Sample Answers to Question 1 - Partnership Tax

Sample Answers to Question 1
Partnership Tax
Spring 2011

Exam No. 7277

Asset	IB	Book V		OB	CA
Cash	270,000	270,000	Liability		90,000
AR	0	90,000	Partner
Land Invest	45,000	90,000	Karla	105,000	120,000
			Leon	105,000	120,000
			Melanie	105,000	120,000
Total	315,000	450,000		315,000	450,000

When the partnership paid $144,000 to Leon in complete liquidation of Leon’s interest in the partnership, 24,000 of this payment was not in recognition of Leon’s interest in the partnership (b/c he only had 120,000 in his CA, so the amount above this is not in recognition of his interest in the pship: 144,000 - 120,000 = 24,000). This 24,000 will be considered either a guaranteed payment or Leon’s distributive share under 736(a). Because the payment was not dependent upon the partnership profits, as far as we have evidence of, the payments were probably guaranteed payments. Similarly, b/c Capital is a material income producing factor for KLM, we don’t have to worry about the separate exclusions for a GP in a service partner. B/c this is a guaranteed payment, this results in Leon recognizing 24,000 ordinary income as a result of this guaranteed payment, and the partnership can take an ordinary income deduction equal to this amount. Therefore, both K and M will have a deduction of 24,000, or 12,000 each. The balance sheet will look like this:

Asset	IB	Book V		OB	CA
Cash	246,000	246,000	Liability		90,000
AR	0	90,000	Partner
Land Invest	45,000	90,000	Karla	93,000	108,000
			Leon	105,000	120,000
			Melanie	93,000	108,000
Total	291,000	426,000		291,000	426,000

We have 120,000 that Leon received in recognition of his pship interest. This amount will be analyzed under 736(b). Under 736(b), Leon won’t recognize gain or loss on the transaction unless he doesn’t have enough basis to cover it. He only 105,000 in basis, but he is receiving 120,000 distribution. Thus, he will recognize 15,000 on the transaction; this will be a capital gain under 731.

We also need to grapple w/ the hot asset rules under 751(b). When Leon was a partner, he had 30,000 worth of the AR, but after the distribution, there is a full 90,000 of the AR left to be taxed to the remaining partners. This is shifting the hot asset income, which is prohibited. Because he is receiving too few of the pship hot assets, we will pretend like he is getting a distribution of 30,000 worth of AR, and the remainder in cash, or 90,000 in cash. He is also getting 30,000 of debt relief, therefore, he will redcue his OB bay an additional 30,000. We will reduce his CA and his OB accordingly. He will get a carry over basis in the AR of 0. We will increase K and M’s OB by the amount of debt relief they are assuming from Leon - 15,000 each. This is what the balance sheet will look like:

Asset	IB	Book V		OB	CA
Cash	156,000	156,000	Liability		90,000
AR	0	60,000	Partner
Land Invest	45,000	90,000	Karla	108,000	108,000
			Leon	0	0
			Melanie	108,000	108,000
Total	201,000	306,000		216,000	306,000

Then, we will have him sell back the AR to the pship in a fully taxable transaction. He will recognize 30,000 on this transaction, giving him a cost basis of 30,000. Thus, the partnership will get a 30,000 basis in the AR when it is transferred back to the pship. The pship will also give him 30,000 of the cash. This will pass through to the remaining partner 15,000 each. The balance sheet will look like this:

Asset	IB	Book V		OB	CA
Cash	126,000	126,000	Liability		90,000
AR	30,000	90,000	Partner
Land Invest	45,000	90,000	Karla	93,000	93,000
			Leon		0
			Melanie	93,000	93,000
Total	201,000	306,000		186,000	306,000

Because there is an inside outside basis mismatch of 15,000 b/c of the amount realized by L for the 15k he didn’t have the cash for, the pship can, under 754 make ane elction to increase the inside basis of the pship assets so that the amount won’t get taxed twice. The pship would increase the capital assets (the land held for investment) by 15,000, and this would be split equally between the K and M.

Exam No. 7499

Pship formation:

The KLM appears to be an eligible entity under the check the box regs. Since no election was made to be taxed as a corp, it is taxed as a pship.

Guaranteed payment:

This falls under 736a because Leon (L) is getting a liquidating distribution that is greater than his capital account (getting 144K; cap acct is 120K).

This is a guaranteed payment, which falls under 707c, because there is no mention of income.

Applying 736a, L will get 144K-120K=24K of ordinary income.

The pship will get to take a deduction in the amount of 24K, so Karla (K) will have 12K ordinary income deduction and Melanie (M) will have as 12K ordinary deduction. This will reduce K&M’s outside bases (OB) and capital accounts by 12K each (from 105K to 93K).

Turning to 736b for the remainder of the distribution (120K).

751b applies because L is getting all 741 assets and not any of the 751 asset--the accounts receivable. The accounts receivable is a hot asset. Under 751b, to the extent the partner receives a distribution of hot assets that is not proportional to his share (here 1/3), the regs are going to set up a taxable exchange she that the partners are taxed on the right amount.

L’s interest in the receivable prior to distribution is 30K (90/3=30). L will receive a phantom distribution of 30K with a 0 basis (because under 732 it is the transferred basis, which cannot be written up for hot assets). This will result in 30K ordinary income on the constructive sale to L. The pship transfers cash and recognizes no gain, and it acquires the receivables w a 30K cost basis.

Under 752b treates any decrease in the partners share of liabilities, including pship’s assumption of partners liabilities as if it were a cash distribution to the partner, decreasing his OB. Thus, L has a 30K interest in the 90K loan. When the pship assumes this liability back, his OB decreases by 30K. Thus, L’s OB is now 105-30=75.

On the distribution of the remaining 90K (120-30) cash, L reduces his OB to 0K. Because his OB was at 75 before he took the cash distribution, he has 15K LTCG (assuming he has been in the pship long enough for it to qualify as long term).

In sum, L will have 54K (24K+30K) of ordinary income, and a 15K LTCP.

The partners OB will be reduced by the distribution: Now reduce by 72 (144/2). Thus the partners OB will be (105-12 for the ordinary deduction=93. 93-72=21.)

If the pship did not have a 754 election, then this is how the balance sheet would remain.

If they did have a 754 election, then under 734 and 755, the inside bases would be readjusted.

Exam No. 7401

The LCC by not electing to be an association meets the definition of a pship under 761 and 7701(a)(2). By not “checking the box” under reg. 301.7701-3a, they automatically are taxed as a pship.

Tax consequences to L: (without 754 election)

Under 736(a), L is getting 24K as a guaranteed payment as described under 707(c), thus he will recognize 24K of ordinary income, and the pship will get to take an immediate deduction under 83(h) for the 24K payment. This will pass thru to K and M equally, as the pship shares profits and losses equally and we know 704(b) is met. Next, under 736(b), the remaining distribution of 120 is treated as regular nonrecognition transaction, where L will only recognize gain for distribution in excess of basis under 731(a)(1). L’s excess basis is 15K (120 FMV over 105 AB), so he will recognize 15K of gain. Next, what type of gain is he recognizing? L is only getting cash for his interest, thus he is leaving the pship with more than their share of hot assets (the A/R) which he originally had 30K of. We must make believe he took out this 30K of A/R as part of the overall distribution of 144K, as if he took out 114K of cash and 30K of A/R. Because you can never mark up the basis of hot assets, the basis (which was zero inside the pship), remains zero, and L would recognize 30K of ordinary income under 751(b) distribution of hot assets, but he only has 15K of gain that can be characterized as ordinary income under 751(b), so it will, and all gain above 105K of basis L had in his pship interest will be treated and taxed to him on liquidation as ordinary gain, 24K under 736(a) and 15K under 751(b). Then, he is treated as selling the A/R back to the pship for 30K, and the pship gets a stepped up basis in the hot asset, adding 30K of inside basis (IB) on the asset side. Nothing happens with L regarding the debt, because this is an LCC, and from the balance sheet (B/S) it is apparent that no basis was taken from the loan. Because it is an LLC, no one is liable for the debt and that means the loan in non-recourse. To be eligible to take basis from a non-recourse loan, you must satisfy the 4 prongs of reg. 1-704(2)(e), à 1) meeting the first two parts of the Big 3 (they are met, as per the prompt), 2) NR deductions allocated consistently with some other item associated with property (met as they are all sharing profits and losses equally) 3) Minimum gain chargeback (the prompt does not provide that the pship elected this, thus they must not be able to take basis from the NR loan), 4) all other pship allocations are valid

Effect to K and M as equal remaining partners:

First, there is a 90K liability that must be dealt with. As above, no basis was given out on behalf of the loan, because no “Minimum gain chargeback” is provided for. Thus, when L leaves, it is not like he is getting a 15K distribution under 731/733, and the remains partners M and K are not taking it on as if they were contributing property to the pship. à No effect to M and K’s accounts. As described above, the pship takes an immediate deduction from the 24K payment about FMV on L’s liquidation, passing it thru equally to M and K, and both take a 12K ordinary business deduction, reducing their OB to 93K respectively. Next, from the stepped up basis from the “buy back” of the A/R that L was “forced” to take out under 751(b) and “sell” back to the pship, M and K each get 15K for the total step up in basis to the A/R of 30K, bringing their basis up to 108 each. This leaves an inside/outside basis mismatch because a 754 election wasn’t made (see chart 1). This is because the inside basis of the land asset is not written up as it would under 754 by L’s share, or 15K, which would correct the mismatch.

If a 754 election were made, the basis of the land asset would be written up by 15K, or L’s interest in the land immediately prior to his exit. This makes sense, as M and K should not have to take that extra gain when the land ultimately sold.

Effect to the pship:

Cash will be taken down in the asset side to 126K, as 144K is leaving with L (see chart 1), as well as book value. As explained above, hot assets (A/R) is written up by 30K when it is “bought” back in the forced sale by L, increasing IB by 30K (see chart 1), nothing happens to book value (BV). If no 754 election is made, land stays at 45IB, 90BV (see chart 1). If a 754 election is made, the IB of the land is written up by L’s share, or 15K, for a total of 60K. Thus, if no 754 election is made, total IB for pship is 201IB, 306BV (see chart 1), or if 754 election is made, 216IB, 306BV.

Created by: bojack@lclark.edu
Update: 10 Jun 11
Expires: 31 Aug 12