Sample Answers to Question 3
Partnership Tax
Spring 2014

Exam No. 7875

Distribution of Inventory

This is an operating distribution because the distribution is to someone that is a partner before and after the distribution. Such distributions are generally nonrecognition events. Here, there is no cash disributed and no indication that there is distribution of built-in gain or loss property under 704(c). There is also no indication that the invenntory items are distributed disproportionately to the partners' interests (that is, distributing more 751 or 741 assets to a partner than he or she has an interest in before the distribution). Here, the inventory is distributed pro rata, so 751 rules will not kick in.

The partners' outside bases will be reduced by the basis that they take in the property, preserving the gain built into the property interest. The property basis will be the lesser of the trannsfer basis in the hands of the partnership or the outside bases of the artnership. Thus, here the overall bases in the inventory items is initially 150 in the hands of the partnership. When distributed to P, her outside basis is greater than the total asset basis. Thus, P will take a transfer basis equal to the assets' bases. That is, Item A will retaiin its 120k basis and Item B will retain its 30k basis in P's hands. This will reduce her outside basis by 150k and she will be left with an OB of 150k (down from 300k)

O does not have enough basis to take a transfer basis. Thus, the overall basis he will take is equal to his OB, or 120k. Follwoing the distribution, his OB will be reduced by 120k (the amount of basis taken by the property) to 0k. Now, we must decide how to allocate the 120k basis among the assets. Item A is a 90k loser and Item B is a 30k winner. According to 732(c), the basis decrease will first come from properties with unrealized depreciation. Here, only Item A has unrealized depreciation. Thus, Item A's basis will take the whole 30k basis decrease required. Thus, Item A will have a 90k basis and Item B will continue tohave a 30k basis in O's hands.

This will create an inside/outside basis mismatch, as the partnership will have "lost" a portion of its loss (will have lost 150k of inside basis in assets,while O only decreased OB by 120k). If a 754 election has been made, thenn the Paartnership can make a 75 basis adjustment, adjusting the basis of assets with unrealized appreciation (if any) to compensate for the loss unrecognized.

Regardless, neither the partnership nor the partners will recognize gain or loss in this transaction (if this was a liquidating distribution and since only hot assets, the inventory, was distributed, O couldd recognize loss to the extent of the 30k of basis that disapeared).

P's subsequent sale of Item B is governed by 735. The Item retains its inventory characterization for 5 years after the distribution, in order to prevent changing thecharacter of the partner's gain or loss and avoiding tax liability. Thus, on the sale, P will recognize a 35k gain (65k sale over 30k basis). The income will be ordinary.

The Sprecial Allocation

Special allocations made in a partnership agreement are respected if they have substantial economic effect. Otherwise, the alloation will be determined in accordance with the partners' interests in the partnership.

Economic Effect can be satisfied if the Big Three are satisfied (1.704-1(b)(2)(ii)(b)). This is not the case here. WHile the agreement provides for proper maintenance of capital accounts (the first test), and liquidations will be made in accordance wtih capital accounts (the second), there is no requirement that the partner to whom the distribution is made is unconditionnally obligated to restore capital account deficits. Indeed, P, the limited partner, will have no such obligation as her risk of loss is limited to the initial investment. The distribution is not made to her, however. O as the general partner probably is, however, obligated to restore a deficit in the account. General partners are usually unlimitedly liable to the partnership. Theagreement does not provide this, however, so the big three are probably not met.

Under state law, however, if O is unconditionally obligated to restore any deficit by virtue of his being a general partner (this is likely), then the economic equivalence test is met. (1.704-1(b)(2)(ii)(i)).

The alternate test, which would allow economic effect to the extent that no deficit is created in the capital account, does not apply because althouugh the first two of big three are met, there is no qualified income offset in the agreement.

Although none of the tests are strictly met, what we are looking for is consistency with the underlying economic consequences to ensure that the partner actually recieves the economic benefit/burden of the allocation. This seems likely here. Even if the economic equivalence test is not met (which seems unlikely), O will be actually getting the benefits andd burdens of the allocation. This is true because the allocation is only made when there is profit, so it seems unlikely that the cap. accoutn will ever go negative.

Thus, while allocation in accordance with partnership interests would essentially eliminate the 40k alloation, it seems likely that there should be economic effect. Additionally, there is no indication of offsetting allocations, etc. that would make the allocation insubstantial. Thus, the 120k/80k allocation should stand. Thus, O and P's OBs will be increased by the 120k and 80k allocations (their distributive shares of the profit for that year), and O and P will be taxed on this amount. The character of the gain is determined at the partnership level and will be capital.

There is a possibility that this will be seen as a guaranteed payment. IN such case, the income would be ordinary to O (the 40k portion that is). It would not affect his OB. The partnerrship would also be able to deduct or capitalize the expense. The income would pass through to O once it is deducted by the partnership, regardless of reciept, instead of on O's year in which the partnership's year ended, as with the special allocation. Even though the partnership has steady profits, the 40k is dependent upon the partnership making profits and should not be seen as a guaranteed payment. Congress intended that if a partner performs services for a partnership and there is a related allocation and distribution to the partner that when viewed together is properly characterized as a transaction between a partnership and partner not acting in a partner capacity, then it should be treated as such. In this case, as a guaranteed payment. In Pratt, the court examined whether the activities were in the normal scope of the duties of a general partner and whether they were ongoing and integral to the business. Here, the services that O rendered on behalf of Lilco that the payments seem to be in compensation for are probably those normally performed by a partner in his partner capacity. COngress also outlined six factors to consider, includinng temporal proximity between the services and payment, risk associate with the paymet, whether the partner is transifoty, whether the alloation is primarily for tax benefits, and the value of the partners' interest in relation to the allocation.

Examining all of these factors, it seems that the 40k is an allocation. However, this is a close question, and there may be a better way for the partnership to structure this in order for O to avoid guaranteed payment treatment.

Exam No. 7294

The distribution of inventory to O would have the following consequences:

There would be no gain or loss realized by O because it does not involve a distribution of money (thus no gain) and it is not a liquidating distribution (thus no loss). O has a 120K tax basis in the partnership and cannot take a higher basis in the transfered property than his total basis in the partnership. The assets that he receives have a total of $150K inside basis. He can only take a 120K basis in the properties, however, so some of the basis would be lost. The allocation of basis to the partner (and the basis in O's hands after receiving the property) would be as follows:

Item A: 96K basis

Item B: 24K basis

His basis in the partnership after this distribution would be 0K

Similarly, there would be no gain or loss realized by P on the operating distribution (same reasons as O). However, P has a tax basis of 300K in the partnership and the adjusted basis of the property he receives would be less than that, so he would take the full basis of the property as they were in the partnerships hands (Item A 120K and Item B 30K). His basis in the partnership after this distribution would be 150K.

The partnership would drop its FMV by the total amount of the assets distributed ($180K), and would not recognize gain or loss on the distribution. The partners would likewise drop their capital accounts by the FMV they received and the basis they took.

751(b) is not implicated in this situation because (1) it is an operating distriubtion, not a sale, and (2) neither items of inventory are "substantially appreciated" (+120% appreciation) such that they would be treated as 751 items in a sale.

Because of the basis hair-cut taken by O, the partnership may wish to make a 754 election. In such a case, the partnership would allocated $30K (the amount of basis lost in the operating distribution) to assets of a like-kind within the partnership (in this case ordinary income assets). Since we do not know what, if any, other assets the partnership has we cannot determine the exact allocation ratios.

When P sells Item B it would have no effect to the partnership, but it would result in a $35K ordinary gain to P.

The year in which the partnership allocates $120K of income to O and $80K to P all of the distribution would be treated under normal distributive share rules. The first $40K to O would not be treated as a guaranteed payment (and thus ordinary income, with corresponding deduction for the partnership), because the agreement expressly provides that the payment shall be made with regards to net profits. Furthermore, it is not subject to 707(a) treatment (partner acting outside of their partnership duties) because it appears evident that it is rewarding the partner for their work in the capacity as a partner. Thus the payment is treated under normal 702/731 rules: O would get taxed on $120K (ordinary or capital depending on the character of the transactions at the partnership level) and P would be taxed on $80K (again, character dependent on partnership level). Their respective outside bases would go up by those amounts until and unless they took an operating distribution of those payments. The preceding analysis is based on the assumption that the allocations have substantial economic effect. The facts specify that the partnership agreement meets the first two prongs of the Big Three, but it is ambiguous if the third is met: there is no indication that the limited partner has agreed to pay back a negative account. Further, there is no indication that the limited partner has agreed to a QIO. If this agreement did not have economic effect, the special allocations of income could be subject to an "all the facts and circumstance" tests, for which it would be difficult to determine how the allocations should be made.

Exam No. 7357

The distribution of Inventory.

I assume that none of the inventory was contributed by either partner with a built in gain under [s]704(c) w/in 7 years, or that any CP received their own property contributed under [s]737 w/in 7 years. Otherwise, those P's would have to recognize their respective built-in gains. I don't have info to analyze this, but I thought I'd mention it. Also, I assume those same inventory items were not contributed w/in 2 years by either partner or another partner if they existed that would trigger a presumption of sale under 1.707-4.

Under [s]731(a), no gains from a distribution are recognized from the distribution of property, unless money or "other property" is distributed and those values exceed the P's OB. No cash or marketable securities are distributed here so 731(a) applies. [s]732(b) gives both Oscar and Paige the same basis the Pship held, so each items A will have 120K basis. [s]733 says we have to reduce the OB of each receiving partner accordingly, so Oscar ends up with zero OB and P's OB is reduced to 180K. A problem arises when Item B is distributed to Oscar, because [s]732 and 733 read together only give Oscar the basis in the property up to the extent he has available OB to offset, which he no longer has, so 30K of the basis will be disqualified. Oscar takes the 60L value item with no basis and will realize a full gain when he disposes of it later. Item B for P, however, will carry with it 30K basis and we offset her then available OB to 150K. See Exhibit 3A.

When Paige sells Item B for 65K, she realizes and recognizes a gain of 35K and that gain would be ordinary, as it inventory in the hands of the Pship.

The Pship would reduce its inside basis accordingly, and the capital accounts would be similarly reduced to reflect the decreased value in assets held by the Pship. I have no numbers to reflect this but see Exh 3A. The Pship may be entitled to use that basis associated with the inventory given to Oscar and transfer it to another inventory item, so the basis doesn't disappear into the ether. I'd have to look more into that issue.

A few years later: the special allocation of profit.

Whatever the economic arrangement, the Code and Regs will only honor a particular allocation of profits, losses, deductions, credits, etc. if that particular arrangement has Substantial Economic Effect pursuant to [s]1.704-1 and [s]704. Here, the PA appear to have the first two prongs of the Big Three: it calls for CA's being maintained in accord to 704(b), and also requires that on liquidation, the distributions to the P's will be made in accordance with the positive capital accounts. What appears to be missing is the third prong, which either requires that any deficit, on liquidation will unconditionally require the partner in question to restore the negative capital account to zero, or alternatively the PA must have a qualified income offset. If neither of those alternatives exist in the PA, then the overall economic transaction will not have economic effect.

If the Big Three aren't met, so the IRS would recharacterize the economic arrangement under 1.704-1(b)(2) and the Pship will lose all special allocations. This test is applied every year. [s]706(d) also requires the Pship to "close the books" whenever there is a change in the partner's interest or allocations of income, gain, losses, deductions, etc. so the Pship may just prorate this at the end of the year for pre-amendment periods and post-amendment periods. Here, the new amendment appear to have economic effect, because it is not causing any distributions or allocations that would cause either partner to take on excess economic risk: the reason is because the Pship agreement is only allocating "net profits" rather than losses, deductions etc. Therefore, it seems impossible that the Capital Account can drop below zero, unless some additional distributions are made. Here, I think the overall economic arrangement has economic effect. Whether the transaction is substantial depends on whether there is a net decrease in the total aggregate tax liability of either partner. For that, we would have to go beyond the hypo and look at the overall tax liability of each partner in light of their extraneous business affairs. If what the p's were really doing is purporting to recognize "Oscar's extraordinary efforts," while really trying to give O additional income now when Paige may stand to have some heavy gains that year, then the allocation will not have substantial economic effect. However, assuming that there was no net reduction in overall tax liability, then the special allocation will be valid.

A word on the "special bonuses." Here, the nature of the special bonus may qualify as a guaranteed payment, particularly if the bonus is actually a fixed payment. If so, the P's would recieve that as ordinary income under [s]706(c) and the Lilco would have a deduction for those payments. If instead the payments reflect a percentage of income or profit, then this would be a distributive share and would therefore be allocated according to typical distribution rules including separately stating portions of those distributions in accordance with the Hot Asset rules of [s]751; 702(a). I don't have enough info here to more fully analyze this.

Created by: bojack@lclark.edu
Update:  21 May 14
Expires:  31 Aug 15