Answers to Partnership Tax Review Questions
Prof. Daicoff – Fall, 1999
Review Question 1. Olive, Diane, and Ralph:
Pship's balance sheet after O, D, and R contribute their assets is as follows:
(all amounts in thousands)
First Balance Sheet:
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 12 36 Liabilities: None.
Building 12 36 Partners' Capital:
Goodwill 0 12 OAB FMV/CA
Furniture & Olive 28 100
Fixtures 4 8
Accounts Receivable 0 8 Diane 40 100
Securities 40 100
Furn. & Equipment 12 40 Ralph 72 100
Cash 60 60
Totals: 140 300 140 300
Nonrecognition to the pship and to the partners of any realized gain or loss on the formation of the partnership - §721(a).
Pship's IAB in each asset is the same as the contributing partner's AB in that asset, immediately before contribution - §723.
Partners' OAB is the same as the aggregate bases of the assets they contribute - §722. No debt so no need to allocate debt for outside basis purposes, §752.
Holding period of partner in each asset tacks to the pship - §1223(2) and holding period of each partner in each asset tacks to that partner's pship interest, §1223(1). Generally do not allocate different holding periods to different portions of pship interest, RR 84-53.
§704(c)(1)(A) requires that each contributing partner be specially allocated all built-in gain or loss (i.e., the difference between the FMV and the AB of each asset at the time of contribution) on each contributed asset, upon its realization by the partnership (i.e., a subsequent disposition of the contributed asset). Thus, the §704(c) allocations will be:
Built-In §704(c) Gain/Loss:
Assets: AB FMV/BkVal Built-In Gain/Loss Alloc to who?
Land 12 36 24 (capital) Olive
Building 12 36 24 (§1231, capital) Olive
Goodwill 0 12 12 (capital) Olive
Furn. & Fixtures 4 8 4 (§1231 = capital, Olive
probably w/ depreciation recapture which is ordinary income)
Accts/Recvble 0 8 8 (ordinary income) Olive
Securities 40 100 60 (capital) Diane
Furniture & Equip't 12 40 28 (§1231 = capital, Ralph
probably w/ depreciation recapture which is ordinary income)
Cash 60 60 -0- n/a
Totals: 140 300 160
Thus, because of §704(c), each of these 3 partners has to maintain a tax capital account and a book capital account (unlike the usual "1" capital account per partner, which is the book capital account that determines the amount the partner is entitled to on liquidation of the partnership and is maintained and determined under Regs. §1.704-1(b)(2)(iv)(d)).
Partner OAB Tax Capital Account* Book Capital Account**
Olive 28 28 100
Diane 40 40 100
Ralph 72 72 100
Totals: 140 140 300
* note the book/tax disparity which is what §704(c) is designed to correct; also, tax capital account initially is identical to outside basis (OAB) because this partnership has no debt.
** originally, the FMV of the property contributed by each partner.
Now bring in Jeff as a partner:
Nonrecognition to the pship and to the partners of any realized gain or loss on the formation of the partnership - §721(a); however, this rule is overridden in the situation of contributing services for an interest in partnership profits and capital.
On the admission of Jeff to the pship and the exchange of a 1/4 pship interest in pship profits and capital to Jeff in exchange for two years of his future services, Jeff will recognize 75K of ordinary compensation income under §61 and the McDougal case (which is the value of his pship interest); the pship will have a §162 business deduction of 75K; and the pship will be deemed to have sold a pro rata share (1/4) of each of the pship's appreciated assets in exchange for Jeff's services, under the McDougal case. Jeff will thus have 75K of OI under §61 (which is not available for the §83 election, since there are no restrictions on his receipt of the pship interest); an OAB of 75K under §722; and the holding period starts at the date of admission for his pship interest.
This admission of a partner is a two-step transaction: the sale of 1/4 of the pship assets for 75K in cash, then the payment of 75K in cash to Jeff in exchange for his pship interest. Thus, the pship will have gain or loss on the deemed sale of 1/4 of all its assets, which gain or loss will be allocated entirely between Olive, Ralph, and Diane in accordance with the §704(c) rules, see above chart re: built-in gain/loss.
Result to Pship and Other Ptnrs:
Deemed Sale of 1/4 Assets:
1/4 Each Asset: AB FMV/BkVal Built-In Gain/Loss Alloc to who?
Land 3 9 6 (capital) Olive
Building 3 9 6 (§1231, capital) Olive
Goodwill 0 3 3 (capital) Olive
Furn. & Fixtures 1 2 1 (§1231 = capital, Olive
probably w/ depreciation recapture which is ordinary income)
Accts/Recvble 0 2 2 (ordinary income) Olive
Securities 10 25 15 (capital) Diane
Furn. & Equipment 3 10 7 (§1231 = capital, Ralph
probably w/ depreciation recapture which is ordinary income)
Cash 15 15 -0- n/a
Totals: 35 75 40
So, Olive is taxed on 16 of capital gain (assuming no depreciation recapture on either the building or the furniture and fixtures, which is unlikely) and 2 of OI.
Diane is taxed on 15 of capital gain.
Ralph is taxed on 7 of capital gain (assuming no depreciation recapture on the furniture and equipment).
The built-in gain and income increases their OABs and their tax capital accounts, but not their book capital accounts, because there has been no "book" gain.
Partner OAB & Tax Cap Acct* Book Cap Acct**
Olive 28 + 18 = 46 100
Diane 40 + 15 = 55 100
Ralph 72 + 7 = 79 100
Totals: 140 + 40 = 180 300
* OAB and Tax Cap. Acct. are identical, still.
** no change, b/c no book "gain" has been realized, yet.
The pship's 75K deduction under §162 for Jeff's services will be allocated 1/3 to each of Olive, Diane, and Ralph (as the non-service partners), which will then decrease their OABs.
Partner OAB
Olive 28 + 18* - 25 = 21
Diane 40 + 15* - 25 = 30
Ralph 72 + 7* - 25 = 54
* the §704(c) gains, listed above.
And, the pship will have a stepped-up, FMV basis in 1/4 of each of its assets, while the inside basis (IAB) of 3/4 of each asset will be its old IAB:
IAB in 1/4 Each Asset: IAB in 3/4 Each Asset: Total IAB:
Land 9 9 18
Building 9 9 18
Goodwill 3 0 3
Furniture &
Fixtures 2 3 5
Accts/Recvble 2 0 2
Securities 25 30 55
Furniture &
Equipment 10 9 19
Cash 15 45 60
Totals: 75 105 180
Pship's Initial Balance Sheet (After Admission of Jeff):
Assets: AB FMV/Bk Val Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furniture & Olive 21 75
Fixtures 5 8
Accounts Receivable 2 8 Diane 30 75
Securities 55 100
Furniture & Ralph 54 75
Equipment 19 40
Cash 60 60 Jeff 75 75
Totals: 180 300 180 300
Note: there is no disparity between inside basis and outside basis, at this point. No need for a §754 election for any special basis adjustments to reconcile any inside/outside bases differences.
Partner OAB & Tax Cap Acct Book Cap Acct
Olive 28 + 18 - 25 = 21 100 - 25 = 75
Diane 40 + 15 - 25 = 30 100 - 25 = 75
Ralph 72 + 7 - 25 = 54 100 - 25 = 75
Jeff 75 75
Totals: 180 300
Losses (deductions, losses) which are realized or incurred at the partnership level will flow through to the 4 partners under §702; however, the amount of each partner's deductible pship deductions and losses will be limited by the amount of each partner's outside basis, under §704(d). As each partner has outside basis at this point, this should not be a concern immediately. Losses are also further limited by the at-risk rules of §465 and the passive activity loss rules of §469.
Review Question 1.(a): If Addit also agreed to employ Ralph as a consultant for 12K per year regardless of Addit's income, then that payment each year would most likely be characterized as a "guaranteed payment" by Addit to Partner Ralph. This is because the payment is a fixed salary and because the payment is determined without respect to the pship's income. Regs. §1.707-1(c) Ex 1.
Guaranteed payments under §707(c) generate income to the partner, the character of which depends on why the payment is made. Here, since it is for his services, Ralph would have 12K of OI each year under §61; and the pship would have a §162 deduction, which deduction would be allocated to ALL of the 4 partners, thus decreasing their outside bases and their capital accounts by 1/4 of 12K, or 3K each [different from the deduction of 75K in the earlier part of the problem!]. This is because the guaranteed payment is a "hybrid" payment; treated for the most part as a transaction between unrelated taxpayers (even though between partner and pship) but treated for some purposes as a payment from a pship to a partner (i.e., for timing purposes).
Thus, the timing of the §707(c) guaranteed payment would be the same as if the payment were a distributive share of pship income to Ralph, under §702. It would be deemed to be paid to Ralph, included in his income (even if not paid to him!),,and deducted by the pship as of the end of the pship's taxable year, just like distributive shares.
Pship's Second Balance Sheet (After Guaranteed Payment):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furniture & Olive 18 72
Fixtures 5 8
Accounts Receivable 2 8 Diane 27 72
Securities 55 100
Furniture & Ralph 51 72
Equipment 19 40
Cash 48 48 Jeff 72 72
Totals: 168 288 168 288
Review Question 1.(b): If Olive contributes assets and a nonrecourse liability to the pship, then she will have §752 debt relief (treated as a deemed distribution from the pship to her) and she and the other partners will have §752 debt assumption (treated as a deemed contribution of money to the pship).
Assuming that Jeff does not become a partner and that there are only three partners at first, and also ignoring the effects of the contributed property by the other two partners, the pship's balance sheet will initially look like:
Pship's Initial Balance Sheet (With Liabilities):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 10 35 Liabilities: 60
Building 20 55 Partners' Capital:
Goodwill 0 40 OAB FMV/CA
Furniture & Olive 35* 100
Fixtures 5 20
Accounts Receivable 0 10 Diane 40* 100
Securities 40 100
Furniture & Ralph 72* 100
Equipment 12 40
Cash 60 60
Totals: 147 360 147* 360
*(plus the 60K debt); debt not yet allocated for outside basis purposes.
Olive's Tax Capital Account will be 35 and her Book Capital Account will be 100.
Assuming for a moment that the debt is nonrecourse, it must be allocated to the partners to increase their OABs. And, O is deemed to have received a cash distribution equal to the debt relief she experiences of 60K, which is netted against her share of the debt she is allocated. There is no "partnership minimum gain" (PMG) because book value > debt, so no Tier 1 allocation, §1.752-3(a)(1); there is 60 - 30 = 30 of Tufts-type "minimum §704(c) gain" on the Land and Bldg contributed by Olive, so 30 of the 60 debt will be allocated to her under Tier 2 and Regs. §1.752-3(a)(2); and the remaining 30 of the debt is "excess nonrecourse liabilities" and will be allocated under Tier 3 to O, D, and R equally (because they share profits equally, and excess nonrecourse debt is allocated according to profit-sharing percentages in the absence of a specific agreement), or 10 each. So, O receives a deemed cash distribution of 60 - 40 or 20, which reduces her OAB to 15. Thus, their OABs will be, including the debt:
Initial OAB - Debt Relief Tier 1 Tier 2 Tier 3 Total OAB
O 35 -60 + 30 + 10 = 15
D 40 + 10 = 50
R 72 + 10 = 82
Total: 147
Now, you may want to examine the liability to see if it is recourse or nonrecourse:
_______________________
Rules:
"recourse" liab = one for which any partner or a related person (defined in Regs. §1.752-4(b) wrt §267(b)) bears the economic risk of loss for that liab under Regs. §1.752-2 - Regs. §1.752-1(a)(1)
"nonrecourse" liab = one for which NO partner or a related person (defined in Regs. §1.752-4(b) wrt §267(b)) bears the economic risk of loss for that liab under Regs. §1.752-2 - Regs. §1.752-1(a)(2)
"Bearing the economic risk of loss" means the ptnr would have to pay for the liability if all pship assets were worthless and all pship liabs were due and payable, Regs. §1.752-2(b)(1), including all ptnr's obligations under the pship agrmt to contribute to the pship, pay the creditor, and obligations under guarantees, indemnification Ks, pledges, or security agreements to other ptnrs or to the creditor, Regs. §1.752-2(b)(3) and (5).
Constructive Doomsday Liquidation Approach: Regs. §1.752-2(b) adopt a "doomsday scenario" to test who will bear the economic risk of loss of a liability: pretend that all the pship's assets including cash become worthless and all its debts immediately due and payable, allocate gains and losses and adjust Capital Accounts, and constructively liquidate. Rule = ptnr bears the economic risk of loss for the net amount he must pay directly to creditors or contribute to the pship at the time of the constructive doomsday pship liquidation.
The doomsday constructive liquidation is simply a "mechanism" to determine who bears the risk of loss of a liability. Doesn't matter that ptnr's net worth is NSF to pay - Regs. §1.752-2(f) Ex 3.
IS THE DEBT RECOURSE?
You can calculate this, using the constructive doomsday liquidation approach:
Olive Diane Ralph
Beginning Capital Accounts* 100 100 100
* all beginning capital accounts are 1/3 x 360 (total value of pship assets) - 1/3 x 60 (debt) = 100
Now, apply constructive doomsday liquidation approach:
Loss-sharing ratio 33% 33% 33%
Constructive Doomsday Liq'n: Regs. §1.752-2(b). Result = pship incurs loss, which would be shared equally by the partners because they share income, gain, loss, and deduction equally, so capital accounts would be decreased equally. The loss on the Land and Bldg is: Amt. Realized = 60 debt relief (why? why isn't this zero?)
- IAB = but here you use book value of 90 (see Regs. 1.752-2(a)(2)(i)) of land and building b/c §704(c) applies)
Realized Loss = 30; plus there is loss on each other asset of the pship:
Realized Loss on all other assets = Amount Realized -0- minus IAB but use book value if you assumed all other assets were contributed and had §704(c) issues of 270, or of IAB if you assumed not contributed assets for a loss of 117 - see Regs. §1.752-(2)(b)(2(ii); plus assume cash is worthless, see Regs. §1.752-2(b)(1)(ii) ), for a total loss of either 300 or 147 which is allocated 1/3, 1/3, 1/3:
100 100 100
or 49 49 49
Capital Accts would then be: 0 or 51 for each partner 0 or 51 0 or 51; which are all positive.
Since no partner has a payment obligation under Regs. §1.752-2(b)(3) or bears the economic risk of loss under Regs. §1.752-2, the liability is a nonrecourse liability, Regs. §1.752-1(a)(2).
HOW ALLOCATED? - (This is redundant with the foregoing, but it simply gives you a more detailed explanation of what I've already discussed.)
Rules: Regs. §1.752-3(a) says:
You allocate nonrecourse debt according to:
a) ptnr's share of "pship minimum gain;" plus
b) ptnr's share of "minimum §704(c) gain;" plus
c) ptnr's share of excess nonrecourse liabilities (= any liabilities left over).
Tier 1. Is there any pship minimum gain for §752 purposes? Pship min gain is the gain the pship would realize if it disposed of the property subject to the nonrecourse liability for no consideration other than full satisfaction of that liability. Usually, PMG is debt - IAB or 60 - 30 = 30; real §704(c) gain on the Land and Bldg is 90 - 30 = 60. Here, because it is contributed propery, PMG is determined by debt - book value. Thus, there is no PMG for §752 purposes, b/c the nonrecourse debt amount (60) does not exceed the book value (90) of the land and building - see Regs. §1.704-2(d)(3) for calculation of pship min gain for §752 purposes when there is a book/tax disparity; use book value instead of IAB.
Tier 2. Is there any "minimum §704(c) gain" (for the §752 regs. purposes only - there is still real §704(c) potential gain of 60)? Yes, Olive has 60 (debt) - 30 (IAB) = 30 of "minimum §704(c) gain" in the land and building, which is entirely allocated to Olive as the contributing partner by §704(c). So 30 of this 60 debt is allocated to Olive.
Tier 3. The rest of the debt, 60 (debt) - 30 (Tier 2 amount) = 30 = excess nonrecourse liabilities, under §1.752-3(a)(3), which are allocated in accordance with the partners' interest in partnership profits, which would be 1/3 to each partner, or 10 each (in the absence of an agreement to the contrary).
WHAT ARE OAB'S?
OAB
Olive 35 + liability assumption (30 + 10) - 60 (debt relief) = 15 - see below for explanation*
Diane 40 + 10 = 50
Ralph 72 + 10 = 82
* Deemed Distribution and Deemed Contribution:
A contribution of property encumbered by a nonrecourse debt where the debt exceeds basis is treated as a realization of some of the §704(c) built-in gain on the property, even if the debt exceeds FMV (cite = Tufts case). Regs. §1.752-3(a)(2). Olive's liabilities are decreased by 60, the amount of the debt she is relieved of, upon contribution to the pship; §752(b). At the same time, Olive's share of pship liabilities increases by 1/3 of 30 (the amount by which the debt exceeds her §704(c) type gain) or 10 (§752(a)), plus her minimum §704(c) gain on the land and building of 60 debt - 30 basis, or 30. Then, you net this decrease and these increases, for a net decrease of 20. Regs. §1.752-1(f). So, Olive will be treated as having received a distribution of money from the pship in the amount of 20. Because her outside basis was 35, this will not result in any §731(a)(1) gain to her, and her outside basis will go to 35 - 20 = 15.
The other partners' outside bases will increase by 10 (which is their share of the 60K debt).
Other Items:
§721 nonrecognition to Olive and the pship on her contribution.
§722 Olive's OAB starts out at 35, which is an exchanged basis from the AB in the contributed property (then gets adjusted as shown above).
§723 IAB to pship of contributed assets is a transferred basis from Olive, so all the same as her AB in them.
HP tacks for both Olive and the pship; §1223(1) and (2).
Review Question 2.(a):
Addit must file a Form 1065 under §6031 and Reg. §1.6031-1(e)(2). Assume a calendar year.
Separately stated items - Code Section
1. STCG on stock 8K 702(a)(1)
2. Net LTCG 8K (10-2) 702(a)(2)
Supposed to net LTCG and LTCL under Regs. §1.702-1(a)(2)
3. 1231 gain 4K 702(a)(3)
4. dividends 8K 702(a)(5)? or (7); §1.708-1(a)(8)(ii)
dividends eligible for the 243 deduction (probably N/A); but this could be a variable effect item -- Form 1065 requires dividends to be separately stated for purposes of the §469 PALS
Net of separately stated items: 28K
2K charitable contribution - passes thru to the ptnrs and must be separately stated under 702(a)(4), but is not deductible by pship in computing its taxable income, 703(a)(2)(C).
4K of tax-exempt interest is not included in income, but it increases ptnrs' OAB (later).
Specially allocated items -
NONE (no special allocations in this partnership).
Bottom-line income or loss - remaining items:
gross receipts from sales 100K
cost of goods sold <20K>
salaries §162 <12K>
depreciation §168 <12K>
legal fees §709(b)(1) <3.2K>** -amortized-
** NOTE: Legal fees associated with organization (e.g., negotiation and preparation of a pship agreement) are organizational expenses under §709(b)(2) and Regs. §1.709-2(a), and are not currently deductible but may be amortized over 60 months beginning with the month in which the pship begins business, at the election of the pship, §709(b)(1). However, to the extent that these fees are for transferring assets to the pship, they are not organizational expenses, cannot be amortized, and must be capitalized and added to the basis of the pship's assets, Regs. §1.709-2(a). Attorney should have kept careful and separate records/files for these two matters. So, most likely only 1/5 x 16, or 3.2 (at the most) of these fees will be amortizable in Year One.
Net gain: 52.8K
Pship's taxable income = 80.8 (28 + 52.8)
Ptnrs' shares (1/4) = 20.2
Pship will provide Schedule K-1 (Form 1065) to each ptnr.
Each ptnr will include 1/4 of each separately stated item and 1/4 the bottom-line net gain on his or her individual return, §702(a), in the year ending Dec. 31 of Year One - §706(a). Olive, Ralph, Diane, and Jeff are liable for the tax due next April 15.
Review Question 2.(b): Effect on OABs:
START WITH BALANCE SHEET AT END OF PROBLEM 1:
Pship's Initial Balance Sheet (After Admission of Jeff):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furniture & Olive 21 75
Fixtures 5 8
Accounts Receivable 2 8 Diane 30 75
Securities 55 100
Furniture & Ralph 54 75
Equipment 19 40
Cash 60 60 Jeff 75 75
Totals: 180 300 180 300
OAB's: are increased by the ptnr's distributive share of pship income, under §705(a)(1)(A); increased by the ptnr's share of tax-exempt income under §705(a)(1)(B); and decreased (but not below zero) by the ptnr's share of pship losses under §705(a)(2)(A) and the ptnr's share of nondeductible, noncapitalizable expenditures under §705(a)(2)(B).
So, each ptnr's OAB (and capital account, by the way) is increased by 20.2 TI of pship; + 1K of tax-exempt interest income; - 0.5K of charitable contribution; for a net effect of + 20.7:
OABs as adjusted
Olive 21 + 20.7 = 41.7
Diane 30 + 20.7 = 50.7
Ralph 54 + 20.7 = 74.7
Jeff 75 + 20.7 = 95.7
Review Question 3.: If Addit sells all its securities for 112K, at a time when its balance sheet is:
Pship's Initial Balance Sheet (After Admission of Jeff):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furniture & Olive 21 75
Fixtures 5 8
Accounts Receivable 2 8 Diane 30 75
Securities 55 100
Furniture & Ralph 54 75
Equipment 19 40
Cash 60 60 Jeff 75 75
Totals: 180 300 180 300
Built-In §704(c) Gain/Loss:
Assets: Original AB FMV Built-In Gain/Loss Alloc to who?
Securities 40 100 60 (capital)* Diane
*15 of this BIG has already been taxed to Diane; 45 is left (see below)
Partner OAB & Tax Cap Acct Book Cap Acct
Olive 21 75
Diane 30 75
Ralph 54 75
Jeff 75 75
Totals: 180 300
Then Addit has:
Amount realized: 112
Adjusted basis in securities (IAB): 55
Realized Gain: 112 - 55 = 57
*Amount of §704(c) gain: originally 60 (see above), of which 15 was already recognized by Diane on the admission of Jeff into the pship, so the remaining §704(c) gain is 45, to be allocated to Diane, assuming the traditional method is being used under §704(c); Regs. §1.704-3(b). It increases her OAB and her tax capital account, but not her book capital account, because it does not represent a book gain.
The remaining 57 - 45 = 12 of gain is allocated 1/4 to each partner, or 3 to each, thus increasing their OAB and book capital accounts, because it does represent a book gain - Regs. §1.704-1(b)(2)(iv)(b)(3).
Pship's Balance Sheet (After Securities Sale):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furniture & Olive 24 78
Fixtures 5 8
Accounts Receivable 2 8 Diane 78 78
Furniture & Ralph 57 78
Equipment 19 40
Cash 172 172 Jeff 78 78
Totals: 237 312 237 312
Partner OAB & Tax Cap Acct* Book Cap Acct
Olive 21 + 3 = 24 75 + 3 = 78
Diane 30 + 45 + 3 = 78 75 + 3 = 78
Ralph 54 + 3 = 57 75 + 3 = 78
Jeff 75 + 3 = 78 75 + 3 = 78
Totals: 237 312
* note the OABs and Tax Cap Accts are still identical. They vary mainly due to pship liabilities, of which there are none, here.
Review Question 4.: Begin with the initial balance sheet from Problem 1:
Pship's Initial Balance Sheet (After Admission of Jeff):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furn. & Fixtures 5 8 Olive 21 75
Accounts Receivable 2 8 Diane 30 75
Securities 55 100
Furn. & Equipment 19 40 Ralph 54 75
Cash 60 60 Jeff 75 75
Totals: 180 300 180 300
Assume no §704(c) issues, meaning that you should assume that all assets were acquired for cash by the pship after its formation and none was contributed by a a ptnr.
This is a "redemptive" distribution of cash and all the partnership's accounts receivable (the A/R are §751 "HOT" assets) to one ptnr, in exchange for a reduction in his pship interest. It looks like a disproportionate distribution, under §751(b), because Ralph gets more than his share of the pship's sole §751 "hot" asset, the accounts receivable.
The analysis is that the usual distribution scheme of §731/§732 applies, with the caveat that §751(b) may override the usual treatment. Do not do the usual 4-step analysis of §731/§732, however, since it appears that §751(b) will override it (cites = §731(c), §732(e), Regs. §1.751-1(b)(1)(iii)). §751(b) applies whenever a dist'n has the effect of altering the ptnrs' interests in §751 property, which is defined in §751(b) as "unrealized receivables" and "substantially appreciated inventory," §751(b)(1)(A)(i) and (ii), respectively.
What's the purpose of §751(b)? Well, the dist'n above effectively shifts all of the OI inherent in the pship to Ralph, and all the CG to the other three partners. §751(b) is designed to prevent the assignment of the character of the income (to prevent certain ptnrs from getting all the OI assets and others from getting all the CG assets). We have no facts to indicate that there is any depreciation recapture in this partnership, so its only "hot" §751(b) assets are the Accts/Receiv.
Ralph here exchanges 2/3 of his 1/4 partnership interest for the A/R worth 8K plus cash of 42:
1. First, calculate Ralph's pre-distribution 1/4 interest in each pship asset, to see if the distribution is disproportionate triggering application of 751(b):
Ralph's 1/4 interest in each asset of the pship:
IAB FMV Ralph's 1/4 IAB & 1/4 FMV Type of Asset:
Land 18 36 4.5 9 §741 asset
Building 18 36 4.5 9 §741 asset
Goodwill 3 12 0.75 3 §741 asset
Furn. & Fixtures 5 8 1.25 2 §741 asset
Realized Accts Rec. 2 2 0.5 0.5 §741 asset
Unrealized Accts Rec. 0 6 0 1.5 §751 asset
Securities 55 100 13.75 25 §741 asset
Furn. & Equipment 19 40 4.75 10 §741 asset
Cash 60 60 15 15 §741 asset
Totals: 180 300 45 75
What does Ralph actually get?
42K of cash and 2K of realized A/R = a total of 44K §741 assets (and he is entitled to 73K worth of §741 assets) plus
6K of §751 assets (unreal A/R) (and he is entitled to only 1.5K of these §751 assets).
How much excess A/R (751 assets) did R receive? 6 - 1.5 = 4.5K.
By receiving all the A/R, A effectively exchanged 4.5K worth of his interest in 741 assets for the other ptnrs' interests in the remaining A/R = 4.5K.
However, because this is a redemptive distribution, it is easiest to do this problem via a partnership exchange table:
R's postdist'n R's R's predist'n R's
interest in actual interest in change in
p/s assets dist'n p/s assets interests
Hot Assets (1/10 of 0) = 0 + 6 - (1/4 of 6) = 1.5 = 4.5
§751*
Cold Assets (1/10 of + 44 - (1/4 of 294) = 73.5 = (4.5)
§741 250) = 25
So, R got 4.5K too much of the §751/hot assets and 4.5K too little of the §741/cold assets.
2. Make the phantom distribution of §751(b): to Ralph of §741 assets with a value of 4.5K (what he didn't get that he was entitled to).
In the absence of a specific agreement among the partners as to the properties deemed to be distributed, the phantom dist'n is pro rata among the assets in the class of §741 assets (here, there are 7 types) - Regs. §1.751-1(g) Ex 4(c), but the regs do allow the ptnrs to specify property within the class of nondistributed assets that are deemed to be dist'd.
Relative FMVs of pship's §741 assets:
FMV Pro rata amt to Ralph or FMV of Phantom Distribution
Land 36 36/294 x 4.5K = 551 (not in thousands)
Building 36 same operation = 551
Goodwill 12 " 184
Furniture &
Fixtures 8 " 122
Securities 100 " 1,531
Real. A/R 2 " 30
Furniture &
Equipment 40 " 612
Cash 60 " 918
Totals: 294K 4,500
So, the phantom distribution consists of the above assets in the above proportions.
3. The regular operating rules of §731 and §732 apply to the phantom dist'n:
4-step analysis here:
1. Generally, distributions are tax-free to the ptnrs - §731(a).
However, money dist'ns in excess of OAB do create gain - §731(a)(1). Cash = 918 which is not more than Ralph's OAB of 54K.
Dist'ns of property don't create gain b/c the "gain" equal to the excess dist'n over OAB can be preserved in the transferred basis of the dist'd property. So, ptnr's basis in the prop distributed will be, under §732(a)(1), the pship's IAB (but not to exceed the receiving ptnr's OAB - §732(a)(2)).
2. Calculate interim OAB: Effect on OAB under §733: reduce OAB but not below -0-, by the amt of the money dist'd to the ptnr - §733. Reduce Ralph's OAB from 54K - 918 cash = 53,082 = Ralph’s interim OAB
3. Ralph's basis in the assets "phantomly distributed" = pship's IABs in the pro rata shares of each asset. Do this after you reduce OAB for the cash distribution:
Ralph's basis in these assets = lesser of pship's IAB or 53,082 (Ralph's interim OAB) => not likely to be limited, here, by §732(a)(2).
Ralph's basis in the assets "phantomly distributed:" AB to Ralph of
IAB FMV Phantom Distribution
Land 18 36 18/36 x 551 = 276
Building 18 36 18/36 x 551 = 276
Goodwill 3 12 3/12 x 184 = 46
Furn. & Fixtures 5 8 5/8 x 122 = 76
Securities 55 100 55/100 x 1,531 = 842
Real A/R 2 2 2/2 x 30 = 30
Furn. & Equipment 19 40 19/40 x 613 = 291
Totals: 118 232 1,837
4. Adjust OAB by the AB of property dist'd (det'd under 732). - 733:
Reduce Ralph's OAB from 53,082 - 1,837 AB in the above-listed assets = 51,245.
NOTE: Ralph's remaining interest in the pship is worth 70.5K (75K - 4.5K phantom dist'n).
4. Constructive Sale or Exchange:
On this fictional exchange, Ralph exchanges 4.5K worth of §741 assets phantomly distributed to him (=what he didn’t get) (in which his basis is as listed above) to the pship, in exchange for 4.5K worth of unrealized Accounts/Receivable (§751 assets) (what he actually got too much of) in which the pship has an IAB of 0.
(A) This results in a total of 1,744 of CG to Ralph as calculated below (4,500 amt. realized - basis (1,837 + 918 in cash)):
FMV of Assets AB to Ralph of Assets
Phantomly Dist'd to Ralph Phantomly Dist'd
4,500 - 1,837 - 918 in cash = 1,744 CG ---- §1001.
And, Ralph gets the 4.5K of A/R at a §1012 cost basis of 4.5K.
(B) The pship realizes and recognizes 4.5 amt. realized - 0 IAB in A/R = 4.5K of ordinary income on the constructive sale of the A/R, which is taxed (allocated) 1/3 to Olive, Diane, and Jeff (1.5K to each), thus increasing their OAB's by 1.5K each. — §702(a)(8), §705(a)(1)(A).
Pship receives all the assets phantomly distributed to Ralph at a cost basis, §1012, as listed below:
Pship's new IAB in the Portion of its Assets Phantomly Dist'd to Ralph & Then "Sold" Back to Pship
Land 551
Building 551
Goodwill 184
Furn. & Fixtures 122
Realized A/R 30
Securities 1,531
Furn. & Equipment 612
Cash 918
Total: 4,500
5. §731 distribution of the remaining A/R (Ralph's portion of the A/R) and the 42K of cash; (this is what he actually got that he was entitled to; his pro rata share of these assets):
Ralph now receives the rest of the unrealized A/R worth 1.5K, the realized A/R worth 0.5K, and the 42K of cash in a regular, 731 dist'n.
4-step analysis here:
1. Generally, distributions are tax-free to the ptnrs - §731(a).
However, money dist'ns in excess of OAB do create gain - §731(a)(1). Cash here of 42K does not exceed Ralph's OAB of 51,245.
Dist'ns of property don't create gain b/c the "gain" equal to the excess dist'n over OAB can be preserved in the transferred basis of the dist'd property. So, ptnr's basis in the A/R distributed will be, under §732(a)(1), the pship's IAB (but not to exceed the receiving ptnr's OAB - §732(a)(2)).
2. Calculate interim OAB: Effect on OAB under §733: reduce OAB but not below -0-, by the amt of the money dist'd to the ptnr - §733. So Ralph's OAB is reduced from 51,245 - 42 cash = 9,245 = interim OAB.
3. Ralph's basis in the 2K worth of A/R = pship's IAB in A/R of 0.5K. §732(a)(1).
[Do this after you reduce OAB for the cash distributions.]
Ralph's basis in the A/R = lesser of 0.5 (which is 500) (IAB) or 9,245 (Ralph's OAB) = 500 -- §732(a)(2). No limitation here by OAB.
4. Adjust OAB by the AB of property dist'd (det'd under §732). - §733:
Reduce Ralph's OAB from 9,245 - 500K AB in A/R = 8,745.
6. Summarize:
Ralph has an OAB of 8,745 (dropped from 54,000);
Ralph's basis in the A/R worth 8K is 4.5K (§1012 cost basis) + 500 (§732(a)(1) basis) = 5K (so there is 3K of lurking OI in the A/R to Ralph); and
Ralph recognized 1,744 of capital gain on the constructive sale.
NOTE: how his OAB afterwards, plus his basis in dist'd assets = his OAB b/4 dist'n plus the capital gain he recognized on the distribution [8,745 + 5,000 + 42,000 cash = 54,000 +1,744]. You can use this to check your results.
Pship has 4,500 of ordinary income on the constructive sale; so that each of the other partners has 1,500 of taxable ordinary income, which increases their OABs.
Redo the balance sheet:
Pship's Balance Sheet (After ALL Transactions)
Assets: AB FMV/BkVal Liabs & Ptnrs' Capital
Land 18+ 36 Liabilities: None.
Building 18+ 36 Partners' Capital:
Goodwill 3+ 12 OAB FMV/CA
Furniture & Olive 22.5 75
Fixtures 5+ 8
Accts/Recvble -- -- Diane 31.5 75
Securities 55+ 100
Furniture & Ralph 8.745 25
Equipment 19+ 40
Cash 18 18 Jeff 76.5 75
Totals: 139,245 250 139,245 250
No need for a §754 election because there is no discrepancy between OAB and IAB.
A final issue is: how should the basis increase in the pship's §741 assets that results from the application of §751(b) be allocated among the partners - which partners should benefit from it?
Here, only Olive, Diane, and Jeff are taxed on the gain on the constructive sale of the receivables, so only they should benefit from the step-up of in the basis of the §741 assets. You should be able to specially allocate this basis increase (which has already been included in IAB in the immediately preceding balance sheet) to these 3 ptnrs so that they are each taxed on less gain on the disposition of these assets than they would have been. See Regs. §1.704-1(b)(5) Ex 14(i) for some support for making this special allocation.
Review Question 5.: Begin with the balance sheet of the pship:
Pship's Initial Balance Sheet (After Admission of Jeff):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furniture & Olive 21 75
Fixtures 5 8
Accounts Receivable 2 8 Diane 30 75
Securities 55 100
Furniture & Ralph 54 75
Equipment 19 40
Cash 60 60 Jeff 75 75
Totals: 180 300 180 300
The ptnrs agree to retire Diane as a ptnr for 75K in cash.
Review Question 5.(a): Results of a sale of Diane's interest to the 3 other ptnrs for 25K cash each: (§741 Capital Gain treatment applies with a §751(a) Ordinary Income override.)
§741/§751 analysis:
Steps:
1. Determine Diane's amount realized: = 75K
2. Determine Diane's total OAB (adjusted as of time of sale for pship income up thru sale; §705(a)): = 30K
Note: Diane's realized gain = 45K, which would be all capital gain under the general rule of §741, but for the exception of §751(a), which essentially undercuts §741 entirely and looks thru the pship to see what kind of assets are inside it. Have to do the §751 analysis to determine how much OI Diane will have on this sale, under §751(a).
3. Calculate Diane's §751 gain:
A. --What are the §751 assets? §751(a)(1) and (2) define them as "unrealized receivables" (plus see the cases in the text) and "inventory items" as defined in §751(d) (need not be substantially appreciated).
The only §751(a) asset in the pship = is the Accounts/Receivable, under §751(a)(1):
--Unrealized Receivables: = 6K of the accounts receivable, here. 2K of the accounts receivable are "realized," because they have a basis of 2K (from the deemed sale on Jeff's admission to the p'ship).
Would also include any rights to payments for goods delivered, to be delivered, if not already included in income, services or future services, depreciation recapture portion of gains under §1245 and 1250 (even if asset is not appreciated!). Here we have no facts to indicate any depreciation recapture or ability to calculate it.
--Inventory Items: = These generally are: stock in trade, inventory, prop held primarily for sale to customers in the ord course of business, but ALSO includes all prop that is not cap asset or §1231 asset either in the hands of the pship or the ptnr. There is no "inventory" in this pship, under §751(a)(2) and (d).
B. --calculate the §751 amount realized by Diane w.r.t. each asset = ptnr's share of FMV of each asset (this assumes buyer and seller have not agreed to a price allocation; if they have, it'll be respected):
accts receivable 1/4 x 6 = 1.5K
C. --calculate Diane's share of the pship's IAB in this asset - here, it's as if pship distributed assets to ptnr and ptnr gets a §732 transferred basis in the assets:
accts receivable 1/4 x 0 = 0
D. --calculate Diane's §751 gain = 1,500 - 0 = 1,500 OI under §751(a).
4. Calculate the residual gain, which will be CG under §741:
Diane's residual amount realized = 75 - 1.5 = 73.5K
Diane's residual OAB = 30K - 0 = 30K
Diane's residual §741 gain = 43,500, which will be LTCG since his holding period for his pship interest tacked from the assets he contributed to the pship (appreciated securities, which assumedly he held for more than 1 year). Look to A's HP for his pship interest = entity theory. Gray, 11 TCM 17 (1952).
5. Do not adjust pships' IAB as a result of this sale, §743(a), unless there is a §754 election in effect.
Each of Olive, Jeff, and Ralph will add 25K to his or her OABs, under §1012 and §742, because they each now have paid an additional 25K in cash for their partnership interests.
Redo balance sheet:
Pship's Balance Sheet (After Buyout of Diane):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furniture & Olive 46 100
Fixtures 5 8
Accounts Receivable 2 8
Securities 55 100
Furniture & Ralph 79 100
Equipment 19 40
Cash 60 60 Jeff 100 100
Totals: 180 300 225 300
The problem now is that IAB and OAB do not match. There is now a need for a §754 election, so that a special inside basis of pship assets can be created for each ptnr, to take into account the fact that each paid 25K in cash to buy out Diane (essentially they each invested 25K more into this partnership).
Review Question 5.(a) Cont'd.
Results of a liquidation of Diane's interest by the pship for 75K cash (60K cash and pship'd have to sell some securities to raise the other 15K):
Assume the pship sells 15K of securities. Because its IAB in this portion would be (15 x 55)/100 = 8.25, there would be 6.75 of capital gain to the pship, which would be allocated 1/4 to each ptnr = 1.6875 to each one (increases OAB and is taxable, flows thru to each ptnr).
Note: Cap. accts. stay the same because there is no book gain - in reality this gain would be §704(c) gain but I asked you to ignore §704(c) issues.
Pship's New Balance Sheet (After Sale of Securities):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furn. & Olive 22.6875 75
Fixtures 5 8
Accounts Receivable 2 8 Diane 31.6875 75
Securities 46.75 85
Furniture & Ralph 55.6875 75
Equipment 19 40
Cash 75 75 Jeff 76.6875 75
Totals: 186.75 300 186.75 300
Now, pship can give 75K cash to Diane in complete liquidation of her 1/4 pship interest.
Results to Diane:
Amt. Realized = 75K cash
OAB = 31,688
Realized Gain = 43,312 realized under §1001 principles.
But, go to §736 to characterize and recognize this loss. (use the §735 flowchart!):
§736: §736(b) = everything other than §736(a) [typically, payments for cash and inventory, and pyts for stated goodwill (e.g., where K provides for them), also distributions of unrealized receivables]
§736(a) = IF retiring ptnr = gen ptnr and capital is not an income producing factor in the pship, THEN §736(a) includes payments for (NOT distributions OF) unrealized receivables and unstated goodwill - §736(b)(2). Here, b/c capital is probably not a material income producing factor in the pship (it's an advertising company!) and Diane is a general ptnr, then Diane's share of the unrealized receivables and unstated goodwill are within §736(a). [If you decided that capital was a material income-producing factor, then the entire 75K would be a §736(b) payment because no premium was paid; recall that §736(a) also applies to "premiums" above and beyond the value of the pship assets.] All of the rest of the payment to Diane is a §736(b) payment as an amount paid for Diane's interest in the pship assets.
A. §736(a) payments are either §702 distributive share if det'd acc to pship income; or §707(c) guaranteed payments if det'd w/o r. t. pship income.
The portion of the 75K cash payment to Diane which is attributable to unrealized receivables (accounts receivable of 6K) and the net appreciation in the unstated goodwill (of 9K) or a total of 15 out of 300 worth of pship assets, will be treated as a §707(c) guaranteed pyt b/c the amount is fixed and unrelated to pship income. The amount of the §736(a) payment is 15/300 x 75 = 3,750.
This 3,750 §736(a) portion is a guaranteed payment (b/c det'd w/o r. t. pship income) under §736(a)(2). Guaranteed payments:
(1) create OI to Diane - §707(c)
(2) ordinary deduction to pship under §162(a), which flows through 1/3 to each of Olive, Jeff, and Ralph
(3) the deduction flow-thru reduces Olive, Jeff's, and Ralph's OAB's by 1,250 each, §705(a)(2)(A).
B. The rest of the payment (71,250) is a §736(b) payment.
§736(b): provides for regular §§731/732 treatment of distribution as a liquidating distribution, and §751(b) overrides also.
Does §751(b) apply? No, because all of the §751 "hot" assets have already been "paid for."
So, §§731/732 liquidating distribution rules apply to this cash dist'n of 71,250:
3-step analysis here (a little modified):
1. Generally, distributions are tax-free to the ptnrs - 731(a).
However, money dist'ns in excess of OAB do create gain - 731(a)(1). Cash = 71,250 which is more than Diane's OAB of 31,688. Diane has 39,562 of LTCG under 731(a)(1). Holding period tacks from securities, so long term. Loss can be recognized in a liquidating distribution, §731(a)(2), but here there is no loss realized.
2. Calculate interim OAB: Effect on OAB under §733: reduce OAB but not below -0-, by the amt of the money dist'd to the ptnr - §733, OAB goes to -0-.
3. Diane got cash, so there are no basis issues under §732(b) and (c). Recall different basis rule in liquidating distributions than in operating distributions.
Result to Pship:
§731(b) nonrecognition on the cash dist'n.
B/c there is no §754 election, there is no basis adjustment to the pship's IAB for its properties on this liquidation of Diane's interest.
If a §754 election had been made, then there would be an adjustment under §734(b)(1)(A) by the amount of the gain recognized to Diane on this liquidating distribution.
The pship's final balance sheet will be:
Pship's Final Balance Sheet (After Liquid'n of Diane's Interest):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furn. & Fixtures 5 8 Olive 21,438 75*
Accounts Receivable 2 8
Securities 46.75 85
Furn. & Equipment 19 40 Ralph 54,438 75*
Cash -- -- Jeff 75,438 75*
Totals: 111.75 225 151,314 225*
*Technically, each capital account should be reduced by 1,250, but I am ignoring this. Unclear.
NOTE: There is now a discrepancy between IAB and OAB, which would be fixed by a §754 election. The election would allow a basis adjustment to be made for ALL ptnrs under §734(b). The amount of the adjustment would be the amount of gain recognized by Diane, §734(b)(1)(A).
Summary: Diane has 3,750K OI plus 39,562 of LTCG plus 1,687 of gain from the securities sale, or a total of 45K on this transaction, which serendipitously (will not always) adds up to her realized gain calculated at the outset of this problem!. The other 3 ptnrs share a deduction of 3,750K overall. However, their OABs are now larger than the pship's IAB in its assets, so a §754 election is needed.
NOTE: The more OI Diane has, the higher the deduction to the other ptnrs, so Diane's and the remaining partners' interests are adverse.
Compare this result with the sale result: Diane has 1,500 OI and 43,500 of LTCG, or a total of 45K. Same amount of overall gain but different character. Each of Olive, Jeff, and Ralph will add 25K to his or her OABs, and there is also a 45K discrepancy between inside basis and outside basis, so a §754 election is needed.
NOTE: The remaining ptnrs will want goodwill to be unstated, to increase the §736(a) payments which create deductions for them. Diane will want to state it, to increase her LTCG and minimize her OI (it'll then be a §736(b) pyt.).
Review Question 5.(b): If Ann buys Diane's interest for 75K cash, then:
§741/§751 analysis applies:
Steps:
1. Determine Diane's amount realized: = 75K
2. Determine Diane's total OAB (adjusted as of time of sale for pship income up thru sale; §705(a)): = 30K
Note: Diane's realized gain = 45K, which would be all capital gain under the general rule of §741, but for the exception of §751(a), which essentially undercuts §741 entirely and looks thru the pship to see what kind of assets are inside it. Have to do the §751(a) analysis to determine how much OI Diane will have on this sale, under §751(a).
3. Calculate Diane's §751 gain, which was done in part (a) of problem 5 as: 1,500 - 0 = 1,500 OI under §751(a).
4. Calculate the residual gain, which will be CG under §741:
Diane's residual amount realized = 75 - 1.5 = 73.5K
Diane's residual OAB = 30 - 0 = 30K
Diane's residual §741 gain = 43,500, which will be LTCG ....
5. Do not adjust pships' IAB as a result of this sale, §743(a), unless there is a §754 election in effect.
Ann's OAB for her 1/4 pship interest will be 75K, under §1012 and §742.
Redo balance sheet:
Pship's Balance Sheet (After Ann's Buyout of Diane):
Assets: AB FMV/BkVal Liabilities & Ptnrs' Capital
Land 18 36 Liabilities: None.
Building 18 36 Partners' Capital:
Goodwill 3 12 OAB FMV/CA
Furn. & Fixtures 5 8 Olive 21 75
Accounts Receivable 2 8 Ann 75 75
Securities 55 100
Furn. & Equipment 19 40 Ralph 54 75
Cash 60 60 Jeff 75 75
Totals: 180 300 225 300
The problem now is that IAB and OAB do not match. There is now a need for a §754 election, so that a special inside basis of pship assets can be created for Ann only, to take into account the fact that she paid 75K in cash to buy out Diane. Note that her pro rata share of the pship's IAB is 1/4 x 180 = 45, while she paid 75 in cash for her pship interest. She should insist that the pship make a §754 election (however, if she is unable to achieve this, she may use §732(d) to approximate the results of a §754 election to her).
Results of a §754 Election:
In this case, §754 would allow a §743(b) adjustment to pship's inside basis to be made w.r.t. Ann only. The amount of the adjustment is: the excess of her OAB (75K) over her proportionate share of the pship's IAB (45K), or 30K. So, Ann would be entitled to a special basis increase in IAB for her only of 30K, under §743(b)(1).
This basis increase would be allocated among the pship assets under the rules of §755 and associated regulations to those assets only which are appreciated. All of the assets in this pship are appreciated, so the special basis increase would go pro rata to the pship's assets.
(Generally, see the Foxman case.)
Review Question 6.: Brainstorm in class. a:\pship99.rqa