Sample Answers to Question 3
Partnership Tax
Spring 2009

Exam No. 1054

Formation of the partnership. Company is a 2-member eligible entity under CTB. Since no election was made to be taxed as an association, it is taxed as a partnership. N and O’s contributions of cash are non-recognition events. Each partner’s outside basis immediately after formation is equal to the cash they contributed. So too are their capital accounts. Thus, N and O begin with outside basis and capital accounts of $20K and $80K, respectively.

The loan. The $200K loan potentially increases each partner’s outside basis. Although the loan is labeled as recourse debt, no partner bears economic risk for repayment because of their limited liability. Accordingly, the loan is treated as non-recourse under Reg. § 1.752-1(a)(2). Since neither partner has partnership minimum gain or § 704(c) gain, the entire non-recourse liability is allocated in accordance with the partners’ interests in partnership profits. Accordingly, the loan is divided evenly and after the loan is made, N and O have outside bases of $120, and $180 respectively, with no change in capital accounts.

The first year of operations. Ordinary income and capital gain are both characterized at the partnership level and pass through separately to the partners. Thus, N and O both receive pass-through income of $10K in OI and $15K in LTCG. Accordingly, their outside basis and capital accounts are both increased by $25K each.

Olivia’s payment. The $100K payment to Olivia is either a § 707(a) payment to a partner acting in a non-partner capacity or a § 707(c) guaranteed payment. Because there does not appear to be an issue with multi-tax-year payment shifting, the effect of classification under (a) or (c) is immaterial. Because Olivia is rendering services to the partnership after it has started operations, her services are not amortizable start-up costs. Unless the nature of her work requires the $100K payment to be capitalized, it will be a deductible expense to the partnership. In any event, it will be ordinary income to Olivia, and not treated as a partnership distribution and would not (directly) reduce her basis.

Assuming the $100K payment is deductible, then the deduction would pass through $50K to each partner, thus bringing each partner’s total distributive share for the year to a $25K loss. N does not have a sufficient capital account balance to sustain this pass through. She begins with a $20K capital account, increased by $25K for her share of the OI and LTCG, bringing it to $45K prior to passing through the payment to Olivia. Because N is not obligated to restore a deficit capital account, his capital account cannot go negative. If it goes negative because of an unexpected distribution, then the QIO will step in to bring it back to zero. Such is not the case here, however. Thus, when the $100K payment to O passes through, it will be allocated $45K to N and $55K to O. The final net pass-through to N is a $20K loss. The final net pass-through to O is a $30K loss, although she has to contend with $100K of ordinary income.

Because N is being paid $100K, she presumably spends enough time working at the partnership to qualify as an active participant under the § 469 regulations, thus allowing her to deduct the $30K passed-through loss. She has sufficient basis to absorb the loss, and her $80K investment is at risk, so her loss is not limited under § 465. It is not clear if N actively participates or not. If he is a passive participant, then his entire $20K loss would be suspended, unless he has income from another passive activity (a PIG) to offset the loss (the PAL). If the passive activity loss does not present an obstacle to N, then the loss would be deductible in full, since it is exactly equal to his basis (which, in turn is equal to his amount at risk).

Exam No. 1471

Under 721, the contributions by Nate and Olivia are nonrecognition events. Under 722, Nate takes a initial OB of 20k with capital account 20k, and Olivia takes initial OB of 80k and capital account of 80k. Under 723, the LLC (p-ship) has inside basis and book value of 100k.

Now the p-ship incurs a debt of 200k, and increases inside basis and book value to 300k. Under 752(a), some or all of the partners will get a OB increase based on their share of the liability. Although labeled a recourse debt, neither Nate nor Olivia are bearing personal liability because they are shielded by the LLC form. Under 1.752-1(a)(1), a liability is nonrecourse to the extent that no partner bears the economic risk. Here, neither partner bears an economic risk beyond their contribution of capital.

Under 1.752-3, a partner’s share of nonrecourse of p-ship liabilities is the sum of: 1) the partner’s share of minimum gain under 704(b); 2) the amount of any precontribution gain that a partner would recognize on disposition of property and; 3) share of liabilities determined by partner’s share of profits. There is no minimum gain because the p-ship has not made deductions below the debt amount. There is no 704(c) precontribution issue because both partners contributed cash. The liability will thus be allocated according to the partner’s share in the profits. The agreement provides that both will share equally in the profits, so each gets a 100k OB increase.

At this point, Nate has OB 120k, Olivia takes OB 180k. Capital accounts do not change. The p-ship has a inside and book value of 300k. Olivia is receiving a guaranteed payment of 100k in her first year, regardless of the p-ship’s profits. Under 707(c), this is treated as guaranteed payment for services. Thus, Olivia will have 100k of ordinary income under 707 and she will report the income when she receivees it. The p-ship will get a 162(a) deduction in this amount. So p-ship has ordinary loss of 100k to factor in. Since the company has ordinary income of 60k, and ordinary deductions of 140k (100k deduction because of Olivia + 40k deduction), it has a ordinary loss of 80k, and a capital gain of 30k. Its total loss is 50k, and the p-ship must allocate the deduction to each partner. The p-ship agreement says the partners will share losses equally, but this arrangement must have economic effect or it will not be respected. The agreement complies with the first two of the big three under the 704(b) regs. However, neither is required to restore a negative capital account. Since there is a QIO provision, the deduction will have economic effect under the alternate test so long as it does not create a deficit in capital account. If each is allowed to take a 25k deduction, Nate’s capital account will fall to negative 5k. The result is that Nate can only take a 20k deduction, and Olivia will take the rest (30k). Under 1.704-1(b), Nate’s capital account falls to zero, and Olivia’s capital account falls to 50kk. Under 705(a), OB’s amounts will fall in the same manner.

The character of the losses taken by both partners depends on the character of the loss inside the p-ship. Since the loss is attributable to ordinary deductions and losses, both Nate and Olivia must take ordinary losses. Nate takes a 20k ordinary loss on the year, and Olivia takes a 30k ordinary loss, but offsets this amount with an ordinary gain of 100k. Thus, Olivia must recognize 70k ordinary gain.

Exam No. 1795

First, the guaranteed payment to Olivia should properly be recognized as ordinary income to her and deductible by the partnership under 162. Even though she is likely acting in her capacity as a partner, this is a guaranteed payment not related to partnership profits.

Although without the payment to Olivia the company would have realized 50k profits, after the payment they have a 50k loss. Although they have both capital and ordinary gain and you cannot deduct capital losses against ordinary gain, you can deduct ordinary losses against capital gain. See balance sheet.

Although the operating agreement satisfies the alternative test for economic effect and the partners have agreed to share all loses and gains equally, Nate will be limited to 20 loss in the first year because there is not an unconditional agreement to restore negative capital accounts. Though the loan is in name recourse because no one is personally at risk, it should be allocated as a non-recourse loan. As long as some of the partners have positive capital account and there is not an unconditional agreement to restore negative capital accounts, allocation of non-recourse loss cannot have substantial economic effect. After Nate’s loss is limited by his capital account the remaining loss will pass to Olivia.

If Nate had agreed to restore a negative capital account, the regulations under 1.752 would have operated to assure he had plenty of basis. Under the regulations 1.752 allocation of non-recourse liability is made in a three tiered fashion according to 704(b) gain under 704(c) on encumbered property and finally according to the partnership agreement, either profit sharing arrangement or especially designated for this purpose.

Although no one has personal liability and this would not seem to satisfy the test for substantial economic effect, because the loan is in name a recourse loan, it is possible that Nate and Olivia would be able to split their losses equally and argue “all the facts and circumstance” to justify the allocation.

Although it is not altogether clear what the company does, since the only asset we know of is cash it seems likely this could be an investment company. Since the only thing contributed was cash, this doesn’t have any effect on 721 basis. However, it may have substantial effect on the parties’ ability to claim any loss. The 465 at risk rules would limit the losses the party could deduct to amounts they actually have at risk. In this case that would be limited to their actual cash contributions. In addition, although Olivia is most likely active in the business, Nate might be prevented from taking passive activity losses under 469. From what we know it doesn’t seem he materially participates in the venture. If the transaction with Olivia is somehow not considered part of the company’s taxable year, then each member would have 10k ordinary income and 15k capital gains.

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