Sample Answers to Question 1
Partnership Tax
Spring 2013
Exam No. 4464
Judy Tax Consequences:
Any gain or loss on the sale of a partnership interest is capital under §741, unless there are hot assets involved. Since we have both unrealized A/R and inventory here, we have to look at §751 as well.
Judy receives $40,000 cash from Bob and is relieved of her $45,000 share of the partnership debt, for total consideration of $85,000. Her adjusted basis in her partnership interest is $75,000, so she has a gain of $10,000. Reg. §1.75101(a)(2) says we must calculate how much ordinary income would have passed through to Judy if the partnership had sold the assets. The gain on the inventory is $20k • 25% = $5k ordinary income. The gain on the A/R is $80k • 25% = $20k. So Judy would have had $25k ordinary income. The land is a loser asset, with $60k capital loss, of which 25%, or $15k, is Judy's share. So Judy's $10k net gain is comprised of $25k ordinary income and $15k capital loss.
Bob Tax Consequences:
Bob will not recognize gain or loss as the transferee partner in this sale of a partnership interest and will receive a cost basis. §742. Under §743, the basis of the partnership property will not be adjusted as a result of this sale absent a §754 election. This would cause an inside-outside basis mismatch of $300k to $310k (the $10k difference matches Judy's net gain on sale). Bob would be penalized in the short term, as the partnership gains would flow through 25% to him, essentially taxing him twice. His higher basis will make everything work out in the end, but savvy investors would rather have tax savings today. That said, §754 is expensive and burdensome and sticks around for the life of the partnership.
If the partnership had made a §754 election, Bob's inside bases would adjust per §755 to reflect the $10k in net gains already taxed to Bob. First, the adjustment would be allocated based on relative appreciation between the two classes of assets: capital and hot. The hot assets have total appreciation of $100k, while the land shows depreciation of $60k. Therefore, we would allocate a $25k basis increase to the hot assets and a $15k basis decrease to the land. The basis adjustment between the hot assets would also be based on relative appreciation: $20k to A/R and $5k to inventory.
Collection
of A/R
When the partnership collects the $80k, it passes through the $80k gain to its partners as ordinary income. Absent a §754 election, this will increase each partner's basis by $20k (§705(a)(1)). While it is a taxable gain, there is no book value gain, so the partners' capital accounts remain the same. At this point, Cash basis & FMV increases by $80k and A/R disappears, so the Total Asset basis = $380k and FMV = $340k. Liabilities basis = $390k (still the $10k mismatch) and FMV = $340k (unchanged).
In the case of a §754 election, the inside basis of the A/R would be $20k, so the gain would only be $60k, which would pass through to the other partners. Total Asset basis = $370k and Liabilities = $370k ($310k + $60k pass-through gain to other partners). Bob's basis remains at $85k, while the other partners' bases = $95k.
When the partnership sells the loser asset to Karen, §707(b) limitations may come into play. §707(b)(1)(A) says that the loss is disallowed in a sale between the partnership and a person owning >50% of capital or profits interest. Fortunately in this case, Karen only owns 25%, so the partnership can recognize the capital loss of $60k and pass this through to the partners, whose bases will decrease by $15k each to $60k ($70k for Bob). Again, no impact on the capital accounts since there was no gain / loss at the BV level. Total Asset basis = $320k and FMV = $340k. Liabilities basis = $330k ($10k mismatch) and FMV = $340k.
In the case of a §754 election, the inside basis of the land would be $215k, and the resulting $45k loss would only pass through to Karen, Xavier and Yolanda. Total Asset basis = $325k and Liabilities = $325k ($370k - $45k pass-through loss). Bob's basis remains at $85k, while the other partners' bases = $80k.
Karen would get a cost basis of $170k in the land.
Exam No. 4943
Under the first transaction on January 1, 2013 the following tax consequences would take place:
Judy
Judy's sale to Bob constitutes a liquidation of her partnership interest. The first place to start analyze the basis of her interest in the property in the company and determine the character of each property's gain or loss and the effect it has for Judy:
Inventory: In this case is a hot asset under Section 751 rules. The company has a built in gain of $20,000, which makes Judy's portion $5,000
Land held for investment: This is a capital asset with a built in loss of $60k on the company's level making Judy's portion $15,000 of Long Term Capital Loss
A/R: The company's $80,000 in A/R results in a $20,000 portion of income. This is also considered a hot asset under Section 751.
Bank Debt: The assumption of this debt by Bob reflects an income item under Crane of $45,000.
The result to Judy is as follows: She receives $85,000 in compensation from this transaction. $40,000 in cash from Bob and $45,000 in debt forgiveness in Bob's assumption of the debt. Because of the character of this money, the $85k worth of income is characterized according to section 736 as follows:
$25,000 in ordinary income because of the hot asset rules under 754.
$45,000 in debt forgiveness reduces her basis down to $30,000
$15,000 long term capital loss from the disposition of the land held for investment
And $30,000 is return of capital or a distribution to her and is non-taxable under section 736.
Bob
In this scenario Bob purchases Judy's interest for $40,000 in cash. The payment of money to Judy does not create income for Bob and he takes his position as a 1/4 owner in LLCo. During this process, Bob also takes on $45,000 worth of debt (which is forgiven from Judy when she leaves). This makes his inside and outside basis the $40,000 in cash he puts into the company and $45,000 worth of debt he is obligated to pay. The basis gained from taking on the debt is the same regardless if it is recourse or non recourse. This is because all four partners are sitting in the same position and share losses equally.
Karen
As Karen is not party to this transaction, there is no tax affect.
LLCo
LLCo would have to choose whether or not to make a Section 754 election at the time Judy leaves the company. The payment between Bob and Judy has no tax effect on LLCo. Please see Balance Sheet: Problem #1 (a) for a non election and Problem #1 (b) for the 754 election.
After the purchase of Judy's share, the following transaction occurred later in 2013 resulting in the following tax consequences:
For the land sale:
Karen
Because the sale is an arm's length transaction, the partnership does not need to treat the transfer of the proprety to Karen as a distribution. Even if they had, it would should $175k in cash coming in, Karen's basis being adjusted up by $175k and then a non taxable distribution to Karen of $175k. Karen would not take a carry over basis in the property but instead of a basis of $175,000 representing the price that she paid to have the property.
LLCo
The sale of the property is a realization event. In this case it would depend on whether the company elected to readjust their basis under 754. In the scenario where they had not, then they would have a $60,000 long term capital loss which would be passed through to each partner at $15,000. Had they made the section 754 election then all the partners but Bob would receive their $15,000 deduction.
For the receipt of the A/R:
For the company ti would depend on whether the 754 election was made or not. In the case that it was not, than everyone would receive a $20,000 share of ordinary income from the transaction. In the case that it was made, than Bob would lose out on the $20,000 share.
For Judy: None of the second half transaction would apply to her because she had fully liquidated her share and was no longer a partner.
Exam No. 4058
Consequences of J's
§ 741 provides the basic framework for the sale of a p'ship interest. It provides that all gain or loss is capital gain or loss unless there are § 751 issues. Under the Crane/Tufts theories, J's amount realized includes not only teh cash she received but also the amount of debt she got to walk away from. Thus, she realizes $85,000 ($40k cash + $45k debt) on her sale. This results in a $10k gain to J. But what character is the gain?
J is getting to walk away from her share of a couple of hot assets. The § 751 regs tell us to determine how much gain or loss the p'ship would recognize on a sale of these assets for their FMV, then determine the partner's share of that gain. On a sale of the accounts receivable (included under § 751(c)), the p'ship would realize $80k gain. J's 1/4 share = $20k. On sale of the inventory (included under § 751(d)), the p'ship would realize $20k gain. J's 1/4 share = $5k Thus, J has ordinary income of $25,000 on the sale of her p'ship interest to B.
B receives a cost basis upon his purchase of the p'ship interest. He also receives basis for the p'ship debt he is assuming. He therefore has an $85k outside basis in the p'ship. § 752(a).
See Exhibit A for a balance sheet w/ Bob on & Judy off.
This transxn results in a inside/outside basis mismatch. The p'ship can correct it by making a § 754 election & allocating basis for B's benefit under § 755. We would allocate to appreciated items first, meanig the only capital asset wouldn't get any of the basis (it would actually take a basis decrease so that when the p'ship sells the land for a loss, B wouldn't be allowed to take the loss).
Consequences of Collection of Account Receivable
The account receivable turns to cash & the gain from the sale is passed through to the partners. The character of the income is ordianry because accounts receivable are ordianry income assets and we determine the character of pass through items at the p'ship level under § 702. The total gain that passes through is $80,000, allocable $20,000 to each partner. The partners' outside bases increase accordingly. Their capital accounts don't increase bc an asset was just turned into cash.
See exhibit B for a balance sheet after the sale of A/R.
If the p'ship had made a § 754 election, some of that gain would not be realized to B.
Sale of Land to K
Upon sale of the land to K for $170,000, the p'ship can recognize a capital loss of $60,000. Land held for investment purposes is a capital asset and, again, we determine the character of items of income, gain, or loss at the p'ship level. § 707 provides some limitations for sales of land from partnerships to partners. It attempts to distinguish between contributions & distributions, which are tax free, and sales which are taxable. There is a two year period in which there is a presumption that a contribution & related distribution are disguised sales. On these facts, K has been holding her p'ship interest for a "few years." Thus, it looks like there would not be a presumption against her. If the sale did occur w/in a two year period, it would be K's burden to prove that it was not a sale. Also, K is a 1/4 partner so she is not considered a controlling partner or a "related partner" and there are no limitations on losses under § 707. This loss will pass through equally to the partners, meaning that each partner can take a $15,000 loss. This loss will need to be stated separately on their tax returns under § 702.
If the p'ship had made a § 754 election, B's loss would have been limited bc the 754 election works both ways.
Created by: bojack@lclark.edu
Update: 13 Jun 13
Expires: 31 Aug 15