Sample Answers to Question 2
Partnership Tax
Spring 2006
Exam No. 1447: See pdf file here.
Exam No. 1416
To start, LLCs may elect to be
taxed as partnership under the § 301.7701-3 “check the box” regulations. From
the facts, it appears such election has been made by the LLC.
The operating distribution of $150K worth of accounts receivable (AR) to D means that he has taken out more than his “fair share” of a “hot asset” under § 751(b)(1). Because D and E each have a 50% interest in profits and losses, there will be tax consequences to D and to the LLC (thus E) for taking out all of the AR. The IRC intends to make sure that each partner is taxed on her fair share of the ordinary income items inside the partnership, which means that distribution as such will be recharacterized by the Code.
First, under § 751, D will be treated as though he was distributed $75K worth of the AR and a “mixed bag” worth $75K of other items in the LLC. To determine what other assets he is deemed to have been distributed, we look to the total FMV of the other assets in the LLC ($150K + $100K = $250K) and consider that he has been distributed a portion of these assets in the proportion that each is worth relative to the total FMV of the assets. Thus, he is deemed to have received $45K (75K x 3/5) and $30K worth of the land (75K x 2/5). His basis in the land would be deemed to be $6K. When these items are distributed to D it is considered a tax-free distribution to him under § 731. Under § 733, D’s outside basis would now be $85K – $45K – $6K, totalling $34K.
Second, D is treated as though he sells the money and the land back to the LLC in exchange for the $75 worth of “hot asset” AR. The result is that D must recognize $24K worth of capital gains on the sale (30K for the land minus $6K basis in the land). D then takes the $75K worth of AR at a cost basis of $75K (when he later collects on the $150K AR he will be taxed on $75K as ordinary income). Meanwhile the LLC is deemed to have sold $75K worth of AR, for which it will recognize $75K of ordinary income that will all be passed through to E. This will increase E outside basis to $160K. D’s capital account will be lowered by $150K for a end result of $50K. E’s will remain the same at $200K.
In the second distribution, hot assets will not be an issue since the AR are gone and there are no other hot assets in the LLC. The $150K distribution to E under § 731 will not be taxable to either E or the LLC. Under § 705 and § 731, E’s basis will be reduced by $150K, for an end basis of $10K. Her capital account will be reduced by the same amount.
Exam No. 1508
Operating distributions of property are generally non-recognition events for the partner and partnership, pursuant to § 731. § 733 provides that such distributions reduce the partner’s outside basis by the basis of the property in the partnership’s hands, and that basis transfers to the partner according to § 732(a).
§ 731(a)(1), however, provides that excess cash over basis is gain from the sale or exchange of a partnership interest. Also, if the property is subject to § 704(c) built-in gain or loss, the partnership holds “hot assets” subject to § 751(b), or triggers § 737 anti-abuse rules, the non-recognition can be upset.
The distribution to D of the unrealized receivables would be treated by § 751(b)(1)(A)(i) as a sale or exchange of property in exchange for part of D’s capital interest in DE, and it would not meet any of the exceptions as a liquidation or return of contributed property.
§ 751(b) regs requires the distributee partner, D to engage in a constructive exchange of interests with DE.
D receives a non-recognition distribution of 75 in receivables (basis of 0), and 75 comprised of a phantom pro-rata share of “non-hot” assets, 45 cash, and 30 land (basis of 6). This reduces D’s basis by 51, the value of the cash and the basis in the land, to 34. The value of his interest is reduced by 150, to 50.
D then exchanges the 75 basket of “non-hot” assets back to DE for the remaining 75 in “hot” receivables, in a transaction taxable to D and E. D recognizes 24 in capital gain on the land, and takes a cost basis of 75 in the receivables. DE passes through 75 in ordinary income to E (amount realized, 75, less a basis of 0), and acquires 45 cash and 30 in land. E’s outside basis is increased by 75. (Reg. § 1.751-1(b)(2)(ii) excludes D from the partnership equation on the phantom transaction, so E can properly be allocated the balancing gains).
The resulting bases of D and E are as follows: D’s basis is 34, and his capital account 50; E’s basis is 160, and her capital account 200; DE no longer holds any accounts receivable, and holds land worth 100, with inside basis of 44.
On the distribution of cash to E, there are no longer any hot assets, and E takes a non-recognition distribution of 150, reducing her basis to 10, and her capital account to 50. D bears no impact in this transaction.
DE is left with land worth 100, and a basis of 44. D and E each have capital accounts of 50, and