Sample Answers to Question 3
Partnership Tax
Spring 2016

Exam No. 4393

The initial balance sheet of CGH would look like Exhibit A. No party would recognize gain or loss on the contribution of assets to the partnership with the exception of G. No gain or loss is recognized on contributions to a partnership under 721. The basis each partner has in their partnership interest is carried over from the basis of their contributed assets under 722.

Redacre and the Equipment should be capital assets in the hands of CGH unless H was a dealer in the equipment. Since the equipment is unencumbered by any loan I will assume that the equipment was for operations, and should therefore be a capital asset in H’s hands and consequently in the hands of CGH. The precontribution gain for the equipment will be allocated to H if the equipment is sold within the first 7 years of transfer to CGH under 704(c). If the equip was inventory in the hands of H (even if not inventory for CGH) and it is sold in the first 7 years, H will recognize ordinary gain of $500k (assuming the value does not decline). If the FMV of the equipment declines, CGH has three options for allocating the gain. The traditional method would give ordinary gain to H subject to the ceiling rule which caps gain at FMV over basis. C and G, however, would not be able to recognize their loss. CGH could use the traditional method with curative allocations which would also use the ceiling rule, but then would change the tax allocation of subsequent transactions to give C and G the loss. Or the partnership could use the remedial method, which would actually recognize the full precontribution gain of $500k to H but would then split the subsequent loss between C and G (evenly per the partnership agreement).

The basis of the contributed assets in the hands of CGH would be equal to the basis in the hands of the contributing partners under 723. G’s OB would be reduced because CGH assumes the recourse loan ( 752(b) ), but since G’s basis in RA was only $500k, G’s OB would end up being zero. Further, G would have to recognize gain under 731(a). This gain would be capital under 741 and presumably long term. This leaves a basis mismatch of $300k in the balance sheet. Under the Regs, CGH could file an election to increase the inside basis of Redacre due to G’s recognition of gain but this is apparently a painful process and incurs additional ongoing recordkeeping. It might be worth it for $300k of basis though. C gets 800k additional basis due to CGH’s assumption of the loan. C as General Partner ultimately bears responsibility for the loan since CGH agreed to pay it back and repay G if the lender goes after G for the debt. Under 752(a) this entitles C to a basis increase.

In the first year, the partnership has a $100k operation loss. The partners originally agreed to split losses 20% to C, 20% to G and 60% to H. These loss allocations will change once CGH has positive cash flow, but that is not the case yet. The current allocations should give $20k of loss to C, $20k of loss to G, and $60k of loss to H. It is unknown from the facts how the $100k of loss would impact the assets on the balance sheet. The capital accounts of C, G, and H would each be deducted $20k, $20k, and $60k respectively. C’s capital account is allowed to go below zero under 704(b) because C has agreed to restore a negative capital account.

C and H are also allowed to pass through losses of $20k and $60k respectively, with a corresponding reduction in their outside basis, under 704(d). G cannot pass through a loss because G does not have OB. The loss for G would remain “trapped” at the partnership level until G is able to gain basis, at which point G could use the loss to offset gain or pass the loss through.

Exam No. 4637

Formation:

Per 721, C, G, H, and CGH each recognize no gain or loss upon their respective contributions to CGH. They each take a carryover basis from their respective contributed properties per 722; CGH takes a substituted basis in each of the properties per 723. Thus,

C: 10k outside basis (OB) and 10k CA (no 704(c) gain);

G: 500k OB and 200k CA (300k 704(c) ordinary gain arising from the relief of 800k debt from 500k basis);

H: 100k OB and 600k CA (500k 704(c) cap. gain); and

CGH: 610k and 810k CA.

Allocation of Debt:

This is a recourse debt, and it will be considered a recourse liability to the extent that any partner bears the economic risk of loss for the liability (1.752-2(a)). Here, C is the only general partner in an LP, and it is thus the only partner who bears the economic risk of liability; even though CGH has expressly agreed in the PA to pay off the loan and will indemnify G if the bank ever forecloses on the note, the regs. assume that at-risk partners will fulfill their obligations, and thus that guaranty is superfluous. Accordingly, the Doomsday scenario isn’t necessary to determine who will be allocated the debt. C is allocated the 800k of debt, and its OB is thereby increased by 800k to 810k. Now G is treated as having received a distribution of 800k per 752(b), and her basis will accordingly decrease, but not below zero. Her A/B before the distribution was 500k, and now it is zero (705(a)(2)), and she recognizes a 300k capital gain per 731(a)(1). See exhibit 3A for updated balance sheet.

The allocations of profits and losses are appropriately stipulated in the PA; they’re free to allocate the 20/20/60 proportions and then change it to 40/10/50 so long as the taxes follow the economics, i.e., the allocations have substantial economic effect per 704(b) and the corresponding regs: CAs will be maintained per the regs., CAs will be liquidated according to positive CAs, and C has agreed to a CA deficit restoration obligation, while G and H agreed to the alternate test using a QIO.

After the first year, the 100k ordinary NOL would be allocated 20k to C, 20k to G, and 60k to H. C’s CA would thus be reduced to -10k, and it can take this loss because it has agreed to restore a deficit upon liquidation. Furthermore, because C is at risk here, its loss is not barred by 465(b); if it were a publicly traded corp., then 465 wouldn’t bar its loss anyway, and the same goes for a 469 passive loss as to C, again assuming C is publicly traded-if not, then 469 may step in and bar the loss to the extent that this is deemed a passive activity and there are no more passive gains from which to deduct the loss, and if C is not materially participating in the trade/business, then it would be passive. However, because C is a general partner, it’s assumed that G is materially participating, so the loss should be allowed. G’s CA would be reduced to 180k, but her basis is at zero, so 704(d) will not allow her to take a corresponding tax deduction, but she can carry it forward to when she does have basis from which to deduct a loss. H’s CA would be reduced to 540k. G and H, however are limited partners, and per 469(h)(2), limited partners are per se passive. Thus, their respective losses are deductible only to the extent of their passive gains.

No 754 elections seem necessary at this point because there aren’t yet any inside-outside basis mismatches.

Exam No. 4073

Whatever liability any of the partner’s is subject to from the partnership, will increase that partner’s basis in the partnership.

At the formation of the partnership, Gabriela will have a realizing and recognized gain. She kind of ruined things for herself by contributing a property that is subject to a massive liability, but which she has a very low basis in. Gabriela will recognize a 300k capital gain upon contributing the property to the partnership. The gain will be capital because she was holding it for investment and contributed property maintains the character it had in the contributing partner’s hands. The amount is 300k because her basis in the property is 500k and the debt is 800k. This means her basis in the partnership would be 500k-800k= -300k, but we aren’t really supposed to have negative basis in partnerships so that will become a recognized gain upon contribution. Note, as explained below, that Gabriela is not going to have to be subject to this recourse loan once it is in the partnership, and accordingly will not get a basis bump for being liable for a portion of it. Gabriela will however have a 200k capital account because of her “equity” in the property.

Hannah will have a 100k basis in the partnership at formation, a carryover from her adjusted basis in the equipment before contributing it to the partnership. She will also have a capital account worth 600k, as explained below, her capital account will not increase due to the partnership assuming Gabriela’s recourse debt.

Corp will have a 10k capital account in the partnership at formation, this is from buying into the partnership with cash. Corp’s basis however will be 810k (10k + 800k(from being liable for the recourse debt)) because Corp will bear the burden of economic risk from the assumption of Gabriela’s liability, explained below.

To determine the partners’ bases in the partnership, we will have to run the DOOMSDAY scenario in order to see how to distribute any basis gained from the recourse loan. Because the loan is recourse, it will not be distributed based on profits (as seen with nonrecourse loans) but rather who bears the “economic risk of loss.” Note that the DOOMSDAY scenario is going to be affected by the fact that Corp has agreed to a restoration clause in the partnership agreement, but neither Hannah nor Gabriela has agreed to this, rather they have agreed to the qualified income offset. This offset means should their capital account ever somehow drop below -0-, any of the next incoming income items will be accounted toward them to bring the capital account back to -0-. So under this DOOMSDAY scenario, in which all assets value becomes -0-, even cash, and all of the partnership’s liabilities become due and then ask “who’s left holding the bag?” Here the answer is emphatically Corp. As stated above Hannah and Gabriela’s capital accounts can’t really drop below -0-, additionally in their favor is that they are limited partners, so if the partnership were to dissolve, creditors would not be able to go after them. So that would leave poor Corp left holding the whole bag, all 800k of it from that recourse debt. And because Corp is the only general partner, Corp has nobody left to go after. Accordingly, 100% of the basis gain from assumption of Gabriela’s liability will go to Corp.

See Question 3 Exhibit 1 for the Partnership’s balance sheet as of the formation of the partnership.

The income will be split according to the partnership agreement. Gabriela will have 20% = 160k. Corp will also have 20% = 160k. Hannah will have 60% = 480k.

All income and deductions will pass through to the partners on the last day of the partnership’s taxable year.

How the deductions are split will be more interesting. Gabriela is entitled to 20% of the deductions, but she will not be able to take the full 20%. 20% of 900k = 180k, but Gabriela only has 160k of basis. She can take up to that 160k, but not more. Gabriela’s basis after the first year will be -0- still and her capital account will still be 200k. One thing to be on the lookout for though is the nature of Gabriela’s income and deductions. As a limited partner it is possible that these items will be passive activity to her and would not be usable against any non passive income she might be earning. It is unclear from the fact pattern whether she is actively involved in the partnership, for the items to be non passive, she must be regularly, continuously, and substantially engaged in the business. The same caveat goes for Hannah, but not Corp because Corporations are not subject to the passive loss rule.

Hannah is entitled to 60% of 900k = 540k in deductions. With the passed through income, her basis in the partnership is 580k, so she will be able to take the full amount of her deduction. Hannah’s basis after the first year will be 40k and her capital account will be 540k.

Corp. is entitled to 20% of 900k like Gabriela, but unlike Gabriela, Corp will be able to take the full deduction because Corp has plenty of basis in the partnership, after the income passes through, Corp has 970k basis. Note however, that Corp’s capital account will be -10k after the deductions and it will have to be restored if and when the partnership liquidates as it is subject to the capital account restoration of the BIG 3.

See Question 3 Exhibit 2 for the partnership balance sheet after all income and deductions pass through.

Created by: bojack@lclark.edu
Update:  20 May 16
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