Sample Answers to Question 1
Partnership Tax
Spring 2016
Exam No. 4393
While A and B have
formed an LLC under state law, it will be treated as a partnership under 7701
for tax purposes based on their election to not be taxed as an association (corporation).
Because only 50% of the assets are stock it will not be treated as an
investment company under 721(b) c.f. 351(e), 1.351-1(c). Therefore under 721(a)
the contributinos from A and B will be tax free to them. Each will receive a
carryover basis in their partnership interest from the contributed assets under
722. A will have $400k of basis and B will have $200k of basis. ABL will also
have a carryover basis in the contributed assets of 400 for the stock and 200
for the building under 723. If the partnership decided to sell the assets in
the next year it would be able to tack any applicable holding period under
1223. The assets in the hands of ABL will have the same asset character
(ordinary or capital) as they would in the hands of the respective contributing
partner under 724. In this case, each asset would likely be a capital asset
unless A or B were dealers in the respective assets
they contributed.
While A and B
decided to split their profits and losses equally, this does not mean that
depreciation on Blackacre will be split evenly. B has already heavily
depreciated Blackacre, so A has essentially “lost out” on the depreciation
unless depreciation has changed. The solution under 1.704-1(b)(2)(iv)(g)(3)
is to have tax depreciation match the book depreciation for the noncontributing
partner. In this case, the first year depreciation on a 10-year straightline
would be $20k of tax loss and $50k of capital loss (10% of the FMV of the
building). Since A and B are splitting losses evenly, A and B should each get
$25k of book loss from their capital accounts, and theoretically, A should be
able to get a tax loss of $25k, but since there is only $20k of tax loss to
allocate, the partnership has three options, discussed below.
Traditional Method
Under this method, A would get all of the
tax loss and B would get no tax loss. After year one, A would have OB of $380k
(400k - 20k of tax depreciation) and a capital account of $450k (500k - 50k of
book depreciation). B would have a $200k basis ($200k - zero of tax
depreciation) and a capital account of $450k. ABL would have 180k of inside
basis in Blackacre. This method would result in a basis mismatch due to the
“loss” of sufficient tax allocation suffered by A.
Traditional Method w/ Curative Allocation
Under this method, the tradiaional method
would be used as above, but the next tax items that come in would have their
tax allocations modified to end up compensating A for missing out on taking
advantage of the depreciation (i.e. there would be “curative allocations”).
This method would initially result in a basis mismatch (as in the Traditional
Method) but when the “curative allocations” are recognized this mismatch will
be fixed, making this likely the best option for ABL to select.
Remedial Method
The last method is likely the least
desireable for A and B, but it recognizes that essentially A would be taking
advantage of an accelerated depreciation that is normally afforded when a
partnership “steps in the shoes” of the contributing partner for purposes of
depreciation. In this case, the $200k of basis would be depreciated normally
over 10 years, but the $300k of gain is depreciated over 20 years (which is the
time period that A would have had to depreciate the property if A had bought it
new). The result is that for 10 years ABL will have $20k of capital
depreciation PLUS $15k of capital depreciation for a total of $35k of capital
depreciation for the first 10 years ($15k per year for the next 10 years after
that). This $35k of capital depreciation is split between A and B per their
agreement, with each getting $17.5k of capital depreciation. A would match that
for tax depreciation, so A would have $17.5k of tax depreciation the first
year, and B would get the remainder (20k - 17.5k) $2.5k of tax depreciation. So
after year one, A would have $382.5k of OB with a capital account of $482.5k. B
would have OB of $197.5k and a capital account of $482.5. And ABL would have an
inside basis of $180k in Blackacre. This method would initially result in a
significant basis mismatch which would be protracted for a significant amount
of time, but ultimately results in the problem being fixed. However, A’s
position is initially made WORSE by selecting the remedial method.
At
all times discussed the basis of the stock held by ABL should remain the same.
Exam No. 4739
Formation of ABL, LLC:
An LLC is a partnership for Federal Income
tax purposes so long as no election under Reg 301.7701-3 has been made.
Because, no election has been ABL is a parternship and will be “taxed” under
Subchapter K of the Code.
Under IRC 721(a) no gain or loss is
recognized to a partnership or a partner in the case of contribution of
property to the partnerhsip in exchange for an interest in the parternship. On
contribution of the stock by A, A recognizes no gain even though she realizes a
gain of 100K. On contribution of blackacre, B recognizes no gain even though he
realizes 300K of gain. ABL will not recognize any gain on the contributions of
A or B, when contributed. It is important to note, that b/c A and B each
REALIZED gain, this indicates that both A and B will each have IRC 704(c) gain
- A has built-in-gain of 100K, and B has built-in-gain of 300K.
Under IRC 722 each partner, A & B will
get a transfered basis equal to the adjusted basis of the porperty they
contributed. So A will have a basis in her partnerhsip interest of 400K, and B
will have an basis in his partnerhsip interest of
200K. Under, IRC 1223 because the stock is a capital gain asset, the holding
periods for A will tack.
Under IRC 723 the ABL’s basis in the
property received is the carry-over basis plus any gain recognized by the
contributing partner. Here, Stock has an basis to the
partnerhsip of 400K and Blackacre has a basis to the partnership of 200K. The
holding period for the partnerhsip also tacks under IRC 1223.
See Balance Sheet, Question 1, Exhibit A for the partnership’s opening balance sheet.
Consequences
of the Contribution of Depreicable Property:
When a partner contributes depreicable
property to a partnership, the partnership takes over the remaining recovery
period, and has to use the same method as the contribting partner. IRC 168(i)(7). This means that ABL is required to recover its tax
basis over the remaining 10 years of recovery period - 20K/year. Additionally,
this also means that ABL must recover its book value using the same 10-year
straight line depreciabtion that is used for tax depreciation - 50K/year. See.
Reg 1.704-1(b)(2)(iv)(g)(3)
ABL
after Year 1:
See Balance Sheet, Question 1, Exhibit B for the partnerships balance sheet after year
1, taking into account the depreciation deduction.
Note that on the balance sheet, there is a
dispartity of between A’s book and tax bases of 5K (ignoring A’s 100K of
built-in-gain) due to the fact that the book deduction was 25K to each A &
B, and the tax basis deduction, all allocated to A was only 20K. This issue is
a ceiling rule issue.
To alleviate this issue, ABL can either
use the remedial method (Reg. 1.704-3(d)) or the traditional method with a
curtive allocation (Reg. 1.704-3(d)).
-under the remedial method, DONT USE THIS
METHOD! - but, but it basically treats A and the PSHIP as if it went out and
bought 1/2 of a newer asset comprable to the depreciated asset in the
partnerhsip, then the regs slow down the depreciation of the portion of the
epreciable proeprty in the partnerhsip that is treated as the “new 1/2 asset”
that A bought - its messy, and no partnerhsip wants this hasle, instead ABL
should use the method below - the trad. mehtod with
curative allocations.
-under the curative allocation method, ABL
is able to allocate for tax purposes, ordinary income to B despite the
economics between the partners being different that the allocation. ABL will
have to wait until an item of ordinary income arries in ABL’s hands. The
contributing partner, B will take the income/depreciation for tax purposes, and
the noncontributing partner will eventualy have a basis and book match.
Exam No. 4148
Hugeco will be taxed as
a partnership because A and B have not made an election to be a corporation under
the Check the Box Regulations.
Formation
A’s transfer of stock and B’s transfer of Blackacre to
Hugeco are non-recognizable transactions under §721. A gets an outside basis equal to her
adjusted basis in the stock of 400K. B
gets an outside basis equal to his adjusted basis in the property of 200K.
§722. Since there is built-in gain in
each contributed item, A and B will retain that built-in gain and it will be
allocated to them on a subsequent disposition under §704(c)(1)(A). They each get capital accounts equal to the
fair market values of their contributions, so they each have 500K in their
capital accounts. Hugeco takes a
carryover inside basis in each item under §723. The opening balance sheet is exhibit 1.
Depreciation
The tax depreciaiton on Blackacre is 20K per year for
10 years. Since the book depreciation
schedule must match the tax depreciation schedule, Blackacre will have a book
depreciation of 50K per year. Reg. 1.704-1(b)(2)(iv)(g)(3). Hugeco allocates the tax depreciation first
to the noncontributing partner in an amount equal to their book depreciation
and any leftover depreciation gets allocated to the contributing partner.
§704(c)(1)(A).
Here, there is not enough tax depreciation to match A’s book
depreciation of 25K per year. A gets all
20K of tax depreciation, but there remains a balance sheet distortion of
5K. Under the ceiling rule, the
deductions allocated cannot exceed the partnerships deductions for the taxable
year. Reg. 1.704-3(b)(1). The partnership may opt to correct the
distortion using either the Traditional Method with Curative Allocations or the
Remedial Method. Under the Traditional
Method with Curative allocations, the partnership is allowed to make curative
allocations to A of up to 5K per year of taxable depreciation from another
asset, but this is not an option in this partnership with only one depreciable
asset. Another option under this method
is to allocate an extra 5K of income to B, but there is no other income in the
partnership at this point. Under the
Remedial Method, the partnership makes up an income item of 5K and sticks this
on B’s return, while A gets additional depreciation in the same amount. The resulting balance sheet with the
distortion is exhibit
2. The balance sheet after the
remedial method to correct the distortion is exhibit 3.
Under the remedial method, the remainder of the
partnership’s book basis in the property is recovered using any recovery period
and depreciation method available to the partnership for newly purchase
property that is placed in service at the time of contribution. Reg. 1-704-3(d)(2). Here, the partnership would get 20 year
straight-line depreciation from a third party.
The amount by which the book basis exceeds the tax basis is 300K. The first 4 years, the book basis will be
reduced by the same method as the adjusted tax basis which is 10 year. At the end of 4 years, the method switches to
20 year, so the remaining 300K will be reduced by 15K per year which will be
less than the 20K of tax depreciation, so A will get 15K and B will get 5K in
deductions for the remaining 6 years.
Created by: bojack@lclark.edu
Update: 20 May 16
Expires: 31 Aug 17