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.

2. Formation of a Partnership: (CHP 2)

4. 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).

5. Contribution of Property:

3. 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)

4. 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.

6. 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

7. 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.

4. Non-recourse liab;

2. 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.

5. 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.

2. 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

8. 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.

9. 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 3^rd 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)

10. 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

11. 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 1^st 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).

4. Examples

4. In-Kind Exchange

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

3. 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)

4. 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.

5. 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)

6. “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

2. 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

12. 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)

3. Partnership Operations Chp 3

13. Basic Rules;

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

3. §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.

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

5. 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)

6. 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

7. 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

4. 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.)

5. 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))

6. 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!

4. Partnership Allocations; (CHP 4)

7. Policing Special Allocations;

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

4. 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)

5. 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

4. 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)

5. 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

6. 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)

7. 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))

4. Assume a per-capita allocation

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

6. 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)

8. 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

3. 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

9. 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 t