Sample Answers to Question 1
Partnership Tax
Spring 2006
Exam No. 1281
At the formation of the ABC partnership, none of the
partners will recognize any gain, nor will the partnership. IRC 721(a) states
that no gain or loss will be recognized upon contribution to a partnership of
property in return for a partnership interest. In addition, all three partners
are donating cash, and not property with built in gain, so there isn’t any gain
to be recognized. Each partner will receive an outside basis of $100k for their
partnership interest under IRC 722. The cash will, as it always does, have a
basis inside the partnership equal to its face value, which is confirmed by IRC
723. At the time of formation, ABC’s balance sheet will look like attached
balance sheet (in blue book) 1.1.
When the partnership borrows money, some (or all) partners
will get an increase in basis due to the borrowed money under under IRC 752(a) and the Crane/Tufts rule. In this situation, the loan is nonrecourse
because the bank can only go after the secured property to recover its money,
and not the partners themselves. Reg. s. 1.752-1.
This is true even though there is a general partner. Because the debt is
nonrecourse, the accrued basis will be allocated to the partners by the three
tier system of Reg. s. 1.752-3(a)(1)-(3). At the time
of purchase, there is no minimum gain because the value of the property exceeds
the outstanding debt it secures and there is no 704(c) issue, so the basis will
be allocated according to each partner’s share of partnership profits. In this
case the basis will be allocated $400k to A and $200k each to B and C. After
accounting for the debt and basis and purchasing the equipment, see Bal. Sheet
1.2.
In the first year, the partnership breaks even except for
the $300k of depreciation on the purchased equipment. This loss will pass
through to the partners under IRC 704. The partnership would like for it to
pass through $150k to A and $75k each to B and C. To do this, the partnership
would have to include “the big three” in its partnership agreement as described
in Reg. s. 1.704-1(b)(2)(ii)(b). Presuming the
partnership maintains its capital accounts properly and agrees to liquidate
based on those capital accounts, the qualified income offset will allow the
partnership to allocate the basis as it wants under Reg. s.
1.704-1(b)(2)(ii)(d).
However, the partnership will not be allowed to allocate the
basis as it wants because it is not in the land of nonrecourse deductions in
the first year. This can be seen by the capital accounts - if the loss passed
through as indicated, B and C would have a positive capital account while A’s
capital account is negative. Even though he is a general partner, he has
apparently not agreed to restore a capital account deficit. If A is not
required to restore a capital account deficit, taking his c.a. negative while
other partners still had positive accounts would effectively be allowing him to
take a loss which accrues to other partners. The liberal Reg
s. 1.704-2 rules on allocating nonrecourse debt apply
only when you are losing the bank’s money. Instead, the loss will have to pass
through $100k to each partner. In year two, if the depreciation continues at
$300k a year, the partnership could pass through the deduction in the 50/25/25
ratio because there is a minimum gain chargeback provision and there will be
partnership minimum gain to allocate. (See Bal. Sheet 1.3, final after year
one).
A, B and C have
plenty of basis under 704(d) to pass the loss through, but B and C may run
afoul of the passive loss limitations on deductions under IRC 469. Passive activity
in general is any rental activity or any business where the partner doesn’t
actively participate. LP’s are generally passive by definition, so they may be
limited to taking their loss against other passive income only. There is no
at-risk issue here because they are still losing their money, not the bank’s.
The bottom line: the formation of the ABC partnership is a non-event, the debt will
be allocated according to each partner’s interest in profits, and ABC will have
a loss of $300k that passes through $100k to each partner. B and C may be
limited by the passive loss rules to applying that loss only against passive
activity gain. There are no relevant elections the partners could use to vary
their tax consequences.
Exam No. 1141
At start up each partner contributes cash to the partnership. Under IRC Section 721, neither the partners nor the partnership will recognize gain on the exchange of cash for the partnership interest. The partnership can make an election under the Check the Box Regulations to be taxed as a corporation. The initial outside basis in the partnership to Al, Beth, and Cora under IRC Section 722 is $100,000 for the cash contributed. The opening balance sheet for the partnership is as follows.
Assets Basis Book Value Liabilities Basis Book Value
Cash 300K 300K None
Partner’s equity
A 100K 100K
B 100K 100K
C 100K 100K
Totals 300K 300K 300K 300K
When the partnership acquires the 800,000 debt under, Section 752 and the regulations the partners get basis in the partnership for the debt that it has acquired. State law definition does not control over whether or not the debt is recourse or nonrecourse. A liability is nonrecourse to the extent that no partner bears the economic risk, under Reg. 1.752-1(a)(2). The loan is only secured by the equipment, and none of the partners will be personally liable if the loan defaults so it is a nonrecourse loan. Each partner’s share of nonrecourse liabilities are allocated under Reg. 1.752-3. Nonrecourse debt is allowed in accordance with 1) partner’s share of minimum gain, 2) partner’s share of 704(c) property, and 3) in accordance with the partner’s share of profits. The partnership agreement complies with the first two of the big 3, has a qualified income offset provision and a minimum gain chargeback provision so the allocations of nonrecourse deductions will have economic effect. There is no minimum gain and no Section 704(c) property so the nonrecourse debt will be allocated in accordance with the partnership’s share of income. The 800,000 debt will be allocated 50% to Al for 400,000 and 25% to Beth and Cora for 200,000 each. The basis of Al’s partnership interest will be 500K and Beth and Cora’s will be 300K. The equipment will have a cost basis of 1.1M under Section 723. After the purchase of the property the balance sheet will look as follows.
Assets Basis Book Value Liabilities Basis Book Value
Equipment 1.1M 1.1M None 800K
Partner’s equity
A 500K 100K
B 300K 100K
C 300K 100K
Totals 1.1M 1.1M 1.1M 1.1M
After the first year of operation the deductions will pass through to each partner in accordance with the partnership agreement because the partnership complies with the alternative test for economic effect. Under Section 705 the capital accounts of the partners will be increased by the partnerships share of the $210,000 income which is distributed to each partner according to the partnership agreement and decreased by the share of partnership liabilities. The partnership has a net operating loss of 300,000 which is attributable to the depreciation on the equipment. The deductions are not recourse deductions at this point because there is no built in gain in the equipment. The equipment after the depreciation has a FMV of 800K which is equal to the debt securing it of 800K. Under the partnership agreement the losses pass through 50% to Al and 25% each to Beth and Cora. 50% of the loss to Al is 150K. Al has enough basis for the deduction of 150K, but his capital account is only at 100K. Passing the entire loss to him would create a negative capital account. Under the alternative test the allocation will have economic effect only to the extent of the capital account, the remaining deduction will be distributed to the remaining partners. Al receives a recourse deduction of 100K, bringing his capital account to zero. The excess 50,000 of the deduction will be distributed to Beth and Cora equally. Under the partnership agreement Beth and Cora receive 75K of deduction plus the 25K that could not be passed through to Al. All three partners have a capital account of 0. The basis of each interest is reduced by 100K, bring Al to 400K and Beth and Cora to 200K. The balance sheet is as follows.
Assets Basis Book Value Liabilities Basis Book Value
Equipment 800K 800K None 800K
Partner’s equity
A 400K 0
B 200K 0
C 200K 0
Totals 800K 800K 800K 800K
Under IRC Section 465 of the code the losses could be disallowed under the at risk limitations in the code because the debt is non-recourse debt. However, the losses will still likely be allowed because of the exceptions in the code for non-recourse debt.
Exam No. 1447: See pdf file here.