Partnership Tax

Bogdanski

Spring 2017

Exam Answer Outlines

Question 1

On the sale of her partnership interest, Liz realizes a gain. Her amount realized on the sale includes her share of the partnership’s debt. IRC § 752(d). The debt is recourse because of the guaranty. Upon the constructive liquidation called for by the regulations under IRC § 752, Liz would be called upon to pay half the debt without reimbursement from Mo. Therefore, Liz’s share of the debt is one half, or $50,000. Her amount realized is therefore $300,000, and her overall gain is $100,000.

Because the partnership holds “hot assets” (accounts receivable and inventory), Liz is treated as selling her share of those assets, or one half. Upon a sale of the “hot assets” by the partnership, $100,000 of ordinary income would be realized, half of which ($50,000) would pass through to Liz. Therefore, of Liz’s $100,000 gain on the sale of her interest, $50,000 is ordinary. IRC § 751(a). The other $50,000 of gain is capital gain. IRC § 741.

Because Liz’s interest is completely terminated, the partnership taxable year closes as to her as of the date of the sale. IRC § 706(c)(2)(A). In determining Liz’s share of income and loss for the partial year, the partnership may either close the books as of the date of the sale, or pro rate its full year’s results to Liz based on the number of days she held her interest.

Nina receives a cost basis in her partnership interest. IRC § 742. The basis includes not only the $250,000 cash Nina paid, but also Nina’s share of partnership debt. IRC § 752(a). Upon the constructive liquidation called for by the regulations under IRC § 752, Nina would be called upon to pay half the debt without reimbursement from Mo. Therefore, Liz’s share of the debt is one half, or $50,000, and Nina’s basis in her partnership interest is $300,000.

Generally, there is no increase in the partnership’s basis upon the sale of a partnership interest. IRC § 743(a). However, under IRC § 754, the partnership may irrevocably elect to adjust the basis of its assets to reflect the additional “outside” basis of $100,000 resulting from the purchase by Nina. The increase in “inside” basis is only for the benefit of Nina. IRC § 743(b).

If an election under IRC § 754 is made, the $100,000 basis increase is allocated among the partnership’s assets under IRC § 755. This requires segregating the ordinary income-type assets from the capital gain-type assets, and allocating the increase between the two classes based on the relative appreciation within each class. IRC § 755(b). Here, each class has appreciation of $100,000, and so the $100,000 elective basis increase is allocated one-half to each class.

The increase is then allocated within each class based on the relative appreciation of each asset, with depreciated assets receiving a downward basis adjustment. Here, within the capital gain-type asset class, the publicly traded stock is appreciated by $60,000 and the land is appreciated by $40,000. Thus, 60 percent of the $50,000 basis increase, or $30,000, is allocated to the stock, and 40 percent of the $50,000 basis increase, or $20,000, is allocated to the land.

Within the ordinary income-type class, the appreciation on the receivables is $150,000, and the appreciation on the inventory is negative $50,000. Therefore, 150 percent of the increase for the class is added to the basis of receivables, and 50 percent of the basis increase for the class is subtracted from the basis of the inventory. The result is a $75,000 increase to the basis of the receivables, and a $25,000 decrease to the basis of the inventory. Again, these basis adjustments affect Nina only, not Mo.

The sale of 50 percent of the interests in partnership profits and capital causes a constructive termination of the partnership. IRC § 708(b)(1)(B). This closes the taxable year of the partnership as to Mo, as of the date of the sale of Liz’s interest. On that date, LM is deemed to (1) transfer all of its assets and liabilities to a new partnership in exchange for interests in the new partnership, and (2) liquidate, distributing the partnership interests to Mo and Nina.

Question 2

The formation of Parco results in no gain or loss to any party. Each partner takes a $50,000 cost basis in his or her partnership interest.

In the first year, Parco’s income and deductions pass through equally to each partner. Each partner’s basis in his or her partnership interest increases by his or her distributive share of Parco’s taxable income, or a $50,000 increase for each partner. IRC § 705(a)(1).

Upon receipt of a capital interest in exchange for services, Terry recognizes ordinary income under IRC § 83. The amount of the income is the fair market value of the interest Terry receives, or $200,000. This amount also becomes Terry’s “tax cost” basis in Terry’s partnership interest.

Under IRC § 83(h), Parco is allowed to deduct the $200,000 value reported as income by Terry, unless the nature of Terry’s services is such that the $200,000 amount is properly considered a capital expenditure, adding to the basis of Parco’s assets. The deduction passes through equally to Renee and Sasha, and it decreases the basis of each of their partnership interests. IRC § 705(a)(2).

Upon issuing a partnership interest to Terry, Parco is deemed to transfer a portion of its assets to Terry in a taxable transaction, in exchange for $200,000 worth of services. Because the capital interest being transferred to Terry represents one quarter of partnership capital, one quarter of each asset is deemed to be transferred in a taxable exchange. This results in ordinary income to Parco of $100,000 with respect to the receivables, and gain to Parco of $50,000 with respect to the land. These income items pass through equally to Renee and Sasha, and they increase the basis of each of their partnership interests. IRC § 705(a)(1).

Terry is then treated as contributing back to Parco the assets deemed to have been exchanged. Under IRC § 723, Parco takes these assets with the same basis Terry had in them, which is a “tax cost” of $200,000, the assets’ fair market values. Therefore, Parco’s basis in the receivables is increased to $100,000, and Parco’s basis in the land is increased to $250,000.

When Parco collects on the $400,000 receivable, it recognizes ordinary income of $300,000. Under the principles of IRC § 704(c), all of this gain should pass through to Renee and Sasha, because the gain was “built in” at the time of Terry’s admission.

Question 3

When Afton and Brett form LLC, no gain or loss is recognized to any party. Each partner receives a cost basis in the partnership interest acquired.

When LLC borrows $800,000, each partner is treated as contributing cash to LLC totaling that amount, thus increasing his or her basis in his or her partnership interest. IRC § 752(a). Because the debt is nonrecourse, it is allocated between the partners based on their shares of partnership gain, which at this time is 10 percent to Afton and 90 percent to Brett. Reg. § 1.752-3(a). Thus, Afton’s “outside” basis is increased from $40,000 to $120,000, and Brett’s “outside” basis is increased from $160,000 to $880,000. LLC’s basis in the real estate is $1,000,000.

The annual depreciation on the property is $100,000, resulting in an operating loss of that amount. In the first year of LLC’s operations, this passes through to the partners according to the partnership agreement, because the agreement satisfies the alternate test for economic effect under the regulations under IRC § 704(b). The agreement’s allocation of the partnership’s loss to the partners does not result in a negative capital account to Brett. Therefore, the loss passes through $10,000 to Afton and $90,000 to Brett. Their “outside” bases and capital accounts are decreased accordingly. At the end of year 1, Afton has an “outside” basis of $110,000 and a capital account of $30,000. Brett has an “outside” basis of $790,000 and a capital account of $70,000.

In year 2, the agreement’s allocation does not have substantial economic effect. Because Brett is not obligated to restore a negative capital account, Brett may not have a negative capital account unless “nonrecourse deductions” are involved. Because at the end of year 2 the book value of the real estate is not less than the outstanding balance on the debt, no “minimum gain” has yet occurred, and therefore no “nonrecourse deductions” are involved. Brett is allowed a deduction of only $70,000 of loss, equal to his capital account. The other $30,000 of loss passes through to Afton. At the end of year 2, Afton has an “outside” basis of $80,000 and a capital account of zero. Brett has an “outside” basis of $720,000 and a capital account of zero.

In year 3, the passed-through loss is solely attributable to “nonrecourse deductions,” which can be passed through to the partners as they wish so long as the requirements of Reg. § 1.704-2 are met. Here the requirements are met, including the rule that some other significant item attributable to the property must be allocated in the same percentages as the deductions. In this case, all items are allocated on a 10/90 basis at this time. Therefore, the year 3 loss passes through $10,000 to Afton and $90,000 to Brett. At the end of year 3, Afton has an “outside” basis of $70,000 and a capital account of negative $10,000. Brett has an “outside” basis of $630,000 and a capital account of negative $90,000.

The depreciation deductions reduce the basis of the real estate in LLC’s hands by $100,000 a year, leaving $700,000 of “inside” basis at the end of year 3.

The passed-through losses are subject to the passive activity loss rules of IRC § 469. Under IRC § 465, the debt is likely to be treated as “qualified nonrecourse financing,” and therefore the passed-through losses are not likely to run afoul of the at-risk rules. IRC § 465(b)(6).

The cash distribution to Afton results in no recognized gain or loss. IRC § 731. Afton’s basis in Afton’s partnership interest is reduced by the $2,000 distributed. IRC § 733.

The cash distribution to Brett will trigger income to Brett under the qualified income offset. Under Reg. § 1.704-1(b)(2)(ii)(d) (last paragraph), because the distribution reduces Brett’s capital account below zero, Brett must be specially allocated the first $8,000 of gross income recognized by LLC so as “to eliminate such deficit balance as quickly as possible.” This will result in less income being allocated to Afton.

Created by: bojack@lclark.edu
Update: 19 May 17
Expires: 31 Aug 18