Sample Answers to Question 2
Partnership Tax
Spring 2011

Exam No. 7108

Since STU does not elected to be taxed as an association, they will be taxed as a partnership. Upon formation of the STU partnership, Terry and Ursula’s contribution of $120,000 cash each will not be taxable event. Their outside basis as well as their capital account will each be $120,000 after the contribution. The partnership will then have cash on the books with an inside basis of $240,000 and a book value of $240,000.

Sue will also not recognize any loss for her contribution of the building with the built in loss § 721. Instead § 704(c) keeps the build in loss with the contributing partner. The partnership’s inside basis in the building will be the carryover basis from the contributing partner of $360,000 under § 723 and the book value of the property will be the $180,000 FMV at time of contribution. Sue will initially take an outside basis of $360,000, however, since the partnership is assuming the recourse debt of $60,000 Sue’s outside basis will be adjusted and the recourse debt will be run through § 752. Since it is recourse debt assumed by the partnership, a doomsday scenario must be run through to see which partner bears the true economic effect of the debt § 1.752-2. If all of the partnership’s assets were sold for 0, each partner would be equally liable to pay off the debt since they are all equal general partners. As a result, each partner’s share of the recourse debt will be $20,000 since that’s the economic impact it has on each partner from the partnership assuming the recourse debt. Terry and Ursula’s outside basis will each be increased by their share of partnership liability of $20,000 each, bringing their outside basis to $140,000. Sue’s outside basis of $360,000 will be adjusted to increase her $20,000 share of the partnership liabilities, but also decreased by the $60,000 of personal liability assumed by the partnership from her contribution. This $60,000 is treated as if the partnership gave her a cash distribution and she paid off the debt. Therefore, Sue’s outside basis at the end of all of this will be $320,000. The balance sheet of STU after formation will be:

	Assets			Liabilities
	Adj. Basis	B.V.		Adj. Basis	B.V.
Cash	240,000	240,000	Debt		60,000
Building	360,000	180,000		Equity
			Sue	320,000	120,000
			Terry	140,000	120,000
			Ursula	140,000	120,000
Total	600,000	420,000	Total	600,000	420,000

For year 1 depreciation of the building, using a 10 year straight-line depreciation method, there will be $36,000 of tax depreciation and $18,000 of book depreciation. The book depreciation will be allocated equally to all three partners, since they have agreed to share in deductions equally, so each partner’s capital account will be lowered by $6,000. The $36,000 of tax depreciation will first be allocated to Terry and Ursula, the noncontributing partners, in an amount equal to their share of book depreciation § 704(c)(1)(A). Thus, Terry and Ursula’s outside basis will each be decreased by $6,000. The remaining $24,000 of tax deprecation will then be allocated to Sue, lowering her outside basis by $24,000. This allocation will have substantial economic effect, since the partnership agreement satisfies all of the big three requirements. The balance sheet after year 1 will be:

	Assets			Liabilities
	Adj. Basis	B.V.		Adj. Basis	B.V.
Cash	240,000	240,000	Debt		60,000
Building	324,000	162,000		Equity
			Sue	296,000	114,000
			Terry	134,000	114,000
			Ursula	134,000	114,000
Total	564,000	402,000	Total	564,000	402,000

At the end of 10 years, assuming that STU’s gross income and deductions continue to offset each other exactly, and none of the debt has been repaid, all partners will have an outside basis of $80,000 and a capital account of $60,000.

The fact that the partnership normally uses a 30 year straight line depreciation method for purchases would only matter if they elected to use the remedial method to correct any distortions created by the ceiling rule. However, here since there was enough tax depreciation for the noncontributing partners to cover their book depreciation, there were no ceiling rule issues. The partnership could have a § 754 election to correct any mismatch in inside and outside basis, however, we do not have any transactions here that would be affected by the § 754. The partnership will also want to be weary if Sue was a dealer in real estate and the partnership held the asset as a capital asset. If the partnership decided to distribute or sell the asset within 5 years of contribution, the ordinary income taint from the contributing partner would still be around.

Exam No. 7361

See balance sheet 2, p. 1 & 2 for figures

S, T, and U are forming a partnership, and thus the non-recognition rules of § 721 are applicable. Under §721 no gain or loss is recognized to STU or the individual partners upon contribution of property in exchange for a partnership interest. So start with the cash contribution of T and U, the definition of property includes cash, so this is ok. As such, neither T nor U recognize any gain on the exchange. § 721. Each takes a substitute basis in the partnership equal to their cash basis, or $120,000 each § 722. Since the FMV of their contribution was $120,000 each has a partnership interest, reflected in the capital account, of $120,000. Since cash is not a capital asset, T and U cannot tack their holding period under §1223(1). Instead, it commences on the date of exchange. STU also realizes no gain or loss on the cash exchange § 721. It takes a carryover basis in the cash, of $240,000. § 722. STU’s holding period in the cash is tacked. § 1223(2).

However, S has to make things difficult by contributing encumbered property. The FMV of the building is $180,000. While, it is subject to a liability, under Crane taxpayers include the amount of debt in property that is exchanged in the amount realized. As such, S does not recognize a loss on the sale even though he contributed a loser property. § 721. His capital account, or partnership interest, is also valued at $120,000. He takes a substitute basis of $360,000 in his partnership interest (outside basis). § 722. Since the land is a capital asset, his holding period can be tacked. § 1223(1). STU does not realize any gain or loss on the exchange of a partnership interest either. § 721. STU takes a carryover basis § 723 of $360,000. STU’s holding period in the asset is tacked. § 1223(2).

But we’re not done. Under § 752(b), to the extent that S is relived of liability, S is treated as having a distribution of cash from STU. This is viewed as a return of capital, and reduced S’s outside basis by the amount of the distribution. Since everyone is an equal partner, and S was liable for $60,000 before the exchange, he has been relived of $60,000. Thus his capital account must be decreased by $60,000, as if he received as cash distribution. Furthermore, under § 752(a) any amount of debt assumed by a partnership is reallocated to all partners, i.e., each is treated as having contributed cash, which increase their outside basis under §§ 731, 733. STU has assumed a $60,000 recourse liability. Thus, each partner is deemed to have contributed $20,000 cash, increasing their outside basis by $20,000 each. In the end, S has an outside basis of $320,000 and S and T each have an outside basis of $140,000.

Special attention needs to be paid to the building however because it is a § 704(c) asset. 704(c) property is any which at the time of its contribution to the partnership has a book value (FMV) that differs from the contributing partner’s adjusted tax basis in the property. As S had a $360,000 basis, and the FMV was $180,000 this property clearly qualifies. Because of this large built in loss at the time of contribution, when the partnership takes losses, it must allocated these losses in a particular manner, described below. This ensures that there is no income shifting amongst partners, and it avoids timing and character distortions.

At the end of year 1, everything offsets and STU only has a $36,000 operating loss that is in the form of a depreciation deduction from the building. This decreases the inside basis of the building by $36,000. Book depreciation will be taken at the same percentage, i.e., 10%. so $18,000 a year. At the end of year 1, the building has an inside basis of $324,000 and book value of $162,000. Since the partners equally split losses, each partner reduces their capital account by $6,000. This leaves S, T, and U with a capital accounts worth $114,000. Since this deduction is coming from deprecation of a capital asset, it will be a long-term capital loss. T and U also reduce their outside basis to $134,000. While T and U did not have a tacked holding period, they have held their partnership interests for at least a year. Now, under § 704(c) S will reduce his outside basis by $24,000 to $296,000. This loss is also characterized as capital.

The limitations to partnership losses to not come into play in the situation. No one is deducting more than that which is at risk, and there is no passive activity loss.

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