       business income
                                                                                      Dividend Income -
                                                                                   ($3,800) Section 1231
                                                                                      Losses)] x 33.3%
       (4) Debt increase (deemed cash             $30,000   $15,000      $15,000     Pam :[( $150,000 x
       contribution)                                                                 40%) – ($90,000 x
                                                                                          33.33%)]
                                                                                      Other Partners:
                                                                                    [($150,000 x 30%) –
                                                                                    ($90,000 x 33.33%)]




                                                   20-48
Chapter 20 - Forming and Operating Partnerships




       (5) Pam’s new 6.67% capital                 $40,000        ($20,000)     ($20,000)     Additional 6.67%
       interest                                                                             capital interest to Pam
                                                                                                is a guaranteed
                                                                                            payment to Pam and a
                                                                                             deduction allocated
                                                                                               equally to other
                                                                                                    partners
       (6) Cash guaranteed payments                          0             0                     Partners don’t
       received                                                                               increase the basis of
                                                                                                their partnership
                                                                                            interests by the amount
                                                                                               of cash guaranteed
                                                                                               payments received
       (7) Section 1231 losses                     ($1,267) ($1,267)           ($1,267)        ($3,800) x 33.33%
       (8)Ending tax basis                        $140,000         $65,000       $65,000 Sum of (1) through (7)



        b. Pam’s basis is $136,000, Sergei’s basis is $61,000, and Mercedes’ basis is $61,000
           as computed in the table below:

                    Description                    Pam            Sergei       Mercedes          Explanation
       Ending tax basis given facts in part       $140,000         $65,000       $65,000 See solution to part a.
       a.                                                                                   above
       Campaign contribution                      ($4,000)         ($4,000)      ($4,000) ($12,000) x 33.33%
                                                                                            Non-deductible
                                                                                            expenses must reduce
                                                                                            a partner’s tax basis
       New ending basis given facts in part       $136,000       $61,000       $61,000
       b.



    69. [LO 6] Alfonso began the year with a tax basis in his partnership interest of $30,000. His
        share of partnership debt at the beginning and end of the year consists of $5,000 of
        recourse debt and $5,000 of nonrecourse debt. During the year, he was allocated $40,000
        of partnership ordinary business loss. Alfonso does not materially participate in this
        partnership and he has $1,000 of passive income from other sources.




                                                    20-49
Chapter 20 - Forming and Operating Partnerships


        a. How much of Alfonso’s loss is limited by his tax basis?

        b. How much of Alfonso’s loss is limited by his at-risk amount?

        c. How much of Alfonso’s loss is limited by the passive activity loss rules?

        a. Because Alfonso’s basis before the loss allocation is $30,000, $10,000 of his $40,000
           loss allocation is limited by his tax basis and will carryover to the following year.

        b. Of the $30,000 loss not already limited by Alfonso’s tax basis, $5,000 is limited
           because Alfonso’s at-risk amount is only $25,000 ($30,000 regular tax basis less the
           $5,000 nonrecourse debt not allowed in calculating the at-risk amount). Thus,
           $25,000 of loss remains after the tax basis and at-risk limitations and Alfonso has a
           $5,000 at-risk carryover.

        c. Because Alfonso doesn’t materially participate in the partnership, he may only deduct
           the $25,000 loss remaining after the tax basis and at-risk limitations to the extent he
           has passive income from other sources. Thus, he may deduct $1,000 of the $25,000
           loss currently and will have a $24,000 passive activity loss carryover.

    70. [LO 5, 6] {Research} Juan Diego began the year with a tax basis in his partnership
        interest of $50,000. During the year, he was allocated $20,000 of partnership ordinary
        business income, $70,000 of §1231 losses, $30,000 of short-term capital losses, and
        received a cash distribution of $50,000.

        a. What items related to these allocations does Juan Diego actually report on his tax
        return for the year? {Hint: See Reg. §1.704-1(d)(2) and Rev. Rul. 66-94.}

        b. If any deductions or losses are limited, what are the carryover amounts and what is
        their character? {Hint: See Reg. §1.704-1(d).}




                                                  20-50
Chapter 20 - Forming and Operating Partnerships


        a. According to Rev. Rul. 66-94, Juan Diego should increase his basis first by his
           $20,000 share of ordinary business income and then reduce it by his $50,000 cash
           distribution. At this point, his remaining basis of $20,000 will be reduced to zero by
           the $70,000 Section 1231 losses and $30,000 short-term capital losses allocated to
           him. Reg. §1.704-1(d)(2) describes how Juan Diego’s $20,000 tax basis before
           considering the loss allocations should be allocated to the two types of losses. The
           table below illustrates the required calculations:

                                          (1) Original      (2) Amount Deducted         (1) – (2) Loss
                                              Loss                Currently               Carryover
              Section 1231 losses                $70,000           $14,000                      $56,000
                                                                  ($20,000 x
                                                              $70,000/$100,000)
              Short-term capital                  $30,000           $6,000                     $24,000
              losses                                              ($20,000 x
                                                              $30,000/$100,000)


        b. As indicated in the table above, Juan Diego’s $80,000 loss carryover (due to his
           $20,000 tax basis limitation) will be characterized as a $56,000 Section 1231 loss
           and a $24,000 short-term capital loss.

    71. [LO 6] Farell is a member of Sierra Vista LLC. Although Sierra Vista is involved in a
        number of different business ventures, it is not currently involved in real estate either as
        an investor or as a developer. On January 1, year 1, Farell has a $100,000 tax basis in his
        LLC interest that includes his $90,000 share of Sierra Vista’s general debt obligations.
        By the end of the year, Sierra Vista’s general debt obligations have increased to
        $100,000. Because of the time he spends in other endeavors, Farell does not materially
        participate in Sierra Vista. His share of the Sierra Vista losses for year 1 is $120,000 and,
        as a partner in the Riverwoods Partnership, he has year 1 Schedule K-1 passive income of
        $5,000.

        a. Determine how much of the Sierra Vista loss Farell will currently be able to deduct on
        his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive
        activity loss limitations.

        b. Assuming Farrell’s Riverwoods K-1 indicates passive income of $30,000, determine
        how much of the Sierra Vista loss he will ultimately be able to deduct on his tax return
        for year 1 and list the losses suspended due to tax basis, at-risk, and passive activity loss
        limitations.

        c. Assuming Farrell is deemed to be an active participant in Sierra Vista, determine how
        much of the Sierra Vista loss he will ultimately be able to deduct on his tax return for
        year 1 and list the losses suspended due to tax basis, at-risk, and passive activity loss
        limitations.




                                                    20-51
Chapter 20 - Forming and Operating Partnerships


        a.




    72. [LO 6] {Research} Jenkins has a one-third capital and profits interest in the Maverick
        General Partnership. On January 1, year 1, Maverick has $120,000 of general debt
        obligations and Jenkins has a $50,000 tax basis in his partnership interest. During the
        year, Maverick incurred a $30,000 in nonrecourse debt that is not secured by real estate.
        Because Maverick is a rental real estate partnership, Jenkins is deemed to be a passive
        participant in Maverick. His share of the Maverick losses for year 1 is $105,000. Jenkins
        is not involved in any other passive activities and this is the first year he has been
        allocated losses from Maverick.




                                                  20-52
Chapter 20 - Forming and Operating Partnerships


        a. Determine how much of the Maverick loss Jenkins will currently be able to deduct on
        his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive
        activity loss limitations.

        b. If Jenkins sells his interest on January 1, year 2, what happens to his suspended losses
        from year 1? {Hint: See Sennett v. Commissioner 80 TC 825 (1983) and Prop. Reg.
        §1.465-66(a).}


        a. Jenkins may not deduct any losses currently, and he will have a $25,000 loss
           suspended by the tax basis limitation, a $30,000 loss suspended by the at-risk
           limitation, and a $50,000 loss suspended by the passive activity loss limitation as
           illustrated in the table below:




                                                  20-53
Chapter 20 - Forming and Operating Partnerships




              Description         Tax Basis        At-risk      Passive          Explanation
                                  Limitation      Limitation    Activity
                                                               Limitation
           (1) Beginning Tax       $50,000         $50,000                         General debt
           basis and At-risk                                                  obligations of general
           amount                                                           partnerships are treated
                                                                             as recourse debt. Thus,
                                                                              Jenkins’ beginning at-
                                                                             risk amount is the same
                                                                               as his beginning tax
                                                                                       basis.
           (2) Increase in         $30,000           $0                     Nonrecourse debt
           nonrecourse debt                                                 generally not included
                                                                            in at-risk amount.
           (3) Tax basis and       $80,000         $50,000                           (1) + (2)
           At-risk amount
           before ordinary
           business loss
           (4) Ordinary          ($105,000)
           business loss
           (5) Loss clearing      ($80,000)                                 Loss limited to $80,000
           the Tax basis                                                           tax basis
           hurdle
           (6)Loss suspended      ($25,000)                                         (4) - (5)
           by Tax basis
           hurdle
           (7) Loss clearing                      ($80,000)                           (5)
           Tax basis hurdle
           (8) Loss clearing                      ($50,000)                 Loss limited to $50,000
           At-risk hurdle                                                       at-risk amount
           (9) Loss                               ($30,000)                         (7) - (8)
           suspended by At-
           risk hurdle
           (10) Passive                                        ($50,000)       (8)Jenkins is not a
           activity loss                                                      material participant
           (11) Passive                                           $0                 Given
           income
           (12) Loss used to                                      $0          Loss only used to the
           offset Passive                                                   extent of passive income
           income
           (13) Passive                                        ($50,000)          (10) – (12)
           activity loss
           carryover




                                                   20-54
Chapter 20 - Forming and Operating Partnerships


        b. According to Sennett v. Commissioner 80 TC 825 (1983), a partner with losses
           suspended by the tax basis limitation disappear when the partnership interest is sold.
           Thus, Jenkins will lose the $25,000 loss suspended by the tax basis limitation. In
           addition, Prop. Reg. §1.465-66(a) provides that Jenkins may utilize the $30,000 loss
           suspended by the at-risk limitation to offset any gain he would otherwise report from
           the disposition of his partnership interest. Finally, Jenkins may deduct the $50,000
           passive activity loss carryover in the year of disposition.

    73. [LO 6] {Planning} Suki and Steve own 50 percent capital and profits interests in Lorinda
        LLC. Lorinda operates the local minor league baseball team and owns the stadium where
        the team plays. Although the debt incurred to build the stadium was paid off several
        years ago, Lorinda owes its general creditors $300,000 (at the beginning and end of the
        year) that is not secured by firm property or guaranteed by any of the members. At the
        beginning of the current year Suki and Steve had a tax basis of $170,000 in their LLC
        interests including their share of debt owed to the general creditors. Shortly before the
        end of the year they each received a $10,000 cash distribution, even though Lorinda’s
        ordinary business loss for the year was $400,000. Because of the time commitment to
        operate a baseball team, both Suki and Steve spent more than 1,500 hours during the year
        operating Lorinda.

        a. Determine how much of the Lorinda loss Suki and Steve will each be able to deduct on
        their current tax returns, and list their losses suspended by the tax basis, at-risk, and
        passive activity loss limitations.

        b. Assume that sometime before receiving the $10,000 cash distribution, Steve is advised
        by his tax advisor that his marginal tax rate will be abnormally high during the current
        year because of an unexpected windfall. To help Steve utilize more of the losses
        allocated from Lorinda in the current year, his advisor recommends refusing the cash
        distribution and personally guaranteeing $100,000 of Lorinda’s debt, without the right to
        be reimbursed by Suki. If Steve follows his advisor’s recommendations, how much
        additional Lorinda loss can he deduct on his current tax return? How does Steve’s
        decision affect the amount of loss Suki can deduct on her current return and the amount
        and type of her suspended losses?




                                                  20-55
Chapter 20 - Forming and Operating Partnerships


        a. The members (either Steve or Suki) may deduct $10,000 in losses currently, and they
           will have a $40,000 loss suspended by the tax basis limitation, and a $150,000 loss
           suspended by the at-risk limitation as illustrated in the table below:

           Description        Tax Basis            At-risk                 Explanation
                              Limitation          Limitation
       (1) Beginning Tax      $170,000             $20,000     General debt obligations of LLCs are
       basis and At-risk                                        treated as nonrecourse debt. Thus,
       amount                                                     Suki or Steve’s beginning at-risk
                                                                 amount is $150,000 less than their
                                                                        beginning tax basis.
       (2) Distribution        ($10,000)          ($10,000)
       (3) Tax basis and       $160,000            $10,000                   (1) + (2)
       At-risk amount
       before ordinary
       business loss



       (4) Ordinary           ($200,000)                                  $400,000 x50%
       business loss
       (5) Loss clearing      ($160,000)                        Loss limited to $160,000 tax basis
       the Tax basis
       hurdle

       (6)Loss suspended       ($40,000)                                      (4) - (5)
       by Tax basis
       hurdle
       (7) Loss clearing                          ($160,000)                    (5)
       Tax basis hurdle
       (8) Loss clearing                          ($10,000)        Loss limited to $10,000 at-risk
       At-risk hurdle and                                       amount on line (3). This amount is
       currently                                               currently deductible because Steve is
       deductible                                               an active participant in the activity.
       (9) Loss                                   ($150,000)                  (7) - (8)
       suspended by At-
       risk hurdle




                                                      20-56
Chapter 20 - Forming and Operating Partnerships




        Under these facts, Steve may deduct $120,000 in losses currently (a $110,000 increase
        over the loss he could deduct in part a.), and will have a $80,000 loss suspended by the
        at-risk limitation as illustrated in the table below:

               Description        Tax Basis        At-risk             Explanation
                                  Limitation      Limitation
            (1) Beginning Tax     $170,000         $20,000      General debt obligations of
            basis and At-risk                                        LLCs are treated as
            amount                                                nonrecourse debt. Thus,
                                                                  Steve’s beginning at-risk
                                                               amount is $150,000 less than
                                                                   his beginning tax basis.
            (2) Increase in         $50,000       $100,000     [(100,000 + 50% x $200,000)
            debt allocation                                    - $150,000] for tax basis and
                                                                  [100,000 – 0] for at-risk
                                                               amount because guaranteeing
                                                                 the debt makes it recourse
                                                                            debt
            (3) Tax basis and      $220,000       $120,000                (1) + (2)
            At-risk amount
            before ordinary
            business loss
            (4) Ordinary          ($200,000)
            business loss
            (5) Loss clearing     ($200,000)                     Loss is less than tax basis
            the Tax basis                                                 limitation
            hurdle
            (6)Loss suspended          $0                                 (4) - (5)
            by Tax basis                                                                       Suki
            hurdle                                                                             may
            (7) Loss clearing                     ($200,000)                (5)                deduct
            Tax basis hurdle
            (8) Loss clearing                     ($120,000)     Loss is limited to at-risk
            At-risk hurdle and                                   amount on line (3). This
            currently                                               amount is currently
            deductible                                          deductible because Steve is
                                                                an active participant in the
                                                                          activity.
            (9) Loss                              ($80,000)               (7) - (8)
            suspended by At-
            risk hurdle

           $10,000 in losses currently (the same amount of loss as in part a.), and she will have a
           $90,000 loss suspended by the tax basis limitation and a $100,000 loss suspended by
           the at-risk limitation as illustrated in the table below:




                                                   20-57
Chapter 20 - Forming and Operating Partnerships




               Description        Tax Basis        At-risk              Explanation
                                  Limitation      Limitation
            (1) Beginning Tax     $170,000         $20,000      General debt obligations of
            basis and At-risk                                      LLCs are treated as
            amount                                               nonrecourse debt. Thus,
                                                                 Suki’s beginning at-risk
                                                               amount is $150,000 less than
                                                                 her beginning tax basis.
            (2) Distribution       ($10,000)      ($10,000)
            (3) Decrease in        ($50,000)         $0            [($200,000 x 50% ) –
            debt allocation                                         ($300,000 x 50%)]
            (4) Tax basis and      $110,000        $10,000             (1) + (2)+ (3)
            At-risk amount
            before ordinary
            business loss
            (5) Ordinary          ($200,000)
            business loss
            (6) Loss clearing     ($110,000)                   Loss is limited to the tax basis
            the Tax basis
            hurdle

            (6)Loss suspended      ($90,000)                              (5) - (6)
            by Tax basis
            hurdle
            (7) Loss clearing                     ($110,000)                 (6)
            Tax basis hurdle
            (8) Loss clearing                     ($10,000)      Loss is limited to at-risk
            At-risk hurdle and                                   amount on line (4). This
            currently                                              amount is currently
            deductible                                         deductible because Suki is an
                                                                 active participant in the
                                                                          activity.
            (9) Loss                              ($100,000)              (7) - (8)
            suspended by At-
            risk hurdle

    74. [LO 6]{Research} Ray and Chuck own 50 percent capital and profits interests in Alpine
        Properties LLC. Alpine builds and manages rental real estate, and Ray and Chuck each
        work full time (over 1000 hours per year) managing Alpine. Alpine’s debt (both at the
        beginning and end of the year) consists of $1,500,000 in nonrecourse mortgages obtained
        from an unrelated bank and secured by various rental properties. At the beginning of the
        current year, Ray and Chuck each had a tax basis of $250,000 in his LLC interest
        including his share of the nonrecourse mortgage debt. Alpine’s ordinary business losses
        for the current year totaled $600,000 and neither member is involved in other activities
        that generate passive income.




                                                   20-58
Chapter 20 - Forming and Operating Partnerships


        a. How much of each member’s loss is suspended because of the tax basis limitation?

        b. How much of each member’s loss is suspended because of the at-risk limitation?

        c. How much of each member’s loss is suspended because of the passive activity loss
           limitation? {Hint: See §469(b)(7).}

        a. Each member will have $50,000 of loss suspended because of the tax basis limitation
           as reflected in the table below:



              Description         Tax Basis        At-risk      Passive           Explanation
                                  Limitation      Limitation    Activity
                                                               Limitation
           (1) Beginning Tax      $250,000        $250,000                      Because the LLC’s
           basis and At-risk                                                     mortgage debt is
           amount                                                             qualified nonrecourse
                                                                             financing, it is included
                                                                            in both the tax basis and
                                                                                  at-risk amount
           (2) Ordinary          ($300,000)                                      50% x $600,000
           business loss
           (3) Loss clearing     ($250,000)                                 Loss limited to $250,000
           the Tax basis                                                            tax basis
           hurdle
           (4) Loss               ($50,000)                                         (2) - (3)
           suspended by Tax
           basis hurdle
           (5) Loss clearing                      ($250,000)                           (3)
           Tax basis hurdle
           (6) Loss clearing                      ($250,000)                Loss limited to $250,000
           At-risk hurdle                                                        at-risk amount
           (7) Loss                                  $0                              (7) - (8)
           suspended by At-
           risk hurdle
        b. A
           s indicated in the table above, none of the members’ loss allocation will be suspended
           because of the at-risk limitation.

        c. Each member’s $250,000 loss remaining after the tax basis and at-risk limitations
           (see table in part a.) is deductible currently. Although rental real estate ventures are
           generally treated as passive activities under §469(c)(2), §469(b)(7) provides an
           exception for taxpayers that work more than half of the time in real property trades
           or businesses and work more than 750 hours in real property trades or businesses in
           a given year. Given the facts in this problem, both members will be treated as active
           participants and will therefore be able to immediately deduct $250,000.




                                                   20-59
Chapter 20 - Forming and Operating Partnerships



    Comprehensive Problems
    75. [LO 2, 4, 5] Aaron, Deanne, and Keon formed the Blue Bell General Partnership at the
        beginning of the current year. Aaron and Deanne each contributed $110,000 and Keon
        transferred an acre of undeveloped land to the partnership. The land had a tax basis of
        $70,000 and was appraised at $180,000. The land was also encumbered with a $70,000
        nonrecourse mortgage for which no one was personally liable. All three partners agreed
        to split profits and losses equally. At the end of the first year Blue Bell made a $7,000
        principal payment on the mortgage. For the first year of operations, the partnership
        records disclosed the following information:

        Sales revenue                                                           $470,000
        Cost of goods sold                                                      $410,000
        Operating expenses                                                       $70,000
        Long-term capital gains                                                   $2,400
        Section 1231 gains                                                          $900
        Charitable contributions                                                    $300
        Municipal bond interest                                                     $300
        Salary paid as a guaranteed payment to Deanne (not included in expenses) $3,000


        a. Compute the adjusted basis of each partner’s interest in the partnership immediately
        after the formation of the partnership.

        b. List the separate items of partnership income, gains, losses, and deductions that the
        partners must show on their individual income tax returns that include the results of the
        partnership’s first year of operations.

        c. (Optional) Using the information generated in answering parts a. and b., prepare Blue
        Bells’ page 1 and Schedule K to be included with its Form 1065 for its first year of
        operations along with Schedule K-1 for Deanne.

        d. What are the partners’ adjusted bases in their partnership interests at the end of the first
        year of operations?




                                                  20-60
Chapter 20 - Forming and Operating Partnerships


        a. This initial adjusted basis for Keon is $23,333, for Aaron is $133,333, and for
           Deanne is $133,333 as shown in the calculations with table below:


                   Description                    Keon           Aaron        Deanne        Explanation
           (1) Basis in contributed                $70,000
           land
           (2) Cash contributed                                  $110,000      $110,000
           (3) Debt allocated to                   $23,333        $23,333       $23,333
           partners
           (4) Relief from                        ($70,000)
           nonrecourse mortgage
           (5) Gain recognized                             $0            $0            $0 (4 )- [(1)+
                                                                                           (2)+ (3)] if
                                                                                           positive,
                                                                                           otherwise 0
           (6) Partners’ initial tax               $23,333       $133,333      $133,333 (1) + (2) +
           basis                                                                           (3)+ (4) + (5)




        b. The partners’ shares of ordinary business loss and separately stated items are
           reflected in the table below:




                                                         20-61
Chapter 20 - Forming and Operating Partnerships




           Description              Total             Keon      Aaron      Deanne    Explanation
    (1) Partners’ initial                            $23,333    $133,333   $133,333 See problem
    Tax basis                                                                       a. above
    (2) Sales revenue                  $470,000
    Less:
    (3) Cost of goods                  (410,000)
    sold
    (4) Operating                       (70,000)
    expenses
    (5) Guaranteed                       (3,000)
    payments
    (6) Ordinary                       ($13,000)     ($4,333)   ($4,333)   ($4,333) [Sum of (2)
                                                                                    through (5)]
    Business Loss
                                                                                    x 33.33%
    Separately Stated
    Items on Schedule
    K-1:
    (7) Long-term capital                 $2,400        $800       $800       $800 $2,400 x
                                                                                   33.33%
    gains
    (8) Section 1231                         $900       $300       $300       $300 $900 x
                                                                                   33.33%
    gains
    (9) Municipal bond                       $300       $100       $100       $100 $300 x
                                                                                   33.33%
    interest
    (10) Charitable                         ($300)    ($100)      ($100)     ($100) ($300) x
                                                                                    33.33%
    contributions
    (11) Mortgage                       ($7,000)     ($2,333)   ($2,333)   ($2,333) ($7,000) x
                                                                                    33.33%
    reduction (deemed
    cash distribution)




                                                     20-62
Chapter 20 - Forming and Operating Partnerships




    (12) Self-employment               ($10,000)   ($4,333)   ($4,334)   ($1,333) Line 6 +
    Loss                                                                          $3,000
                                                                                  guaranteed
                                                                                  payment to
                                                                                  Deanne
    Partners’ ending tax                           $17,767    127,767    127,767 (1) + (6)+
    basis                                                                         (7) through
                                                                                  (11)




                                                   20-63
Chapter 20 - Forming and Operating Partnerships


        c. Blue Bell Partnership’s page 1 and Schedule K to be included with Form 1065 and
           Deanne’s Schedule K-1 are shown below:




                                                  20-64
Chapter 20 - Forming and Operating Partnerships




                                                  20-65
Chapter 20 - Forming and Operating Partnerships




                                                  20-66
Chapter 20 - Forming and Operating Partnerships




        d. Keon has an ending basis of $17,767, Aaron has an ending basis of $127,767 and
           Deanne has an ending basis of $127,767. These amounts are calculated in the table
           included with the solution to part b. above.

    76. [LO 4, 5, 6] The TimpRiders Limited Partnership has operated a motorcycle dealership
        for a number of years. Lance is the limited partner, Francesca is the general partner, and
        they share capital and profits equally. Francesca works full-time managing the
        partnership. Both the partnership and the partners report on a calendar-year basis. At the
        start of the current year, Lance and Francesca had bases of $10,000 and $3,000
        respectively, and the partnership did not carry any debt. During the current year, the
        partnership reported the following results from operations:

        Net sales                                                               $650,000
        Cost of goods sold                                                      $500,000
        Operating expenses                                                      $160,000
        Short-term capital loss                                                   $2,000
        Tax-exempt interest                                                       $2,000
        Section 1231 gain                                                         $6,000

        On the last day of the year, the partnership distributed $3000 each to Lance and
        Francesca.

        a. What outside basis do Lance and Francesca have in their partnership interests at the
        end of the year?

        b. To what extent does the tax basis limitation apply in restricting the partners’ deductible
        losses for the year?

        c. To what extent does the passive activity loss limitation apply in restricting their
        deductible losses for the year?

        a. Lance has an ending basis of $5,000 and Francesca has an ending basis of $0 as
           illustrated in the table below:

            Description                Total             Lance     Francesca     Explanation
                                                       (Limited)   (General)
       (1) Partners’ initial                             $10,000      $3,000 Given
       Tax basis
       Basis Increasing
       Items:
       (2) Section 1231 gain                 $6,000       $3,000      $3,000 $6,000 x 50%




                                                      20-67
Chapter 20 - Forming and Operating Partnerships




       (3) Tax-exempt                        $2,000       $1,000    $1,000 $2,000 x 50%
       interest
       (4) Basis Before                                  $14,000    $7,000 Sum of lines (1)
                                                                           through (3)
       Distributions
       (5) Cash distributions                           ($3,000)   ($3,000) Given
       (6) Basis Before                                  $11,000    $4,000 (4) + (5)
       Loss Allocations
       (7) Sales revenue                  $650,000
       Less:
       (8) Cost of good sold             (500,000)
       (9) Operating                     (160,000)
       expenses
       (10) Ordinary                     ($10,000)      ($5,000)   ($5,000) [Sum of (7) through
                                                                            (9)] x 50%
       business loss
       (11) Short-term                     ($2,000)     ($1,000)   ($1,000) ($2,000) x 50%
       capital loss
       Partners’ ending tax                               $5,000        $0 (6) + (10) + (11) or
       basis                                                                limited to a basis of
                                                                            zero. Thus, the tax
                                                                            basis limitation
                                                                            applies to Francesca.


        b. As indicated in the table in part a., Lance’s loss allocations are not limited by his tax
           basis; however, Francesca’s total losses are limited to $4,000—his tax basis prior to
           his loss allocations.

        c. Although Lance’s loss allocations are not limited because of his tax basis, his share
           of the ordinary business loss is classified as a passive activity loss because he is a
           limited partner. Thus, he must carryover his $5,000 ordinary business loss as a
           passive activity loss until he either receives passive income or he sells his partnership
           income. His $1,000 short-term capital loss is not limited because it is a portfolio
           rather than a passive loss. The passive activity loss rules don’t apply to Francesca
           because he works full time managing the partnership and would be classified as a
           material participant.




                                                      20-68
Chapter 20 - Forming and Operating Partnerships


    77. [LO 2, 4, 5] LeBron, Dennis, and Susan formed the Bar T LLC at the beginning of the
        current year. LeBron and Dennis each contributed $200,000 and Susan transferred
        several acres of agricultural land she had purchased two years earlier to the LLC. The
        land had a tax basis of $50,000 and was appraised at $300,000. The land was also
        encumbered with a $100,000 nonrecourse mortgage (i.e., qualified nonrecourse
        financing) for which no one was personally liable. The members plan to use the land and
        cash to begin a cattle-feeding operation. Susan will work full-time operating the
        business, but LeBron and Dennis will devote less than two days per year to the operation.
        All three members agree to split profits and losses equally. At the end of the first year,
        Bar T had accumulated $40,000 of accounts payable jointly guaranteed by LeBron and
        Dennis and had made a $9,000 principal payment on the mortgage. None of the members
        have passive income from other sources.

        For the first year of operations, the partnership records disclosed the following
        information:

        Sales revenue                                                                 $620,000
        Cost of goods sold                                                            $380,000
        Operating expenses                                                            $670,000
        Dividends                                                                       $1,200
        Municipal bond interest                                                           $300
        Salary paid as a guaranteed payment to Susan (not included in expenses)        $10,000
        Cash distributions split equally among the members at year-end                  $3,000

        a. Compute the adjusted basis of each member’s interest immediately after the formation
        of the LLC.

        b. When does each member’s holding period for his or her LLC interests begin?

        c. What is Bar T’s tax basis and holding period in its land?

        d. What is Bar T’s required tax year-end?

        e. What overall methods of accounting are available to Bar T?

        f. List the separate items of partnership income, gains, losses, deductions and other items
        that will be included in each member’s Schedule K-1 for the first year of operations. Use
        the proposed self-employment tax regulations to determine each member’s self-
        employment income or loss.

        g. What are the members’ adjusted bases in their LLC interests at the end of the first year
        of operations?

        h. What are the members’ at-risk amounts in their LLC interests at the end of the first
        year of operations?




                                                  20-69
Chapter 20 - Forming and Operating Partnerships


        i. How much loss from Bar T, if any, will the members be able to deduct on their
        individual returns from the first year of operations?

        a. LeBron’s adjusted basis is $216,667, Dennis’ adjusted basis is $216,667, and Susan’s
            adjusted basis is $16,667 as calculated in the table below:


                   Description               LeBron          Dennis        Susan        Explanation
           (1) Basis in contributed                                          $50,000
           land
            (2) Cash contributed                  $200,000   $200,000
           (3) Debt allocated to                                             $50,000 Nonrecourse
           susan only                                                                   debt >
                                                                                        Susan’s tax
                                                                                        basis in
                                                                                        contributed
                                                                                        property
           (4) Debt allocated to                   $16,667    $16,667        $16,667 [$100,000 -
           partners                                                                     $50,000] x
                                                                                        33.33%
           (5) Relief from                                                 ($100,000)
           nonrecourse mortgage
           (6) Gain recognized                         $0             $0           $0 (5 )- [(1)+
                                                                                        (2)+ (3)+
                                                                                        (4)] if
                                                                                        positive,
                                                                                        otherwise 0
           (7) Partners’ initial tax              $216,667   $216,667        $16,667 (1) + (2) +
           basis                                                                        (3) + (4) +(5)


        b. The holding period for LeBron and Dennis begins when they receive their LLC
            interests because they only contribute cash. In contrast, Susan’s holding period
            includes the holding period for the land he contributed since Susan held the land as
            either a capital or Section 1231 asset.



                                                     20-70
Chapter 20 - Forming and Operating Partnerships




           c.   Bar T receives a $50,000 tax basis in the land and will include Susan’s holding
                period as part of its holding period.


           d. Bar T must adopt a calendar year end because all of its members have calendar year
                ends.


           e. Bar T may adopt either the cash or accrual method of accounting. It may generally
                use the cash method because it does not have a corporate member. However, it must
                use the accrual method in accounting for its inventory related transactions (i.e., the
                hybrid method).


           f. The member’s separately stated items are listed on lines (2), (3), (11), and (13) in the
                table below. Note that LeBron and Dennis have self-employment income under the
                proposed regulations because they are responsible for some of Bar T’s debt. Susan
                clearly has self-employment income under the proposed regulations because he works
                full time in the enterprise.


        Description                 Total         LeBron     Dennis      Susan           Explanation
(1) Members’ Initial Tax                          $216,667   $216,667     $16,667 See part a. above
Basis
(2) Dividends                         $1,200         $400       $400         $400 $1,200 x 33.33%
(3) Municipal bond                      $300         $100       $100         $100 $300 x 33.33%
interest
(4) Deemed cash                      $40,000       $20,000    $20,000                Accounts payable
                                                                                     are only allocated to
contribution from
                                                                                     LeBron and Dennis
accounts payable                                                                     because they
                                                                                     guaranteed them
(5) Cash distributions              ($3,000)      ($1,000)   ($1,000)     ($1,000)




                                                     20-71
Chapter 20 - Forming and Operating Partnerships




(6) Deemed cash                                                         ($9,000) Because Susan was
                                                                                 originally allocated
distribution to Susan for
                                                                                 the first $50,000 of
mortgage repayment                                                               the nonrecourse
                                                                                 mortgage, the
                                                                                 repayment goes to
                                                                                 reduce her share of
                                                                                 the debt.
(7) Member’s Tax Basis                            $236,167   $236,167     $7,167 Sum of (1) through
                                                                                 (6)
Before Loss Allocation
(8) Sales revenue                $620,000
Less:
(9) Cost of good sold            (380,000)
(10) Operating expenses          (670,000)
(11) Guaranteed payments          (10,000)
(12) Ordinary Business          ($440,000) ($146,667) ($146,667) ($146,667) [Sum of (8) through
                                                                            (11)] x 33.33%
Loss
(13) Self-employment loss       ($430,000) ($146,667) ($146,667) ($136,667) Line (12) + $10,000
                                                                                  guaranteed payment
                                                                                  to Susan
Members’ ending Tax                                $89,500    $89,500        $0 (7)+ (12) but not less
basis                                                                             than zero. Susan
                                                                                  must carry over
                                                                                  $7,167 + ($146.667)
                                                                                  or ($139,500) of
                                                                                  ordinary loss.
        g. As indicated in the table in part f. above, the ending basis for LeBron is $89,500, the
            ending basis for Dennis is $89,500, and the ending basis for Susan is $0.




                                                     20-72
Chapter 20 - Forming and Operating Partnerships


        h. Generally, the members’ at-risk amounts will be less than the amount of their tax
            bases to the extent they are allocated nonrecourse debt that is not qualified
            nonrecourse financing. In this case, the members’ at-risk amounts are the same as
            their tax bases in part g. because the nonrecourse mortgage is qualified nonrecourse
            financing and the accounts payable are treated as recourse debt (i.e., they are
            guaranteed by LeBron and Dennis).


        i. As indicated in the table in part f. above, the $146,667 loss allocated to LeBron and
            Dennis is not limited by their tax bases. However, given the facts provided, they
            cannot deduct their losses currently and each has a $146,667 passive activity loss
            carryforward because they are not material participants in the enterprise. As for
            Susan, her $146,667 loss is initially limited to her $7,167 tax basis leaving her with a
            $139,500 loss carryforward. However, because she is a material participant in Bar
            T, she may deduct the $7,167 currently.




                                                  20-73

				
DOCUMENT INFO
Shared By:
Categories:
Stats:
views:3371
posted:5/31/2011
language:English
pages:73