Sample Answers to Question 1
Partnership Tax
Spring 2014

Exam No. 7294

The initial contributions of cash by the partners to the partnership would not be recognized under section 721 of the code as a gain or loss. Taking out the loan also would not involve a gain or loss. Because it is a general partnership and their is no property (land or building) that the loan would pertain to (indeed, it is a cash loan for business operations) it would almost certainly be recourse. Thus the basis of the loan would be allocated in accordance with the partners liability for payment as calculated by the "doomsday scenario". If the partnership sold all of its assets (including cash) for $0 it would have a $500K loss, of which 40% would pass to T, 40% to U, and 20% to V. All partners have to restore a negative capital account and are liable as general partners, but only T and U would actually have a negative capital account in this situation (with a total of -$250K). However, there is only $200K of basis to allocate, so it would have to be pro rata between T and U (60% to T and 40% to U). Exhibit 1.1 illustrates what the final balance sheet would look like for this loan.

At the end of the year in determining the distributive share for the partners, the partnership has $400K of losses to pass through. These would be alloacted 40% to T, 40% to U, and 20% to V per the partnership agreement because the allocations meet the Big Three and they have substantial economic effect. It is possible that some of these losses could be subject to disallowance/capitalization if they were considered organizational expenses (i.e. incident to the creation of the partnership). However, it is more likely that they are not incident to the creation of the partnership, but rather necessary for the ongoing operations of the partnership, and would thus pass through in full. Assuming this, the partnership would take a $400K loss while T and U would both take a $160K loss deduction and V would take an S80K loss deduction (characterized based on the transactions at the partnership level yielding the losses, likely as capital) on their individual tax returns. Their final balance sheet is illustrated under Exhibit 1.2. It does not matter that T and U have negative capital accounts because (1) they are general partners (usually) required by law to pay into the partnership on deficit and (2) even if state law didn't require this, they explicitly signed on to the Big Three necessitating them to do so. Further, there are no elections available to the partnership at this time, as their is no inside/outside basis mismatch.

Exam No. 7875

As TUV is a business entity (division of profits for carrying on trade or business) that is not a corporation or a trust (the election has not been made and is characterized as a "general partnership), has two or members, is not publicly traded, and is not eleigible as a Qualified Joint Venture, TUV is a partnership for at least the purposes of Subchapter K.

After their initial contributions of cash, T, U, and V have capital accounts equal to the amounts of cash they contributed. They take outside bases equal to their cost bases (ie equal to the ccash they contributed). At this point, the balance sheet looks like Balance Sheet A.

Once the partnership borrows money, T, U, and V's bases will change. This depends on whether the liability is recourse or nonrecourse. For partnership tax purposes, a debt is recourse to the extent that any partner beawrs the economic risk of the liability (1.752-1(a)(1)). If no partner bears the economic risk, then the liability is nonrecourse. To determine economic risk, the "Doomsday Scenario" is applied. Here, we make a constructive liquidation and ask what would the partners have to pay back if the assets securing the debt were sold in partial or full satisfaction of the debt, all other assets (including cash) became worthless, and the partnership liquidated (1.752-2(b)). Here, there is no property securing the debt. If all the cash became worthless, each partner, as a general partner, would have an obligation to restore deficits of the partnership. Here, T, U, and V have agreed to share profits and losses 40/40/20. So, of the 200k debt, T would be responsible to restore 80k, U would be responsible for 80k and V would be responsible for 40k. Incidentally, there is no indication that the deductions are related to nonrecourse debt or contributed property, so no special allocations of those deductions need to be made.

The next question to ask is whether this allocation of the debt would be respected. As the Big Three are explictly met here by the agreements provisions 1-3, the allocation has economic effect. It is also substantial because the allocations have a reasonable probability of substantially affecting the dollar amounts to be recieved from thepartnership, independent of tax consequences. That is, the tax effects are also going to have actual economic effect.

Thus, T, U, and V's bases will be adjusted by their share of the debt. Incidentally, whether the debt is recourse or nonrecourse, the liability will affect the bases the same since T, U, and V share profits and losses in the same way. Nonrecourse liabilities are allocated based on how the partners share profits. So, after the liability is borrowed, the balance sheet looks like Balance Sheet B.

The NOL is shared according to the partnership at 40/40/20 (again, the allocation is respected because the Big Three is satisfied and there is substantiality - resulting in substantial economic effect (1.704-1(b)(2)(ii)). So, T has a 160k share of the loss. U also has 160k, and V has an 80k share.

Loss is deductible if it is less than the partners' outside basis (704(d)), it is less than the amount the partner has at risk in the activity (465), and passive losses are only deductible up to passive gain (469). Here, there is no indication that the loss is passive. As general partners that are presumably participating materially in the business, it is unlikely that the losses are passive.

As the partners are general and have an unconditional obligation to restore any deficits, they are at risk for the full amount of the losses.

For T: The 160k share of the loss exceeds his outside basis. As his basis is only 130k, his loss deduction is limited to that amount. He does not lose the 30k entirely, but it is deferred until his outside basis is increased (e.g. by assuming more liability, contributing to the partnership, when the partnership has gain, etc.).

For U and V, the shares of loss are less than their bases. Thus, they can use their entire share of the loss.

Thus, following distribution of loss, T has an outside basis of 0, U has 20k basis, and V has a 110k basis.

The share of the losses that is passed through may be deducted by T, U, and V against their personal income taxes. The character of the loss is determined at the partnership level (703(a)). It will affect the taxes of the partner in the taxable year of the partners within which the Partnership's taxable year ends. Here, the tax year of the partnership is probably the calendar year, asssuming the partners are also calendar year tax payers (a fair assumption for individuals). The partnership could elect to use a different tax year within three months of the calendar year, potentially allowing the partners to defer income (or loss in this case. There is no reason for them to want to defer the loss, probably) until the following tax year. The partnership would, however, have to pay interest on any deferment. As there is only loss here, there is no reason that this election should be made by the partnership. There is also no evidence that there is a business purpose (25% of all gross reciepts or reasonable under all the facts) for a different partnership tax year.

To the partnership, the contributions by the partnership are nonrecognition events (just as to the partners) (721(a)). The partnership does not pay tax, but instead calculates is taxable income and reports it. The shares of loss or income pass through to the partners, as described above. Some deductionns, like charitable ones, are not available at the partnership level, but there is no indication that the deductions in this case were not properly made at the partnership level. The deductions will also, ostensibly, reduce some part of the partnership's inside basis. As it is not clear what the partnership's operations are or what the deductioons are, however, it is unclear how the deductions might affect inside bases book values.

Exam No. 7990

Formation

Upon formation of the partnership there is no recognition of gain to either the partners or the partnership per §721. Each partner has an adjusted basis and capital account in their partnership interest equal to their cash contribution. Here, this would be $50k for T, $100k for U, and $150K for V, for a total of $300k equity on the partnership. On the asset side of the balance sheet, the psp. has a cash asset with a $300k basis and $300k book value. See Exhibit 1.

Loan

The psp. borrows 200K to finance its operations. The fact pattern does not indicate whether the loan is recourse or non-recourse. The result to the partners and the partnership is the same either way. We can presume that the loan is recourse, because it was not procured to purchase property and non-recourse loans are primarily used for property purchase. The issue is how to allocate the debt to each partner.

A partnership liability is a recourse liability only to the extent that a partner or any person related to a partner bears the economic risk of loss with respect to that debt. We use this determination to allocate the debt among the partners. The partner bears economic risk of loss for a partnership liability to the extent that that he ultimately would be obligated to pay for the debt if all partnership assets were worthless and and all partnership liabilities were due and payable. Here, we have to create a construtive liquidation where all of the assets are now worthless. Who will be stuck footing the bill for the loan in a doomsday scenario? If all $500,000 cash disappearned, each partner's capital accounts would be completely wiped out. There would be a 200k loss, allocated 80k to T(40%), 80k to U(40%), and 40k to V(20%) per the psp agreement, creating a negative capital balance of those amounts.

Do the partners bear the economic risk of loss for these amounts? Here, we want to know whether the Big 3 is satisfied for economic effect. Here, the psp. agreement requires that capital accounts be properly maintained, that liquidations of the psp. are made in accordance with capital accounts, and partners are required to restore negative capital accounts. Here, the Big 3 is satisifed in the doomsday scenario and each partner bears economic risk of loss for her share of the loan. Accordingly, the debt is allocated to the basis of each partner in accordance with each's share of the economic burden. Tara gets an increase of 80k, U gets an increase of 80k, and V gets an increase of 40k. The capital accounts are untouched because equity is not affected. As a result, T has a psp. basis of 130k, U as a basis of 180k, and V has a basis of 190k. Total liabilities are 500. Total asset of cash is 500k as well. See Exhibit 2.

1st Year's Operations

After the first year the psp. receives 100k ordinary income and 500 k ordinary loss. This would be nonseparately stated income items determined at the psp level. This results in a net operating ordinary loss of $400k. Per the psp. agreement, the loss should be allocated 160 to T, 160k to U, and 80k to V.

Are the deductions to partners' bases acceptable? We need to look at the tax code's psp. limitations first. §704(d) provides that a loss is allowable as a deduction only to the extent of a partner's outside basis. The main concern here is T and U. Her outside basis in her partnership is 130k. The loss to be allocated is $16k. 704(d) will limit this loss to 130k. and the other $30 will be suspended and can be used again in the future when she has adequate basis. U's basis will now be 20. V will now have a basis of 110.

Are the deductions to the partners' capital accounts acceptable• Two of the partners will now have negative account balances. As long as the Big 3 is followed and there is substantial economic effect, this will be allowed. Here, the Big 3 is followed, so this is acceptable. T now has a capital account of -110k. U now has a capital account of -60, and V has a capital account of 70. In the event of immediate liquidation, T and U will be required to make payments to V to balance out the capital accounts. To see the new balance sheet, see Exhibit 3.

§465 at-risk limitation are not an issue because the Big 3 is satisfied and the loan is recourse. The §469 passive activity limitation is not an issue because this is a general partnership, and each partner is presumed to be working hard in the business. We also want to know whether these deductions are considered "organizational expenses," because if they are they would not be deductible(only to the amount of $5,000). We don't know what the deductions in this case are attributable to.

Note that there is now a mismatch between the partners' aggregate outside basis and the basis in the assets, but §754 would not apply here.

Created by: bojack@lclark.edu
Update:  21 Apr 17
Expires:  31 Aug 18