Sample Answers to Question 3
Partnership Tax
Spring 2015

Exam No. 1358

 

See pdf file here.

 

 

Exam No. 1556

Formation of Partnership

 

Under 721(a), no gain or loss is recognized to a partnership or partner in the case of a contribution of property. Even though this will be considered an investment company under the exception of 721(b) because money is considered securities under 351, it won’t matter because no gain can be recognized due to the fact that the contributions are solely money. No gain is realized. The partners’ bases in their interests will be the amount of such money contributed under 722, so Tao will get an 80k basis in her interest and Umi will get a 20k basis in her interest. Further, capital accounts will be create in their respective names in the amounts of their respective contributions.

 

Because the three requirements in the primary test for economic effect are met under 704(b), the partners are allowed to allocate gains and losses in any way they choose. Therefore, the gains and losses can be share equally.

 

Exhibit A shows the balance sheet of the partnership immediately after formation.

 

Obtaining the Recourse Loan

 

Under 752(a) an increase in partner’s liabilities will be treated as a contribution of money by such partner to the partnership, so this will increase will increase the partners’ outside bases. Under Reg. 1.752-2, we run through the doomsday scenario to see how to allocate the basis of the liability acquired. In this doomsday scenario, we assume all assets have 0 FMV and see how much each partner is liable for. Because the agreement allocates losses equally, 100k of the loss will be sustained by each partner. When we take this amount out of each partner’s capital account, Tao will have a -20k capital account and Umi will have a -80k capital account. Thus, the liability is proportionally allocated 2/10 x 200k = 40k to Tao and 8/10 x 200k = 160k to Umi.

 

Change of partnership agreement

 

The taxable year of a partnership does not close with respect to the partners here. They can make this allocation because they have satisfied the requirements under 704(b).

 

Gross Income

 

From 706(d)(1), we know that if there is a change in any partner’s interest, each partners’ distributive share shall be determined by the use of the methods prescribed by the secretary which takes this variation into account. The two proscribed methods are the proration method or the interim method.

 

If they used the interim method, they would close the books at the time of the partnership change and calculate the actual losses and gains. We don’t know what the income/losses looked like on October 1, so we’ll assume the use of the proration method.

 

Using the proration method, 3/4 of the loss will be allocated according to the old arrangement and 1/4 of the loss will be allocated according to the new arrangement. Therefore, looking first to the old arrangement 3/4 of the loss will be split 50/50. There is a total loss of 60k. 3/4 of the loss is 45k. 45k will be split 50/50 meaning 22.5k ordinary losses will pass through to both Tao and Umi. 1/4 of the loss is split 60 to Tao and 40 to Umi. 1/4 of the loss is 15k. So, 9k of this loss will go to Tao and the remaining 6k of the loss will go to Umi. Therefore, 31.5k loss will pass through to Tao as ordinary deductions. And, 28.5k of the loss will pass through to Umi as ordinary deductions. These losses will reduce their capital accounts and outside bases according to their respective losses (deductions).

 

The partnership will experience a 60k loss. Though, this is not taxed under 701 - a partnership is not subject to income tax - rather, the partners are liable for income tax in their separate capacities.

 

This passes through to each partner even though it is not distributed because the income (and deductions in this case) passes through as it is earned in the partnership.

 

The balance sheet will look like exhibit B.

 

 

Exam No. 1685

 

            Formation of a partnership is generally not a recognition event for either the partners or the partnership. 721 says no gain or loss is recognized to the partnership or partners when they transfer property to the partnership. There is an exception in 721(b) which says that gain is recognized for everyone if they transfer property to an investment company as defined in 351(2)/1.351. Under 1.351-1(c), if 80% or more of the assets consist of marketable securities, cash, IOUs, and transfer result in a diversification of interests, it is an investment company. Here, 100% of the transfers consisted of cash. Although it would have been safer to contribute some regular property instead of all cash, Tao and Umi and Firm should still get 721 nonrecognition because nothing suggests that the transfers “result in diversification of interests.” (That would be like if they ended up receiving multiple stocks and here they just got a partnership interest.)

 

            722 says a partner’s basis in a partnership is a carryover basis of the property they transferred in. Cash always has a basis of its face value. Thus Tao gets an 80k basis in Firm, and Umi gets a 20k basis in firm. Next, the partnership takes a basis in contributed property that carries over from the contributor. Here, the partnership has a 100k total basis in cash, its only asset.

 

            The day it formed, Firm borrowed a 200k recourse loan from a bank. The rule is that when a partnership borrows money, the partners get basis for that. 752. The issue is who gets the basis for the debt? The debt basis allocation analysis depends upon whether the loan is recourse or nonrecourse which is determined based on whether any partner is personally liable for the debt. Here, Tao and Umi formed a general partnership. Under state law, it is likely that they are liable for the debts of the partnership because they are general partners. Thus this is a recourse debt which means basis allocation is determined by 1.752-2 according to the partner’s economic risk of loss.

 

            The problem specifies that Firm’s partnership agreement satisfies all the requirements for the primary test for economic effect. That means that they meet the Big Three 1.704-1b2iib, which specifies that capital accounts must be maintained a certain way, that capital accounts will be honored on liquidation, and that any partner with a deficit in his capital account has the obligation to restore it on liquidation. This matters because whether thee partner has promised to restore a deficit capital account or has a QIO impacts the 1.752-2 “doomsday scenario” for debt allocation. First, we imagine all the partnership assets are worthless and sold for 0 consideration, then we pass through the loss. That is a 300k loss split 50/50 (100 of cash that became worthless and the 200 in loan proceeds). T gets a deficit capital account of 80-150 = -70, and U gets 20-150= -130. This is the amount that they would have to restore on doomsday. Since they are both general partners and both agreed to restore a deficit capital account they both would have to pay it. Thus T gets 70k basis for debt and U gets 130. Please see balance sheet 3 B to see their status after borrowing the loan and taking basis allocations for it.

 

            The next issue is how the year one net operating loss will be allocated to T and U. They began with a 50/50 split and then changed it up 2 months later to 60/40. That is allowed, they can change their agreement and it will still be respected by the IRS, so long as they continue to follow the big three. The 60//40 agreement was in place at the end of the taxable year (because Firm has two members who are both on the calendar year it appears to be a calendar year entity); so the 60/40 allocation will be followed.

 

            The Firm will pass through the partners’ distributive share of income to them under 702. Here, they had income of 140 and losses of 200 so this will be netted to a loss of 60,000. This loss will be passed through to the partners at the close of the partnership tax year. Tao gets 60% of the 60k loss for 36k, and Umi gets 40% of the 60k loss for 24,000. T and U will each see a reduction in their outside basis and book value that corresponds to the pass through. See balance sheet C for how they look after the losses pass through.

 

            U ends up with a deficit capital account and that’s fine because U promised to repay it.

 

            The next issue is whether or not T and U can take their entire loss on their personal return. there are three types of limits to taking a loss: basis limits, at-risk limits, and passive limits. T and U both had enough basis to take the losses they did out of Firm. Under the at-risk limits, the losses still pass through to the partner, but the partner can’t take losses on their individual return to the extent that the partner is not at risk. T is fine under the at-risk rules, he will get to deduct his entire loss on his personal return, and so is U (because they have enough $ they personally put into Firm and they are both on the hook for portions of the 200k loan.

 

            Passive loss limitations could come up if either of them are not heavily involved in the operations of the partnership. As well, these will be capital losses when deducted, and so if T and U don’t have other capital income, they might not be able to deduct much on their personal returns as you can only deduct 3k of capital loss against ordinary income and here they had 60k loss.

 

 

 

Created by: bojack@lclark.edu
Update:  27 Jan 16
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