Sample Answers to Question 2
Partnership Tax
Spring 2016
Exam No. 4073
XY: This is a complete liquidation of the partnership.
The partnership has no realizing or recognizing gain or loss.
The account receivable is a hot asset, subject
to IRC 751(b). Accordingly, any gain or loss attributed with it will be
ordinary. Also, because it is a hot asset, Yvette cannot simply take it from
the partnership without Xander recognizing an ordinary gain on the receivable.
Both partners’ shares in the hot asset were effected because all items of
income and loss are to allocated equally between the partners, Yvette’s
interest in the receivable went from 50% to 100% and Xander’s went from 50% to
0%. This means that Xander must in same way be given the ordinary income item
right away upon liquidation of the partnership. To accomplish this, Yvette
constructively receives 1/2 of the receivable (FMV 50k) as well as 1/2 of the
land (FMV 50k). Her constructive basis in the receivable will be -0- and 90k for the land. The basis in the
receivable is carried over from the partnership, and because it is a hot asset,
the basis cannot be increased above what it was inside the partnership. The
basis in the land will be carried over from the partnership, but limited by
whatever outside basis Yvette has left over after granting the carryover basis
from the hot assets; here that means she will carry over her full outside basis
of 90k. Xander would do the same. Yvette then constructively buys the other
half of the receivable, worth 50k, with her constructivley held 1/2 of the
land, also worth 50k. This will trigger a capital LOSS to Yvette of 40k on the
“sale” of the land. It will be capital because in the hands of the partnership
the land was a capital asset. Yvette will now have a basis in the receivable of
50k. When Yvette collects on the receivable, she will have 50k of ordinary
gain. Xander’s basis in the land will become 140k (90k (his outside basis at
the time of the liquidation that is applied to his half of the land) + 50k
(Xander’s “cost basis” obtained in the constructive transaction by exchanging
the FMV 50k receivable for the FMV 50k of land that Yvette “held”). Note, that
Xander has a realizing event upon the dissolution of the partnership. Xander
must pay tax on the 50k of income from the receivable he is “selling” to Yvette
immidiately. When Xander sells this land he will have an ordinary gain. Because
he is a dealer in real estate, the property takes on the status of an inventory
item under IRC 735(a)(2). Despite the
property not being an inventory item in the hands of the partnership, IRC
751(d) makes the item an inventory item by way of it being held by Boris, in
whos hands it is an inventory item, which is kind of circular, way to go
Congress and the Internal Revenue Code. Even if Xander did have the land past
the 5 year limit that is imposed by IRC 735, it would still be ordinary income
to him.
Exam No. 4582
Liquidation
Upon liquidation, partners generally do not recognize
a gain or loss unless there is money distributed in excess of their outside
basis. However, if one partner receives more than his fair share of “hot
assets” as defined under § 751, this may pose a problem. Here, Yvette is
receiving more than her fair share of hot assets, namely the A/R. This means
that all the ordinary income would be taxed to her (when its eventually
received) and Xander gets the capital loss that comes with the land held for
investment. This is not fair. Therefore, what will happen is Yvette will be
treated as though she receives a distribution of her share of all the assets
and then exchanged her share of the land for her share of the A/R in a taxable
transaction.
Yvette’s share of the partnerships assets are: 1/2 of
the A/R and 1/2 of the land. Her basis in the A/R will be $0 and her basis in
the land will be $90. This is because she can only allocate up to her outside
basis in the partnership to her distributed assets under § 732 and can only
allocate basis in hot assets up to the partnership’s basis in them. Because the
partnership’s basis in the A/R is $0, she can’t allocate any of her basis to
the A/R so it all goes to the land. This is convenient because the
partnership’s basis in half the land is also $90. She does not recognize a gain
because she did not receive any money in excess of her basis.
When she exchanges the land for the remaining A/R,
this is a taxable transaction. Her basis is $90 but she is only receiving $50
worth of assets in return. Therefore, she has a $40 capital loss on her share of
the land. She does, however, get a $50 basis in the remaining A/R. So now
Yvette owns the A/R with a basis of $50 and a FMV of $100.
The partnership must recognize $50 in ordinary income
for the “sale” of the A/R to Yvette. Since Yvette has now “left” this income
all passes through to Xander and he must pay it. When Yvette “sold” her half of
the land back to the partnership, the partnership takes a cost basis in that
part of the land. So instead of it going back on the books at $90, it only goes
on at $50. So now the basis in the land is $140. When it gets distributed to
Xander, under § 732, his basis can only be $90 because that was his basis in
the partnership.
Collection of A/R
When Yvette collects the A/R, she recognizes $50 of
ordinary income - because A/R is an ordinary income asset and it retains that
quality after distribution - because her basis was $50. ($100 - $50 = $50)
Selling the Land
Because Xander is now a real estate professional, any
profit he recognizes from the sale of the land is ordinary. While typically the
land would have retained its capital classification upon distribution, because
he is a dealer in land it is inventory to him which is an ordinary income
asset.
Exam No.
4443
Dealing with the Hot Asset
Under 751(b), if a partner
recieves disportionalte amounts of hot (or nonhot) assets on liquidation of a
PSP, 751(b) treats that portion of the distribution as an exchange of such
property between the partner and the PSP. In Rev. Rul. 77-412, the IRS rules
that in the case of a two-person PSP, 751(b) is applid by treating the
distribution as a sale or exchange between the distributee partner and the PSP.
Because the
distribution of accounts recievable to Y--and the land to X--shifts both of
their interests in hot and non-hot assets, the shift is indentified and
considered a sale or exchagne of the property between each partner and the PSP.
Before the distribution, the partner’s shared the hot and nonhot assets
equally--each shared 50% of hot and 50% of nonhot. After the distribution, Y
has 100% of the hot assets, and X has 100% of the nonhot assets.
As a result, each is
considered to have recieved a constructive distribution in which the PSP
distributs the distributee partner’s share of hot and nonhot assets.
X and Y will both be
treated as recieving a distirbution of:
• Accounts recivable with a basis of 0 and an
FMV of 50, and
• Land with a basis of 90 and an FMV of
50.
Under the normal
distribution rules, no gain or loss will be recognized under this deemed
distributionm, and each will have a carryover basis in the assets.
After this
constructive distribution, the partner is deemd to transfer the hypotehtically
exchanged property for the assets he or she actually recieved in the
distirbution.
In this case, X will
be treated as exchanging his share of the hot assets back to the PSP in
exchange for the remaining 50% share of land. He will recognize 50K in oridnary
income as a result of this transaction, and the IB of the accounts recievable
will be 50K. After the transaction, X will have
Y will be treated as
selling the 50% share of the land back to the PSP in exhange for the remaining
50% share of the accounts recievable. She will recognize a 40K capital loss on
this transaction (50 FMV - 90 basis). The 50% share of the land will get an FMV
basis of 50K.
After this
constructive transaction, the accounts recievable will have a 50K basis and a
100K FMV, and the land will have a 130 K basis (90+40) and a 100K FMV. The
assets will be distirbuted to X and Y with those bases.
Liquidating
Distribution Analysis
The general rules for
PSP distributions in sections 731, 732, and 733 determine the tax results of
liquidating distributions to partners, but 736 does not apply becuase that section
contemplates payments by an ongoing PSP.
Under 731, a partner
recognizes no gain or loss on a disribution to the partner unless the the money
she recieves is greater than her OB. Here, no money was distributed to X or Y,
so neither of them recognizes gain under 731.
Under 732(a), a
partner generally takes a carryover basis in property distributed by a PSP, and
the distributee partner’s OB is reduced by the distributed property. A
partner’s basis in distributed property cannot, however, exceed the partner’s
OB, less any money reiceved in the same transaction. In this case, the
distribution of land to X encounters the “never more” basis limitation of
732(a)(2), because X’s OB was 90, and the IB of the asset distributed to him is
130K. As a result, X’s basis in the distributed land is 90K, and it’s FMV is
100K.
Under 732, Y’s basis
in the accounts recievable she takes out of the PSP will have a carryover basis
of 50K in her hands, with a FMV of 100K.
Note that if this were
an ongoing distribution, X’s basis adjustment would result in an OB/IB
Mismatch, but under under 734, the IB of a PSP’s assets generally is not
adjusted as a result of a property distribution by the PSP unless it has a 754
election in effect. If a PSP does have a 754 election in place, then under 743,
the inside basis is adjusted to correct such a distortion. These sections don’t
come into play here, because this is a fully liquidating distribution.
Subsequent Sales of
Distributed Property
Under 735, when Y
sells the recievable, she wll have 50K (100K realized - 50K basis) of OI
income.
X doesn’t get the
benefit of the 735, and he will recognize OI
when he sells the land because he is a real estate professional at that
time, even though it was a capital asset to the PSP.
Created by: bojack@lclark.edu
Update: 20 May 16
Expires: 31 Aug 17