Sample Answer to Question 3
Partnership Tax
Spring 2004
Exam No.
4646
There is no realization when the partners contribute cash to the LLC under 721. Each receives an OB equal to the cash contribution of 50 under 722 and the partnership gets a carry over basis of 100 in the contributed cash. When the partnership borrows money cash goes up 60 on the assets side of the balance sheet and each partner receives additional basis of 30 under 752 and the operating agreement. Since this is an LLC both members are free from risk of loss under the loan, the LLC itself is only on the hook to the extent of its assets, but the members personal assets are not on the line without some other guarantee. Effectively the loan is non recourse as to the members
At the end of the first year, the partnership has a net loss of 110 which is passed equally (55 each) to both J and K. J has enough basis to take out the whole 55 as required by 704d but has not agreed to make up a negative capital account nor has he agreed to a minimum gain charge back so that he can take losses of the banks money, so the last 5 of loss is diverted to K leaving J with OB of 30 and CA 0. K on the other hand has agreed to make up negative capital accounts so her 55 pass to her reducing her OB to 25 and her CA at -5. Then K gets the 5 loss that J could not take further reducing her OB to 20 and her CA to -10. This distribution will be respected because it has economic effect meeting the big three or in J’s case the alternate QIO.
Because the nature of the loan is non recourse K may not be able to use the loss because she is not at risk for the loss and must carry forward the loss to a later year. 465 does not allow a partner to take out more losses than the aggregate of cash contributed, the basis of the property contributed, and recourse debt. Despite this issue the partners might satisfy 465 with one of the exceptions which allow qualified non recourse debt to increase the at risk amount if it is a non recourse loan from a commercial lender securing real estate. There maybe a further problem with passive loss limitations depending on Karen’s role in the LLC she may not be able to pass out these losses that are due to rental activity unless she can rebut the presumption that as an LLC member she is a passive participant in the LLC’s activities. To do this she must show that she is regularly continuously and substantially participating in the management of the LLC.
When Jeff contributes the machine it is a non realizing event under 721 and he gets a carry over basis in it of 20 under 722 and the partnership takes the same IB in it under 723. This property has decline in value since J got it and so it is 704c property with built in loss which should be taxed to him when the partnership disposes of it. When the partnership sells the equipment there is a tax loss of 20 – 16 = 4 and a book gain of 16 – 15 = 1. Under the Traditional method all of the built in gain or loss must be attributed to the contributing partner. So J would get the entire loss of 4. This disposition of property presents a ceiling rule problem because J should really have gotten a capital loss of 5 not 4 but the ceiling rule prohibits gain or loss from exceeding the gain or loss realized by the partnership. This allocation will cause a disparity in the inside and outside bases. Alternatively, the partnership could elect the traditional method with curative allocations which would give J only the cap loss of 4 now but would reallocate later items of loss to him so that he gets all of his built in losses. It would also assign to K an item of capital gain of 500 or half of the 1k that the partnership experienced post contribution. This election would get rid of any inside outside basis mismatch eventually. Finally the partnership could elect the remedial method, under this method the partnership would create items of gain and loss to offset the effects of the ceiling rule at the time of the sale. First it would allocate the full right Capital loss to J of 5. Then it would create an item of 1 capital gain which it would distribute amongst the members according to the operating agreement. The effect is that there is no inside or outside basis mismatch at any time.
The fact that J contributes the property only to sell it looks a little fishy because it seems like he is attempting to pass his capital loss to someone who might be able to use it like J. This sort of behavior is frowned on by the service as it was in Orrisch where one party was attempting to give all the losses to the party that had the ability to use them. There is a note that the disposition of the equipment was unplanned, but it all still looks like J and K are using the partnership for tax avoidance because the contribution of the equipment was not old and cold.