Sample Answers to Question 2
Partnership Tax
Spring 2015

Exam No. 1922

Since the partnership is one where capital is a material income-producing factor, B’s share of the AR is within 736(b). Bill is getting more than his share of "hot assets" under 732(c). His fair share is 1/3 of the receivables or $30K. 732(c) does not want the remaining partners to avoid the ordinary income associated with receivables and keep only the long term capital gains associated with the other asset - real estate. Thus the transaction is suspect and will be handled according to 751(b).

To handle this, treat the transaction as if B took out the assets in proportion to his fair share: $10K cash (basis of $10K), $50K real estate (with basis of $45K) and $30K of AR (with 0 basis). In a taxable transaction, B sells the real estate and cash back to the partnership to buy the remaining $60K of AR. As result, B capital gain of $5K on the real estate. He now has all $90K of AR with a basis of $60K (what he paid for it). B will not recognize any ordinary income on the AR until he collects on it.

The partnership has ordinary income of $60K for the sale of the AR which immediately passes to A & C. Additionally, the partnership’s basis in the real estate has now increased by $5K which increases A & Cs’ outside basis by $2.5K each (it sold $50K of real estate with $45K basis and then bought it back for $50K which gives the partnership $50K basis in the property). See exhibit 4 for partnership balance sheet.

Exam No. 1685

ABC is a partnership, so it is taxed under subchapter K. Subchapter K is generally rather kind to partners on liquidating distributions. ABC made a liquidating distribution to Bill and the general rule for liquidating distributions is that a partner’s outside basis will become his or her basis in the distributed property. A liquidating distribution is generally a nonrecognition type of event under 731 and 732. If there is a gain, it is generally a capital gain. However, Bill and ABC may not get the benefit of all of this because when Bill left the partnership and took more than 1/3 of the accounts receivable, he upset the shares of hot assets amongst the partners and triggered 751.

When a partner leaves, their partnership year ends on that day and any income passes through to them. Here, Bill left on 1/1/16. Although ABC’s partnership tax year is not specified here in the problem, we can presume they have a calendar year tax year because the members are all humans with calendar tax years as provided in the exam instructions and nothing suggests they have a special business purpose tax year. Under 706(b), ABC will fall into 706b1B(ii) since there is no 50% majority, ABC will use the taxable year of its principal partners, which means if all with > 5% interest in profits/capital are on the same year, then ABC must use that. Here, A, B, and C are all calendar year. Since no other transactions happened on 1/1/16 except bill’s departure, so long as they are on calendar year, Bill had no income from ABC to pass through to him for the 2016 partnership year.

Next, when a partner leaves, we must determine if he is getting a 736(a) payment. This would be if he gets a distribution on liquidation that is greater than his share of the partnership value. Here, his partnership value is 90,000 and he takes out a distribution worth 90,000, so it does not appear that he is getting any special retirement bonus or pass through of partnership income in his retirement distribution.

The next step is to look at whether the liquidating distribution is altering the shares of hot assets in the partnership on departure. Accounts receivable are a hot asset - that is, an ordinary income generating type of item. Since Bill took all of the hot assets when he left, that definitely altered the shares of hot assets amongst the partners. Thus 751(b) kicks in because he took out more than his share. 751(b) says that when a partner receives a distribution of unrealized receivables in exchange for all or part of his interest in the partnership, the transaction is treated like a sale of property between Bill and ABC. He goes from having 1/3 share of hot assets to all of it.

This will be treated as if B only took out his share of the hot asset, plus the other items in the partnership, then sold the other items back to the partnership, and the end result will be ordinary income for A and C this tax year. So we imagine that instead of 90k of account receivable, Bill took out 10k of cash, 50k of real estate, and 30k of the account receivable. In that imaginary transaction, he would take his 55k of basis and apply that to the stuff he took out. The rule is 732(c) which says that the partner’s basis controls, with the exception that the basis of hot assets cannot be written up. Thus bill takes 1/3 of the account receivable [basis 0, FMV 30]; 1/3 of the cash [10K basis, 10k FMV], and 1/3 of the land [45k basis, 50k value].

Next, we imagine that Bill returns to ABC anything he didn’t actually get in the transaction, meaning: we imagine he sold the land and money back to ABC. This means that Bill will recognize 5k of capital gain for his 2016 tax year, because the land had a 45 basis and 50k FMV he gained 5k. Now, ABC has a stepped up basis in the land of +5 which makes sense because Bill just paid +5 tax on it.

In exchange for contributing to ABC the cash and money he didn’t actually get, we imagine that A and C gave Bill their shares of the account receivable, in a taxable transaction. When ABC ‘sold’ Bill A and C’s shares of the account receivable, that generated $60,000 of ordinary income to ABC (2/3 of the 90k). That income will pass through to A and C, the remaining partners, 50/50 under their new agreement that A and C are equal owners.

A will recognize $30,000 ordinary income

C will recognize $30,000 ordinary income

B will recognize $5,000 capital gain

AC will have a new basis in the real estate of $140k.

Bill will have a basis in the accounts receivable of 0. At the time that he collects the 90,000 account receivable, he will have 90,000 ordinary income. Because A and C were taxed on 30k of ordinary income their bases will each increase by that amount. For ABC balance sheet after bill retires please see question 2 exhibit A.

Next, the AC partnership is left with an inside/outside basis mismatch because there is a basis of 170,000 in assets but A and C have 85k + 85K for 190,000. A and C have the option of making a 754 election to try to fix the mismatch. If it’s just the two of them they might not want to go this route, there is not that big of a mismatch here and the accounting expenses might be greater than any tax ‘savings’ they get in the short term. If they don’t, basis will eventually make it all come out right in the end.

Exam No. 1556

This is a liquidating distribution which is treated similarly to an operating distribution with slightly different basis rules. Under 732, the basis of property distributed by a partnership to a partner in liquidation of partner’s interest shall be equal to the outside basis of such partner’s interest reduced by any money distributed.

The basis is allocated in a two tier approach. First, the basis goes into any unrealized receivables and inventory items UP TO the adjusted basis of each such property in the partnership. Therefore, because the account receivable is a hot asset, the basis cannot be allocated to it past the basis it had in the partnership. Therefore, the basis of the accounts receivable will be 0 in the hands of Bill.

Further, this is a disproportionate distribution of hot assets (751 assets) which triggers the application of 751(b) because Bill is actually taking more than his share of the hot assets. Therefore, we make believe that he took out a mixed bag of consideration. We artificially put the non-hot assets into his consideration. It would look like he only took out 30k of the receivables and the rest of his distribution will be treated as a piece of all the other assets of the partnership (10k cash and 50k of the real estate). We’ll make believe he got out just his share of the hot assets and just his share of everything else. This first part of the transaction: none of the basis goes into the hot asset because outside basis cannot increase the basis of hot assets beyond their basis inside the partnership. Therefore, his portion of the real estate asset, according to 732(b), will get the entirety of Bill’s outside basis minus the 10k cash received. So, he will receive that portion of the real estate with a basis of 45k.

Then, we’ll have him return to the partnership anything he didn’t actually get in exchange for the rest of the hot asset in a taxable transaction.

So, he returns the make believe assets in exchange for the rest of the receivable in a taxable transaction. This results in 60k income for the partnership which immediately passes through to the remaining partners. This also results in a capital gain to him equal to 5k (50k FMV - 45k basis). In this second step, Bill takes a capital gain of 5k from ‘returning’ his portion of the real estate back to the partnership. Bill will thus have the receivable asset with a FMV of 90k and a basis of 60k.

Finally, because of this second step, the partnership’s capital assets’ bases will go up by the portion of them that A pays tax on. As such, the inside basis of the real estate will increase by 5k.

736 is not triggered as a potential guaranteed payment issue because the partner did not get more than his distributive share (90k).

The final balance sheet after the partner liquidation can be seen on Exhibit A.

Created by: bojack@lclark.edu
Update:  27 Jan 16
Expires:  31 Aug 17