Sample Answers to Question 3
Partnership Tax
Spring 2011

Exam No. 7274

 

The allocations for the dividend from the stock and bond are different than the partners’ interests in the partnership.  Under 704(a), a partner’s distributive share is whatever is listed in the partnership agreement subject to 704(b).  Under 704(b), a partner’s distributive share will be the partner’s interest in the partnership agreement if an allocation does not have substantial economic effect.   Substantial economic effect is tested by starting with the most obvious, the allocation must have economic effect and be substantial.  For an allocation to have economic effect, it must be consistent with the underlying economic arrangement of the partners meaning the partner who gets the allocation must get or bear the benefit or burden.  This tested first by the Big Three.   For an allocation to have economic effect under the Big Three the capital accounts must be kept according to the regulations under 704(b), the capital accounts must be followed at liquidation and if a partner has a negative capital account at liquidation, they must be unconditionally obligated to restore it on liquidation.  Per the prompt, the first 2 requirements are met.  However, the agreement does not require the members to restore any deficit in their capital accounts.   They allocations do not satisfy the big three.  Because the first to requirements of the Big Three are met but the last one is not, the allocation can have economic effect under the alternative economic effect test.  Under the alternative economic effect test, if 1 and 2 of the Big Three are met, the allocation will have economic effect if there is some other obligation of the partners to put more money into the partnership that would cover a negative balance or the agreement must have a qualified income offset.  A qualified income offset requires that if a partner’s capital account goes below zero because of an unexpected distribution, that partner will be allocated the next items of income or gain and that partner will pay tax until the partner’s capital account is back to zero.  The operating agreement does not have a qualified income offset and there are no more obligations of the members to make additional outlays.  The agreement doesn’t meet the alternative effect test.  Lastly, the allocation will be upheld if it can meet the economic effect equivalence.  To do this the agreement when interpreted by state law or other side agreements, ensures that liquidation of the partnership will produce the same results as the Big Three.  If it does, then the allocation has economic effect.  If it doesn’t that allocation does not have economic effect.  It is hard to tell what state law will do here but even if the allocation were to have economic effect equivalence under state law, it still must be substantial.

 

There are two types of allocations that are deemed insubstantial per se – shifting and transitory.  An allocation is shifting if at the time the allocation becomes part of the agreement, there is a strong likelihood that the capital accounts of the partners will be unaffected by the allocation and the total tax liability of the partners is less than if there had been no allocation.   The allocation of tax exempt interest and dividend solely to A and B respectively is a shifting allocation.  When the LLC has tax exempt interest and dividend income it will pass through to the partners and their capital accounts will increase.  The tax exempt interest allows for an increase to avoid taxation in the future.  So if the LLC makes and equal amount of each, both members CA go up by the same amount as if there had been no allocation at all.  A and B have shifted their income around and the allocation is no longer substantial. 

 

Because the allocation of tax exempt interest and dividend income is borderline with economic effect and is not substantial, it will not be upheld under 704(b). Therefore the allocations must be done by the partners’ interest in the partnership so 50/50.   IN 2011, the members will each get 2000 of interest and 2500 of dividend income that will be stated separately on their individual tax returns.  Their outside basis goes up 4500.  There is also 2000 of taxable interest income that will be passed through to the members.  They will get an outside basis increase 1000 each. 

 

In March of 3/12, Bart transfers blackacre to AB.  AB treated it as a contribution.  If a partner transfers property to the partnership for money or if the partner transfers money to the partnership for property, it can either be a sale between the p-ship and the partner or a contribution followed by a distribution. If it is a sale, normal income tax rules apply.  If it is a contribution followed by a distribution then it is a tax free return of basis.  The IRS will look at the substance of the transaction over the form of the transaction to decide based on the facts and circumstances of each case.  However, there is a two-year rebuttable presumption that if within 2 years the partner transfers property to the partnership and the partnership transfers money to the partner or vice versa, it is presumed to be a sale unless the taxpayer can show otherwise.  This transfer was 9 months apart so the 2 year rule will apply.  AB and B will have a hard time rebutting this presumption because the amount of the distribution was 51K, which is close to the FMV of the property plus the amount of the distribution to A.  It will be deemed a sale.  Bart’s gain on the sale will be 5K (40K-35K).  B owns 50% of the capital and profit interest of the company so he won’t be considered a related partner.  In order to be related, he would need to own more than 50% of capital or profit interest.  Because he is not related partner, he will not have a limitation on the gain.  He holds the land for investment so it will be a capital asset and he will recognize capital gain.  The partnership will get a cost basis in the property of 40K, instead of the carryover basis from B of 35K.  Because this was a sale and there was no basis carryover, the partnership will not get to tack B’s holding period, the holding period will start over on the day of the sale.  AB will still have the reduction in cash.  At this point AB will need to correct the capital account books.  B is not getting 51K of distribution, he is only getting 11K of distribution.  B will get a book value increase of 40K.  He is also not considered to have contributed the property so his book value must be reduced by the value of blackacre, 40K.  Overall his book value will have a net decrease of 11K, the amount of the distribution he received. 

 

 

Exam No. 7426

 

            For the same reasons stated in Question 2, the AB LLC will be treated as a partnership (they have not elected to be a corporation, and will not be deemed to be one).

 

When the curtains are first pulled back for us on the AB partnership, the balance sheet will appear as in 3.1 (see attached).

 

It should be noted up front that these partners are in serious risk of being limited in their losses (if any) by the passive activity loss limitations of § 469. A passive activity is any trade or business in which taxpayers do not material participate (or a rental), and is determined separately for each partner). Limited partners are per se passive under § 496(h), and LLC members (such as A and B here) are treated as limited partners. This designation of limited partners can be rebutted by showing that a taxpayer worked at least 500 hours in a year (§ 1.469-5T(a)(1)). However, given that the partnership only has stocks, bonds, and (later) some investment real estate, the should be careful if they expect to take any losses. There is no indication that they are real estate professionals under §469(c)(7) or a “mom & pop rental house” under § 469(i).

 

2011 allocations

 

            In 2011 the partnership will attempt to allocate $4,000 tax-exempt government bond interest to A, $5,000 of capital gain from the preferred stock to B, and presumably split the $2,000 of bank account interest income $1500 to A and $500 to B (so that each have the same total gain for the year of $5500, as agreed to in their partnership agreement). An allocation such as this will only be recognized for tax purposes if it is found to have substantial economic effect under § 704(b). Unfortunately for A and B, this will not.

 

            There are generally three ways to be found to have substantial economic effect. First, the partnership may meet the economic effects test, commonly known as the Big Three, under § 1.704-1(b)(2)(ii). Second, a partnership can meet the alternate test under § 1.704-1(b)(2)(ii)(d), which effectively alters the final step of the Big Three. Finally, a partnership can fall back on the economic equivalence test of § 1.704-1(b)(2)(ii)(i), which merely asks if you reached the same effective end result as the first two despite not meeting the tests themselves.

 

            AB does not satisfy the Big Three. The Big Three requires, first, that the partnership agree to maintain and determined capital accounts in a certain way. Namely, they agree to increase capital accounts by money contributed by a partner, FMV of property (net of liabilities) contributed by a partner, and by allocations of income and gain to a partner. Additionally they agree they will decrease capital accounts by money distributed to a partner, FMV of property (net of liabilities) distributed to a partner, expenditures, and allocations of loss and deductions to a partner. Here it would appear that AB has agreed to this first step. Second, the Big Three requires that, upon liquidation, distributions will be made according to positive capital accounts. The partners have agreed to this here. Finally, the Big Three requires that the partners agree that, upon liquidation, partners with negative capital accounts are obligated to repay any deficit. AB has expressly agreed not to do this here, by agreeing that neither member must make any additional outlays of cash or property (unless the state law requires them to do so, but this is very unlikely and the facts do not indicate it). Therefore, AB fails the Big Three.

 

            AB will also fail the alternate test. Although they meet the first two steps of the Big Three as noted above, they do not have a qualified income offset as required by the alternate test. This would have required the partnership to repay unexpected losses and distributions that caused any capital account to drop below zero. Since this is not present, the partnership fails the alternate economic effect test.

 

            Finally, AB fails the economic equivalence test. Here there is no guarantee that any partner will bear any economic risk of loss by repaying negatives (even by way of a promissory note). The AB agreement does not have economic effect.

 

            Note that even if the AB partnership had been found to have economic effect, it would have failed the “substantial” portion. This portion is really just a scam catcher, and asks if there is a reasonable possibility that the allocation will affect the money received by the partners from the partnership independent of tax consequences. The partnership’s decision to give all tax-free income to A only, despite otherwise allocating equally items of gain (and loss), is the very definition of a shifting allocation. That is, the allocation is not affecting how much money anyone gets, just how much tax is paid. Although we don’t know who or what A and B are, if, for example, B is not a tax-paying entity, the partnership has just managed to avoid all tax.

 

            Regardless, the partnership’s allocations do not have economic effect. Therefore, under § 1.704-1(b)(3), they will be deemed to have been split in accordance with the partners’ actual interests: $2,000 tax-free bond interest to each partner, $2,500 preferred stock dividend to each partner, and $1,000 bank interest income to each partner. At the end of 2011, the AB balance sheet will appear as on 3.2 (see attached).

 

2012 contributions/distributions

 

            When B contributes Blackacre to the AB partnership, he will not recognize any gain or loss under § 721 (immediately, anyway). Under § 722, B will take a carryover basis to his outside basis, increasing it by $35,000, and increasing his capital account by $40,000 (Blackacre’s FMV at the time of contribution). Blackacre will take a carryover basis into the partnership, going in with $35,000 basis and $40,000 FMV. The partnership will tack the holding period under § 1223(2), although we do not know here how long B has held Blackacre. However, all this is true only if this is a true, valid contribution.

 

            AB 9 months later makes a distribution of cash to each partner ($10,000 to A, $51,000 to B). This is immediately suspect due to the imbalanced nature of the distribution and the closeness in time to B’s contribution of BA. This will not be a mixing bowl transaction under § 737, however, as Blackacre itself was not distributed out. However, it will likely be considered a sale of property under § 707(a)(2). This rule is designed to prevent recharacterizing “sales” as contributions then distributions of property, which (if unchecked) would have the effect of deferring gain by only changing outside basis (instead of recognizing it as one should on a sale).

 

            Under § 1.707-3 through -8, the regulations list factors to determine if such a series of transactions was actually a sale, with the general rule of considering the earliest transfer first. The primary among them is proximity in time, although there are others such as the transferor having a legally enforceable right to subsequent transfers (none here), the partner’s right to receive the later transfer being secured (none here), and similar ones indicating that the “distribution” must have happened. More importantly, § 1.707-3(c)(1) creates a rebuttable presumption that a transaction is a sale if within a 2 year period a partner transfers property into the partnership and the partnership transfers property to the partner.

 

            The bottom line is: if it smells like a sale, then it probably is a sale. This transaction stinks, and will be recharacterized as a sale by B of Blackacre to the partnership. This means that the basis and capital account increases that B took must be taken away, and the entire transaction re-calculated as though an actual sale happened between B and the partnership. B will have a good argument here that at least $10,000 of the distribution was actually a distribution, as A got the same amount and the property only had a FMV of $40,000. The extra $1000 could easily be accounted for with appreciation or “interest” paid to B for the passage of time, and will likely still be included in the sale.

 

            Assuming he successfully rebuts the presumption that $10,000 of his distribution was payment for Blackacre, B will be deemed to have sold Blackare to AB for $41,000. He will be able to use his basis against this, for a total personal gain of $6000 (capital, either long-term or short-term depending on how long he has held it). The anti-abuse rules of § 707(b)(1) will not apply because B is not attempting to recognize a loss (and does not appear to own more than 50% of the partnership), and the asset was not ordinary in his hands as far as we can tell, so the anti-abuse rules of § 707(b)(2) should not apply either.

 

            This means that both A and B will still have received “legitimate” distributions of $10,000 each. Under § 733, each partner’s outside basis will be reduced by $10,000, and their capital accounts likewise. Neither will realize any gain (or loss) from this, as they both have sufficient basis to cover it under § 733.

 

            AB will take a step-up cost basis of $41,000. This likely assumes that the FMV has gone up to $41,000 in the interim. It is possible that the extra $1000 is deemed to be some sort of gratuity payment to B for his sale of the property, which would likely be deductible (or, more likely, capitalized into Blackacre itself, as it was required for the purchase of the property). Assuming the simpler solution of the FMV having risen in the 9 months, the AB balance sheet will appear as in 3.3 (see attached).

 

 

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