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Course: Partnership Tax Spring Nofar 2001
School: Wayne State University
Year: 2001
Professor: unknown
Course Outline provided by Legalnut.com

TAXATION OF PARNERSHIPS OUTLINE

 

  1. Introduction

    1. Basics: Subchapter K of the Code (§§ 701-761)

      1. Sometimes it becomes necessary to treat the partnership as an entity instead of a conduit

        1. This leads to two competing theories – “entity theory,” which treats the partnership as a separate taxable entity, and “aggregate theory,” which treats the partnership as a bunch of individual taxpayers

    2. Partnerships vs. Corporations;

      1. Why Use a Partnership?

        1. Partnerships are the vehicle of choice for small transactions

        2. Avoids double taxation of income; top individual tax rate is 39.6% with a top capital gain rate of 20%, while corporate rate is 34-35% with no favorable capital gain treatment

          1. Caveats: can avoid double tax if corp. pays salary and interest (but this is limited by the code); also the “accumulation & bailout game” (letting retained earnings accumulate and bail out in some sneaky way – no passive loss rules for corporations)

        3. Self employment tax §1402: Net earnings from SE include a ptnr’s GI derived from a trade or business. A limited ptnr’s distributive shr of ptnrshp income is excluded from the definition of SE income on the theory that such income is a return on an investment. §1402(a)(13) as a guaranteed pmt for services of a limited ptnr. (P.24)

        4. Converting corp to ptnrshp: requires liquidation of corp therefore triggering corp tax and shsr liability. §332-336. A C corp can elect to become an S corp with no immediate tax consequences, but asset appreciation and other income accruing prior to conversion are still subject to corp level tax when those gains are ultimately realized. §1374 (P.24)

          1. Easy to convert a ptnrshp to a LLC or LLP. Rev Rul 95-37 1995-1 CB 130 . (P.25)

      2. Why Use the Corporate Form?

        1. Publicly traded entities are always taxed as corporations (§7704). Publicly traded partnerships (PTP) are taxes as corps §7704; unless 90% or more of income is from passive activity §7704©. If want venture capital, executive compensation techniques (e.g. incentive option plans)-these characteristics require the corp form of business.

          1. Cant use S-corp if foreign investors

        2. Complexity of partnership tax; dislike of Form K-1.

        3. Poor advice upon business formation!

    3. Partnership Classification;

      1. A P/S is a P/S for tax purposes if the “box is checked” – the rules are very liberal on what qualifies as a partnership. However, it may be classified as a corporation if 3 of these 4 characteristics are met:

        1. Continuity of life

        2. Centralized management

        3. Limited liability

        4. Free transferability of ownership interests

        5. (also note that “associates” and “business objective with profit sharing” are also included, but are always met by both P/S and corp.)

      2. From most liability to least liability: Ordinary P/S, LP, LLP, LLC.

 

 

 

 

 

 

 

 

 

 

  1. Formation of a Partnership: (CHP 2)

    1. Joint Venture: Podell v Commissioner P10; JV is a special combination of 2 or more persons where profit is sought without any actual ptnrshp or corp designation. Elements: K, agreement for joint control, contribution of $, prop, sharing of p/l. P’s wanted profits to be capital gains and IRS wanted it to be ordinary income. Prop was deemed ptnrshp prop. Whether a JV has been created is a q of fact. JV is treated as a ptnrshp for federal tax purposes §7701(a).

    2. Contribution of Property:

      1. General Rule: no recognition of gain/loss for contributions of property (except for certain investment P/S) (§721)

        1. Ptr. takes interest in P/S = adj. basis in contributed property (exchanged basis) §722. (Must contribute property-not services§1.721-1(b)(1)) (§§ 722, 723); his basis in his interest is called outside basis (OB) . Even though P has realized gain under §1001, §721(a) says the gain is not recognized. §721 parallels §351.

          1. Policy reason for non-recognition: is that the transfer of property to a Ptnrshp is considered to be a mere change in form of P’s investment. And is viewed as a business transaction that s/not be impeded by tax.

          2. Contrast OB to his capital account, which will be valued at the FMV of the contributed property.

          3. Services contributed for PS int McDougalv Commissioner (P51);

          4. Profit for services (P.57); Hale v Comm;

            1. Rev Pro 93-27 (P.63).

        2. P/S takes transferred basis in property rec’d §723 = to contributing ptr.’s adjusted basis of property + cash given, increased by unrecognized g/l §721(b); holding period also carries over §1223(2); basis in the property is called inside basis (IB). Basis to Ptnrshp is the adjusted basis of that property in P’s hands immediately after the deemed sale §723.

        3. Generally, contributions of services ¹ property (interest received for services is income to taxpayer); however, just “what is property” is often a fuzzy issue (Stafford – letter of intent is property)

          1. Also, different treatment if services are given for a profits (rather than capital) interest; this is discussed later

        4. Pre-contribution/Built-In Gain or Loss §704©

          1. A ptr must be allocated any pre-contribution gain or loss upon sale of the property he contributed §704©(1)(A) (P.29). This is not the case with corp’s and its shsr.

          2. Ceiling rule: g/l is limited to amt of actual unrealized g/l at time of contribution. Reg. §1.704-3(b)(1) (Pg. A-12)

          3. Thus, if A contributes $100 property with basis $70, the following results:

            1. A takes P/S basis of $70, P/S takes $70 basis in property

            2. If the property increases in value to $120 and the P/S sells it, $30 of the $50 gain (120-70=50) must be allocated to A because it represents pre-contribution (or built-in) gain; the remaining $20 may be allocated in any way

        5. Holding Period & Character;

          1. Holding period to ptnrshp §1223(1) “tacks on” (P/S takes ptr.’s period) if property is a capital asset or is §1231 property. P’s holding period in PS begins on the day following the date of P’s purchase of the PS int Rev Rul 66-7. (P.32)

          2. Character (capital vs. ordinary) is determined at the entity level, unless §724 applies (see below)

      2. Special Rules (§724) (ic)

        1. Unrealized Receivables – g/l is always ordinary

        2. Inventory Items – ordinary if g/l is recognized by P/S within 5 years of contribution

        3. Capital Loss Property – capital if g/l recognized by P/S within 5 years of contribution (and thus can only offset CG); this only applies to built-in losses

        4. §724 prevents contributing ordinary income property to a PS for purposes of converting it into capital gain property. §24 disregards a PS from using the contributed property for a different purpose.

    3. Partnership Accounting;

      1. This involves the “financial accounting” of keeping a P/S’s books; it helps to have had some basic accounting courses.

        1. Ptr.’s capital account =

          1. Increases by value (not basis!) of contributions + his share of book (not tax) income

          2. Decreases by value (not basis!) of distributions + his share of loss

      2. Capital Account Accounting Rules (TR §1.704-1(b)(2)(iv)(b)) (same as #d above)

        1. Increase for:

          1. Contributions – of (1) cash, or by (2) FMV (net (less) of liabilities) of contributed property

          2. Operations – by share of P/S (3) income/profit. Profit is added to OB & IB. Both are increased by the same amt.

          3. (4) Assumption of liab p37.

          4. (5) §704© pre-contribution gain only affects OB and not IB – capital acct. §1.704-1(b)(2)(iv)(b)(3). (P 38) .

        2. Decrease for:

          1. Distributions – by cash or FMV of property distributed. §731 distribution is tax-free unless distribute > basis. Then CG.

            1. First recognize and increase each partner’s capital account for his share of any unrecognized inherent g/l in distributed property!

          2. Operations – by share of P/S losses (or any other asset decrease that doesn’t affect liabilities)

      3. Transactions Resulting in Tax and Book Cap Acct. Disparities;

        1. Contributions;

          1. There will be a disparity if a ptr. contributes property with a different basis and FMV (e.g., contrib. of property with basis 100, FMV 150)

            1. Ex: A contrib land (b 100, FMV 150); AB contrib cash of 150; following balance sheet results:

              1. Assets

                1. Cash 150 b 150 BV

                2. Land 100 b 150 BV

                3. Total 250 300

              2. (No Liabilities)

              3. Capital Accounts

                1. A 100 tax 150 BV

                2. B 150 tax 150 BV

                3. Total 250 300

            2. Note that in the example, total tax capital account = P/S IB; each ptr.’s tax capital = his “share” of IB (i.e., his contribution to IB); and each ptr.’s tax capital also = his OB [this relationship will be complicated later by liabilities]

            3. We will see later that if the P/S was to sell the land, the $50 gain must be allocated to A (§704(c))

        2. Revaluations (i.e., “booking up”) (ic)

          1. Some transactions permit a partnership to “book up” (or down) its assets to current FMV. These include:

            1. New or existing ptr. makes a contribution for an interest in the P/S, and

            2. Upon a distribution that liquidates a ptr.’s entire interest [but not upon a ptr.’s sale of his entire interest!]

          2. Upon revaluation, the book capital account is altered, while the tax capital account remains the same

    4. Contribution of Encumbered Property (Liabilities) (§ 752) P.43

      1. General Rule: each ptr. is deemed to have contributed cash in an amount equal to his share of P/S liabilities. Incr OB/IB if assume liab.

        1. §1.722-1 re-characterizes a contribution of encumbered prop as a cash transaction. To the extent that the P is relieved of liab he is treated as having rec’d a distr of cash from PS. The constructive distribution triggers rules governing operating distributions §731. Under §731 a distribution of cash is considered a return of capital, which reduces a P’s OB (but not below zero). (P.43)

        2. Recourse Liab:

          1. (p43) A contributes land w/ fv of 150 and adj basis of 50 and mortg of 30 in exchange for 50% of PS. B contributes 120 in cash. PS has net worth of 240 (150 - 30 + 120). If PS assumes mortg then A’s OB is 50-15 of debt relief = 35 & B’s OB is 120 of cash + 15 of debt assumed = 135 OB.

        3. Recourse Liab in excess of basis:

          1. If A’s adj basis in land is 10k instead of 50 and liability is recourse. A’s OB under §722 is 10. A’s OB is then decreased (and B’s OB is increased) by the net amt of the debt that is allocated away from A to B§1.752-1(f) and is deemed to have rec’d a “constructive cash distribution from PS ” of 15 (1/2 of 30k recourse liab). This would yield a –5k OB (10-15). §733 precludes this by stating that a distribution cant reduce a P’s basis less than zero. §731(a)(1) treats the excess portion as gain from sale or exchange of A’s newly acquired PS interest. §1.722-1 This gain is treated as a capital gain under §741.

 

        1. Non-recourse liab;

          1. A contributes land fv of 150 and adj basis of 50 and prop is encumbered by 30 mortg. A has 15 of liab relief and his OB is 50-15 = 35 and B’s OB is 120+15 mortg assumption. Non-recourse liab is allocated based on shr of PS profits unless otherwise specified.

        2. Non-recourse liab in excess of basis:

          1. A contributes land fv 150 and adj basis of 10 and property is encumbered by 30 mortg non-recourse liab. Under Tufts the amt realized by th PS on disposition of the land subject to non-recourse debt includes the amt of the debt relief even if the debt exceeds the value of the property. As a result the amt realized will at least include 30 of debt relief regardless of the actual value of the land. PS recognizes 20 of gain (30 – 10 adj basis) when it sells the parcel and under §704©(1)(A) the gain must be allocated to the contributing P. So if A contributes land w/ a basis of 10 and non-recourse debt of 30 then20 of liability is allocated to A §704(c). The remaining 10 of liab if allocated according to A & B’s share of PS profits. If share equally then 5k to each A=10+5 & B =5.

      1. Allocation; If liab doesn’t state whether its recourse or non-recourse then its always recourse.

        1. Recourse liabilities – according to who bears the risk of economic loss (P.43)

        2. Non-recourse liabilities – by same means as profits are shared (p.45)

        3. How are recourse liabilities shared?

          1. The key is economic risk of loss (p. 42) – whose pocket would the money come from if the P/S went belly up? This is determined by doing a “constructive liquidation” of the P/S; to the extent that any ptr is responsible for repaying a liability, that ptr has the economic risk of loss.

            1. Steps to “constructive liquidation” (§1.752-2(b)(1)); the following are deemed to occur:

              1. All liabilities become due and payable

              2. All assets (including cash) become worthless (except for property held in name only to secure debt)

              3. All assets are disposed of in taxable transactions for no consideration (other than satisfying non-recourse debt secured by the property)

              4. P/S allocates all items of income, g/l, etc. for its last taxable year ending on date of constructive liquidation, and

              5. The P/S liquidates

            2. Also assume all ptrs live up to their obligations; don’t worry about built-in g/l for purposes of this test

            3. Also note: get rid of the non-recourse liabilities first, before determining who bears the risk on recourse liabilities

          2. See p. 109-113 for examples

        4. How are non-recourse liabilities shared? (§752 regulations)

          1. Because by definition no ptr. bears the economic risk of loss, there must be an alternate way of allocating non-recourse liabilities

          2. Apply following analysis: a ptrs share of non-recourse liabilities is equal to the sum of:

            1. His share of P/S minimum gain

              1. i.e., sum of non-recourse deductions allocated to ptr. + non-recourse distributions made to her

            2. His share of “§704(c) minimum gain” (the amount allocable to him under §704(c) if the property was disposed of for no consideration other than satisfaction of liabilities)

              1. ex.: ABC P/S; C contribs land (300 b, 1,000 FMV, 900 nonrec. liab.) C has $600 minimum gain (900-300)

            3. His share of “excess non-recourse liabilities”, i.e., those non-recourse liabilities not allocated under a or b.

              1. Can be shared either by profit share, by P/S agreement (so long as arrangement is consistent with some item with SEE) or by non-recourse deduction allocation

              2. By profit shares is most common and is the “default” method; by deduction is next-most common

              3. Thus, in the example under (b)(i) above, the remaining 300 (900 - 600 min gain allocation) of the liability would probably be allocated 100 to each ptr (assuming they share profits equally)

        5. Additional Notes;

          1. All of these could be treated as Tufts-type taxable events; however, they aren’t! (Tufts only for P/S debt forgiveness, not reductions in liabilities stemming from contributions of property)

          2. RR 88-77 – accrued expenses ¹ liabilities for §752 purposes; RR 95-26 – short sales = §752 liabilities

    1. Contribution of A/R and A/P (Assignment of Income Doctrine)

      1. The assignment of income doctrine basically says that income inherent in A/R must be taxed to the contributing ptr.; he cannot “assign” it away via the P/S

        1. Schneer v Comm; (P.78);

      2. Traditional rule (the “unrealized receivable” approach): When A/R (or A/P) are contributed, the income interest in the receivable (or deduction for A/P) must be taxed to the ptr. This is done by:

        1. Treating A/R as property for §721 (nonrecognition of g/l on contributed property)

        2. Giving the P/S a zero basis in the receivables under §723 (P/S’s basis)

        3. Characterizing income received by the P/S upon collection as ordinary under §724 (character of g/l)

        4. Allocating income to the contributing ptr. under §704(c) (Ptr.’s distributive share)

      3. However, note the approach in Schneer – you can assign the right to unearned income if it is from a source similar to the P/S activity. Which rule is the correct one is unclear.

    2. Partnership Liabilities and Loss Limitations:

      1. Recall that ptr’s share of P/S liabilities is included in OB – changes in a ptr’s share of liabilities are treated as contributions/distributions.

      2. Basis Limitation on Loss Allowance (§704(d))

        1. If OB = 0, loss carryforward until ptr has positive basis (from later income, contribution, or P/S borrowing)

          1. In other words, a ptr cannot deduct losses in excess of OB

          2. Sennet – ptr. sold interest for note in 1968; $240k allocated to loss in same year; $109k contributed in 1969. Loss is unusable in 1968 because of zero basis

            1. How to avoid this screw-up? Can make sale in ’69, or make contribution in ’68 (note that contributing a promissory note would not work – no basis in your own note!)

        2. Loss limitation may come into play when ptr is allocated a loss from another ptr’s contribution or loan from a 3rd party

      3. Basis Effects of Partnership Liabilities;

        1. General Rule:

          1. Increase in ptr.’s share is treated as a cash contribution §752(a); This increases OB (checked smn p.41). A/P on the cash basis are disregarded. Crane v Comm 331 US 1 (1947).

          2. Decrease in ptr.’s share is treated as a cash distribution §752(b)

        2. Ex: AB formed; A contribs property ($70 b, $100 FMV, $80 liab); B contribs $20. Result:

          1. P/S IB in prop= 30, BV = 70; A’s OB = 30, book cap. acct. = 20; B’s OB = 60, book cap acct. = 20

          2. Why? A gets a decrease in liability of 40, so he is treated as though he was distributed this amount; B gets an increase in liability, so he is treated as though he contributed this amount

      4. General Loss Limitations;

        1. See chart at end of outline

        2. Related Persons

          1. §267, §707(b)(1) – no losses allowed on sales to “related persons” (i.e., family, related corps, trusts, tax exempt orgs, etc.)

          2. Note that control requirements for “related” corps, etc. is 50% – but is increased to 80% by §1.752-4(b) + anti abuse rule in (b)(2)(4)

        3. At-Risk Rule

          1. Pritchett – to deduct loss, must be “at risk” for repaying the liability the loss creates – i.e., can’t be a contingent liability (holding P/S agreement requiring indemnification from LP’s sufficed to make the LP’s “at risk)

            1. Also: court will not discount when determining how much ptr. is at risk

        4. Passive Loss Limitations

          1. This basically kills tax shelters by disallowing passive losses if they outweigh passive gains (excess is a suspended loss)

    3. Disguised Payments for Services or Use of Property

      1. Basic problem: it is advantageous for a P/S to structure compensation for services relating to capital investment as a distributive share

        1. Why? Because if arms-length, the service ptr. gets income and the P/S has to capitalize the cost, resulting in yet more tax income for all ptrs.

        2. Ex.: ABC P/S has $60 income this year; A is architect, P/S gets him to design building for $60; if arm’s length, A gets $60 of income; ABC must capitalize cost of services, so it can’t offset it’s income with a deduction; thus A, B, and C each have an additional $20 of income to report

        3. Contrast above ex. to if transaction is considered a distributive share; A gets his $60 share, and there are no further consequences to P/S or B and C

      2. Several “bad factors” in determining treatment (§707(a)(2)(a) leg. history)

        1. Low risk (most imp – ptr’s share risk; independent K’s don’t)

        2. Transitory status

        3. Pmts are contemporaneous with services

        4. Tax benefits

        5. Continuing interest is small

        6. Does ptr perform similar services for others in similar situations?

        7. Disguised fees

          1. If ptr performs services, there is a related allocation to ptr, and these two facts taken together = a transaction between unrelated parties, then it is an arm’s length transaction

    4. Exchange of Partnership Interest for Services; (p48)

      1. Services for a Capital Interest

        1. Capital interest = one which entitles the holder to a current claim on P/S net assets or profit.

        2. How to tell if there is a capital interest involved? Do the “liquidation test” -- hypothesize that after service ptr gets his interest, the following occurs; if ptr is entitled to a distribution, it is a capital interest:

          1. All P/S assets sold for FMV

          2. Resulting g/l are allocated among ptrs according to their agreement

          3. All P/S liabilities are satisfied, and

          4. Remaining assets are distributed to ptr.’s in accordance with the agreement

        3. Effect

          1. Service ptr must include income equal to the FMV of the capital interest received §61(a); his basis is §1012.

          2. The capital ptr/P/S may get §162(a) deduction (subject to §263)

          3. Timing rule is unclear: either §706(a) last day of P/S year, or §83 date of transfer. Important, because that’s the date you assess FMV. §83 deals with all transfers of property in connection with the performance of services. If an interest is rec’d w/o restriction then income is realized upon receipt. If the interest is rec’d subject to substantial restriction then §83(a) provides that its fmv is included in GI when the restrictions lapse. I.e. in the 1st taxable yr in which the service partners rts are transferable or not subject to substantial risk of forfeiture. §83(c)(1).

            1. Election: a transferee of restricted property is permitted to elect under §83(b) to include the value of property in income at the time of its receipt. §83(b)(2).

 

        1. Examples

          1. In-Kind Exchange

            1. A has stock (10 b, 60 FMV); exchanges for services from B

            2. A has 50 CG (as though he sold the stock) and bus expense ded. of 60 (as though he used “sale” proceeds to pay B)

            3. B has 60 of OI §61(a) income and P takes capital interest (interest in future earnings and underlying assets) at §1012 “tax cost basis” equal to amt included in income.

          2. Transfer of Capital Interest (McDougal)

            1. O has horse (10 b, 60 FMV); gives ½ interest to T for services

            2. O has 25 CG and 30 bus expense ded.; T has 30 OI

            3. What if O has to capitalize?

              1. At the end of the day, O has horse worth 30 on which he has a basis of 10, so O should have a 20 gain. Credit O with cost of T’s services before you determine the amount of gain; cost of services is 30, so basis jumps to 40 (from 10)

          3. “Circle of Cash” – permits O to avoid gain from above example

            1. O borrows $30

            2. O gives T $30 for services

            3. T contributes $30 to P/S

            4. P/S distributes $30 to O, who repays the loan

      1. Services for a Profits Interest;

        1. An exchange of services for a profits interest is not a taxable event

          1. Except for narrow exceptions – profits int has fairly certain income stream, interest is in publicly traded P/S, or service partner disposes of his interest within two years of receipt

    1. Organization & Syndication Expenses (§709) (ic)

      1. Organization cost; (P. 71) (finish)

        1. Defined – lawyers and accountants actually creating the P/S (as opposed to startup costs such as investigating business opportunities), licensing and filing fees, etc.

        2. Treatment – may be treated as a “deferred deduction” – essentially, the expense is amortized over no less than 60 months (5 years); amortization period begins when business operations begin; Each ptr.’s share of OB reduced by amortization amount each year. (can also treat in same manner as syndication expenses).

      2. Syndication expenses;

        1. Defined – costs of marketing P/S to investors; includes broker fees, cost of tax opinions, etc.

        2. Treatment – Never amortized or deducted; they must be capitalized (and thus only recognized upon dissolution)

 

  1. Partnership Operations Chp 3

    1. Basic Rules;

      1. Taxable Year and Method of Accounting; (p.90)

        1. §706(a) requires a P to include his shs of PS income/loss in his tax return for the taxable yr in which the PS ends. (P.90). No fiscal yr is permitted under §706(b)(1)(B) unless a business purpose can be established for a different taxable yr.

        2. On the last day of the P/S’s tax year, each ptr. is treated as receiving his share of P/S income.

        3. A partnership must have a valid business reason for its taxable year or else it must use the “required year.” (And mere convenience or desire for deferrals is not a valid business reason!). The “required year” is determined in the following order (if not #1, then #2, etc.):

          1. If one or more ptrs. with > 50% interest (majority) (in profits and capital) use the same tax year, then use that year (p.90).

          2. If PS has two 30% indiv P’s with a calendar yr and one 40% corp ptnr with a fiscal yr, the PS must use a calendar yr.

          3. If all principle ptrs. (>5% of profits or capital) have the same tax year, use that year

          4. The year with the “least aggregate deferral” (aggregate deferral = sum of each ptrs. deferral that year) (see example p. 24)

        4. Opting out of required tax year;

          1. Can opt out (of course) if a valid business reason; no definite rules here, but you can definitely do it if ³ 25% of income is in the last 2 months of the tax year

          2. Can also do a §444 election (rather than §706(b)(1)(B) election) (p.92) – but only if the tax year chosen is within 3 months of the required year, and you must prepay estimated tax for the deferral period

        5. Method of Accounting – Can choose any method, but are limited by partners – must accrue if C corp is a ptr., P/S is a §461(i) tax shelter, or had > $5M in income for three years

      2. Income Computation & Items Omitted or Separately Stated;

        1. Each ptr. must account separately for items listed in §702(a)(1-7): (Note this is a reporting rule that has nothing to do with how things are actually divided up)

          1. STCG / STCL

          2. LTCG / LTCL

          3. §1231 g/l

          4. charitable contributions

          5. dividends with deduction under subchapter B

          6. §901 taxes paid to foreign countries & US territories

          7. other income, g/l, deduction or credit items determined by regulation

            1. Listed in TR §1.702-1(a)(8)(i); includes wagering, medical expenses, alimony, intangible drilling costs, etc., etc.

            2. Also: TR §1.702-1(a)(8)(ii) – “variable effect” items (item that would give ptr. different liability if not accounted for separately)

          8. Taxable income/loss, exclusive of other items requiring separate computation under this subsection

        2. Computation of P/S Income (§703(a)):

          1. Omit separately-stated items

          2. No “inappropriate deductions” – e.g., personal exemptions, itemized deductions

          3. No deductions whose benefits pass directly to the ptrs. (ex.: no NOL deductions b/c benefit flows directly to ptrs.)

      3. Elections and Character;

        1. Elections are handled at the P/S level; all ptrs. must agree – no one can opt out. (a few exceptions in §703(b))

        2. Podell (P.10)– character of income (capital or ordinary) is determined at the P/S level

          1. side note: Podell would be subject to the self-employment tax since he isn’t a limited ptr.

        3. Bayse – can’t assign income (or character of income) away; income is taxed to he who earns it (here, medical P/S is taxed even though the compensation was directed to an unsecured trust)

        4. Rev Ruling 68-79 (P.74); new P for only 6 months at PS sold stk at gain. If PS held stk > 1 yr then it’s a LTCG for all P’s even if P only owned PS interest for 6 months. In computing GI for P, use PS LTCG in the stk, not P’s holding period in the PS.

          1. Demirjian v Comm (P.75); P’s had no PS agreement; their property was condemned and each P took their ½ of the §1033 proceeds and only one P reinvested it. IRS said that since no election was made under §703(b) to replace §1033 prop the gain is included in PS income and the non-recognition rule doesn’t apply. Ct deemed the a PS and the PS is required to make the election.

        5. Transmutation of Character Rules

          1. CL à OL – if ptr. contributes what would be CL property in his hands to P/S, it remains CL property to the extent of built-in CL if sold within 5 years (partial taint) (§724(c))

            1. Note you measure built-in CL at date of contribution; thus, contribution of CL property with basis 400 & FMV 500; P/S sells for 350; result is $50 CL even though it is less than ptrs’ basis

          2. OI à CG – same rule; retains OI character – key difference is that the entire gain is OI (not just extent of built-in OI) if sold within 5 years (total taint) (§724(b))

      4. Adjustments to Outside Basis (OB) (§705)

        1. Principle: income is taxed once and only once – “preserve the exemption or the sting of the denial”

        2. Basic Rules:

          1. Increase OB for:

            1. Contributions

            2. Taxable Income Allocated to Ptr.

            3. Tax-Exempt Income Allocated to Ptr.

          2. Decrease OB for:

            1. Distributions

            2. Losses (including expenses and NOL’s) allocated to Ptr.

            3. Nondeductible, noncapitalized expenses (e.g., penalties, political contributions, charitable contributions) (except for capitalization expenses – why? who knows!)

          3. Don’t decrease OB below zero!

 

 

 

 

 

 

 

 

 

 

  1. Partnership Allocations; (CHP 4)

      1. Policing Special Allocations;

        1. General Rule: the P/S agreement controls how taxable income is allocated (§704(a))

          1. HOWEVER, §704(b) permits the IRS to reallocate if the agreed-upon method of sharing does not have substantial economic effect (SEE)

            1. Thus, in Orrich, there was no SEE for agreement that allocated all depreciation deductions to ptr. with lots of taxable income because “gain chargeback provision” (which would, on a sale of asset, allocate gain representing depreciation to O; the remaining gain would be split equally)

          2. In absence of P/S agreement (or if no SEE) the Code dictates each ptr. allocation according to each ptr.’s interest in P/S – i.e., what would happen upon liquidation

            1. This is sometimes called PIP – for “ptr.’s interest in P/S” - see below

        2. 3 Ways to Sustain an Allocation;

          1. The allocation meets the SEE definition (TR §1.704-1(b)(2)); see below for details (Safe Harbor Provision)

          2. The allocation is in accordance with ptr.’s interest as described in TR §1.704-1(b)(3)

          3. The allocation is governed by special rules of TR §1.704-1(b)(4)

        3. Determining Economic Effect (the “EE” of “SEE”)

          1. The “Big 3” Tests (must answer “yes” to each)

            1. Are capital accounts properly kept?

            2. Are liquidations made according to capital accounts?

            3. After liquidation, is there an unconditional obligation for ptrs to restore their deficits, if any?

          2. Alternative test (usually for LP’s)

            1. a & b of the basic test above

            2. There is a Qualified Income Offset (QIO) provision

              1. i.e., if there is a cash distribution to a ptr that creates a deficit for that ptr, the next item of income must be allocated to that ptr. to get him back to zero

            3. Allocation doesn’t create a deficit in excess of ptr’s obligation to restore it

        4. Determining Substantiality (the “S” of “SEE”)

          1. Essentially, a material non-tax reason for the allocation

            1. Generally, something is substantial if there is a reasonable possibility the allocations will substantially affect pretax dollars

            2. It is generally not substantial if there is a strong likelihood that after-tax present value consequences to one ptr will improve and that present value consequences to no other party will not be worse (a.k.a. the After-Tax Exception)

          2. It is subjective, but there are guidelines; for example:

            1. Shifting Tax Consequences – no SEE if:

              1. Negligible net effect on capital accounts, and

              2. Tax liability of all ptrs is less than without the allocation

            2. Transitory Allocations

              1. If P/S has both original and offsetting allocations, and when the allocations become part of the P/S agreement it is likely that the net effect of both allocations is negligible, and the ptrs total tax liability is reduced, then there is no SEE

          3. Substantiality is presumed if:

            1. 5 Yr. Rule – if item is not offset within 5 years, presume substantiality

            2. Value = Book Value Rule – assume tax depreciation = real depreciation (rule only applies to allocation of depreciation deductions)

 

        1. What happens if there is no SEE? There must be a re-allocation of the offending item according to PIP (§1.704-1(b)(3))

          1. Assume a per-capita allocation

          2. Look to facts & circumstances to determine each ptrs interest to rebut per-capita presumption (see also ex. 7 in the TR above)

          3. Special rule for ptrs violating rule 3 on EE (compare what each ptr would receive if P/S liquidated in current year to what each would receive if liquidated previous year)

      1. Allocation of Nonrecourse Deductions; move to chp 2)

        1. A sale of property with outstanding nonrecourse loan means outstanding loan balance must be included as an asset received from the sale

          1. Tufts (ic)– P/S gets $1.8M non-recourse loan, buys apt. complex; later sells complex for $1.4M when economy busts. Basis at time of sale is $1.455M. P/S claims $.055M loss. Ct. says NO – must include outstanding loan balance in sale price (here, $.4M), so actually a $400k gain

            1. Court’s theory: when property is transferred subject to a nonrecourse liability, the liability is treated as an amount realized; result: CG except for depreciation recapture

          2. Alternative theories:

            1. Tax Benefit – gain because of tax benefit; result: all inc. ordinary

            2. Cancellation of Debt – result: $455 OI, $55 OL

      2. Allocation of “built-in” gain or loss (§704(c)) (on a sale)

        1. Normally, tax must follow book; however, there is a problem when there is either:

          1. A contribution of §704(c) property (i.e., property where FMV ¹ basis, yielding “built-in” g/l)

          2. A revaluation via §1.704-1(b)(2)(iv)(f)

        2. There are three ways to handle this: traditional, traditional with curative allocations, and remedial allocations

          1. Remember: the basic goal of §704(c) is to prevent the shifting of built-in (i.e., pre-contribution) gain or loss to other partners

          2. Any of the below methods may be chosen for a particular asset BUT note the anti-abuse rule – can’t choose method that will shift g/l

        3. #1 The Traditional Method (with Ceiling Rule) (§1.704-3(b)) (p177)

          1. Noncontributing ptr is treated as if he purchased an undivided interest in the property for its FMV, with allocations for tax purposes made consistent with that treatment

          2. Ceiling rule: a P/S can only allocate g/l to the extent of g/l, income, or deduction that the P/S actually recognizes

          3. Ex.: AB P/S; A contributes land (60 b, 100 FMV), B $100

            1. If P/S sells land for $100, none of $40 tax gain is allocated to B since she sustained no book gain; A recognizes $40 gain

            2. If P/S sells land for $120, A must recognize $40 gain; the remaining $20 is split according to the P/S agreement (e.g., both A and B get $10 if they split proceeds equally)

            3. If P/S sells land for $70: AB has $30 book loss but $10 tax gain; even thought B has a $15 loss, he cannot claim a tax loss. A recognizes the entire $10 tax gain

              1. Note how this screws up the ptrs tax and book accounts: B now has a $85 book capital account, but retains a $100 tax capital account – she has a $15 economic loss that is not recognized by a tax loss

              2. Similarly, A had a $40 economic gain upon contribution, offset by a $15 loss upon sale, for a net $25 economic gain – making his book capital account $85 ($100-$15). However, he only recognizes $10 of tax gain (increasing his tax capital account to $70)

              3. This result is compelled by the ceiling rule – it will presumably be offset upon liquidation of the P/S (i.e., B gets $85 and thus recognizes a $15 loss; A gets $85 and thus recognizes a $15 gain

        4. #2 Traditional Method with Curative Allocations (§1.704-3(c))

          1. This is the same as the traditional method, but it permits reallocation of other gains for tax purposes to cure disparities (it “cures” the disparities caused by the ceiling rule)

            1. The reallocation must not exceed the amount of the ceiling limited item for the tax year, and is of the same character or type as that item

          2. Ex.: Same facts as above (AB P/S; A contributes land [60 b, 100 FMV], B $100) but add: AB invested the $100 in stock

            1. The land is sold for $70 ($30 book loss, $10 tax gain); stock is sold for $150 ($50 gain for both tax and book)

              1. Again, there is a $15 disparity on the sale of the land as in the example above

              2. To prevent this, can allocate $40 of the stock gain to A and $10 to B for their tax accounts. This has the effect of increasing A’s tax account from $70 (balance immediately after the land sale) to $110; it does the same for B, increasing his account from $100 (balance unaffected by land sale) to $110. To illustrate:

                1. A B

                2. Beg Bal 60 tax 100 book 100 tax 100 book

                3. Land Sl. 10 tax (15) book -- tax (15) book

                4. Stk Sl. 40 tax 25 book 10 tax 25 book

                5. Total 110 tax 110 book 110 tax 110 book

        5. #3 Remedial Allocations (§1.704-3(d))

          1. Basically permits P/S to ignore ceiling rule and “make up” tax allocations to match book allocations

          2. Allocate all P/S income or loss to noncontributing ptr until tax = book; if insufficient income or loss to do this because of the ceiling rule, then make up a remedial allocation to the noncontributing ptr and an offsetting allocation to the contributing ptr.

          3. Ex: Same facts again (AB P/S; A contributes land [60 b, 100 FMV], B $100)

            1. Land is sold for $70. B gets a “made up” tax loss of $15; A gets similar gain. To illustrate capital account effects:

              1. A B

              2. Beg Bal 60 tax 100 book 100 tax 100 book

              3. Land Sl. 10 tax (15) book -- tax (15) book

              4. Remed. All. 15 tax 0 book (15) tax 0 book

              5. Total 85 tax 85 book 85 tax 85 book

        6. Depreciable Property;

          1. Depreciation complicates allocations of built-in g/l because g/l must be recognized over the life of the property (instead of just waiting for sale)

          2. General Rules

            1. P/S steps into contributing ptr’s shoes on depreciation

            2. Book depreciation = tax depreciation

            3. If basis ¹ FMV, book & tax depreciation occur at the same rate

          3. Depreciation & Traditional Method

            1. Generally, the noncontributing ptr is allocated the same amount of depreciation for tax purposes as they are for book; if depreciation exceeds the noncontributing ptr’s share, then the contributing ptr is allocated the balance.

            2. Ex: A contributes equipment (80 b, 120 FMV), B contributes $120; on equipment, 10-yr. straight-line recovery pd. with 4 remaining years

              1. Note that AB must recover its $80 tax basis over the remaining recovery period of 4 years (i.e., $20/yr.)

              2. Also note that AB must recover its $120 book basis over the same recovery period of 4 years (i.e., $30/yr.)

              3. Thus: each ptr. suffers an actual economic loss of $15 from book depreciation per year; therefore, out of the $20 tax depreciation available, allocate $15 to B (the noncontributing ptr.); the remaining $5 goes to A

                1. Thus, A gets less depreciation and is “overtaxed” each yr.; in this way, he recovers the built-in gain on his contributed property

            3. Variant #1: Same facts, but A’s basis at contribution is only $40

              1. Thus CD has only $40 of tax basis to recover (i.e., $10/yr.) (book recovery remains the same – $30/yr.)

              2. Each ptr. again suffers an actual economic loss of $15/yr. from book depreciation; however, only $10 of tax depreciation is available. This is all allocated to B. However, this creates a disparity in B’s capital accounts that will increase by $5 each year.

              3. Thus, the ceiling rule will force B to be overtaxed $5 per year for 4 years (thus taxing B on a portion of A’s built-in gain). The disparities will not be resolved until the P/S is liquidated or A or B sells their interests

          4. Depreciation & Traditional Method + Curative Allocations

            1. If there are other resources available to make curative allocations, the P/S can prevent the disparity in the example above

            2. Ex: Same facts, but P/S has $20 of income per year (split $10 each between the ptrs)

              1. Allocating $5 to B and $15 to A in the tax capital accounts will cure the disparity above (book allocation would remain $10 to each ptr)

          5. Depreciation & Remedial Method

            1. P/S adopting this method must use special rule to determine amount of any book item (including depreciation) with respect to that property)

              1. Special rule loosely considers that the contributing ptr sold the property on a deferred basis to the P/S on date of contribution for its FMV.

                1. To the extent of transferred basis, P/S steps into ptr’s shoes for both book and tax purposes and must use ptr’s depreciation method

                2. To the extent FMV exceeds basis (the “balance of value”) is treated for book purposes as though P/S bought the property for this amount; for this latter amount, P/S can use any depreciation method

                3. Thus, property is “split in two” and treated as though it were two assets

            2. Ex: Same facts as above (Ex: A contributes equipment (40 b, 120 FMV), B contributes $120; on equipment, 10-yr. straight-line recovery pd. with 4 remaining years; $20 income/yr.)

              1. P/S treated as though it received two pieces of equipment, on contributed by A worth $40 and one purchased for $80

              2. With respect to the “contributed portion,” must use A’s depreciation method over remaining life (e.g., $40 straight line for 4 yrs., or $10/yr.) for both book and tax

              3. with respect to the “purchased portion,” P/S can choose its own method; presume it chooses a 10-year period. Depreciation is $80 for 10 years, or $8/yr. for book purposes

              4. Thus, AB gets book depreciation of $18 (10+8) for the first 4 years, and $8 for the remaining 6 years

                1. Thus, for its first 4 years, AB will have $2 of income for book purposes (20 inc. - 18 depr.); it will have $10 for tax purposes (20 inc. - 10 depr.)

                2. For these four years, A & B would each be entitled half the $20 income and $18 depr. for book(or $10 and $9 each, for a net of $1 each) and $10 inc. each for tax; however, under the traditional method B would get $9 of depr. and A only $1; thus A would have $1 tax inc. and B $9.

                  1. This causes A’s book/tax disparity to be reduced and B’s to be unaffected (see p. 94)

                3. This changes in the last 6 years; although $4 of book depr. is allocated to B, the ceiling rule prevents any allocations for tax purposes. Thus, a $4 remedial offsetting decrease must be made to B’s tax account and an offsetting increase to A’s account

        7. Choice of Method;

 

          1. If all ptrs in same tax bracket, it makes no difference

          2. Otherwise, choose method with most aggregate tax savings; if disparity between ptrs’ brackets is large, this is probably traditional; if small disparity, then probably traditional with curative allocations (if there are no income offsets, then remedial – the traditional with curative allocations is generally better because of the accelerated depreciation)

          3. Anti-Abuse Rules (§1.704-3(1)(10))

            1. Can’t choose method with “view to shifting tax consequences of built-in g/l among ptrs in a manner that substantially reduces the present value of the ptrs’ aggregate tax liability

            2. Typically arises with the use of accelerated depreciation methods where the asset’s economic life is longer than the cost recovery time

        1. Revaluations;

          1. Sometimes called “reverse §704(c) allocations,” this permits, upon a change in P/S interests, all built-in g/l’s to be recognized for book purposes and allocated by the P/S agreement terms; the tax items are not recognized; this leads to the same type of disparities from the contribution of property with built-in g/l

          2. These disparities are taken care of by the same types of allocations illustrated above

      1. Family Partnerships;

        1. Even if a P/S complies with §704(b), its allocation still might not be respected if it is a family P/S

        2. “Assignment of Income Doctrine” – Income must be taxed to the earner; it cannot be shifted away (Lucas v. Earl)

        3. §704(e) overrules prior interpretations on when to recognize family P/S if P/S has capital as a material income-producing factor

          1. If a person has a capital interest, they are a ptr regardless of how that interest was acquired (i.e., a right to capital upon liquidation)

          2. However, if that interest was received as a gift or purchase from a relative, donee can only report his share if donor has received adequate compensation for services to P/S

        4. For service P/S – only treat as ptr if you actually perform services; distributive share cannot exceed reasonable compensation for those services

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

MIDTERM-----------------------------------------------------------------------------------------------------------------------------------------------------------------

  1. Partner-Partnership Transactions CHP 5

    1. Side Arrangements with Partner & Guaranteed Payments

      1. The basic question: what is a §704(b) distributive share, a §707(c) pmt., or §707(a) pmt.?

        1. Categories

          1. §704(b) distributive share = aggregate treatment to pmts for service/capital if amt. is determined with reference to P/S income; use P/S accounting method

          2. §707(c) – ptr gets guaranteed pmt. – hybrid approach; for:

            1. §§61(a) (income to ptr), 162(a) (deductible to P/S), 263 (capitalization trumps deduction) – treat as though not a ptr

            2. all other purposes, treat as distributive share

            3. use P/S accounting method

          3. §707(a) – an arm’s length transaction – treat as though not a ptr.; use ptr’s accounting method

        2. Also see chart p. 123

        3. Note in a “minimum guaranteed pmt” situation, if P/S income to ptr. is > than minimum pmt., the whole thing is a distributive share (and not a guaranteed pmt.); if P/S income to ptr. is < than min. pmt., the min. pmt. exceeding ptr’s share of P/S income is a guaranteed pmt.

      2. Ask: is ptr. acting as a ptr or as a stranger? If stranger, then arm’s length; then ask, is amount determined with respect to P/S income? If yes, then dist. share; if not, then guaranteed pmt.

  2. Leaving a Partnership CHP 8

    1. General Notes

      1. General Rule: §741 – sale = CG/CL; §743 – (a) sale has no effect on IB of P/S assets (Entity Theory)

        1. But §751 Override: ordinary g/l if attributable to ordinary income assets (Aggregate Theory)

      2. Effect of Sale

        1. Seller: record g/l in amount = to amount realized - OB; gain is capital except for §751 override (can use installment – §453)

        2. Buyer: takes cost basis in interest bought; takes seller’s capital accounts (both tax and book) and seller’s share of IB

          1. This usually means IB/OB is inconsistent, but can adjust under §753(b)/§755 if P/S has made a §754 election

      3. Gergen’s Exit Strategy Primer

        1. Conflict between buyer and seller – buyer wants as much value to be ordinary as possible; seller wants as much allocated to capital assets or to “goodwill” as possible

          1. Because of this conflict, the government will respect the parties allocations (but be sure you like it, because once you choose it, you’re stuck with it!)

        2. Note general rules above (and don’t forget to divide numbers down to ptr’s share!)

        3. Mechanics of Computation:

          1. Determine Hot Assets

          2. Allocate sale price to selling ptr based on FMV (ptr’s share of FMV of hot asset)

          3. Determine basis by basis selling ptr would have in distribution (ptr’s share of basis of hot asset)

          4. Calculate ordinary income (step 2 - step 3 = x)

          5. Calculate CG/CL by using balance of selling ptr’s remaining sales price minus OB (s.p. - OB = x)

        4. Note Ledoux – sale of ¼ interest in dog track for $800k; assets are worth $310k (so interest sold is worth $77.5k); 800-77.5 = $722.5 – how is this allocated? How much can be thrown to goodwill?

          1. MG: P/S shot Ledoux in the foot by not having a valuation agreement (got to put some value on hot assets to keep from looking ‘fishy,’ but can otherwise assign bulk to goodwill)

    2. Sale of Partnership Interest

      1. Consequences to Seller if Partnership has “Hot Assets”

        1. “Hot Assets” (a.k.a. §751 property) = unrealized receivables and substantially appreciated inventory

          1. Unrealized receivables = a right to payment for goods delivered (or to be delivered), services rendered (or to be rendered), and §1245 depreciation recapture items

          2. Substantially Appreciated Inventory = Inventory that has appreciated > 120% in the aggregate

            1. §751(d)(i)(b) anti-abuse rule – if assets are acquired to avoid the 120% rule (e.g., to water down the aggregation), they don’t count for “hot asset” evaluation

        2. 1997 change – inventory does not have to be substantially appreciated to be subject to §751(a) (still must be for §751(b))

        3. Follow “Mechanics of Computation” above

      2. Installment Sales

        1. If at least one payment is received after the year of sale, the installment method must be used (§453)

        2. Basically, pro rata gain is recognized with each pmt. (gross profit x pmt./K price)

          1. Note: assumption of debt = pmt.; impute interest if not adequate interest (or original issue discount)

        3. Exceptions: no installments for inventory or recapture income, or for pmts for services

        4. How do installment sales apply to P/S interests?

          1. If P/S has §751 property, treat as though sold outside the P/S; not allowed to defer recognition of gain

      3. Consequences to Seller and §754 Elections (Optional Basis Adjustments)

        1. The problem: buyer succeeds to sellers share of IB, but takes cost tax basis (OB); this can lead to duplication of g/l (seller has recognized g/l according to rules above, but buyer will be forced to recognize it again upon sale/collection of asset)

          1. To illustrate: AB P/S; A & B each have OB, share of IB, and capital accounts of $100; A sells to C for $300 (A will recognize a 200 CG [300-100])

            1. P/S Books immediately after sale:

              1. Assets

                1. Inventory 100 IB, 200 FMV

                2. Land 100 IB, 400 FMV

                3. Total Assets 200 IB, 600 FMV

              2. Capital Accounts

                1. Tax capital Book capital FMV

                2. C 100 100 300

                3. B 100 200 300

                4. Total 200 200 600

            2. The problem: A has already been taxed on the $200 increase; if the P/S sells the assets for their FMV, C will have to recognize this gain again – unfair, especially since C paid a $200 premium for his interest (The overtaxation would be reversed upon liquidation by C getting a loss, but that is unacceptable)

            3. A §754 adjustment here would increase IB by it’s difference between OB, or $200 ($300 OB - C’s $100 ½ share of the 200 IB)

          2. Note: Because seller’s capital account carries over to buyer, tax capital no longer = OB!!!!

          3. MG refers to tax capital as adjusted basis, or AB (and distinguished from OB) and book capital as the capital account, or CA; I’ll use this convention from now on

        2. The solution: can elect to adjust IB to reflect OB

          1. Election is made at P/S level

          2. Election made for given tax year at any time during that year

          3. Once made, this election applies to every sale in every subsequent transaction of the year made and in future years; the election can be revoked for administrative convenience (but not for adverse basis consequences – it is difficult to get a revocation – easier to liquidate and start anew)

        3. Mechanics of §743(b) (i.e., of the §754 election):

          1. Aggregate amount – transferee basis in int. (OB) - transferee proportionate share of basis in P/S assets (IB) = x

            1. i.e., OB - IB = x

          2. Only transferee benefits from adjustment (P/S does not record the adjustment in its books) – accountant keeps separate record of new ptr’s basis

          3. Allocate among assets (Special Rule, then General Rule)

            1. Special Rule: divide among capital/§1231 assets and noncapital assets based on relative amount of net appreciation in each class of asset

            2. General Rule: next, within each class further allocate in a manner that has the effect of reducing the difference between FMV and adjusted basis (allocate on a per-asset basis)

              1. Minor hitch: only appreciated assets are adjusted (i.e., not those that have declined in value); since depreciated assets are used in calculating adjustment amount, there is a problem – the adjustment amount is too low! Solution: allocate among appreciated assets on pro-rata basis

          4. To illustrate: AB has stock (40 IB, 100 FMV) and inventory (60 IB, 100 FMV); A & B each have 50 in their capital accounts (both tax and book); A sells to C for $100

            1. There is $50 (100 OB - 50 share of IB) to allocate; step one divides this between the stock and inventory based on relative appreciation

            2. There is $60 of appreciation in the stock (100-40) and $40 of appreciation in the inventory (100-60). Therefore, $30 of the $50 allocation goes to the stock, the remaining $20 goes to inventory (Step 2 isn’t reached)

          5. Effect of §704(c)

            1. Since buyer steps into shoes of seller, he also takes seller’s built-in g/l

      4. Mid-Year Sales and Allocations

        1. Normally, P/S tax year does not change due to change in interests

 

          1. Two exceptions: if sale or exchange of ³ 50% of total interest in capital and profits, tax year closes for all ptrs; if ptr disposes of his entire interest, tax year closes for that ptr only

          2. §706(d) requires that if there is a change in interest, each ptr’s distributive share P/S items must be determined under method prescribed by regulation (no regulations have been promulgated)

            1. Instead interim closing method is used (close books, determine income/loss as if year end;

              1. Alternative: use proration method to determine P/S income – wait until tax year ends, prorate annual income/loss on a daily basis

            2. 1984 legislation prevents using this to allocate expenses to new partners that occurred before they were admitted to the P/S – “allocable cash basis items” must be allocated to days to which they relate economically (§706(d)(2))

    1. Distributions

      1. General Distribution Rules

        1. Current Distribution means ptr’s interest continues; Liquidating Distribution means ptr’s interest terminates

        2. Capital Accounting Rules

          1. P/S must recognize inherent g/l for book (not tax) purposes. To do this:

            1. Adjust all ptrs capital accounts to reflect how inherent g/l would be allocated if there had been a taxable disposition

            2. Reduce distributee’s capital account balance by net FMV of distributed property

          2. Recall that if distribution is for all or part of a ptr’s interest, then all assets may be revalued (“booked up”)

          3. Character & Holding Period (§735 – similar to §724 [contributions])

            1. If inventory item is sold within 5 years of its being distributed, or is an unrealized receivable, then OI

              1. Unless there is a §754 election in place – basis remains the same for distributed property

        3. Recognition of g/l (§731)

          1. Normally, no recognition of g/l (distributee just reduces OB, preserving inherent g/l in his P/S interest); only recognize gain if a cash distribution in excess of OB

            1. Cash distribution – just reduce OB by amount of cash distributed (also, remember that a reduction of liability = a cash distribution)

              1. Ex.: A has $100 OB; he gets a $75 liquidating distribution; if his share of P/S liabilities is $50, then he is deemed to have received $125 (50+75) and must recognize $25 gain (125-100)

            2. For a marketable securities distribution, the distribution is treated as cash = Total FMV of asset - ptr’s share of appreciation

              1. Ex.: A has $50 OB; AB distributes securities (40 IB to P/S, 100 FMV) to A; A is treated as though he received $70 – A’s share of appreciation is 30 ([100-40]/2), and thus is deemed to have received 40 + 30 = 70. A has a 20 gain on the distribution (70 - 50 OB = 20)

              2. Basis in security = that derived under §732 + gain recognized (in above example, 40+20=60)

          2. Loss is only recognized in a liquidating distribution, and then only in the event that:

            1. If cash/unrealized receivable/inventory – CL to the extent that OB > cash + basis of distributed property (to prevent conversion to ordinary loss)

        4. What is basis in distributed property, and how is basis allocated to distributed assets?

          1. Current distributions: Basis of distributed property (other than cash) = basis as held by P/S, except:

            1. If P/S basis of distributed property > ptr’s ROB, use §732(c) (New revision below)

              1. ROB = reduced OB (OB - cash received)

          2. Liquidating distributions: basis = ROB

            1. Also note: if property basis < ROB, then CL (unless receivables, etc. are involved); if property basis is > ROB, then allocate (no CG)

          3. NEW Aug. 1997 Revision to §732(c) (How to allocate basis)

            1. Applies when:

              1. Insufficient OB on distribution

              2. Liquidating distribution of capital assets + basis step-up

            2. Rules:

              1. “Hot asset” takes carryover basis if sufficient OB; if insufficient OB (i.e., basis step-down), then use option (ii) below (§732(c)(1)(a))

              2. Remaining basis – determine net increase or decrease in basis, if any (§732(c)(1)(b))

                1. If an increase, allocate among assets in accordance with their relative unrealized appreciation; if any balance, allocate in accordance with FMV (applies to total liquidations only)

                  1. Ex.: A liquidates his interest (55 b); he gets 2 assets, X (5 b, 40 FMV) and Y (10 b, 10 FMV). Neither asset is a “hot asset”

                  2. There is a net increase in basis of 40 (55-5-10=40); this must be distributed among the assets

                  3. X = 5 (starting basis) + 35 (unrealized appreciation) + 5 (4/5 of total FMV)

                  4. Y = 10 (starting basis) + 0 (no appreciation) + 5 (1/5 total FMV)

                2. If a decrease, allocate in proportion to unrealized loss up to unrealized loss, then in proportion to basis

        5. Special Rule Under §732(d)

          1. Recall that if P/S does not have a §754 election in effect, a purchaser of an interest is not entitled to special basis adjustments in P/S assets; this could be a windfall/hardship to ptr who recently purchased his interest; thus, 2 special rules are provided:

            1. If the property is distributed within 2 years of the purchase of the interest, can elect to treat it as though a §754 election was made

            2. In some circumstances, the above rule is mandatory, including:

              1. FMV of P/S assets is > 110% of total bases

              2. If transferee’s int. had been liquidated immediately after acquisition, there would be a shift of basis from non-depreciable to depreciable property

              3. If a §754 election had been taken, transferee’s adjustment would have changed basis of property actually distributed

            3. Ex.: XYZ – each ptr has $5k in both OB and cap account; P/S has following assets: Land #1 (1k b, 5k FMV); Land #2 (2.5k b, 5k FMV; Land #3 (.5k b, 3k FMV); Equipment (2k b and FMV) (Totals: 6k b, 15k FMV); the P/S has no §754 election in effect

              1. X sells to W for $5k; later during the year, the P/S dissolves; W gets Land #3 and the equipment

              2. Absent §754(d), W would allocate his $5k OB between Land #3 and equipment according to their relative bases [note: under old rule of allocation] (i.e., $1k and $4k respectively) – a misallocation because land is appreciated while equipment isn’t; thus, W will get a higher basis in the equipment than he should and thus higher depreciation deductions in the future

              3. §754(d) forces W to increase Land #3’s basis to $3,000 (a $2,500 increase), increasing its basis relative to the equipment (so OB would be allocated $3k and $2k, respectively)

            4. Basis Adjustment to remaining ptrs:

              1. If gain to distributee ptr, increase basis of capital assets

              2. If loss to distributee ptr, decrease basis of capital assets

            5. See also §1.743-1(b)(2)(ii); §1.732-1(d)(1)(v)

        6. Partnership Terminations

          1. P/S terminates if sale or exchange of ³ 50% of total P/S interests in capital and profits in a 12-month period

          2. Upon termination, P/S deemed to make liquidating distributions to all ptrs in proportion to their interests, who are then deemed to have contributed them to a new P/S

          3. Additional things that happen on termination:

            1. Tax year of P/S ends

            2. New P/S not bound by old P/S elections

            3. Termination may result in g/l recognition under §731

            4. Termination may change bases that new P/S has in its assets

      2. Optional Basis Adjustments (§734(b))

        1. Basic Problem – if distributee takes different OB (or recognizes g/l) from P/S IB, there is a disparity – can lead to artificial increases or decreases at P/S level; §734(b) permits an adjustment to correct this

          1. Key: after distribution, look at each remaining ptr’s OB and share of IB – if they are different, an adjustment may be in order

        2. Determining the amount of the adjustment

          1. If g/l, increase/decrease basis of P/S assets by amount of g/l

          2. If different basis taken, increase or decrease basis of P/S assets by difference in OB/IB (if lower basis taken, increase basis, and vice-versa)

        3. Allocating the adjustment (§755)

          1. Divide adjustment between capital/§1231 and noncapital assets

            1. If adjustment is triggered by g/l to distributee, then all goes to capital assets

            2. If adjustment is triggered by a change in basis of an asset in a given class, adjustment only goes to the assets in that class

          2. Allocate the amount of adjustment to assets within both classes to reduce the difference between FMV and adjusted basis

        4. Problems and Pitfalls

          1. If exiting ptr purchased his interest, results are often goofy

          2. If one entire asset class is distributed, can’t make an adjustment to other asset classes (even if asset in same class is later acquired, can’t make adjustment that would increase the disparity between basis and FMV)

            1. MG: this is the “great defect” in §734(b)

        5. See examples p. 171-8

      3. “Hot Assets” and Disproportionate Distributions (It gets ugly – §751(b))

        1. Recall that “hot assets” = certain ordinary income items (unrealized receivables and substantially appreciated inventory)

        2. Purpose of §751(b) – prevent taxpayers from using liberal distribution rules to convert OI into CG

          1. This can happen (absent these rules) if there is a mix of hot and cold assets in a P/S – for example, receipt by distributee of cold asset relieves him of his share of hot asset (OI) liability

        3. The Cure – If distributee receives hot assets in exchange for her interest in cold assets (or vice versa) the distribution is treated as a sale or exchange, in the form of three separate transactions:

          1. Hypothetical Distribution

            1. Distributee is treated as though he got a current distribution in which his interest decreased by the disproportionate distribution

          2. §751(b) Exchange

            1. Ptr deemed to have sold property received in hypothetical distribution for an equal amount of the type of asset in which his interest increased

          3. Non-§751(b) Exchange

            1. The balance of the distribution is treated via the normal distribution rules

        4. Four-step analysis for §751(b) problems

          1. Construct P/S Exchange Table (PET) – see sample at end of outline

            1. Ex.: ABC has hot asset (2400 b, 3000 FMV) and cold asset (600 b, 1500 FMV), and ABC each have 1000 OB/cap acct.; A gets capital (cold) asset in complete liquidation

            2. PET =

              1. Hot à 0 + 0 - 1000 = (1000)

              2. Cold à 0 + 1500 - 500 = 1000

            3. Table makes clear that distribution is disproportionate – A’s interest in hot assets have decreased by 1000 while his cold asset interest has increased

            4. Thus, A is deemed to receive 1000 of hot assets in the hypothetical distribution, to transfer this hypothetically distributed hot asset back to the P/S, and receive a liquidating distribution of the remaining $500 worth of cold asset

 

          1. Analyze hypothetical distribution

            1. A has no g/l; takes transferred basis in hot asset of $800 (2400/3 – 1/3 of inventory is deemed distributed [1000 of 3000], so divide IB by 3); his OB reduced from 1000 to 200

            2. ABC has no g/l; basis in remaining 2000 hot asset is 1600

          2. Analyze §751(b) exchange

            1. A treated as though he transferred the hypothetically-distributed hot asset back to the P/S in exchange for the remaining 1000 worth of cold asset

            2. Thus, A has OI of 200 and takes a cost basis in the cold asset of 1000

            3. ABC receives (hypothetically) 1000 of hot asset in exchange for the cold asset (in which it had a basis of 400); thus ABC recognizes a 600 CG. It has a 1000 basis in the “new” hot asset (total new basis in hot asset of 1000+1600=2600)

          3. Analyze non-§751(b) exchange

            1. P/S distributes remaining cold asset to A

            2. A has no g/l, takes basis in cold asset equal to his outside basis of 200 (reduced from 1000 after hypothetical hot distribution earlier)

            3. ABC has no g/l and no tax consequences at all

        1. Additional Notes

          1. Don’t forget loans – if liquidating ptr no longer owes, his share of liabilities is considered a cash (cold asset) distribution

          2. RR 84-102 – §751(b) also applies to other ptrs when a ptr buys an interest – because it dilutes their share of liabilities

          3. Additional examples p. 185-194

    1. Retirement or Death of a Partner (§736)

      1. Retirement

        1. Liquidation or Sale?

          1. Generally, P/S can structure pmts to retiring ptr as either a sale of his interest or a liquidating distribution

            1. Spector – once you choose, though, you’re stuck with it – IRS won’t look beyond your choice (sale would benefit ptr by giving him CG; liquidating distribution as guaranteed payment benefits P/S by giving it OI deduction)

        2. How to treat liquidating pmts to retiring ptr?

          1. General Rule (§736(b)): normal distribution to extent pmts are in exchange for retiring ptr’s interest in P/S property

          2. Exception (only applies to retiring GP in service P/S): amounts paid for unrealized receivables or for goodwill – these are treated as guaranteed pmts or income distributions (§736(a) - backwards!)

            1. unrealized receivables = mandatory; goodwill = optional

          3. Note on deferred payments

            1. If pmts to retiring ptr are made over > 1 year and are mixed between payments for P/S property and guaranteed pmts, how do you determine what type they are?

            2. General Rule: Can allocate in any manner (property payments can’t exceed ptr’s interest in P/S property)

              1. Better for retiring ptr to front-load pmt for property and take CG; better for P/S to front-load guaranteed pmt and take deductions

              2. If P/S cannot agree, default is pro rata if pmts are fixed and pmts for property first if pmts are not fixed

        3. Installments

          1. Unless exceptions above apply, installment is treated as a distribution; this is advantageous because:

            1. No interest imputation requirement

            2. Can recover basis first (before recognizing gain)

            3. No limit on type of asset that can be reported

            4. Possibility of deferring portion of §752(b) distribution, if any

        4. Goodwill

          1. If a payment is deemed to be in exchange for goodwill, the P/S may deduct it; however, the retiring ptr will give up CG treatment

        5. How to handle hot assets? No real answer!

      2. Death of Ptr

        1. Upon death, ptrs’ tax year closes; estate takes stepped-up basis his P/S interest (if §754 election, then there is an associated IB adjustment); the P/S does not terminate

          1. However, basis is not stepped up for “IRD” (Income with Respect to Decedent)

          2. 1997 changes – IRD includes pre-death P/S income (irrelevant because it shows up on decedent’s short-year form), §736(a) and §753 payments, common law items (items that would be IRD in hands of ptr – i.e., A/R, installment notes)

    2. Transformation of a Partnership;

      1. Liquidation & Formation of New P/S

        1. Have to choose a “path”; which path may affect asset basis if IB ¹ OB, and may affect building period of interest. Choose between:

          1. §1223(i) – Substituted Basis Transactions (e.g., contribution to P/S) – holding period of property received = holding period of property transferred (if capital/§1231 property)

          2. §735(b) – on liquidation of P/S, take ptrs holding period of assets

      2. Merger of P/S’s;

        1. 50% continuity of interest = surviving P/S (and thus is not a liquidation); if multiple P/S over 50%, then one with most contributed capital is the surviving P/S

        2. Surviving P/S takes same basis as “dead” P/S in contributed assets (i.e., assets don’t pass through ptr’s hands)

      3. Converting a P/S into a Corporation;

        1. P/S gives assets to Corp for stock. Result:

          1. Asset keeps IB

          2. Holding period for assets is the same as for stock

        2. P/S gives asset to ptrs, who exchange it for stock. Result:

          1. Assets take OB

          2. New holding period

        3. Ptrs give interest to Corp; P/S then liquidates. Result:

          1. Asset keeps IB

          2. Ptrs use same holding period as stock (because interest, not assets were transferred by ptr)

 

 

  1. Anti-Abuse Rules

    1. Disguised Sales

      1. §707(a)(2)(b) was enacted to prevent using P/S to avoid sale treatment (as in Otey – contributing property, P/S takes loan, distributes cash to ptr)

      2. Rule: A contribution and related distribution will be deemed a sale if:

        1. P/S would not have transferred money or property to the ptr “but for” the transfer of their property to the P/S, and

        2. In the case of transfers that are not simultaneous, the subsequent transfer is not dependent on the entrepreneurial risk of P/S operations

      3. Presumptions – if transfers occur within two years of one another, presumed a sale; if more than two years, presumed not a sale

        1. Presumption can be rebutted by facts and circumstances. Regs list things that tend to prove not a sale:

          1. Certainty of timing and amount of 2nd transfer

          2. Second transfer is legally enforceable

          3. Second transfer is secured in any way

          4. 3rd party is obligated to make a loan to the P/S to enable it to make the 2nd transfer

          5. P/S has incurred, or is obligated to incur, debt to enable it to make the 2nd transfer

          6. P/S distributions, allocations, or control of operations are designed to effect the exchange of the benefits and burdens of the ownership of contributed property

          7. Amount of distribution to a ptr is disproportionately large in relation to general and continuing interest in the P/S

          8. Ptr has no material obligation to return distributions to the P/S

        2. Exception: Distributions out of normal cash flow or for “reasonable” guaranteed payments are not presumed sales (also, don’t forget the first test!)

      4. Liabilities and Disguised Sales

        1. Since contributing encumbered property = a cash distribution to the extent that ptr is no longer liable for debt, is this deemed a sale?

          1. Only if the liability was incurred in anticipation of the transfer (e.g., a nonqualified liability)

          2. Must therefore determine if liability is ‘qualified’ or ‘nonqualified’

          3. 2 factors in determining if ‘qualified’:

            1. When it was incurred?

              1. > 2 yrs. – conclusive presumption that it is qualified

              2. £ 2 yrs. – qualified if:

                1. proceeds used to acquire/improve property, or

                2. incurred in ordinary course of business and substantially all assets of business are transferred (liability cannot be > than property securing it)

            2. For what purpose?

          4. Special Rules

            1. Nonqualified, nonrecourse liabilities – recall test for ptr’s share of nonrecourse liabilities; here, only use part 3 of that test – his share of “excess nonrecourse liabilities”

            2. Qualified Liabilities – portion of a qualified liability can be treated as consideration if a partial sale – lesser of amount that would be so considered if nonqualified, or ptr’s “net equity %” (consideration rec’d/ptr’s net equity) multiplied by liability amount

            3. Distribution of Loan Proceeds – if P/S incurs liability within 90 days of distribution from loan proceeds, the distribution is only taken into account to the extent of the ptr’s “allocable share” (amt distributed traceable to liability/total liability)

          5. Additional Rules

            1. §704(c)(1)(b) – if §704(c) property is distributed within 7 years of contribution, contributing ptr must recognize §704(c) g/l as if property had been sold

              1. Exception: not if like-kind exchange

            2. §737 – if within 7 years of contribution, contributing ptr gets distribution of property other than contributed property, then ptr must recognize gain = to lesser of excess distribution (property value - [OB - any cash distributed]), or ptr’s net precontribution gain from last 7 years

    2. The General Anti-Abuse Rule (§701)

      1. Statement of the Rule (§1.702-2)

        1. P/S must be ‘bona fide’ (i.e., substance over form; MG – this has no real teeth)

        2. Economic income must = tax income UNLESS the Code says otherwise – in which case you can’t violate Code’s intent (intent determined by facts and circumstances test)

        3. IRS agents must get national office approval to use general rule, since it encompasses many other, more specific rules

      2. See examples in Code §1.701-2(c) (especially examples 6, 8(10), 9, 11(13) (note the ones in parenthesis refer to the misprinted sections in Rose’s edited IRC)

 

 

Comparison of Loss Limitations
 
Sub K §704(d), §752
§415 at-risk rules
PAL §469
 
Apply 1st – can only take loss if positive OB
Apply 2nd (’76, ’86)
Apply 3rd (’86)
Effect
Suspend loss until ptr has P/S income, or creates outside basis by contrib or borrowing
“Basket” is the entity
Suspend loss until ptr has income from “activity” or increases at-risk amount by contrib or borrowing
“Basket” is activity if a §465(c)(1) activity; for others, it may be entity at individual level
 
Suspend loss until T has income from and passive investment or until T terminates that investment
“Basket” is all passive activities
Scope
All entities taxed as a P/S
All types of businesses conducted by individuals or closely-held C corps
 
All “passive activities” in which T doesn’t actively participate
Debt-financed deduction
Flow through if P bears economic risk of loss or nonrec. loan from a non-ptr
Flow through if ptr. is at risk (i.e., rec. loan with no protection for others – loan cannot be from ptrs)
(at risk for “qualified nonrec. financing if RE
 
 
Debt-financed distributions
Reduce OB; if OB = 0, then CG
 
Reduce “at risk” amount; if that amount = 0, then OI and offsetting suspended loss*
 
 

* Ex.: AB P/S borrows $100 and expenses in Y1; A is solely liable

Y1 – A has OB of $100 since he is liable for entire amount; A takes deduction, reducing OB to $0 (and his at risk amt., too)

Y2 – B contribs $100 & debt repaid à $100 CG to A; Under at risk rule, A gets $100 OI, $100 suspended loss

Y3 – AB earns $100 – all is allocated to A and is offset by his suspended loss

 

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