Sample Answer to Question 1
Partnership Tax
Spring 2003

Since EF is not incorporated, has not gone public, and has made no election to be taxed as an "association," it is taxed as a partnership. (Hereinafter, EF is sometimes referred to as "the partnership.")

Ella is not taxed on her transfer of land and cash to EF. IRC § 721. EF's basis in the land is a carryover basis from Ella, $85,000. IRC § 723. Ella's basis in her partnership interest is a carryover basis of $85,000, plus a cost basis of $100,000 attributable to the cash, for a total basis in her partnership interest of $185,000. IRC §§ 722, 1012. Frank is not immediately taxed on receipt of his partnership interest, because he receives no immediate capital interest in the partnership. He might be taxed if he sells his partnership interest shortly after EF is formed. If not, his initial basis in his interest in EF is zero.

An issue arises whether the services Frank performs are in his capacity as a partner, or in another capacity. An important factor in this regard is whether the duties he is performing the basic duties of the partnership business; if so, he is more likely to be treated as acting in his partner capacity. One could argue, however, that real estate acquisition is not among the basic duties of a retail and wholesale operation. Among factors indicating that the payments he receives are in his capacity as a partner include the facts that his income is subject to substantial risk; that he is not merely a transitory basis; that the allocation of income to him is indefinite, rather than short-lived; and that there appears to have been no primary purpose of tax avoidance in his being a partner.

If the services Frank renders are determined to be in his partner capacity, IRC §§ 702 and 731 would apply. Frank's distributive share of EF's $200,000 ordinary income would be 15 percent, or $30,000. The income would be ordinary to Frank, as it was in the hands of the partnership. His basis in his partnership interest would increase from zero to $30,000 on account of the passed-through income. The distribution of $30,000 cash would be treated as a tax-free return of Frank's outside basis, reducing it back to zero. IRC §§ 731, 733. Ella would have $170,000 of passed-through ordinary income, and a tax-free distribution of $170,000; her basis would increase to $355,000 with the passed-through income, and decrease back to $185,000 with the cash distribution.

If the economic benefits bestowed on Frank are determined to be not in his partner capacity, IRC § 707(a) would apply. With the payment of the $30,000 to him, Frank would have taxable compensation income from personal services under IRC § 83(a). EF would seek a deduction under IRC § 83(h); however, the deduction would likely be denied on the ground that it was a capital expenditure. Therefore, the $30,000 paid to Frank would be added to EF's basis in the real estate purchased and financed through Frank's efforts. EF would thus have $200,000 of taxable ordinary income, which would pass through $170,000 to Ella and $30,000 to Frank (in addition to Frank's compensation income, discussed earlier in this paragraph). The partners' outside bases would increase to $355,000 for Ella and $30,000 for Frank. The $170,000 distribution to Ella would be tax-free under IRC § 731, but it would reduce her outside basis to $185,000 under IRC § 733.