Sample Answers to Question 2
Partnership Tax
Spring 2009
Exam No. 1054
As a multi-member LLC, KLM is taxed as a partnership under CTB, absent a contrary election. As a passive participant, Matt is likely taxed as a limited partner.
Effect to Matt. When Matt dies on May 1, the partnership tax year closes as to him (only). All partnership items of income, deduction, gain, and loss as of May 1 will pass through to Matt, and be included on his final income tax return. The calculation of Matt’s distributive share for this final short year can be calculated under one of two methods. Under the interim closing of the books method, Matt’s distributive share would be calculated based on transactions actually completed (since KLM is a cash basis partnership) as of May 1. Under the proration method, Matt’s distributive share would be based on his partnership interest and the number of days during the year he was a partner—i.e., 1/3 x 4/12 = 11.1% of KLM’s total annual taxable income of $9,000 (i.e., Matt would be taxed on $999 of income on his final return).
Effect to Seth. Seth steps into the shoes of his father for purposes of receiving the liquidating distribution. Because there is $3,000 in accrued but not yet received income inside the partnership, then Seth will also be taxed on Matt’s 1/3 share of this money ($1000), as income in respect of a decedent. Seth receives a stepped-up basis in Matt’s partnership interest, based on FMV on the date of death. However, this stepped-up basis does not apply to the unrealized receivable. Thus Seth’s stepped-up outside basis will be $41K (FMV at date of death) less $5K (1/3 share of IRD items) = $36K. If the partnership has a § 754 election in place, the inside basis as to Matt’s 1/3 interest in each asset will also be stepped up to FMV on the date of death, except for the two IRD items.
The liquidating distribution. The liquidating distribution will be taxed as any other liquidating distribution would be. First, one must determine whether any portion of the $50K liquidating distribution is a § 736(a) payment. Because Seth is receiving a payment in excess of the FMV of his partnership interest, the extra $9K is likely to be characterized as a § 736(a) payment, in which case it will automatically be characterized as IRD. Thus the $9K payment would be included in Matt’s estate but also taxed to Seth as OI when received. Because the § 736(a) payment is not made in reference to partnership income, it is treated as a guaranteed payment. The partnership would also be able to deduct this $9K payment, unless it should properly be capitalized, which seems unlikely (it seems to be equivalent to a life insurance payment or some type of deductible fringe benefit).
The remaining $41K of the distribution is a § 736(b) liquidating distribution, which is taxed as a distribution by the partnership. The inventory has appreciated more than 20%, thus it is substantially appreciated. Accordingly, the inventory and the unrealized receivable are both § 751 hot assets. Because Seth only receives a cash distribution, he is receiving less than his 1/3 interest in the hot assets and the § 751 regs apply.
Under the hot asset rules, Seth is supposed to receive $14K of inventory and $4K of the A/R, thus he is deemed to have received them, taking a carryover basis of $10K and zero, respectively. He is then deemed to sell these two items to the partnership in exchange for $18K cash. Seth thus realizes $8K of ordinary income ($18K in cash less $10K total basis). KLM then takes a cost basis of $14K and $4K, respectively, in the re-purchased inventory and A/R. On the other hand, if a § 754 election was in place for the partnership, then Seth would have received a stepped-up basis in the inventory (but not the A/R), and accordingly would only recognize $4K of ordinary income in the liquidating distribution. The remaining $23K of the distribution is simply a cash distribution, with no recognition event for the partnership. Because Seth’s basis in the partnership interest stepped up to FMV, and the amount of his § 736(a) distribution is also equal to FMV, he should have no recognized gain outside of the hot asset recognition events.
Effect to Kate and Laura. There is very little effect to Kate and Laura. Because the liquidating distribution is cash, the partnership does not recognize gain or loss in the hypothetical hot asset transaction (although it takes a cost basis in the portion of the A/R that is deemed to be sold back to the partnership). Although a § 754 election impacts Seth, it would not have effect on K or L. The only other effect on K and L is the § 736(a) payment which is likely deductible, thus reducing the amount of taxable income that passes through to them.
Exam No. 1391
First when Matt dies booth his taxable year closes and the partnership’s taxable year as to Matt closes under 706(2). Thus, the partnership will need to calculate the distributive share of its dead member. Since all of its income is ordinary and all of its deductions are ordinary 702(a)(8) allows the partnership to net this stuff out when it is passes. As to Matt’s distributive share the partnership can either close the books and figure out his share or it pro-rate based on the entire years earnings. If it closed the books on May 1 when it had earnings of 3k (the 3k not taken into account for basis purposes) or it could pro-rate it earnings for the 4 month short year, the total earnings where 9k, thus the pro-rated share is 3k. In either case Matt’s share of these earnings would be 1k.
Since Matt died this 1k of earnings will go on his final
short year tax return (it is not IRD).
Since this income passes through Matt’s basis after death will be
32k. Matt’s estate will get a stepped up
basis in Matt’s partnership to FMV, except with regard to accounts receivable,
an IRD, item. Matt’s share of inside
basis for non IRD items was 10k for his 14k fmv share
of inventory, and his basis in the stock was 4k for 5k fmv
share. Thus the estate
2) Next the question provides That the partnership makes a liquidating distribution to Seth of 50,000 cash. This distribution will have 2 components a 736(b) payment for the Seth’s partnership interest in the amount of the FMV of the partnership interest of 41k, and an excess payment of 9k under 736(a). I will consider these separately. Under 751(b) when the estate gets the 41k cash distribution it is contructively getting Cash of 37k and the estate estates 1/3 share of Accounts receivable which are 4k of Accounts receivable (M’s share of hot assets). (751(b) does not call for allocation of inventory if the partnership elects 754 because the inventory is not substantially appreciated with respect to M’s hands. M’s estate’s basis in the inventory is it’s FMV because of 1014). His basis in the inventory will be carryover basis of 0 If this is the case then he will then be deemed to have sold the Accounts reciveble back to the partnership for the other 4k of cash in a taxable transaction resulting 4 gain. There is no other gain
This will cause the partnership to loss 41 cash and gain 4 more basis in its inventory so it has
Absent a 754 election M’ share of the inventory would also constructively come out inventory. 14 inventory (substanitaly appreciated, cause value exceeds IB of 10 by more than 120%). Thus he gets cash of 23, inventory and receivables of 18. The inventory will have a carryover basis of 10, which cannot be marked up, recievables will have a basis of 0, which cannot be marked up. This means he will have remaining basis 4, he will get a capital loss for this basis. The he will constructively sell inventory and receiveables back to the partnership resulting in a gin of 8 ordinary income. Also Estate could get the effect of a 754 election by opting for 732(d) which would give it a higher basis in the inventory so it had no gain of the sale of inventory. However under non 754 election scenario the partnership is out 41 cash and has higher basis in inventory of 4 and accounts receivable of 4.
3) Now as to 736(a) distribution as to the estate this IRD, concerning the partnership it would be a 707(c) fixed payment (does not depend on partnership) Thus the partnership could take a 162 deduction upon payment of it.
The only tax effects with respect to Kat and Laura is that they get a 4,500 loss each that will pass through at the end of 2009. This 9,000 expense will reduce will result in K and L having a net loss of 1k at the end of the year. 9 partnership income 1k going to M’s estate as a distributive share, 9k to the estate as a 707(c) payment thus 9-10= 1k. Leaving K and L each with a 500 loss.
Exam No. 1550
First, the fact that Matt is not active in the partnership (which, again, we’ll assume did not make the election to be taxed as a corporation) means that he may have to bucket any losses as passive activity losses if he’s not a material participant. His limited liability gives him a presumption of passivity. Now that he’s dead, he will not easily be able to overcome a presumption of passivity ever again.
The Death
On death, because we have a subsequent liquidation, any 736(a) items are IRD (income in respect of a decedent) per §753, as well as any receivables that were earned before death but not yet collected.
So what’s 736(a)? We don’t have a GP in a services partnership here, so it’s not A/R or unstated goodwill. It’s just premiums. So we’re OK there.
Note that the partnership year has closed as to M. So on M’s final return, he will have his share of the $3k in ordinary income, $1k.
Not done with IRD: we do, however, have unrealized A/R, which is classic IRD. M’s portion is 1/3 of $12k, or $4k. So the estate takes a stepped-up basis of $41k less the IRD items ($4k), or $37k. The whole amount will be included in the estate—so the IRD will effectively be taxed twice.
On the inside, without a 754 election, there is a basis mismatch; the inside basis of the assets is not written up (they are unchanged from the problem as presented). With a §754 election, we use the §743 rejiggering, and would write up the capital asset by $1k of personal inside basis, bringing it to $13k. We would also write up the inventory by $4k, which is the gain that would be attributed to M if it were sold for FMV.
The Liquidation
On liquidation, we need to act on the §736 discussion above. The value of the interest is $41k, and the amount of the cash payout is $50k. That $9k is 736(a), which will be taxed as ordinary income to S, and will be deducted from 2009’s income to KLM (and divvied to the remaining partners), meaning that KLM will break even in 2009.
The 736(b) property presents its own issue: hot assets under 751(b).
So we need to see what’s hot: here, it’s the A/R. It’s not the substantially appreciated inventory (it’s over 120% appreciated per §751(b)(3)) because he already has basis to cover it through the basis step-up process (assuming the §754 election was made). That means we need to do the phantom distribution dance with the hot assets.
If there was no inside basis step-up, prior to the exchange, S had a $14k share of inventory and a $4k share of A/R, and after, he had zero share of those. So in distributing the $41k of 736(b) cash, it’s actually first a distribution of $18k of hot assets and $23k of cash. This brings S’ basis down by 23 + 10 (the basis in the inventory). S then sells those hot assets back to the partnership and pays ordinary income of $8k in exchange for the remaining $18k in cash. He would also take a $4k capital loss, because he was taxed on the inventory again.
If there was an inside basis step-up, then the only hot asset is the A/R, so S would only pay $4k in ordinary income, and there would be no loss at the end.
After the liquidation, then, absent a §754 election, we have a $2k basis mismatch between the inside and the outside, and if we did the basis rejiggering, it would adjust the A/R and inventory bases to make it all come out right ($1k apiece). The FMV of the partnership is $41k–$4500 (half the $9k premium) per partner, or $73k total on the outside.
KLM has been in operation for many years, so the capital gain and loss to M is LT. There’s not much of it, though—most of the gain to M/S is ordinary.
Created by: bojack@lclark.edu
Update: 20 May 09
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