Sample Answers to Question 2
Partnership Tax
Spring 2013
Exam No. 4201
LLCs can be taxed as a partnership and since they have not elected to be taxed as an association then it seems they are taxed like a partnership.
Formation of G-Lu
Under § 721 there is no gain or loss to G or L upon formation of the partnership. Since they both contributed cash they have an inside basis of their cost, $10,000 for G and $30,000 for L.
Purchase of Equipment
In order the purchase the equipment G and L took out a nonrecourse loan. This is properly characterized as a nonrecourse liability because in the event the partnership liquidated neither partner would bear an economic risk of loss, § 1.752-1. This is true even though G is a general partner, since the loan is nonrecourse. We allocate the nonrecourse liability to the partners outside basis in the following ways (§ 1.752-3): 1) the partner's share of built-in gain in the property. Here there is non minimum gain since the property has a high basis than the debt. 2) The partner's share in other 704(c) property, which also doesn't apply here. 3) In relation to partner's share of the profits. When the debt is entered into G has a 10% share of the profits and L has a 90% share. Thus we allocate $54,000 in basis to L and $6,000 in basis to G. Please see exhibit A for the balance sheet after the purchase of the equipment.
Year One
The only deductions in this year are the $20,000 in depreciation deductions. According the partnership agreement these deductions should be allocated $18,000 to L and $2,000 to G. To see if this can happen we need to see if the allocation has substantial economic effect, § 704(b). The partnership agreement does have substantial economic effect because it follows the first two requirements of the big three: 1) it maintains capital accounts in accordance with the regs and 2) it follows those capital accounts on liquidation. It also follows the third requirement of the big three as to G, he is required to restore a deficit on his capital account. It doesn't follow that requirement for L, but it does contain a qualified income offset, which fulfills the requirement of the alternative test for economic effect. These allocations are also substantial because they are neither shifting or transitory, if they weren't followed the tax consequences to the partners would be very different.
Thus, the allocation is fine and can be followed. Capital accounts and outside basis must be decreased by allocation loss to the partners. So after the first year G has a capital account of $8,000 and an outside basis of $14,000. L has a capital account of $12,000 and an outside basis of $66,000. To determine whether the partners can take the deductions in the current year we must look to see if 1) the deductions are less than their basis, here they are; 2) whether they're less than their amount at risk, here they are because they still have their own money in the partnership, and 3) whether they are from passive activity. This could effect whether L can actually take her deduction because limited partners are presumptively passive. She can take the deduction if she has passive income from another source. These deductions are ordinary and they do not have to be stated separately on the partner's returns.
Year Two
This year the partners cannot do things exactly how they want, because doing that would take L's capital account below zero. Even though she signed up for the QIO, she cannot take her capital account below zero, unless it happens do to an unexpected distribution. Here there is nothing like that, only the regular deduction. This means that $6,000 of her deduction will go to G, because he becomes the one who bears the economic burden once L's capital account is at zero. This means that G get's an $8,000 deduction. Now they both have capital accounts at zero. G has an outside basis of $6,000 and L has a capital account of $54,000. The timing of these deductions for L will still depend on whether she has any passive income.
Year Three
This year is very different. This is because these deductions will increase the partnerships minimum gain. At the beginning of this year the building has a basis of $60,000 (after $40,000 worth of deductions). Thus, after further deductions the basis will be lower than the nonrecourse debt. If the partnership gets rid of the property only in exchange for the debt, they will have $20,000 of minimum gain. Any deductions which increases minimum gain is a nonrecourse deduction and is analyzed under different rules found in § 1.704-2(e). In order for the allocations to work the partnership must meet the big three or the alternate test, which they do here. There must be a minimum gain chargeback provision, which there is here. All other partnership allocations must have substantial economic effect, there are no other allocations. Finally, the allocation must be allocated reasonably consistently with some other item associated with the property. Under this last rule the 90/10 allocation likely won't stand. Instead the partners would have to follow a 75/25 allocation or a 50/50 allocation, which represent the way distributions would be made. This is fair because distributions of income associated with property more closely related to an "economic burden" the partners are taking on with the nonrecourse deductions.
I
assume the partners would want to follow the 75/25 rules since it's closer to
how distributions will be made in the next few years. This means G would get
$5,000 deductions and L would get a $15,000 deduction. At the end of the year G
would have a
Exam No. 4464
Contribution: Neither the partnership nor the partners will recognize gain or loss upon contribution of the cash to the partnership under §721 (assuming the partnership is not an investment company within the meaning of §351, which it does not appear to be). G and L will have a carryover basis of $10k and $30k, respectively, equal to the cash contributed. Exhibit A.
Debt & Equipment: When the partnership secures the $60k nonrecourse debt, the question is how to allocate it among the partners' bases. §752(a). Reg. §1.752-3(a) requires the allocation to minimum gain first (not present because asset value exceeds debt), §704(c) built-in gain second (not present as partnership bought the equipment) and, finally, in accordance with the partners' share of partnership profits and losses. For the first five years, the allocations are 10 G / 90 L, so G would get $6k additional basis, for a total of $16k, and L would get $54k additional basis, for a total of $84k. See Exhibit B.
Year 1 & 2: At the end of year 1, the $20k loss would pass through (§704) $2k to G, reducing his capital account to $8k, and $18k to L, reducing her capital account to $12k. At the end of year 2, L does not have enough capital account to take the full $18k deduction, and she has not agreed to restore a negative capital account, so she can only take a $12k deduction. This leaves $8k for G, which takes his capital account to zero as well. See Exhibits C & D.
Year 3: Once the partners' capital accounts hit zero with nonrecourse deductions, we go to Reg. §1.704-2, which says to deduct the depreciation in accordance with the partnership %'s since the bank can't go after the partners. There are four requirements: (1) the Big Three are satisfied (appears to be the case, with the alternate QIO for L), (2) nonrecourse deductions match other significant item relating to property (match all income / loss distributions), (3) partnership agreement includes minimum gain chargeback provision (it does), and (4) everything else complies with §704. If these four requirements were met, 90% of the $20k, or $18k, in year 3 would again go to L, and the remaining $2k would go to G. See Exhibit E.
However, it is not clear that the fourth requirement is met. To follow the partnership's desired allocations, they must have substantial economic effect, meaning it must be consistent with the actual economic deal. The nonliquidating distributions are 25/75 up to $40k and 50/50 thereafter, which is not the same as the %'s for tax purposes. Therefore, the IRS may require G & L to adjust the profit & loss allocations to reflect the actual economic deal.
However they are allocated, in year 3, someone would have a negative capital account and would have to be allocated the next income in accordance with the minimum gain chargeback provisions. In any case, §465 would disallow the loss in year 3 because the partners cannot take losses beyond their amount at risk. The equipment does not fall under either the public company or RE activity exception. This means that any losses from the depreciation deduction must be carried forward to a future year when the partners have additional amounts at risk, which they can gain from $ or property contributions and debt for which they are personally liable.
Exam No. 4058
First, we need to determine how to allocate the basis
of the $60k nonrecourse loan the p'ship took out.
When a p'ship takes out a loan, the partners are
treated as having made a cash contribution & their basis is adjusted
accordingly under § 752(a). With regard to nonrecourse loans, we first allocate
according to the partners' share of minimum gain (nonexistent in year one),
then according to their share in § 704(c) gain (also nonexistent in year one)
and lastly according to the partners' shares in the p'ship
profits. The partners are sharing their profits 25% to G and 75% to G in the
beginning of the p'ship, because that is how the
operating distributions are allocated. Thus, we allocate 25% of the nonrecourse
debt basis to G ($15,000) and 75% of the nonrecourse debt to L ($45,000).
See Exhibit A for opening balance sheet (before any dep'n ded'ns are taken).
When there are nonrecourse loans, there's no way to give ded'ns economic effect. Even still, partners are allowed to take ded'ns under the Crane/Tufts theories. Thus in year one, G-Lu is allowed to take an ordinary dep'n ded'n in the amount of $20k. When allocating ded'ns, we follow what's in the partners' p'ship agreement unless it has no substantial economic effect. With regard to economic effect, we first look to the § 704(b) regs to determine if the partners have agreed to the Big 3 (maintain capital accounts per Reg. (iv); honor capital accounts upon liquidation; unconditionally agree to an obligation to restore a deficit in the cap acct). G has agreed to the full Big 3, but L has not.
L can satisfy the alternate economic effect test because she has agreed to a qualified income offset. This QIO requires partners to repay unexpected losses & distributions that cause the partner's capital account to drop below zero.
On top of satisfying the economic effect test, teh p'ship agmnt must also satisfy the substantiality requirement. This is basically an anti-abuse rule. There are two types of allocations that are deemed insubstantial per se--shifting allocations & transitory allocations. Allocations are shifting if at the time the allocation bcomes part of the p'ship agmnt, there's a strong likelihood that the cap accts of the partners won't be affected by the allocation & the total tax liability of the partners is less than if there had been no allocation. Transitory allocations are basically the same thing but occur over a period of years. It doesn't look there's any foul play w/ their allocations, sohere's how things would look based on their allocations in the p'ship agmnt.
Year One
G gets to take 10% of the ded'n ($2,000) & L gets to take the other 90% (18,000). This is under the basic framework of reg. § 1.704-1 because we're still playing with both of the partners' own money right now. The book value & basis of the equipment would both decrease by $20k & the partners' capital accounts & O.B.'s would also decrease according to the amount of ded'n they are getting to claim. See exhibit B for the balance sheet at the end of year one.
Year Two
In year two we run into some trouble with L. She has only agreed to a qualified income offset and not to the full big 3, so we can't take her capital account negative on a foreseeable distribution. We will only allow her to take a ded'n to the extent of the amount remaining in her capital account ($12,000). The other $8,000 ded'n would be allocated to G because he is the one who would lose his own money if the p'ship walked away from the debt today and the bank came knocking. Again, we pass through the ded'n on the partners' capital accounts & outside bases. The book value & basis of the building decreases by $20,000. See exhibit C.
Year Three
Year three is when both the partners' capital accounts are depleted & the bank's money is at stake. We are no longer under -1 of the regs but are now under the relaxed rules of -2. Under the -2 regs, a p'ships allocations will be honored if the p'ship agmnt satisfies a multi-part test:
1. The p'ship agmnt has to comply w/ the first two requirements of the Big 3 --> met
2. The 'ship agmnt has to comply w/ the third reqiurment of the big 3 or must contain a QIO --> met
3. The nonrecourse ded'n has to match the %age allocation for some other significant item attributable to this property --> met bc all income, gain, loss, etc. is allocated 10% & 90%
4. There must be a minimum gain chargeback provision (meaning if this dep'n doesn't turn out to be real & the p'ship sells the equipment at a gain, the gain will be allocated in the same way, i.e., 10% & 90%)., and
5. All other allocations in the agmnt comply w/ § 704(b) --> met.
We may thus allocate the dep'n ded'ns 10% and 90% to each of the partners.
Now that we have minimum gain, we need to refigure the partners' basis under Reg. § 1.752-3. We first allocate the partners' basis to the extent of their shares in p'ship minimum gain. The p'ship's minimum gain is the amount of gain that would be realized if the p'ship walked away from the debt (the diff btw the debt & the basis of the asset). Here the p'ship would have $20,000 of minimum gain. Thus, G would receive $2,000 (10% of 20,000) and L would receive 18,000 (90% of 20,000). Again, we don't allocate any § 704(c) gain because it's not present here. Lastly, we allocate the rest of the nonrecourse loan to the partners accdg to their share in p'ship profits, meaning 25% to G & 75% to L. Thus G gets $10k of the basis (25% of $40,000) and L gets $30,000 of the basis (75% of 40,000).
See exhibit D for balance sheet at end of year 3.
Lastly, these partners might have problems taking the full amnt of their ded'ns because of the at-risk rules in § 465. These rules provide that you only get to deduct losses to the extent you have an amount "at risk." This is a nonrecourse loan so once we get into nonrecourse ded'ns, neither partner may have anything at risk because they're playing around w/ the bank's money & not their own. If they are not allowed to take the ded'ns for the current taxable year, they will have to save the ded'ns for a later year in which they have an amount at risk.
Created by: bojack@lclark.edu
Update: 13 Jun 13
Expires: 31 Aug 15