Sample Answers to Question 2
Partnership Tax
Spring 2014
Exam No. 7875
PART A
The LLC is a partnership for the same reasons as in question 1, and since an election for corporate status was not made.
Start with Lori's inventory. Contribution of property is normally a nonrecognition event (721(b)). By contributing the property, she is relieved of debt. As it is nonrecourse, the share of debt is the sum of share of partnership minimum gain, built in gain recognizable from the liability, and the the excess liability split in accordance with partnership property. Here, by contributing the property, L's share of the liability is her amount of 704(c) gain if the property was sold for nothing more than relief of the debt (ie if the inventory was sold by the partnership for the 50k debt, L would recognize 25k of built in gainn under 704(c), since her basis at the time of contribution was 25k) plus her share of the excess nonrecourse liability. The rest of the 50k debt is split 40/40/20 between the remaining partners, as this is how they share profits under the agreement. Thus, L's after-contribution share of the debt is 35k. K's is his 40% share of the 25k excess, or 10k. M's is 5k or her 20% share of the excess).
So, if L contributes the inventory, she is releived of 15k of the debt. She initially gets a carryover basis of 25k in the partnership (equal to her basis in the inventory). She is either treated as being relieved of the full debt andd then assuming her 35k share of the liability or simply being relieved of the 15k net (as though she got the cash value of the debt relieved and then contributed back cash equal to the amount she assumed). In either case, her OB is reduced by 15k overall. Thus, her capital account follwoing contribution is equal to the FMV of the inventory at the time of the contribution less the debt, and she has a 10k basis.
Ken initially gets a 40k basis and 40k book value of capital account from the cash contributed. He is treated as making an additional cash contribution of 10k, the amount of the nonrecourse debt he assumes. THus, he has a 50k basis on the 40k capital account.
M gets a profits interest in the company. The interest's cahracterization - whether capital or profits - is tested at the time of the interest grant (Rev. proc. 2001-43). Here, M gets no interest in the initial capital and, therefore, only has an interest in future profits. As such, her interest is a profits interest rather than a capital one. As the value of the interest is dependent upon future profits, it is difficult to value the interest. Profits interests, therefore, are not usually taxed unless they can be readily valued. An interest is readily valued if it is disposed of within 2 years, relates to a substantially certain stream of income, or is an interests in a publicly traded partnership. None of these apply, thus M is not taxed on her reciept of a partnership interest. Otherwise, this would not usually be a nonrecognition event, since 721 only applies to contributions of property. If the interest was readily valued, M would ahve been taxed on the FMV of the interests and taken a cost basis in the partnership interest (that is, once the interest vested or was elected to be taxed under 83(b)). The partnership would ahve been able to deduct the amount of the partner's tax (ie the FMV of the services) or ccapitalize them if it was a capital expenditure. None of this is applciable because M is not taxed since she has a non readily valuable profits interest. This is good for M because she may be able to convert what would have been Ordinary income on the interest into capital gain later from sale of the partnership interest.
M is, however, treated as contributing 5k in cash as the amount of her liability assumed. She, therefore gets a 5k basis in her interest.
The partnership takes the Inventory with a transfer basis of 25k. The partnership will take the asset as ordinary income property for the first 5 years, even if it is not inventory in the partnership's hands (724(c)provides an exception to the rule that property is characterized at the partnership level from 702(b)). The partnership wont tack the holding period from L becausethe propery is not capital. L will also not tack a holding period onto her interest because the property is not capital inher hands.
Follwoing the contributions, the balance sheet is as in Balance sheet C.
On the sale of the inventory, there is book loss to the partnership of 25k, tax gain of 40k. L has a built in gain on the property of 65k. Under the traditional method with ceiling rule, all of the tax gain would be allocated to L and none of the book loss would be recongized by any of the partners, since the ceiling rule only allows gain or loss to be allocated up to the tax gain or loss realized by the partnership. This would increase L's basis by 40k but not her capital account since the capital account already reflects the buil-in gain.
If curative allocations or remedial method was used, then the book loss would be shared. Here,the book loss would be split 40/40/20 according to the partnership agreement with substantial economic effet. K would get 10k of book loss, L would get 10k, and M would get 5k. To correct this, L would have to get an additional 25k gain to offset these allocations. The end result would be that K could decrease his capital account by 10k, M could decrease hers by 5k,and L would increase hers by a total of 55k (the net of all of the above to L, or her built-in gain less the share of book loss). With curative allocations, actual items of loss would be allocated, whereas inremedial, only accounting items would be allocated.
The partnership can elect to use whatever method it would like as long as it is "reasonable." All of the above are reasonable (1.704-3). These allocations lack substantial economic effect, but the special rules indicate how the allocations are made in accordance with the partnership interests. The character of all of the gain/loss attributable to the inventory will be ordinary income, as it was inventory in L's hadns and it has been less than 5 years since the contribution was made.
When the loan is paid off, the partners' shares of the debt are reduced, thus, their capital accoutns are decreased by the same amounts that they were increased by after the assumption of the debt.
There is no indication that there is a business purpose or reasonable reason to change the tax year (706(b)(1)(c). That is there is no indication that 25% of the gross reciepts are eanred in the last two months. Thus, the tax year will be the same as the principal partners' tax year (presumably the calendar years for these individuals - a safe assumption for individuals), because there is no majority interest holder (706(b)(1)(B)). The partnership may elect to use a year ending in September 30, because all partnerships are allowed to elect any year within 3 months of the required year (444), and September 30 is within three months of December 31 (the required year). However, the partnership will be required to pay interest on the amount of any income deferred from the change (7519).
Exam No. 7294
(A)
The formation of KLM has the following tax consequences:
K recognizes no gain or loss for contributing $40K cash and takes a tax basis of $40K and capital account of $40K. (Addition to basis from nonrecourse loan analysis below)
M does not receive any interest in the underlying capital of the partnership and therefore only has a profits interest. The receipt of this interest would not be taxed unless M sold her interest within 2 years, since the partnership is not publicly traded and does not have a substantially certain and predictable stream of income. She contributed only future services (acceptable if relating to the partnership operations) so she would have a capital account of $0 (addition to tax basis from non-recourse loan analysis below).
L's situation would be much more complicated, and pertains mostly to the allocation of the loan and the pre-contribution gain in the property L contributed. Her account, before taking into account these niceties, would be a basis of $25K and capital account of $40K. However, the non-recourse debt changes all of this:
The tax basis of the partners would be adjusted for their respective assumption of the non-recourse debt that the inventory is subject to (and downwards for the contributing partner to the extent that she is relieved of liability). Since it is a non-recourse loan it is allocated in accordance with partner's shares of (1) minimum gain, (2) 704(c) gain, and (3) respective share of profits. Since this is property that has built in gain (704(c)), that amount is first allocated to the contributing partner (L). The built in gain is determined by the amount the partner would be allocated if the partnership disposed of the asset for the amount of the loan. In this case, the partner would get $25K gain (loan $50K - basis $25K) so L is alloted that basis. The remainder of the loan ($25K) would be allocated based on the partner's share of profits: in this case 40% to K and L, and 20% to M. This results in $10K to K and L, and $5K to M. L is thus afforded $15K of debt relief which reduces her final basis from $60K (original tax basis of inventory + 704(c) gain + profits share - debt relief) to $45K. The debt relief of $15K is treated as a cash distribution to L, which lowers her basis, but since she had enough basis to cover it it would not be taxed. The initial balance sheet is shown at Exhibit 2.1. It shows an inside/outside mismatch as a result of the inventory having a tax basis in the hands of the contributing partner of $25K but also being subject to a nonrecourse loan that would give the partners additional basis in the partnership. This basis is essentially "lost" on the inventory since a partnership cannot change the inside basis of an asset (in this case from 723) when the asset is in the partnership. However...
If the partnership wanted to cure this discrepancy, it could make an election under IRC 754 (via IRC 743). The excess basis ($35K) would be allocated in accordance with IRC 755, in this case wholly to the inventory, yielding a final inside basis of the inventory at 60. The partnership would likely want to make this election since it would otherwise be taking a larger gain on disposition of the property and only seeing the benefit of its excess outside basis on liquidation. See Exhibit 2.2. for balance sheet under 754 election.
At the end of the first taxable year and on sale of the inventory, the tax consequences would be as follows:
Without 754 Election:
Partnership realizes $40K of ordinary gain (ordinary asset because it is inventory, and arguably the partnership is a dealer in the asset anyway). This is because the partnership realizes $65K and has a basis of $25K. It does not appear from the facts that the buyer assumed the nonrecourse liability (since the partnership pays it off later), so the $50K liability is not added to the amount realized. ALL of this $40K ordinary income would pass to the contributing partner (L), since it is within the amount of the original precontribution gain of the property (90 FMV - 25K basis). However, the partnership appears to have suffered a book loss on the transaction, because the FMV was originally $90K and was only sold for $65K (book loss of $25K). This book loss cannot be taken by the partners (absent remedial allocation), because the amount of book loss is limited by the ceiling rule to the amount of tax loss (of which there was none). Thus while the partners capital accounts are decreased, they do not see a corresponding tax deduction.Under the traditional rule this sale would result in the balance sheet at 2.3.
With a remedial election, however, the partnership would give the book loss of $25K, 40% to K ($10K) and 20% to M ($5K). This would be ordinary loss to both partners to match the character of the transaction (and because the partnership is a dealer). To do this the partnership would have to allocate a made up gain of the same amount and character (i.e.ordinary $15K total) to L. K and M's tax basis would drop by $10K and $5, but their capital accounts would not be effected.
With 754 Election
Partnership realizes $5K of gain ($65K amount realized minus $60K inside basis). Similarly, all of this gain would be ordinary and would be allocated to L. Again, the partnership would have a tax gain but a book loss (again a book loss of $25K that bumps up against the ceiling rule), so they could choose to take remedial allocation in the same amounts as above.
Payment of the debt after disposition of the property would lower the cash on the left side of the balance sheet by $50K and would give the partner's a corresponding deduction ($20K to K and L, $5K to M) reducing their basis by the amounts of the deductions. If the profits partner (M) did not have enough basis to take this loss (because they took remedial elections and the full $5K basis was gone) she would be treated as receiving a cash distribution of $5K.
(B)
If KLM wanted to change its taxable year to Sept 30 it would likely only be able to do so if it paid under IRC 444. It is highly likely that the majority interest holders of the partnership use a calendar year (individuals almost always do), so KLM could only avoid paying to take the different year if it received 25% of its gross receipts in August and September, or failing that, if KLM could provide another "compelling reason" why it should be allowed the different calendar year (very difficult to do). From the facts it is impossible to say when KLM does most of its business, although since it involves likely summer activities (recreation at state park) it is not impossible that this test would be met. Further information would be needed if KLM wanted to adopt the taxable year WITHOUT paying to do so.
Exam No. 7990
A. Melissa's Interest in the Partnership
Here, Melissa receives a right to the profits and losses of the psp., but not an interest in any of the initial capital. In essence, Melissa's original interest in the psp. is a profits interest. Is this a taxable event? Revenue procedure 93-27 creates a safe harbor for receipts of profit interests. As long as the partner does not fall within one of three categories, the event is not taxable and the partner will not recognize ordinary income from receiving the interest. The three categories essentionally are: 1) Receiving an interest with substantially certain and predictable income; 2) Disposing of the interest within 2 years; and 3) An interest in a "publicly traded partnership." Here, M does not fall into any of the three categories. Category 1 is arguable, but the business here is a recreational equipment rental business, not something close to a high-quality net lease. Therefore, the receipt of the psp. interest is not a taxable event.
Formation
K and L's contribution of capital to the partnership is not recognized by either the partners or the psp. under §721. K has an initial basis and capital account of 40k for his cash contribution. The debt relief experienced by L will be a taxable event, though. Here, the NR debt that is assumed by the partnership will be allocated to each partner in accord with their share of of the NR liabilities. As will be explained, K will be allocated 10k of the debt, L will be allocated 35k of the debt, and M will be allocated 5k of the debt(even though M does not even have a capital account at this point). There is a problem. L will be relieved of $30k of liability, and this will be treated as a cash distribution to L under §752(b), but her basis is only 25k. Although L was relieved of 30,000 of NR liabilities, L's overall share of psp. liabilities is increased by 27k. This is because L's required 704(c) minimum gain is 25k, and L's share of the amount of the NR liability that exceeds the 25,000 gain is 10k(40% of 25). Only the net decrease of 10k will be taken into acount in applying §752 here to lower L's basis for the debt relief. Since L has a psp. basis of 25k, it will only be decreased by 15k to 10k. As a result, K will have an outside basis of 50 and a capital account of 40. L will have a basis of 10 and a capital account of 40. M will have a basis of 5. On the asset side, there will be cash with 40k basis and 40k b.v. The land will have a 25k basis(carried over from L) and a b.v. of 90k. Refer to Exhibit 4.
Inventory Transaction
Here, KLM will slle the inventory for 65,000 with a tax gain of 40k and a b.v. loss of 25k. As this is an inventory item, loss will be ordinary. The loss is distributed to the partners in accordance with the psp. agreement. Even though M does not have an interest in the capital, she will receive losses from capital in accordance with the partnership agreement. 10k bv loss will be given to K, 10k to L, and 5k to M. Even though M goes negative, the primary test for economic effect is satisfied here and this loss will be allowed.
What about the tax gain? Here, if the traditional method for allocations is used, 25k of the gain(ordinary) will go to L, and the rest will be split between the 3 partners in accordance with the psp. agreement. This is unfair, though, because the partners actually got a book loss, so they should be able to make deductions for their losses. Since under the traditional method of allocation there is no loss, they will not not be able to make these deductions per the ceiling rule.
The psp. could elect to use the remedial method of allocations to cure the mismatch between adjusted basis allocation and book value in this transaction. Here, the all of the gain(up to the value of the property) would be allocated to L, who contributed to the property. Here, L would recognize an ordinary gain of 65k(90b.v.-25k basis). Then the book loss would be allocated each to K and M in accordance with their psp. interests, which in this case would be 10k of loss to K ,and 5k of loss to M.
See Exhibit 5 for the new balance sheet after a traditional method allocation and debt relief.
B.
Here, since we must presume the partners all have the same taxable year, 706(a) would require us to choose a calendar year for taxation. If we want to choose a Sept. 30 year, a "business purpose rule" exception must apply or the psp. must make a §444 election. Here, there appears to be no legitmate business purpose to choose a 09/30 tax year, because under the 4 factor test is not appear that this would be appropriate. In addition, the safe harbor would not apply because we would not have 25% or more of revenue in the last 2 months. The psp. could make a §444 election, though, because a 09/30 taxable year would not create more than 3 months of tax deferral. The psp. would have to make §7519 payments, though, to offset any tax advantages.
Created by: bojack@lclark.edu
Update: 21 May 14
Expires: 31 Aug 15