Sample Answer to Question 2 - Partnership Tax

Sample Answer to Question 2
Partnership Tax
Spring 2003

The $8,000 paid to Stan for the covenant not to compete is characterized under IRC § 736(a) as a guaranteed payment under IRC § 707(c). Thus, it is ordinary income to Stan, and deductible by the partnership (with the deduction passing through $4,000 each to Rachel and Terry). Rachel and Terry's bases in their partnership interests are reduced from $19,000 each to $15,000 each on account of the deduction passing through. IRC § 705.

The partnership possesses "hot assets" – namely, the substantially appreciated inventory. Therefore, the liquidating distribution of the land to Stan triggers IRC § 751(b). Under that Code section and supporting regulations, Stan is treated as (1) receiving a distribution of his share of the inventory (fair market value $15,000) along with $15,000 worth (fair market value) of land (the $30,000 worth he actually got, minus the$15,000 value of inventory deemed distributed); and (2) transferring the inventory back to RST in a taxable exchange for the rest of the land. When the first step takes place, the $15,000 worth of inventory deemed distributed (one third of the inventory) is assigned one third of RST's basis, which carries over to Stan under IRC § 732(b) and 732(c)(1)(A). One-third of RST's $30,000 basis is $10,000, which becomes Stan's basis in the inventory in the first step. The portion of the land deemed distributed to Stan receives a basis of $9,000 (Stan's outside basis of $19,000, minus the $10,000 assigned to the inventory). IRC §§ 732(b), 732(c)(1)(A).

On the second step under IRC § 751(b), both Stan and the partnership (Rachel and Terry) recognize gain. Stan is treated as exchanging his $15,000 worth of inventory (basis $10,000) for $15,000 worth of additional land. This results in $5,000 ordinary income to Stan. RST is treated as exchanging $15,000 worth of land (basis $6,000) for the $15,000 worth of inventory, which triggers $9,000 of capital gain to RST. The $9,000 of capital gain passes through equally to Rachel and Terry, increasing their outside bases by $4,500 each. Thus, their outside basis is $19,500 each.

Stan's basis in the land is $24,000 – the $9,000 basis assigned to the half of the land deemed distributed in the first step under IRC § 751(b), plus a $15,000 "cost" basis in the portion received in the taxable second step. RST's basis in the inventory increases from $30,000 to $35,000. It takes a $15,000 "cost" basis in the one third of the inventory that it received from Stan in the second step under IRC § 751(b); the rest of the inventory (two thirds) retains the basis it had before the distribution, namely $20,000. With the $7,000 of cash remaining in RST, its assets have a total inside basis of $42,000.

There is a $3,000 disparity between Rachel and Terry's outside bases ($19,500 each, or $39,000) and RST's inside basis in its remaining cash and inventory ($42,000). If a Section 754 election is in place, RST would apparently be required to decrease the inside basis of its assets by $3,000. [Bonus point, unnoticed when I wrote this question: Under Reg. § 1.755-1(c)(4), the reduction would not be made to the basis of the inventory. Since the basis mismatch was the result of the increase in the basis of a capital asset, the land, in Stan's hands under IRC §§ 732(b) and 732(c)(1)(A), the downward adjustment would be carried over to a capital asset that RST acquires in the future. – JB ]

If RST elects, it will be an "association," taxable as a corporation.