Sample Answers to Question 1 - Partnership Tax

Sample Answers to Question 1
Partnership Tax
Spring 2009

Exam No. 1391

1) First, formation of the partnership Hank and Irma transfer cash for their partnership interest. The will receive basis carry over basis of 24 for that in their partnership interest under 722. Also, transaction is non-recognition (no gain or loss) under 721. Additionally they will get basis for the share of partnership debt that they assume under 752(b). Jared is transferring in real estate and he is a real estate broker. He will get carryover basis under 722 of 21 (basis in land) in his partnership interest, however that number will be adjusted by 752(a) and 752(b) for the amount of personally liability for which he has been relived and the amount of partnership liabilities that he assumes. Jared’s OB will be decreased by 30 under 752(a) the amount of personal liabilities that the partnership has relived him of and increased under 752(b) for the amount of liabilities that he assumes. 1.752-2(b) provides for allocation of recourse liabilities. This postulates a doomsday scenario where all partnership liabilities become due, and all partnership assets are worthless and disposed of in taxable transaction. Thus if the partnership suffered a loss of 102 (loss of FMV of all contributed assets and debt becoming due). Irma and Jared’s capital accounts would be reduced to zero and Hank would have a capital account of -30. Also, Hank is the only one that can be allocated the loss such that he would have a negative capital account under 704(b) because the agreement as to him follows the big three meaning that he has an unconditional obligation to restore a negative capital account. The other partner’s allocations have economic effect under the alternate economic effect test of 1.704-1(b)(ii)(d) because they have agreements that provide a QIO and the first two parts of the big three. This test provides that allocations of loss will respected until such a partnership agreement until their capital account reaches 0. Thus the entire loss allocation under the dooms day scenario would go to Hank. Meaning He bears the risk for the entire loss because only he has an obligation to restore a negative capital account. Thus he is allocated all of the recourse loss he, as the only one with an obligation to restore a negative capital bears an economic risk of loss with respect to the loan on the property. 1.752-2(b). Thus Hank gets 30k of basis under 754(b) + 24 basis under 722 for a total of 54, Irma gets her 24 of basis under 722. As to Jared he starts with a 722 basis of 21 then it is reduced by 751(a) by 30. The 30 of debt relief is treated a as distribution of cash to Jared which is non-recognition to Jared to the extent of basis of 21. Thus under 731(a) Jared will recognize 9 capital gain, and under 733 his basis in his partnership interest will be reduced to 0 (reduce by amount of cash distributed, but not below 0. Also another consequences to Jared is that the land has built in gain of 33, under 704(c) this gain will be allocated to Jared upon disposition of the land

2) Regarding the partnership it will take the cash with carryover basis under 723, and Jared’s land with carryover basis of 21 as well. Also due to the fact that the land was probably inventory in Jared’s hands that inventory taint will remain with the land in the partnership’s hands for 5 years. (thus if the partnership sold it it would realize ordinary gain). The partnership absent a 754 election will not adjust its IB on the 731(a) distribution to Jared

After contribution absent a 754 election we have the following

Assets

Liabilities

Cash

Inventory Land

Total:

102

Debt

Total

102

3) Given that the contribution to the land creates an inside outside basis mismatch the partnership could make a 754 election to fix this. If it made a such an election 734(b) provides that the partnership increase the basis of partnership property in the amount of gain recognized by the distributee under 731(a)(1). In this case it was 9. Also, I this inside basis will be split between H and I the partner’s who did not receive the distribution. That is H and I will get a personal inside basis, but I am not sure in what proportions. However the IB of the land will increase to 30

4) In year 2 the partnership will sell its parcel of land for 18 cash + 30 debt relive for an amount realized under Crane of 48. The partnerships tax gain on this sale will be 48 – (21 or 30 basis depending on whether 754 election is taken). Thus gain of 27 or 18 (depending).

Since this is 704c property of Jared’s with a built in gain of 33, all this gain will be allocated to Jared under 1.704-3(b)(1) traditional method. Jared basis in his partnership interest will increase by the amount of gain that it allocated to him (see 705(a)). However the fact that Jared’s gain is capped creates a distortion from traditional methods ceiling rule. Also the character of gain will be ordinary to Jared. The character of gain of items passes through under 702. Further another consequence of the sale would be H is relived of partnership liabilities. This is treated by 751(a) as a 731(a) distribution of cash which lowers H’s basis by 30.

After sale, presuming no 754 election, no remedial method or curative allocation

Assets

Liabilities

Cash

Total:

Debt

Total

Alternatively after the sale the partnership could elect to use the remedial method, which provides for remedial allocations (made up gain and loss) of 6 loss to the partnership and an allocation of 6 additional gain to Jared to relieve the distortion from the ceiling rule. That is we recognize the book loss, and Jared’s built in gain with offsetting allocations that are fictional. 1.704-3(d). These allocation would have to be of same the character and this would be ordinary gain and loss. The end game would be that Jared would recognize a net gain ordinary gain of 31, and H and I would recognize a loss of 2 each Additionally you could achieve a similar effect by using the traditional rule with curative allocations where you correct for distortions created by the ceiling rule by allocating items of actual partnership gain and loss. 1704-3(d)

See balance sheet below for results using the remedial method, but without a 754 election

Assets

Liabilities

Cash

Total:

Debt

Total

Exam No. 1054

Partnership Formation. LP is a multi-member eligible entity under the check-the-box regulations. Since no election was made, it is taxed as a partnership. Accordingly, the formation is generally a non-taxable event under § 721.

H and I both contribute $24K cash. Thus, no gain or loss is recognized by either partner or the partnership. H and I both take a tentative outside basis equal to the cash they contributed, i.e., $24K (each). J contributes appreciated real estate encumbered by a loan. Because the liability ($30K) exceeds J’s adjusted basis ($21K), J will recognize income to the extent that relief of liability exceeds his basis. The amount of this recognized gain depends on whether any of the recourse loan, once it is assumed by the partnership, is allocable to J.

Since the $30K mortgage is recourse to the partnership, each partner’s outside basis is increased by the portion of the debt for which the partner bears the economic burden of loss. The burden is calculated under the doomsday scenario prescribed in Reg. § 1.752-2, which asks what each partner would owe if all partnership liabilities are due in full, all assets are worthless, and the partnership disposes of its property in a fully taxable transaction for no consideration with loss items allocated among the partners. In LP’s situation, the partnership take a carryover basis of $21K in Greenacre. Thus, under the doomsday scenario, there would be a $21K loss passed through, $7K to each partner. Under the doomsday scenario, the $30K mortgage would be payable in full. Because I and J are both limited partners, they would be under no obligation to satisfy the mortgage. Nor do I and J assume any contractual obligation to pay the partnership’s debts. Thus H, as the only general partner, would be liable for the entire amount of the loan. Accordingly, the $30K in partnership debt is allocated entirely to H.

After the formation, H has an outside basis of $54K ($24K cash contributed + $30K debt) and a capital account of $24K (equal to the contributed cash). I has an outside basis and capital account of $24K (contributed cash). J recognizes a taxable gain upon his contribution of the land. Because the liability from which he is relieved ($30K) exceeds his basis in the land ($21K), he recognizes a gain of $9K. This is treated as a gain from the sale of his partnership interest, thus it is a capital gain (his ordinary income will come later, when the partnership sells Greenacre). Because the partnership takes a carryover basis of $21K in Greenacre, but J’s outside basis is not increased for the recognized gain, there will be an inside/outside basis mismatch.

Sale of Greenacre. Because J is contributing property with pre-contribution gain, § 704(c) applies, which becomes relevant when LP sells Greenacre to B. B pays $18K cash and assumes a $30K mortgage, thus the total consideration is $48K. Since LP takes a carryover basis of $21K, the total taxable gain realized on the sale is $27K. Yet Greenacre has a book value to the partnership of $54K (FMV at time of contribution), thus there is a book loss of $6K to the partnership, reducing their capital accounts by $2K each. Under § 704(c), the pre-contribution gain of $33K must be taxed to J. This creates a problem, since the total realized tax gain is less than the pre-contribution gain. Under the traditional method’s ceiling rule, the partnership cannot allocate more than the total tax gain or loss. Thus, the partnership must allocate the entire $27K tax gain to J, increasing his capital account. But, when the $6K of economic loss reduces each partner’s capital account by $2K, H and I will have reduced capital accounts without an accompanying pass-through of tax loss, and there will be a book/tax disparity for H and I. This disparity can be solved one of two ways.

First, the partnership could elect to use the traditional method with curative allocations. The year of the sale would be treated the same as under the traditional method, but in future years, $4K of income (i.e., the amount of the disparity caused by the ceiling rule) would be allocated J for tax purposes only, with no effect on his capital account. Because Greenacre was inventory in J’s hand, the entire amount of taxable gain from the sale is characterized as ordinary income to the partnership. Thus, any curative allocation would also have to consist of ordinary income.

Alternatively, the partnership could use the remedial method, in which case $4K of ordinary income in the year of sale would be allocated to J—again, this is for tax purposes only, and would not impact his capital account.

Exam No. 1640

Assuming LP does not elect to be taxed as a corporation under the check the box regulations §301.7701-1 & 2, and is not an “investment company” under the meaning of §351(e), LP will be taxed as a Sub-chapter K, pass-thru entity.

Contribution of property to a partnership in exchange for a partnership interest is a non-recognition event under § 721(a) and therefore the contributions of money and land will not be taxable to any of the partners nor to LP.

LP will have an inside basis on the contributed property equal to the basis of the contributing partner at the time of contribution. §723. Therefore, LP will get an inside basis of $48,000 for the cash contributed by Hank and Irma, and an inside basis of $21,000 for the land contributed by Jared.

Hank and Irma will each have an outside basis in their respective partnership interests of $24,000, because cash has its basis printed right on it. §722. Jared’s contributed land is subject to a recourse mortgage. Under §752(a) & (b) governs the allocation for recourse debt, which creates an increase in Jared’s basis when contributed, but a decrease when the basis is allocated to other partners. Regulation 1.752-2(a) gives basis to each partner to the extent they bear economic risk of loss . The reg calls for a doomsday calculation in which a constructive liquidation assumes $0 value in partnership assets and the debt is due and payable. Under this scenario the only partner bearing the economic risk of loss is the General Partner, Hank who by definition is liable for partnership debts, but also agrees to restore a negative capital account. Therefore, Jared will receive $30,000 outside basis when he assumes the $30,000 liability. (SEE BALANCE SHEET IN BLUE BOOK)

Because Jared was a dealer of real estate the land’s character is ordinary and the character will be preserved upon contribution to LP. §724.

When GreenAcre is sold to Betty, it is sold for a tax gain, but a book loss. Book Losses may only be taken to the extent of tax losses. Reg. 1.704-3(b) commands the following results:

Under the traditional method and the ceiling rule - Upon its sale for $48,000, cash plus relief of liability, there is a book loss of $16,000, but a tax gain of $27,000. Under paragraph (b)1 supra, the entire gain must be allocated to Jared because he had at least that much built in gain remaining. This creates a mismatch in the inside and outside basis.

Under the traditional method with curative allocations – An allocation can be made from some other item of income to reduce or eliminate the disparity of non contributing partners.

Under the remedial method – The partnership may create a remedial item and allocate it to its partners.

Hank is relieved of the $30,000 liability and this takes away $30,000 outside basis.

Created by: bojack@lclark.edu
Update: 19 May 09
Expires: 31 Aug 10