Sample Answers to Question 1
Partnership Tax
Spring 2015
Exam No. 1922
New Partner
As his contribution to
the partnership, J transfers the PT stock to the partnership. This is a nonrecognition
event for both J and the partnership. J gets his pre-existing basis in the
stock as his outside basis ($120K) in the partnership and the partnership gets
J’s basis in the stock as its inside basis ($120K). The partnership will be
able to tack J’s length of ownership of the stock so that whatever duration J
owned the stock will be considered the same duration of ownership for the
partnership. J’s capital account is $700K or the net of his contribution
($1000K value of stock - $300K loan against it).
Nonrecourse loan
As part of J’s
contribution, there is a $300K nonrecourse loan. Since the partnership is
taking on the loan, J will have loan forgiveness. Normally, since all partners
share profits and liabilities equally, they will each take on 1/3 of the loan
and J would be liable for 1/3 or $100K of the loan and thus has $200K loan
forgiveness which will be ordinary income to J. K and L would then have their
basis adjusted by $100K each for taking on the liability of the loan. However,
when a nonrecourse loan basis is less than the amount of liability, the
contributing partner gets the difference between the loan and the basis as part
of his basis for the loan which in this case is $300K - $120K --> $180K
basis to J. Then the remaining basis for the loan of $120K is split three ways
between the partners. J will get an additional $40K and K & L also increase
their outside basis by $40K. J’s total basis is now $120K from contributing the
property and $220K from the loan. He has $80K of loan forgiveness which will be
tax as ordinary income. See Exhibit 1.
Sale of closely held
stock
SEE BELOW - 743(b)
adjustment – Exhibit 2.
Sale of PT Stock
Since the buyer of the
stock is taking the stock with the debt, the partnership is receiving cash of
$820K and renumeration of $300K in the form of debt
relief for total consideration of $1120K. The result is that the partnership
has both tax and book gain on the sale. Under 704(c) traditional method of
allocation, J will take the first $880K of gain ($1000K book value - $120K
basis) because this gain was built into the stock when it was contributed. The
remaining gain is split three ways between the partners for $80K each
(($1120K-880K)/3) increase in outside basis. Whether the gain is capital or
ordinary income depends on how long the stock was held. If it was more than a
year continuously between J’s duration and partnership’s duration then it will
be capital gain.
All three partners
receive $40K increase in capital accounts as the equal split of book gain.
Since the transaction
also has loan forgiveness, the partners outside basis will go down. Since they
all have enough basis to cover the decrease, there is no issue with bases going
below 0 (which is not allowed). The loan forgiveness is just a reverse
transaction of taking on the loan. Thus J’s basis will be reduced by $220K and
K&L will be reduced by $40K. See Exhibit 3.
743(b) Adjustment
Since the partnership
has a substantial built-in loss (more than $250K) on the closely held stock, it
is required to make a 743(b) adjustment. This would allow K & L to keep the
losses built into the closely held stock for themselves rather than sharing it
with J. The bases of properties would be adjusted under 743(b). The 743(b)
adjustment would put J roughly in the position he would have been had he bought
the stock himself. J would receive a 1/3 interest in the stock (worth $200K)
with his own personal basis of $200K. When the stock sold for $570K, J would
have a $10K tax loss and $10K capital loss. K & L would share equally the
tax loss of $420K and remaining capital loss of $20K.
Exam No. 1685
When KL admits Jason,
the existing partners, K & L, revalued the assets and restated their book
values at their current FMV. Their balance sheet immediately prior to admitting
Jason looks like exhibit 1A. They
increased their book values to show the FMV of their shares based on the
current value of the assets. Since they are admitting Jason as an equal
partner, we expect Jason to contribute the same amount as the FMV of K &
L’s shares, that is, $700,000. Here, Jason contributes stock with FMV 1,000,000
and subject to a nonrecourse loan of 300,000 - thus the net of his contribution
works out to $700,000.
The next step is to add
Jason’s contribution of this encumbered property to the KL balance sheet. The
first thing to do on this is to apply 721, 722, and 723. 721 says there is no
recognition of gain or loss on contribution of property to a partnership in
exchange for a partnership interest so we expect Jason will not recognize any
gain or loss (but contributing encumbered property is one area where this could
potentially get taxed). Next, 722 says that the basis of Jason’s contribution
in his hands carries over and becomes his new basis in KL. J had a 120k basis
in the stock he contributed so his new basis in KL is 120k. Under 723, the
partnership takes a basis in the contributed property that is carried over from
the contributor, so KL gets basis of 120k in the publicly traded stock Jason
contributed.
Because KL got this
contribution subject to debt that the pship assumed,
the next step is to apply 752(a), because when a partnership takes on debt, the
partners get basis for that. There is a basis increase for the partners for the
debt the partnership assumed. The way we allocate debt basis depends on whether
the debt was recourse or nonrecourse. Here it is nonrecourse so the 1.752-3(a) reg tells us to distribute the debt basis along three
tiers. First tier is the partner’s share of minimum gain. Minimum gain is
calculated by: debt minus basis equals minimum gain. Here there is 180K of
minimum gain in the public stocks. The partnership has 3 members so they each
get 1/3 of the basis for the minimum gain so that’s + 60,000 debt basis for
each partner. Second tier is to allocate any built in704(c) gain that Jason the
contributor will get, which is only fair for him. Jason has 880,000 built in
gain on this stock (1,000,000 value minus 120k basis), so he will get basis for
the all of the remaining debt basis. Tier 3 is not applicable because there is
no debt left to distribute.
The next step is to
apply 752(b), which says treat debt assumed by KL as a distribution of money to
Jason. KL assumed 300,000 of debt so we subtract that. Jason was up to 300,000
of basis now we subtracted 300,000 so he is at 0 basis. And under 731 gain is
not recognized unless it is greater than the basis - so here what a relief
Jason ended at 0 no taxes for him. Partnership KL still takes his basis of 120k
in the public stock. This is reflected on balance
sheet 1.B
Later that year, KL
sells the closely stock to an unrelated party. First off, since Jason appears
to have joined the partnership midway through the year, there could be some
issues as to how much of the gain or loss on that sale should go to him if
there was some built in when he joined - if we were to prorate or something -
but there is not enough information here to calculate that.
The main issue is that
the closely held stock was sold for 570,000 cash which is a loss to KL of
430,000. This should be a capital loss since it was stock held for investment.
The loss will pass through to the Ps of 143,333 each which we subtract from the
ps capital accounts and books. Uh oh, Jason is at a 0
basis. Under 704d he cannot take losses anymore because he s out of basis.
1.704(d)(1) says that the losses can sit in a holding account and wait for the
partnership to make a profit someday then he can use them (which is good hell
need them on that very appreciated property he contributed. So only K and L get
to have the losses for now if this is the only transaction for the year but it
is not).
The next issue is the
sale of the publicly traded stock that Jason contributed. The stock was sold
for 820K plus 300k of debt relief (crane/tufts) for a total of 1120000. Which
is a gain from the 120k basis of 1,000,000. Usually since the partner are 1/3
partners we expect to split that loss 3 ways however this was contributed
property and under 704c1a we must allocate built-in gain to the partner wo
contributed the property. This ensures that non-contributing partners only get
taxed on their economic income. Jason contributed this property at a basis of 120
and FMV of 1 million, so there is 880,000 of built in gain that must all be
allocated to Jason. The remaining 120,000 of gain gets split three ways so each
gets + 40,000 of gain too. Jason gets + 920,000 gain, K and L each get 40,000
gain on this.
There is an issue about
whether Jason’s holding period tacked when he contributed the public stocks.
You have to own them for a certain amount of time before you can have the
friendlier capital gain rates. If his holding period didn’t tack then L and K
might get stuck with higher ordinary gain tax rates. However, generally if
basis carries over, then holding period tends to tack so L and K might be ok.
As to the publicly held
stock, so long as KL held it long enough to get capital gains rates then the
income on the sale of the stock will pass through to the partner with the same
character. Because under 702(b), character of income is determined at the
partnership level and retains that character as it passed through to the
partners. Except 724 which says when a dealer contributes property it retains
ordinary income character - and Jason is a securities dealer and he contributed
stocks. I presume stocks are inventory in the hands of a securities dealer.
Thus, unfortunately the gain for everybody on Jason’s’ low basis high value
stocks that got contributed and sold is all going to be ordinary income, not
capital gains. This is very sad news for K and L.
When KL’s taxable year
ends, the income will pass through to L, K, and J.
Exam No. 1666
See Ex. 1.A. for initial partnership balance
sheet.
Admission of Jason
In general, under 721, no gain or loss is recognized for either
the partner or partnership when a partner contributes property. However, when a
partner contributes encumbered property, the partnership assumes the debt along
with the property. For encumbered property, the partnership first analyzes per
721-723 as normal and then applies 752. First, there is no gain or loss
recognized and the partnership gets a carryover basis. Then the basis increases
for the liabilities assumed and the basis decreases for the liabilities given
up. The contributing partner's basis cannot go below zero and the excess is
recognized gain. In this case, the partnership will receives Jason's basis in
the stock. Then, the partners will receive an increase of outside basis for the
Jason's liability. Before allocating the liability, the liability has to be
characterized.
In general, when you borrow money, you get basis for it
and when you sell encumbered property, you include the debt relief as income.
See Crane. A liability is considered "recourse" only to the extent a
partner bears the economic risk of loss. 1.752-1(a)(1). A loan is
"nonrecourse" to the extent that no partner bears the economic risk
of loss. 1.752. In this case, the loan is nonrecourse because the bank can only
go after the secured property to recover its money, and not the partners
themselves. 1.752-1. This is true even though the partnership is a general
partnership. Because the debt is nonrecourse, it will be allocated to the
partners by the three tier system under 1.752-3(a)(1)(-(3). The nonrecourse
loan is first allocated to partner's share of partnership minimum gain
(according to 704(b)), then to partner's share of 704(c) property, and finally
in accordance with the partner's share of profits. J has 180K of minimum gain
so J receives 180K of the nonrecourse debt for J's basis. There is also a built
in gain of 880K on the stock contributed by J so J will receive the rest of the
liability (120K) in his outside basis. J's outside basis will increase from
120K (his carry over basis) to 420K after the allocation of the debt.
Thereafter, because J is giving up 300K, his outside basis will decrease by
that amount. After J buys into the partnership he will have an outside basis of
120K and a capital account of 700K. This transaction does not affect K and L.
See Ex 1.B.
The partnership will receive a carryover basis from J.
Generally, the character of the property is characterized at the partnership
level, except if the contributing partner was a dealer. In this case, J is a
dealer so the stock will be characterized as capital stock. Assuming the
partnership satisfies the big three.
Sale of Closely Held
Stock
If a partner sells 704(c) property and recognizes gain or
loss, that gain or loss must be allocated to the contributing partner. There
are three ways to allocate the built-in gain or loss: traditional method,
traditional with curative, and the remedial method. See 1.703-3(b), (c), and
(d). In this case, although the stock was not contributed by K and L, it is
treat as 704(c) property after J joined KL. There is a tax loss of 430K and a
book loss of 30K. The built in tax loss of 400K will be pass thru 50/50 to K
and L, thereby decreasing their basis by 200K each. The remaining tax loss and
book loss of 30K will be distributed 1/3 to each party. This will pass through
as capital loss so they can only be deducted against capital losses.
Thankfully, because the ceiling rule does not apply, the partnership does not
have to use the curative or remedial methods. See Ex 1.C.
Sale of Publicly Traded
Stock
When the partnership sells the stock it has a tax gain of
700K and a book loss of 180K. The built in tax gain will be fully attributable
to J since J contributed the property. J will receive a step up in basis equal
to the tax gain so his basis will be 810K. When the buyer takes on the
liability, the 300K will be treated a distribution for J, thereby decreases his
basis by 300K. J's basis in the partnership after the transaction will be 510K.
But unlike with the sale of the closely held stock the ceiling rule applies.
See Ex. 1.D. Because there is a book loss,
K and L should be able to get that book loss. Because there was not an actual
loss, K and L will not be able to take a loss on their capital accounts. If the
ceiling rule comes into play then the partnership may elect either the
traditional with curative or the remedial method. The traditional with curative
allocations allows the partnership to allocate other items of partnership
income or deductions to the other partners. 1.703-2(c). The allocated items
must match the 704(c) property in character.
Under the remedial method, the partnership first
determines the amount of book items and the partner's distributive shares of
these book items. Then the partnership determines the distributive shares of
these book items under the partnership agreement. Thirdly, the partnership
determines its tax items according to the usual method. Finally, the
partnership simultaneously creates an offsetting remedial item, in an identical
amount, and allocates it to the contributing partner. In this case, K and L
would each get 90K of loss and J would have to offset this with a gain.
Created by: bojack@lclark.edu
Update: 21 Apr 17
Expires: 31 Aug 18