PARTNERSHIP AND SUBCHAPTER S TAX OUTLINE SPRING 2009 VICE PRESIDENT, ASSOCIATE DEAN, AND PROFESSOR BRUCE A.

MCGOVERN STEPHEN A. LIND ET AL, FUNDAMENTALS OF PARTNERSHIP TAXATION: CASES AND MATERIALS (8th ed. 2008) SELECTED FEDERAL TAXATION STATUTES AND REGULATIONS (Daniel J. Lathrope ed., 2009 ed. 2008) LAURA E. CUNNINGHAM & NOL B. CUNNINGHAM, THE LOGIC OF SUBCHAPTER K: A CONCEPTUAL GUIDE TO THE TAXATION OF PARTNERSHIPS (3d ed. 2006)

PART PART PART PART PART PART PART PART PART

1: 2: 3: 4: 5: 6: 7: 8: 9:

AN OVERVIEW OF THE TAXATION OF PARTNERSHIPS AND PARTNERS.........2 FORMATION OF A PARTNERSHIP...................................................................8 OPERATIONS OF A PARTNERSHIP: GENERAL RULES..................................38 PARTNERSHIP ALLOCATIONS......................................................................59 TRANSACTIONS BETWEEN PARTNERS AND PARTNERSHIPS.....................105 SALES AND EXCHANGES OF PARTNERSHIP INTERESTS............................111 OPERATING DISTRIBUTIONS.....................................................................121 LIQUIDATING DISTRIBUTIONS AND TERMINATIONS..................................137 S CORPORATIONS AND THEIR SHAREHOLDERS........................................143

PART 1: AN OVERVIEW OF THE TAXATION OF PARTNERSHIPS AND PARTNERS I. Introduction to Subchapter K a. Congresss goals in enacting subchapter K were to provide simplicity, flexibility and equity as btwn partners. b. Aggregate vs. Entity approaches i. Entity: pship viewed as separate legal entity ii. Aggregate: pship is merely the relationship btwn individuals (no separate identity) (think family to describe a group of people) iii. Subchapter K takes a hybrid approach (i.e., it employs both); takes an aggregate approach, unless doing so would be too complicated 1. E.g., aggregate pship not treated as a separately taxable entity 2. E.g., entity pship must have its own taxable year and method of accounting II. Tax Classification of Business Enterprises a. In General i. Corporation vs. Partnership Taxing Regimes 1. Corporations a. Subchapter C i. Separately taxable entity (entity approach), double taxation ii. Example: GI = $100 (w/ no deductions) 1. Corporation: $100 TI * 35% = $35 tax 2. SH: $65 dividend * 15% = $10 tax b. Subchapter S i. Subchapter K-like ii. Restrictions on sub-S election (e.g., c/n have more than 100 SHs, no non-resident alien SHs). See 1361(b). 2. Partnerships (Subchapter K) a. Pass-through scheme (aggregate approach) b. Partners include share of pship income in individual income (whether distributed or not) c. $100 GI * 35% = $35 tax ii. Classification of Corporations vs. Partnerships 1. Statutory Guidance. The definition of partnership is so broad it includes organizations that arent regarded as pships under state law. See 7701(a)(2). The definition of corporation as an association isnt helpful. See 7701(a)(3). 2. Pre-1997: Kintner Regs. If an entity had 2 or fewer default corporate characteristics, it was a pship; if it had more than 2 it was classified as a corporation. Default corporate characteristics are continuity of life, centralized management, transferrable interests, and limited liability 3. Today. Check-the-box regs. See Reg. 301.7701. b. Corporations and Partnerships i. Check-the-Box Regulations 1. STEP 1: Separate Entity. Is the activity/entity an entity separate from its owners? See I.b.ii. Existence of a Separate Entity for Federal Tax Purposes, infra. a. If no, not subject to classification regulations b. If yes, move on to the next question

2. STEP 2: Business Entity. Is the entity regarded as a

business entity? See Reg. 301.7701-2(a) (not a trust or subject to special treatment). a. If no, the entity is classified as: i. A trust under Reg. 301.7701-4 or ii. Subject to special tax treatment (e.g., a qualified settlement fund under 468B) b. If yes, move on to the next question 3. STEP 3: Eligible Entity. Is the entity an eligible entity under Reg. 301.7701-3(a)? That is, is the entity classified as a corporation under Reg. 301.7701-2(b)(1), (3)-(8)? a. If yes, the entity is a corporation for federal tax purposes (a per se corporation), taxed under Subchapter C or S b. If no, move on to the next question 4. STEP 4: 2 Members. Are there 2 or more members? a. If yes, the entity can elect to be a partnership OR a corporation b. If no, the entity can elect to be a corporation or disregarded for federal tax purposes c. Default Rules. Reg. 301.7701-3(b)(1). i. 2 or more members: treated as a pship ii. 1 member: disregarded as an entity 5. Note: an eligible entity that chooses to be an S corporation automatically is treated as making the election to be a corporation 6. Rev. Rul. 2004-77. Second Owner Cant be a Disregarded Entity. Suppose an eligible entity has 2 owners and 1 of the owners is a disregarded entity (e.g., a single-owned LLC). Since the 2d owner is a disregarded entity, theres really only 1 owner. a. Same result if the disregarded entity is a limited partner in a general partnership. b. There would be 2 owners if the 2d entity is recognized for federal tax purposes. ii. Existence of a Separate Entity for Federal Tax Purposes 1. Matter of Federal Tax Law. Whether an activity/entity exists as a separate entity is a matter of federal tax law and does not depend on the organizations status under state law. Reg. 301.7701-1(a)(1). 2. Undertakings Giving Rise to Entities. A joint venture or other contractual arrangement may create a separate entity if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. Reg. 301.77011(a)(2). a. Joint Profit Motive. Separate entity may exist if coowners of an apartment building lease space and provide services to occupants. Id. b. Not Expense Sharing. An undertaking to share expenses doesnt create a separate entity for federal tax purposes. Id. c. Not Mere Co-ownership. Mere co-ownership of property that is maintained, rented or leased is not a separate entity for federal tax purposes. Id.

3. Podell v. Commissioner. Podell (P) and Young (Y) agreed

that P would provide capital to Y to purchase and renovate property, and they would split the profits. HELD: the agreement gave rise to a joint venture. The key factors considered was the agreement to share profits and a shared right to control. Although P didnt exercise as much managerial control as Y, he retained the power to approve Ys actions through his control over continued contributions. 4. Allison v. Commissioner. Acceptance (A) and Investment (I) agreed that A would arrange financing and I would acquire and subdivide property. A received 75 lots. HELD: no joint venture. There was no joint profit motive to sell the 75 lots. As receipt of the lots was compensation for its financing obligations. 5. Problem 1 (p. 16). Which of the following relationships are likely to constitute a separate entity for federal tax purposes? a. (a) A, B and C purchase a single parcel of land as tenants-in-common and hold the land as an investment. i. No separate entity ii. Reg. 301.7701-1(a)(2) 1. Mere co-ownership of property isnt regarded as a separate entity for federal tax purposes. 2. Last sentence: tenants in common leasing farm property is not a separate entity for federal tax purposes. b. (b) Same as (a), above, except the land is subdivided and A, B and C sell the lots. i. Separate entity b/c they have a joint profit motive ii. Joint venture or other contractual arrangement. See Reg. 301.7701-1(a)(2). iii. Similar to Podell b/c of the profit-sharing and shared right to control. c. (c) Litigator and Negotiator are attorneys who share an office and a secretary. Each attorney services and bills his own individual clients. i. No separate entity ii. Expense sharing arrangements not recognized as separate from owners. Reg. 301.7701-1(a)(2). d. (d) Doctor will locate and purchase a suitable four unit building. Architect will remodel it. When the work is done, the renovated building will be sold by the DoctorArchitect real estate company and Architect will receive 25% of the net profits. i. Separate entity ii. Similar to Podell b/c of the profit-sharing and shared right to control. iii. Allison is distinguishable b/c here there is profit sharing. e. (e) Would the result in (d), above, be different if Doctor and Architect agreed that Doctor will retain three of the units as rental property and Architect will receive one unit to hold as rental property? i. Separate entity status not clear.

ii. One unit to Architect may look like compensation.

See Allison.

iii. This isnt really co-ownership of property. See iv. But, is this really different from Problem 1(d)?
Getting to same result (25% of profits). Reg. 301.7701-1(a)(2).

v. Could go either way. 1. If partners want to be partners, should act

as partners (write up pship agreement, file pship tax return, etc.). 2. If partners d/n want to be partners: a. May make 761(a) election. b. But, investment or active trade or business? vi. Madison Gas & Electric Co. v. Commissioner. Three utility companies jointly constructed a nuclear power plant. Each was entitled to share of electricity, and sold to their own customers at their own rates. HELD: partnership for federal tax purposes. The partners were sharing profits, just as if they sold electricity at the entity level and split the profits. vii. Difficult to reconcile Allison and Madison Gas. f. (f) Fisher will purchase and operate a fishing boat. Lender will provide 10-year nonrecourse financing to Fisher. The arrangement will be evidenced by a note, secured by the boat, which will require repayment of the principal sum ratably over the 10-year period. In addition, Lender will receive 15% of Fishers net profits from the fishing operation each year of the arrangement. i. No separate entity. ii. Like Allison, the lenders being compensated (for the use of money). iii. Looks like lender-borrower relationship. iv. But, some lending relationships are classified as pships (e.g., if lender puts restrictions on business such that theres control and profit sharing). 6. Problem 2 (pp. 16-17). Did the Treasury have the authority to issue the check-the-box regulations? a. Categories of Regulations i. Legislative Regs. Congress delegates legislative power to the Secretary of the Treasury. Courts defer more to these regs. ii. Interpretive Regs. Regs where Congress hasnt delegated authority; the Treasury uses its inherent authority under 7805(a). b. Arg Against Check-the-Box Regs i. Regs should be consistent w/ statutory provision. The definitions of pship and corporation dont give an election. c. Arg For Check-the-Box Regs i. Well-advised clients could elect under the Kintner rules before anyway.

d. Littriello v. United States. T formed a single-member

LLC (disregarded entity) that ran a nursing home. LLC failed to pay federal withholding and FICA taxes and govt went after T. Govt arg: the LLC is disregarded for federal tax purposes. T arg: check-the-box regs are invalid. HELD: uphold the regs. iii. Publicly Traded Partnerships 1. Publicly Traded Partnership. A PTP is a pship where interests are traded on an established securities market or readily tradable on a secondary market. 7704(b). 2. Treated as a Corporation. A publicly traded partnership shall be treated as a corporation. 7704(a). a. Exception for Pships with Passive Income. If 90% of the pships income is certain passive income, it is treated as a pship. 7704(c). c. Trusts i. Trusts. A trust is an arrangement where a trustee takes title to property for the purpose of protecting or conserving it for the beneficiaries. Reg. 301.7701-4(a). 1. Subchapter J. Trusts are subject to subchapter J. Under this subchapter, trust income currently distributed to the recipient beneficiaries is taxed to the beneficiaries. If trust income is accumulated, it is taxed to the trust when earned but not taxed again when distributed. ii. Business Trusts. Business trusts are created to carry on a profitmaking business. A business trust is not classified as a trust, but a business entity under the check-the-box regs. As an unincorporated entity, it will be classified as a partnership if it has 2 members and does not elect to be a corporation. See Reg. 301.7701-4(b). d. Tax Policy Considerations i. Impact of the Check-the-Box Regulations 1. Taxpayers may now choose with greater simplicity and lower compliance costs whether they will pay tax under the corporate tax rules or partnership tax rules. 2. The choice between tax regimes is more broadly available for all businesses. 3. The check-the-box regulations may be more limiting than prior entity classifications for certain foreign entities that are per se corporations under Reg. 301.7701-2(b)(8). ii. Issues 1. Is the policy of many existing tax rules that depend on an entitys status violated by making that status elective? 2. Should the tax law continue to provide parallel, but differing, pass-through treatment for business entities that are partnerships and other entities, such as S corporations? III. Introduction to Choice of Business Entity a. Considerations on Choice of Entity. What best meets the clients goals? i. State Law. Attributes of particular business organization. ii. Federal Income Tax Treatment 1. Corp Subchapter C or S 2. LP, LLC Subchapter K is possible iii. Federal Employment Taxes 1. Partners all income subject to self-employment tax

2. LLC classified as pship, are all earnings subject to selfemployment tax? Not clear. iv. State Taxes. How do states tax entities (e.g., Texas Margin Tax)?

PART 2: FORMATION OF A PARTNERSHIP I. Contributions of Property a. General Rules i. Nonrecognition of Gain or Loss on Contribution. Gains/losses are not recognized to a partnership or a partner for a contribution of property to the partnership in exchange for an interest in the partnership. 721(a). 1. Rationale. The transfer of property to a pship is considered to be a mere change in the form of the partners investment. 2. Property. Property is broadly defined to embrace money, goodwill, and even intangible service-flavored assets such as A/R, patents, unpatented technical know-how and favorable loan or lease commitments embodied in a letter of intent secured through the efforts of the contributing partner. Property does not include services rendered to the pship. 3. 1245 Property. Generally, gains on the disposition of 1245 property must be recognized. 1245(a). But, if a partner exchanges 1245 property for a pship interest under 721, no gain is recognized. See 1245(b)(3). 4. Installment Obligations. Generally, gain/loss results from the sale of installment obligations. 453B(a). But, if a partner contributes property to a pship under 721, no gain or loss will result. Reg. 1.453-9(c)(2). 5. Exception: Investment Company. Subsection (a) does not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (an entity w/ > 80% readily marketable securities) if incorporated. 721(b). ii. Partners Outside Basis in a Partnership Interest. A partners outside basis in a pship interest is the amount of money and AB of property contributed, increased by any gain recognized under 721(b). 722. iii. Partners Holding Period in a Partnership Interest. Generally, the holding period begins the day after the partner contributes property to the pship. The period a partner held contributed property is tacked to the holding period of a pship interest if (1) the pship interest has the same basis as the property contributed and (2) the property exchanged was a capital asset or 1231 property. 1223(1). 1. Capital Asset. Capital asset means property, but does not include: stock in trade or inventory; depreciable or real property used in trade/business; A/R for services or from sale of inventory; and supplies used in trade/business. 1221(a). 2. 1231 Property. 1231 property means depreciable and real property used in a trade/business held more than 1 year. 1231(b)(1). 3. Divided Holding Period. The holding period is divided if the partner acquired portions of the pship interest in exchange for property resulting in different holding periods. Reg. 1.12233(a)(2). A holding period relates to the fraction: [FMV of portion of pship interest received] / [FMV of whole pship interest]. Reg. 1.1223-3(b)(1). See I.a.vi. Problem (pp. 36 37), infra. iv. Partnerships Inside Basis in Contributed Property. A partnerships inside basis in contributed property is the AB of such

property to the contributing partner at contribution, increased by any gain recognized under 721(b). 723. v. Partnerships Holding Period in Contributed Property. The period contributed property was held by the partner tacks on to the pships holding period if such property has the same basis in the pships hands as it would have in the partners. 1223(2). vi. Problem (pp. 3637). A, B, C and D (all individuals) form a general partnership in which they each have an equal interest in capital and profits. All the partners and the partnership are cash method taxpayers. In exchange for their respective partnership interests, each partner transfers the following assets, all of which have been held more than two years: Partner Asset Adjusted Fair Mkt. Basis Value A Land $30,000 $70,000 Goodwill 0 30,000 B Equipment (all 1245 gain) 25,000 45,000 Installment note from the sale of land 20,000 25,000 Inventory 5,000 30,000 C Building 25,000 60,000 Land 25,000 10,000 Receivables for services rendered to 0 30,000 E D Cash 100,000 100,000 1. (a) What are the tax consequences (consider only gain or loss realized and recognized, basis and holding period) to each of the partners? a. Gain/Loss Realized i. 1001: RG/RL = AR AB ii. Partner A 1. $100k AR (pship interest) $30k AB (aggregate) = $70k RG iii. Partner B 1. $100k AR (pship interest) $50k AB (aggregate) = $50k RG iv. Partner C 1. $90k AR (9/10 pship interest) $25k AB (basis of building and receivables) = $65k RG 2. $10k AR (1/10 pship interest) $25k AB (basis in land) = $15k RL v. Partner D 1. $100k AR (pship interest) $100k AB (face value basis in cash) = $0 b. Gain/Loss Recognized i. 1001(c): all gains recognized unless otherwise provided in the Code ii. 721(a): partner recognizes no gain/loss where she contributes property to pship in exchange for pship interest

iii. 1245(b)(3): no gain recognized on 1245 property if transferees basis = transferors basis b/c of 721 iv. Reg. 1.453-9(c)(2): no gain/loss results for disposition of installment obligation if 721 applies v. All partners recognize no gain/loss c. Outside Basis in Partnership Interest i. 722: basis in pship interest = cash + AB of property contributed, increased by 721(b) gain ii. Here, pship is not treated as an investment company iii. Partner As basis = $30k + 0 = $30k iv. Partner Bs basis = $25k + $20k + $5k = $50k v. Partner Cs basis = $25k + $25k + 0 = $50k vi. Partner Ds basis = $100k d. Holding Period in Partnership Interest i. 1223(1): tack period partner held property exchanged if pship interest received has same basis as property exchanged and property exchanged is a capital asset ( 1221) or 1231 property ii. Reg. 1.1223-3(a)(2): pship interest shall not have a divided holding period unless portions of pship interest exchanged for property resulting in different holding periods iii. Reg. 1.1223(b)(1): holding period relates to: FMV of portion of pship interest / FMV of whole pship interest iv. Partner A 1. Assuming Partner A is not a dealer in land (in which case the land would be inventory), the land is either a capital asset (held for investment) or 1231 property (if used in a trade or business). 2. Goodwill is a capital asset (doesnt fall under an exception to property in 1221). 3. Holding period in pship interest is more than two years. v. Partner B 1. 1231(b)(1): equipment is probably 1231 property 2. 1221: installment note is a capital asset, assuming Partner B is not a dealer in land ( 1221(a)(4)) 3. Inventory is not a capital asset or 1231 property 4. $70k (FMV portion of pship interest exchanged for equip + installment note) / $100k (FMV whole pship interest) = 70% a. 70% of pship interest has holding period of more than 2 years

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5. $30k (FMV portion of pship interest exchanged for inventory) / $100k (FMV whole pship interest) = 30% a. 30% of pship interest has holding period beginning day after contribution vi. Partner C 1. 1231(b)(1): building and land are probably 1231 property (assuming Partner Cs not a dealer in land) 2. Receivables for services isnt a capital asset ( 1221(a)(4)) or 1231 property 3. $70k (FMV portion of pship interest exchanged for building + land) / $100k (FMV whole pship interest) = 70% a. 70% of pship interest has holding period of more than 2 years 4. $30k (FMV portion of pship interest exchanged for receivables) / $100k (FMV whole pship interest) = 30% a. 30% of pship interest has holding period beginning day after contribution vii. Partner D 1. Holding period begins on day after cash contribution 2. (b) What are the tax consequences (consider only gain recognized, basis and holding period) to the partnership? a. Gain Recognized to Partnership i. 721(a): no gain/loss recognized to pship for contribution of property in exchange for pship interest b. Inside Basis in Partnership Property i. 723: basis of contributed property = AB to partner at contribution, increased by 721(b) gain ii. Here, pship is not treated as an investment company c. Holding Period in Partnership Property i. 1223(2): tack holding period of transferor if transferees basis = transferors ii. 723: inside basis = partners basis at contribution iii. Pship tacks the period held by partner 3. (c) Although each of the partners contributes property of equal value, D transfers only cash while the other partners transfer property. Section 704(c)(1)(A) requires the partnership to allocate the precontribution gain or loss solely to the contributing partner when the partnership subsequently disposes of the property. What is the objective of that section? See also 724. a. The objective of 704(c)(1)(A) is to disallow partners from assigning income to other partners and impose gains on the partner who held the asset when the gain accrued.

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vii. Proposed Regs on Noncompensatory Options to Acquire

Partnership Interests. Under the proposed regs, 721 does not apply to the transfer of property to a partnership in exchange for a noncompensatory option, but it does apply to the exercise of the option. Prop. Reg. 1.721-2(a) & (b). 1. Example. An individual transfers property w/ a basis of $600 and a FMV of $1k to a pship in exchange for an option to buy a 1/3 pship interest for $5k at any time during the next three years. On the transfer for the option, the individual recognizes $400 of gain. If the individual later exercises the option by transferring property w/ a basis of $3k and a $5k FMV to the pship for a pship interest, that transfer is protected by 721. b. Introduction to Partnership Accounting i. Historical Cost Convention. On the balance sheet, partnership assets are recorded at their book value. Book value will not change until some event occurs that warrants a revaluation of the partnerships assets. ii. Capital Account. Each partners interest in pship assets is reflected on the balance sheet by the partners capital account. The capital account represents a partners equity in the firm. It generally identifies what each partner would be entitled to receive upon liquidation of his or her interest in the pship. It is a mechanism for determining contributions and distributions, and how much gain/loss is allocated to each partner. iii. Maintaining Capital Accounts. A partners capital account is increased by her share of money and property (FMV) contributed to the pship, and also allocations to her of pship income and gain. It is decreased by, inter alia, the amount of money and property (FMV) distributed to her. Reg. 1.704-1(b)(2)(iv)(b), -1(b)(2)(iv)(d)(1). 1. Determining FMV. FMV of property will be regarded as correct if (1) such value is reasonably agreed to among the partners in arms length negotiations, and (2) the partners have sufficiently adverse interests. Reg. 1.704-1(b)(2)(iv)(h). iv. Tax Capital Accounts. Tax capital accounts provide information regarding the partners shares of the partnerships inside basis. We maintain tax capital accounts b/c tax/book disparities highlight and help keep track of 704(c) (gains on contributed property allocated to contributing partner) and reverse 704(c) (revaluation) allocation problems. v. Restating Partnership Assets. Partners may wish to readjust their capital accounts to reflect the current economic condition of the pship. The pship assets are reflected on the pships books at their current FMV and each partners capital account should be increased by her share of the unrealized postcontribution appreciation/depreciation. Reg. 1.704-1(b)(2)(iv)(f). 1. Non-Tax Business Purpose. The adjustment must be made principally for a substantial non-tax business purpose, like in connection with a contribution of money/property by a new partner as consideration for an interest in the pship. Reg. 1.704-1(b)(2)(iv)(f)(5). 2. Gains/Losses Attributable to Partners When Accrued. The pship agreement must require that partners shares of gain/loss take into account the variation btwn AB and book

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value in the same manner as 704(c). Reg. 1.704-1(b)(2)(iv) (f)(4). vi. Problem (pp. 43-44). A, B and C are equal general partners in the ABC Partnership. On formation of the partnership, A contributes $50,000 cash, B contributes land (Parcel #1) with a basis of $40,000 and a fair market value of $50,000, and C contributes securities with a basis and fair market value of $50,000. Prepare the partnerships opening balance sheet and then reconstruct the balance sheet to account for each of the following (cumulative) subsequent events: Assets Liabilities and Partners Capital Adjusted Book Tax Book Basis Value Capital Value Cash $50k $50k Liabilities: None Parcel #1 $40k $50k Capital: Securities $50k $50k A $50k $50k B $40k $50k C $50k $50k $140k $150k $140k $150k 1. (a) The partnership leases Parcel #1 for $15,000 and sells the securities for $50,000. a. Lease Land i. Reg. 1.704-1(b)(2)(iv)(b): increase book capital account by allocations of pship income ii. Distribute $5k ($15k/3) to each partner. iii. Tax capital accounts also increased (by analogy to Regs on book capital accounts) b. Sell Securities i. Convert $50k securities to $50k cash. Assets Adjust ed Basis $115k Book Value $115k Liabilities and Partners Capital Tax Book Capita Value l Liabiliti es: Non e Capital: A B C

Cash

Parcel #1

$40k

$50k

$55k $55k $45k $55k $55k $55k $155k $165k $155k $165k 2. (b) The partnership borrows $300,000 and then buys more land (Parcel #2) for $330,000. a. Borrow $300k i. Increase liabilities by $300k (book and tax) ii. Increase cash by $300k b. Buy Parcel #2 for $330k i. Decrease cash by $330k

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ii. Increase land (Parcel #2) by $330k. See Crane v.

Commissioner (when T acquires land subject to debt, include the unpaid principal balance in AB). Assets Liabilities and Partners Capital Adjust Book Tax Book ed Value Capita Value Basis l Cash $85k $85k Liabiliti $300k $300k es: Parcel $40k $50k Capital: #1 Parcel $330k $330k A $55k $55k #2 B $45k $55k C $55k $55k $455k $465k $155k $165k 3. (c) The partnership distributes $20,000 each to A, B and C. a. Decrease cash by $60k b. Reg. 1.704-1(b)(2)(iv)(b): decrease capital account by amount of money distributed to partner by pship i. Decrease capital accounts by $20k Assets Liabilities and Partners Capital Adjust Book Tax Book ed Value Capita Value Basis l Cash $25k $25k Liabiliti $300k $300k es: Parcel $40k $50k Capital: #1 Parcel $330k $330k A $35k $35k #2 B $25k $35k C $35k $35k $395k $405k $395k $405k 4. (d) The partnership sells Parcel #1 for $65,000. a. Book Gain i. $65k AR $50k AB = $15k RG ii. Reg. 1.704(b)(2)(iv)(b): increase capital account by allocations to him of pship income and gain iii. $15k gain distributed to partners ($5k each) b. Tax Gain i. $65k AR $40k AB = $25k RG ii. 704(c)(1)(A): precontribution gain must be allocated to the contributing partner when pship sells the parcel 1. The first $10k of the RG is allocated to Bs tax capital account (b/c he contributed it) iii. Remaining $15k is distributed equally ($5k each)

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Assets Adjust ed Basis $90k $330k Book Value $90k $330k

Cash Parcel #2

Liabilities and Partners Capital Tax Book Capita Value l Liabiliti $300k $300k es: Capital: A B C

$40k $40k $40k $40k $40k $40k $420k $420k $420k $420k 5. (e) When Parcel #2 has a value of $420,000, the assets and capital accounts are restated to current value, and new partner D contributes $70,000 cash to the partnership in exchange for a 25% general partnership interest. a. Restate Pship Assets i. Reg. 1.704-1(b)(2)(iv)(f)(5)(i): revaluation must be made for a substantial non-tax business purpose, which may be in connection of money/property to the pship by a new/existing partner as consideration for an interest in the pship ii. Reg. 1.704-1(b)(2)(iv)(f): capital accounts increased by their share of unrealized postcontribution appreciation iii. $420k $330k = $90k / 3 = $30k each b. New Partner D Contributes $70k for a 25% Pship Interest i. Increase cash by $70k ii. Reg. 1.704(b)(2)(iv)(b): increase tax capital account by amount of cash/property contributed iii. Tax capital account = $70k Assets Liabilities and Partners Capital Adjust Book Tax Book ed Value Capita Value Basis l Cash $160k $160k Liabiliti $300k $300k es: Parcel $330k $420k Capital: #2 A $40k $70k B $40k $70k C $40k $70k D $70k $70k $490k $580k $490k $580k 6. Suppose the pship sells Parcel #2 for $420k and pays off the loan. a. Book gain = 0 ($420k $420k) b. Tax gain = $420k AR $330k AB = $90k RG

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i. Reg. 1.704-1(b)(2)(iv)(f)(4): gain/loss must take into account the variation btwn AB and book value in the same manner as 704(c). ii. Allocate the $90k RG to A, B and C b/c they were partners when the gain accrued. c. Pay Off the Loan: decrease cash, get rid of the liability

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Assets Adjust ed Basis $280k Book Value $280k

Cash

$280k $280k II. Treatment of Liabilities: The Basics a. Impact of Liabilities on Partners Outside Basis i. Outside Basis Formula. Partners tax basis in pship interest = [initial basis in pship interest] + [increase (decrease) in liabilities]. ii. Increased Share of Pship Liability: Treated as Contribution. Any increase in a partners share of pship liabilities, or any increase in a partners individual liabilities b/c she assumed pship liabilities will be treated as a contribution of money by such partner to the pship. 752(a). 1. Contributions Increase Capital Account. A partners outside basis shall be the amount of money and AB of property contributed. See 722. iii. Recourse vs. Nonrecourse Liability 1. Recourse Liability Defined. A pship liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability. See Reg. 1.752-1(a)(1). 2. Nonrecourse Liability Defined. A pship liability is a nonrecourse liability to the extent that no partner bears the economic risk of loss for that liability. See Reg. 1.752-1(a)(2). iv. Partners Share of Nonrecourse Liability. A partners share of a pships nonrecourse liability is determined in accordance w/ the partners share of pship profits. Reg. 1.752-3(a). v. Partners Share of Recourse Liability. A partners share of recourse liability equals the portion of that liability, if any, for which the partner bears the economic risk of loss. Reg. 1.752-2(a). vi. Problem (p. 46). A, B, C, and D each contribute $25,000 to the ABCD partnership, which then acquires a $1,000,000 building, paying $100,000 cash and borrowing $900,000 on a nonrecourse basis. Assets Liabilities and Partners Capital Adjusted Book Tax Book Basis Value Capital Value Cash $0 $0 Liabilities: $900k $900k Building $1M $1M Capital: A $25k $25k B $25k $25k C $25k $25k D $25k $25k $1M $1M $1M $1M

Liabilities and Partners Capital Tax Book Capita Value l Liabiliti es: Capital: A $70k $70k B $70k $70k C $70k $70k D $70k $70k $280k $280k

17

1. (a) If the parties are equal general partners, what is each

partners outside basis? a. 752, 722: any increase in partners share of liability increases outside basis b. Reg. 1.752-1(a)(2): liability is nonrecourse if no partner bears economic risk of loss i. Assume nonrecourse in problem means that lender restricted recovery to pship assets c. Reg. 1.752-3(a): partners share of pships nonrecourse liability is based on the partners share of pship profits d. Since the partners share profits equally, each partners outside basis = $250k ($25k + $900k/4) 2. (b) What result if the partnership is a limited partnership, A is the sole general partner and all the partners share profits and losses equally? a. Result is the same as part (a) b/c (despite the different structure), profits are still shared equally. 3. (c) What result in (b), above, if the partnership were personally liable for the debt? a. Reg. 1.752-1(a)(1): liability is recourse if any partner bears economic risk of loss i. This debt is recourse b/c the general partner would bear the economic risk of loss of the liability b. Reg. 1.752-2(a): partners share of recourse liability equals the portion of that liability for which the partner bears the economic risk of loss. i. Here, A, as a general partner, bears all the economic risk of loss according to state law. B, C and D, as limited partners, arent affected. c. As outside basis = $925k ($25k initial outside basis + $900k increase in liability) b. Contributions of Encumbered Property i. Contributing Partner 1. Original Outside Basis. Outside basis = cash + AB of property contributed. 722. 2. Debt Relief Decreases Basis a. Pship Assumes Debt. If contributed property is subject to debt, the partnership is treated as having assumed the debt to the extent the debt propertys FMV. Reg. 1.752-1(e). b. Decrease in Liability Treated as Distribution. A decrease in a partners individual liability is treated as a cash distribution from the pship to the partner. 752(b). c. Distributions Decrease Basis. Outside basis is decreased (but not below zero) by cash/property distributions by the pship. 705(a)(2), 733. 3. Increased Share of Pship Liability Increases Basis a. Increased Share of Pship Liability Treated as Contribution. An increase in a partners share of pship liability is treated as a cash contribution by the partner to the pship. 752(a).

18

i. Share of Recourse Liability. A partners share

of recourse pship liability is the portion that partner bears the economic risk of loss. Reg. 1.752-2(a) ii. Nonrecourse. A partners share of NR liability is determined by the partners share of pship profits. Reg. 1.752-3(a)(3). b. Contributions Increase Basis. Outside basis is the amount of money and AB of property contributed. 722. 4. Netting Increases/Decreases. If partner incurs both an increase and decrease in liabilities, only the net increase (decrease) is treated as a contribution (distribution). Reg. 1.752-1(f). 5. Recourse Liability in Excess of Basis. When a partner contributes property subject to recourse liability in excess of his outside basis, the net decrease in liabilities (treated as distribution) will exceed his outside basis. Since distributions decrease basis, this would result in a negative basis. Section 731 recognizes the excess distribution as gain. a. Distributions in Excess of Basis are Recognized as Gain. Distributions are not recognized as gains, except to the extent that money distributed exceeds outside basis. 731(a). b. Capital Gain. Any gain recognized under 731(a) is considered a gain from the sale/exchange of the partners pship interest. 731(a) (flush language). Pship interest is probably capital asset under 741. c. Avoid Result by Remaining Personally Liable. Suppose partner contributes property subject to recourse debt and remains personally liable to the creditor. Under 1.752-1(e), the pship is treated as assuming the liability, resulting in a decrease of individual liabilities. But, the partners share of pship liability increases by the same amount b/c only that partner bears the economic risk of loss. The net result is that the partners outside basis is the AB of the contributed property. 6. Nonrecourse Liability in Excess of Basis. When a partner contributes property subject to nonrecourse liability in excess of his outside basis, the pship will take the property at the partners basis. 723. When the pship sells the property, the AR will be at least the amount of the debt. See Commissioner v. Tufts. This gain should be allocated to the contributing partner. 704(c)(1)(A). Liability is allocated accordingly. a. Liability Allocated to Contributing Partner. A partners share of pship liability includes gain that would be allocated under 704(c) if the pship disposed of all pship property subject to NR pship liability in full satisfaction of the liability and for no other consideration. Reg. 1.752-3(a)(2). b. Remaining Liability Allocated by Share of Profits. After the allocation above, the partners share of pship liabilities is determined by the partners share of pship profits. Reg. 1.752-3(a)(3).

19

ii. Other Partners 1. Original Outside Basis. Outside basis = cash + AB of property contributed. 722. 2. Increased Share of Pship Liability Increases Basis a. Increased Share of Pship Liability Treated as Contribution. An increase in a partners share of pship liability is treated as a cash contribution by the partner to the pship. 752(a). i. Share of Recourse Liability. A partners share of recourse pship liability is the portion that partner bears the economic risk of loss. Reg. 1.752-2(a) ii. Nonrecourse. After allocation (if any) for contributed property subject to NR debt in excess of the contributing partners outside basis, a partners share of NR liability is determined by the partners share of pship profits. Reg. 1.752-2(a)(3). See Reg. 1.752-2(a)(2). b. Contributions Increase Basis. Outside basis is the amount of money and AB of property contributed. 722. iii. Accounts Payable 1. Not Liability. Accounts payable are not considered pship liabilities for purposes of 752. Rev. Rul. 88-77. That is, they do not count for increases (decreases) in individual or a partners share of pship liability and will not be treated as contributions (distributions). 2. Allocate Deductions. When the accounts payable are paid, allocate the deduction to the contributor/assignor. See 704(c) (1), (3). iv. Accounts Receivable: Allocate Income. When accounts receivable are contributed, income inherent in the A/R must be taxed to the contributing partner. See 704(c)(1), (3). v. Problem 1 (pp. 50-51). A and B each contribute $30,000 cash to the ABC partnership and C contributes land held for more than one year, worth $60,000 and subject to a recourse debt of $30,000. A, B and C are all general partners with a one-third interest in the profits and losses of ABC. 1. Review a. Gain Realized i. A and B: no gain realized 1. $30k AR (pship interest) 2. $30k AB (AB of cash is face value) ii. C: $20k gain realized 1. $60k AR = $30k pship interest + $30k debt relief 2. $40k AB in land b. Gain Recognized by Partners and Pship: none ( 721) c. Holding Period i. A and B: begins on day after contribution ii. C: tack on period land was held ( 1223(1): land is either capital asset or 1231 property) iii. Pship holding period for the land includes period C held it ( 1223(2))

20

2. (a) What are the tax consequences to A, B, C and ABC if the land has a basis to C of $40,000 and the partnership assumes the debt? Assets Liabilities and Partners Capital Adjuste Book Tax Book d Basis Value Capital Value Cash $60k $60k Liabilitie $30k $30k s: Building $40k $60k Capital: A $30k $30k B $30k $30k C $10k* $30k** $100k $120k $100k $120k *$40k AB $30k liability **$60k FMV $30k liability a. Assume the terms recourse and nonrecourse in the problem mean recourse and nonrecourse according to the definitions in the Regs. b. A and B i. Outside Basis = original outside basis + increase (decrease) in liabilities ii. Original Basis = $30k 1. 722: outside basis = cash + AB of property contributed 2. Contributed $30k cash iii. Increase in Liabilities = $10 1. 752(a): increase in partners share of liabilities treated as cash contribution 2. 722: outside basis = money + AB of property contributed 3. Reg. 1.752-2(a): partners share of liability is portion that partner bears the economic risk of loss 4. $30k debt/3 partners = $10k iv. Outside Basis = $40 c. C i. Original Basis = $40k 1. 722: outside basis = cash + AB of property contributed 2. Contributed property w/ AB of $40k ii. Debt relief: $30k 1. Reg. 1.752-1(e): when property subject to debt is contributed, pship is treated as having assumed the debt (if FMV) 2. 752(b): decrease in partners liability treated as cash distribution to partner 3. 705(a), 733: outside basis reduced by distributions 4. Decrease outside basis by $30k iii. Increase in Liabilities = $10 1. Same analysis as A and B iv. Net Decrease = $20k

21

1. Reg. 1.752-1(f): net the increases and decreases in liabilities resulting from the same transaction 2. 752(b): decrease in partners liability treated as cash distribution to partner 3. 705(a), 733: outside basis reduced by distributions v. Outside basis = $40k $20k = $20k 3. (b) Same as (a), above, except that the land has a basis to C of $10,000. What could C do to avoid this result? a. C realizes $50k RG ($60k AR $10k AB), but not recognized b. 723: pship inside basis in land: $10k (same as contributing partners) Assets Liabilities and Partners Capital Adjust Book Tax Book ed Value Capita Value Basis l Cash $60k $60k Liabiliti $30k $30k es: Buildin $10k $60k Capital: g A $30k $30k B $30k $30k C ($20k) $30k $70k $120k $70k $120k c. A and B i. Same analysis as part (a) d. C i. Original Basis = $10k 1. 722: outside basis = cash + AB of property contributed 2. Contributed property w/ AB of $10k ii. Debt relief: $30k 1. Reg. 1.752-1(e): when property subject to debt is contributed, pship is treated as having assumed the debt (if FMV) 2. 752(b): decrease in partners liability treated as cash distribution to partner 3. 705(a), 733: outside basis reduced by distributions 4. Decrease outside basis by $30k iii. Increase in Liabilities = $10 1. Same analysis as A and B iv. Net Decrease = $20k 1. Reg. 1.752-1(f): net the increases and decreases in liabilities resulting from the same transaction v. $10k original basis $20k = $10k!!! vi. Outside basis = 0 1. 705(a), 733: distributions decrease outside basis (but not below zero) vii. C realizes $10k gain

22

1. 731(a): gain/loss recognized to the extent distributions exceed outside basis 2. $20k distributions exceed $10 outside basis by $10k viii. $10k gain is likely a capital gain 1. 731(a) (flush language): any gain/loss under this subsection is treated as gain/loss from sale/exchange of pship interest 2. Pship interest probably capital asset under 741 e. How to avoid this result? i. Dont let pship expressly assume the debt. See Reg. 1.752-1(g), Ex. 1. ii. Contribute another $10k cash iii. Pay capital expenditures to increase propertys AB iv. If Partner C contributed a $10k promissory note, it would have no effect on outside basis b/c the partner has a zero basis in the note f. Difference Between Outside and Inside Basis Leads to Double Taxation i. Aggregate Outside Basis = $80k 1. A and B = $40k each; C = 0 ii. Aggregate Inside Basis = $70k (see table) iii. If pship sold the land: $60k AR $10k AB = $50k RG iv. 704(c)(1)(A): $50k precontribution gain allocated to C v. But, C already paid tax on $10k gain vi. Note: pship can adjust basis of land if it makes a 754 election 4. (c) Same as (a), above, except that the debt is nonrecourse, and the partners agree that for purposes of allocating nonrecourse liabilities they each have a one-third interest in profits.

23

Assets Adjust ed Basis $60k $40k Book Value $60k $60k

Cash Buildin g

Liabilities and Partners Capital Tax Book Capita Value l Liabiliti $30k $30k es: Capital: A B C $30k $30k $10k $100k $30k $30k $30k $120k

$100k $120k a. A and B i. Outside Basis = original outside basis + increase (decrease) in liabilities ii. Original Basis = $30k 1. 722: outside basis = cash + AB of property contributed 2. Contributed $30k cash iii. Increase in Liabilities = $10 1. 752(a): increase in partners share of liabilities treated as cash contribution 2. 722: outside basis = money + AB of property contributed 3. Reg. 1.752-2(a)(3): partners share of NR liability is determined by partners share of pship profits 4. $30k debt/3 partners (equal profits) = $10k iv. Outside Basis = $40 b. C i. Original Basis = $40k 1. 722: outside basis = cash + AB of property contributed 2. Contributed property w/ AB of $40k ii. Debt relief: $30k 1. Reg. 1.752-1(e): when property subject to debt is contributed, pship is treated as having assumed the debt (if FMV) 2. 752(b): decrease in partners liability treated as cash distribution to partner 3. 705(a), 733: outside basis reduced by distributions 4. Decrease outside basis by $30k iii. Increase in Liabilities = $10 1. Same analysis as A and B iv. Net Decrease = $20k 1. Reg. 1.752-1(f): net the increases and decreases in liabilities resulting from the same transaction 2. 752(b): decrease in partners liability treated as cash distribution to partner

24

3. 705(a), 733: outside basis reduced by distributions v. Outside basis = $20k = $40k $20k 5. (d) Same as (b), above, except that the debt is nonrecourse and the partners agree that for purposes of allocating nonrecourse liabilities they each have a one-third interest in profits. Assets Liabilities and Partners Capital Adjust Book Tax Book ed Value Capita Value Basis l Cash $60k $60k Liabiliti $30k $30k es: Buildin $10k $60k Capital: g A $30k $30k B $30k $30k C $20k $30k $70k $120k $70k $120k a. C i. Original Basis = $10k 1. 722: outside basis = cash + AB of property contributed 2. Contributed property w/ AB of $10k ii. Debt relief: $30k 1. Reg. 1.752-1(e): when property subject to debt is contributed, pship is treated as havng assumed the debt (if FMV) 2. 752(b): decrease in partners liability treated as cash distribution to partner 3. 705(a), 733: outside basis reduced by distributions 4. Decrease outside basis by $30k iii. Liability Allocated to C: $20k 1. Reg. 1.752-3(a)(2): partner who contributes property encumbered by NR debt is first allocated that portion of the liability equaling the gain that would be allocated to that partner under 704(c) if the property were sold at the time of the contribution for an amount equal to the liability 2. $30k AR (Tufts) $10k AB = $20k RG 3. $20k liability allocated to C 4. 752(a): increase in partners share of liabilities treated as cash contribution 5. 722: outside basis = money + AB of property contributed 6. Increase outside basis by $20k iv. Increased liability: $3,333 1. Reg. 1.752-3(a)(3): liability remaining after reallocation under -3(a)(2) allocated according to partners share of pship profits

25

2. 752(a): increase in partners share of liabilities treated as cash contribution 3. 722: outside basis = money + AB of property contributed 4. $30k liability $20k allocation = $10k remaining 5. $10k liability /3 = $3,333 6. Increase outside basis by $3,333 v. Net Decrease = $6,667 1. Reg. 1.752-1(f): net the increases and decreases in liabilities resulting from the same transaction 2. 752(b): decrease in partners liability treated as cash distribution to partner 3. 705(a), 733: outside basis reduced by distributions 4. $30k + $20k + $3,333 = $6,667 vi. Outside basis = $10k $6,667 = $3,333 b. A and B i. Original Basis = $30k 1. 722: outside basis = cash + AB of property contributed 2. Contributed $30k cash ii. Increased liability: $3,333 1. Reg. 1.752-3(a)(3): liability remaining after reallocation under -3(a)(2) allocated according to partners share of pship profits 2. 752(a): increase in partners share of liabilities treated as cash contribution 3. 722: outside basis = money + AB of property contributed 4. $30k liability $20k allocation = $10k remaining 5. $10k liability /3 = $3,333 6. Increase outside basis by $3,333 iii. Outside basis = $33,333 vi. Problem 2 (p. 51). Attorney, a cash method unincorporated sole practitioner, joins a cash method partnership of three other attorneys all of whom own an equal one-quarter interest in the partnership after Attorney joins the firm. Attorney transfers some accounts receivable for services with a zero basis and a $20,000 face value to the partnership as part of her contribution in exchange for her partnership interest. The partnership also assumes $6,000 of Attorneys accounts payable. What are the tax consequences of the transaction to attorney? See 704(c)(3). 1. Gain/loss realized: $20k AR $0 = $20k 2. 721: no gain/loss recognized 3. 722: initial outside basis = $0 (AB of property contributed) 4. Rev. Rul. 88-77: accounts payable of a cash method pship are not treated as a liability for purposes of 752 5. When pship gets $20k income, the gain will be allocated to Attorney ( 704) 6. When the pship pays the accounts payable, deductions will be allocated to Attorney

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III. Contributions of Services a. Introduction i. Capital Interest and Profit Interest. A partner providing services might receive either a capital interest or a profits interest. 1. Capital Interest. A capital interest is an interest that would give the holder a share of the proceeds if the pship assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the pship. Rev. Proc. 93-27, 2.01. 2. Profits Interest. A profits interest is a partnership interest other than a capital interest. Rev. Proc. 93-27, 2.01. ii. Example. A contributes $1k for a pship interest and B rendered past services to A in exchange for a pship interest. If B has a claim on part of that $1k, he has a capital (rather than profits) interest. b. Receipt of Capital Interest for Services i. Formation of a New Partnership 1. A Contributes Cash and B Contributes Past Services. Suppose A and B want to form a pship, where A contributes $1k and B contributed past services to A.

Cash

Assets Adjuste d Basis $1k

Book Value $1k

$1k

$1k

Liab. and Partners Capital Tax Book Capital Value Liab. 0 0 Capital: A $500 $500 B $500 $500 $1k $1k

27

2. Step One. A is treated as transferring cash to B (Service

Provider). a. B (Service Provider): GI. Partner B has GI (compensation). See 61. b. A: Potential Deduction. Partner A takes a deduction if the services B provided were part of his trade or business or a profit-making activity of A. 212. A takes no deduction if Bs activities were personal. 3. Step Two. A and B are treated as contributing $500 to the pship. a. Nonrecognition. Neither the partners nor the pship recognize gain. 721(a). b. Outside Basis. The partners have a $500 basis in their pship interests. ii. A Contributes Land and B Contributes Past Services. Suppose A contributes land with a FMV of $1k and an AB of $600, and B contributes past services to A in the formation of a pship.

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Liab. and Partners Capital Tax Book Capital Value Cash Liab. 0 0 Capital: A $300 $500 B $500 $500 $800 $1k $800 $1k 1. Step One. A is treated as transferring a interest in the land to B in compensation for Bs services. a. B: GI i. Amount of Income. Service Provider has GI in the amount of FMV of property less any amount paid. See 83(a). ii. Timing of Income. Service Provider has income in the taxable year where her rights are transferable or not subject to a substantial risk of forfeiture. See 83(a). iii. Basis in Land. Service Provider takes a tax cost basis in the land equal to its FMV. See Reg. 1.61-2(d). b. A: Deduction, GI i. Potential Deduction. Partner A takes a deduction (if the expense is deductible under 162 or 212) in the year where Service Provider has GI. See 83(h), Reg. 1.83-6(a). ii. Realization Event. A recognizes gain to the extent Partner A receives an amount that exceeds the Partner As basis in the property. See Reg. 1.83-6(b). 2. Step Two. A and B are treated as contributing a interest in land for a pship interest. a. Nonrecognition. Neither partners nor pship recognize gain/loss. 721(a). b. Outside Basis. Partners outside basis is the AB of property contributed. See 722. Book Value $1k

Assets Adjuste d Basis $800

29

c. Inside Basis. Pship takes the basis of the contributing

partners. See 723. iii. Adding Partners to Existing Partnership 1. Analogy to Formation of New Partnership a. Step One. Pship treated as transferring a portion of pship property to New Partner. i. New Partner: GI. New Partner has GI in the amount of FMV of property. 83(a). New Partners tax cost basis in the property is the amount included in GI. ii. Partnership 1. Realization Event. Pship has realized gain in the amount the presumed value of services exceeds the AB in property transferred. 2. Possible Deduction. Pship takes deduction equal to New Partners GI (if deductible its a deductible expense). b. Step Two. New Partner treated as transferring the portion of pship property to pship. i. Outside Basis. New Partners basis in pship is equal to AB property contributed. See 722. ii. Inside Basis. Pships takes New Partners basis in pship property contributed. See 723. 2. Proposed Regulations a. Partnership Interest = Property. A partnership interest is property within the meaning of 83. Prop. Reg. 1.83-3(e). b. Applicability of 83. The transfer of a partnership interest to a person in connection with the performance of services constitutes a transfer of property to which section 83 and the regulations thereunder apply. Prop. Reg. 1.721-1(b)(1). c. Service Providers GI. The service provider must include in GI the FMV of the property (pship interest) transferred, less whatever the service provider paid for it. 83(a). i. Value of Pship Interest: Safe Harbor. The pship can elect a safe harbor under which the FMV of the pship interest transferred is treated as equal to the liquidation value of that interest. Prop. Reg. 1.83-3(l)(1). 1. Liquidation Value. Liquidation value is the amount of cash that the holder of that interest would receive with respect to the interest if, immediately after the transfer of the interest, the partnership sold all of its assets [including goodwill and other intangibles] for cash equal to the fair market value of those assets, and then liquidated. Preamble to Prop. Regs. d. Partnerships Nonrecognition. Generally, no gain or loss shall be recognized by a partnership upon (i) [t]he transfer or substantial vesting of a compensatory

30

partnership interest; or (ii) [t]he forfeiture of a compensatory partnership interest. Prop. Reg. 1.7211(b)(2). i. Compensatory Partnership Interest. A compensatory partnership interest is an interest in the transferring partnership that is transferred in connection with the performance of services for that partnership, including an interest that is transferred on the exercise of a compensatory partnership option. Prop. Reg. 1.721-1(b)(3). e. Partnerships Deduction. The transfer is treated as a guaranteed payment for services. Prop. Reg. 1.7211(b)(4)(i). Therefore, the pship can deduct the pmt under 707(c) if it is a deductible pmt (e.g., under 162). i. Timing. The timing of the pships deduction (and the service partners GI) is determined under the rules of 83, including 83(h). Prop. Reg. 1.707-1(c). ii. Amount. The amount of the pships deduction includes the amount the service provider must include in GI. 83(h). f. Section 83(b) Election i. The Election. Service provider may elect to include the FMV of property received at the time of transfer less any amount paid for the property. If this election is made, there is no requirement that the property be transferrable and not subject to a subst. risk of forfeiture. If the property is forfeited, no deduction is allowed. 83(b). ii. Treatment as a Partner. If Service Provider does not make the 83(b) election, then the service provider is not treated as a partner during the period that the partnership interest is not vested. If she does make the 83(b) election, then she is treated as a partner immediately upon the partnerships transfer of the interest. Prop. Reg. 1.761-1. iv. Problem (pp. 59-60). C is offered a capital interest in a partnership whose sole asset is a commercial building with a fair market value of $150,000 and an adjusted basis of $90,000. The building has been depreciated on the straight line method. A and B have $45,000 outside bases in their respective partnership interests. C has performed real estate management services for the partnership over the past year and has agreed to perform additional services in the future. Assets Liabilities and Partners Capital Adjuste Book Tax Book d Basis Value Capital Capital Building $90k $150k Liabilitie none s Capital: A $45k $75k

31

B $45k $75k $90k $150k $90k $150k 1. (a) What are the tax consequences to C and to the partnership (i.e., A and B) if in year one C receives a one-tenth capital interest in the partnership as compensation for his management services over the past year?

a. 83(a): C has $15k GI immediately (b/c the pship interest is transferable and not subject to substantial risk of forfeiture) b. C takes a tax-cost basis of $15k (the amount included in GI) c. Prop. Reg. 1.721-1(b)(4)(i): pship takes a deduction i. 83(h): the deduction = amount C included in GI ii. Prop. Reg. 1.83-3(l)(1): liquidation value = $15k ($150k building * 1/10 interest) d. 706(d): deduction allocated to Partners A and B e. 705: deduction decreases basis by $7,500 i. A and Bs Basis = $45k AB $7,500 = $37,500 Assets Liab. and Partners Capital Adjust Book Tax Book ed Value Capita Capita Basis l l Buildin $90k $150k Liab. none g Captial: A $37.5k $67.5k B $37.5k $67.5k C $15k $15k $90k $150k $90k $150k 2. (c) What result in (a), above, if, C receives his interest as compensation for services to be rendered in the succeeding three years provided, however, that if C ceases to render services before the end of year three, C or any transferee of C must relinquish his interest in the partnership. Assume for this

32

problem that the building will have a value of $450,000 and an adjusted basis of $90,000 at the end of year three.

a. Year of Initial Pship Interest Transfer i. 83(a): subject to substantial risk of forfeiture 1. 83(c)(1): subject to subst. risk of forfeiture 2. 83(c)(2): not transferable 3. Thus, C has no GI in current year ii. 83(h): pship has no GI 1. C hasnt realized GI 2. Not realizable event b. Three Years Later i. C has $45k GI (FMV of interest transferred) 1. (Liquidation if pship makes election) ii. Cs outside basis = $45k (tax cost basis) iii. Prop. Reg. 1.721-1(b)(2): pship d/n recognize any gain on this transfer of pship interest c. Gets $45k deduction i. A and B decrease basis by $22,500 d. A and Bs Basis i. Original basis = $75k ii. Increase by $300k ($150 each) for revaluation of building iii. Decrease by $22,500 b/c of deduction iv. $75k + $150k $22,500 = $202,500 Assets Liab. and Partners Capital Adjust Book Tax Book ed Value Capita Capita Basis l l Buildin $90k $450k Liab. none g Captial: A $22.5k $202.5 k

33

$202.5 k C $45k $45k $90k $450k $90k $450k e. Partner C should have elected under 83(b) in Year 1 i. C would have had $15k GI ii. C would have had $15k outside basis iii. If C sold her interest later for $45k, the $30k gain would be a capital gain c. Receipt of a Profits Interest for Services i. Current Law 1. Historical Background a. Negative Implication. Reg. 1.721-1(b) provides that the receipt of a capital interest by a partner is a taxable event. Courts made the negative implication that the receipt of a profits interest was not taxable. b. Diamond v. Commissioner. Kargman entered into a K to purchase an office building. Diamond agreed to arrange a mortgage loan to acquire the building; in exchange she was entitled to 60% of profits/losses. Diamond sold the pship interest to a 3d party, trying to recognize a short-term gain. HELD: the receipt of a profits interest is a taxable event. The profits interest here was easily valued and were exchanged for past services. i. Double Taxation. This causes the holder of a profits interest to be taxed on receipt of the interest and then taxed again when the income is actually earned. 2. Revenue Procedure 93-27 a. General Rule. If a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will not treat the receipt of such an interest as a taxable event for the partner or the partnership. Rev. Proc. 93-27 4.01. b. Exceptions. This revenue procedure does not apply: i. (1) If the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from highquality debt securities or a high-quality net lease; ii. (2) If within two years of receipt, the partner disposes of the profits interest; or iii. (3) If the profits interest is a limited partnership interest in a publicly traded partnership within the meaning of section 7704(b) of the I.R.C. Rev. Proc. 93-27 4.02. 3. Revenue Procedure 2001-43 a. Requirements i. Treat Service Provider as Owner. The partnership and the service provider must treat the service provider as the owner of the interest from the date of its grant, and the service provider must take into account the distributive

$22.5k

34

share of all items associated with the interest for the entire period during which the service provider has the interest. ii. No Deduction. Neither the partnership nor any partner may deduct any amount for the FMV of the interest either upon the grant of the interest or when it becomes substantially vested iii. Rev. Proc. 93-27 Satisfied. All the other requirements of Rev. Proc. 93-27 must be satisfied. b. Effect i. Determination of Profits Interest. The determination of whether an interest granted to a service provider is a profits interest is tested at the tiem the interest is granted, even if that interest is not substantially vested under 83. ii. Non-Taxable Events. The IRS will not treat the grant of a nontaxable profits interest, or the event that causes the interest to be substantially vested under 83, as a taxable event. iii. Section 83(b) Election Not Needed. Thus, a 83(b) election would not be needed if such a partnership interest were not substantially vested at the time it was granted. 4. Problem 1 (p. 73). The AB partnership is a law firm. C, an associate in the firm, is offered a one-third partnership interest in the future profits of the partnership. C is not required to make any capital contribution. Is C taxable upon his admission to the partnership? a. C is probably not taxable under Rev. Proc. 93-27 4.01. Hes providing services in anticipation of being a partner. He doesnt meet the exceptions as long as he doesnt transfer his interest w/in 2 yrs. 5. Problem 2 (p. 74). C, an experienced real estate manager, receives a nonforfeitable one-tenth profits interest in the AB general partnership, whose sole asset is a commercial building with a value of $1,000,000 in return for his agreement to render management services in his capacity as a partner. Net rentals from the building recently have been averaging $100,000 per year. C has been asked to manage the building in the hope that his expertise will increase the rental income and ultimately lead to a profitable sale of the property. a. (a) What are the tax consequences to C upon receipt of the profits interest? i. C may be taxed 1. The steady net rentals may be a substantially certain and predictable stream of income under Rev. Proc. 93-27 4.02(1). 2. C would then have GI under 83 in the amount of the FMV of property (less what he paid0) 3. Pship would have a deduction ii. Arg that C is not taxed

35

1. Net rentals depend on the level of services (not predictable stream of income) 2. High-quality debt securities and highquality net leases provide passive income. b. (e) What result to C and to the partnership in (a), above, if Cs profits interest was subject to forfeiture until C rendered services for the partnership for a period of five years? i. Rev. Proc. 2001-43: Rev. Proc. 93-27 still applies (C not taxed) ii. Proposed Regulations 1. Supersede Current Law. The treasury issued proposed regulations addressing a partners receipt of a partnership interest (both capital and profits interests) for services. When these regulations become final, they will supersede Rev. Proc. 93-27 and Rev. Proc. 2001-43. 2. Problem 2 (p. 74). C, an experienced real estate manager, receives a nonforfeitable one-tenth profits interest in the AB general partnership, whose sole asset is a commercial building with a value of $1,000,000 in return for his agreement to render management services in his capacity as a partner. Net rentals from the building recently have been averaging $100,000 per year. C has been asked to manage the building in the hope that his expertise will increase the rental income and ultimately lead to a profitable sale of the property. a. (a) What are the tax consequences to C upon receipt of the profits interest? i. Prop. Reg. 1.721-1(b)(1): pship interest = property for 83 ii. 83(a): partner taxed on FMV prop. received amount paid iii. Prop. Regs.: pship may elect to use liquidation value 1. Liquidation value: how much would partner get pship sold its assets and liquidated? 2. C would get nothing b/c she has no capital interest iv. If pship d/n elect liquidation value, use current value of future profits b. (e) What result to C and to the partnership in (a), above, if Cs profits interest was subject to forfeiture until C rendered services for the partnership for a period of five years? i. 83(a): C has income in the amount of FMV amount paid (0) ii. Suppose C d/n make an 83(b) election 1. 83(a): to not have income currently, has to be subject to subst. risk of forfeiture and nontransferable a. 83(c)(1): rights to full enjoyment of property conditioned on future performance of subst. services b. Assume, non transferable (rights of transferee subject to restrictions)

36

c. C will have GI when interest vests iii. Proposed Regs: unless service provider makes 83(b) election w/in 30 days, C is not a partner 1. Note: different than 2001-43 (d/n worry about 83(b) election) iv. 5 Years Later 1. Interest vests 2. 83(a): C subject to FMV prop what he paid 3. FMV: liquidation if pship makes election IV. Organization and Syndication Expenses a. General Rule. Except as provided in subsection (b), no deduction is allowed for amounts paid to organize a partnership, or amounts paid to promote the sale of a partnership interest (syndication expenses). 709(a). i. Syndication Expenses Examples 1. Fees paid to a broker to sell partnership interests 2. Fees paid to the SEC to register a publicly traded limited partnership b. Exception. The partnership can elect to deduct in the year it begins business the lesser of: (i) the amount of organizational expenses of the partnership, or (ii) $5,000, reduced by the amount by which the organizational expenses exceed $50,000. 709(b)(1)(A). i. Example 1. Limited partnership spends $1,000 as a filing fee to the Secretary of State. The partnership can deduct all $1,000 (b/c its the lesser of organizational expenses or $5k). ii. Example 2. Limited partnership spends $6,000 as a filing fee to the Secretary of State. The partnership can deduct only $5,000 currently. The remaining $1,000 must be amortized over 180 months. iii. Example 3. Limited partnership spends $53,000 as a filing fee with Secretary of State and to have attorney draft the limited partnership agreement. The partnership can deduct only $2,000 currently. The remaining $51,000 must be amortized over 180 months. c. No Exception for Syndication Expenses. Note there is no exception for syndication expenses (i.e., a pship cannot deduct and amortize syndication expenses under 709(b)). Thus, syndication expenses are subject to the general rule of 709(a): no deduction.

37

PART 3: OPERATIONS OF A PARTNERSHIP: GENERAL RULES I. Tax Consequences to the Partnership: Aggregate and Entity Principles a. The Partnership as an Entity i. Determining and Reporting Income. The Code treats a partnership as an entity for purposes of determining and reporting taxable income. 1. Determining Income. The partnership must determine its taxable income. See 703(a). a. A partnership generally determines its taxable income in the same manner as an individual, with certain exceptions. See 703(a). b. Each partner must take into account his or her distributive share of partnership taxable income, whether the income is distributed or not. See 702(a). 2. Reporting Income. A partnership must report its taxable income by filing an informational tax return (Form 1065). See 6031(a). a. The return generally is due by the 15th day of the 4th month following the close of the partnerships taxable year. Reg. 1.6031-1(e)(2). ii. Treatment as Entity. To determine partnership taxable income, the partnership is treated as a separate entity as follows: 1. Elections. The partnership generally must make all elections. See 703(b). E.g., elections to use method of accounting and method of determining depreciation. a. Demirjian v. Commissioner. Pship was forced to sell an office building; money was distributed to the partners. Partners individually elected under 1033 (nonrecognition) to reinvest the proceeds in similar property. HELD: pship is taxable b/c all computations that affect taxable income must be made by the pship, not individually. 2. Character. Character of tax items is determined at the partnership level. See 702(b). a. Example. Suppose pship holds land as investment (capital asset), and a partner is a dealer in land (i.e., land would be inventory in his hands). If pship sells the land, the type of gain is capital gain. b. Exception. Under Section 724, if certain types of property (receivables, inventory and capital loss property) are contributed to a pship by a partner, that property retains the character it had in the partners hands. 3. Holding Period. Holding period is determined at the partnership level. See Rev. Rul. 68-79. a. Example. Suppose a pship held corporate stock (capital asset) for more than 1 yr. Suppose the partner purchased the pship interest 3 mo. ago. Pship sells the stock. The gain from sale is LTCG. 4. Unified Audit Procedures. IRS audits of TEFRA partnerships are done at the pship level. See 622134. a. Note: TEFRA partnerships generally have 10 partners.

38

5. Taxable Year. A pship must select its own taxable year. See
706(b)(1)(A). b. The Taxable Year i. Partnership Treated as Taxpayer. The taxable year of a partnership shall be determined as though the partnership were a taxpayer. 706(b)(1)(A). ii. Required Taxable Year. The pship must use the required taxable year. Determine if the pship has any of the following taxable years. See 706(b)(1)(B). 1. Majority Interest Taxable Year. The taxable year shall be the taxable year (if any) which, on each testing day, constituted the taxable year of 1 or more partners having (on such day) an aggregate interest in partnership profits and capital of more than 50 percent. See 706(b)(1)(B)(i), 706(b)(4)(a)(i). a. Further Change Not Required for 3 Years. If the majority interest taxable year changes, the partnership will not be required to change to another taxable year for either of the 2 taxable years following the year of the change. See 706(b)(4)(B). 2. Principal Partners Taxable Year. If theres no majority interest taxable year, the pships taxable year will be the taxable year of all of the principal partners of the partnership (i.e., all partners who owns at least a 5% interest). See 706(b)(1)(B)(ii), 706(b)(3). 3. Least Aggregate Deferral. If theres no majority interest taxable year or principal partners taxable year, the taxable year is the one that produces the least aggregate deferral of income. Reg. 1.706-1(b)(2)(C). The taxable year is the taxable year of one of the partners which results in the least aggregate deferral. Reg. 1.706-1(b)(3). The aggregate deferral for a particular year is equal to the sum of the products determined by multiplying the month(s) of deferral for each partner that would be generated by that year and each partners interest in partnership profits for that year. Id. The pship gets its pick if theres more than one qualifying taxable year. Id. See I.b.v. Problem (p. 103), part (g), infra. iii. Business Purpose. A pship may use a taxable year different from the required taxable year if it establishes a business purpose. Any deferral of income to partners is not a business purpose. 706(b)(1) (C). 1. Natural Business Year. A natural business year exists if 25% or more of the partnerships gross receipts for the selected year are earned in the last two months. The test must be satisfied in each of the preceding three 12-month periods that correspond to the requested fiscal year. Rev. Proc. 2006-46. 2. Facts and Circumstances Test. Taxpayer convenience is insufficient to satisfy the business purpose requirement. Rev. Rul. 85-57. a. Example. The [partnership] desires to use a tax year ending September 30 . . . to issue timely tax information . . . to its owners to facilitate the filing of timely returns by its owners. . . . [This reason is one] of convenience to the taxpayer [and is] insufficient to

39

establish that the business purpose requirement for a requested tax year has been met. Rev. Rul. 85-57. iv. Section 444 Election. A partnership may elect to have a taxable year other than the required taxable year. 444(a). 1. Deferral Period 3 Months. The deferral period of the taxable year cannot be more than 3 months. See 444(b)(2). a. Deferral Period. Deferral period means the months between (A) the beginning of the new taxable year, and (B) the close of the 1st required taxable year ending within such year. 444(b)(4). i. Example. If the required taxable year is the calendar year, then the pship could elect Sept. 30, Oct. 31, or Nov. 30. 2. Required Payments. Partnerships making the 444 election are subject to required payments to the govt under 7519. Congress is attempting to require an electing partnership to pay (and in effect keep on deposit) an amount of tax roughly approximating the tax that the partners would have paid on their income for any deferral period if a 444 election had not been made. v. Problem (p. 103). What taxable year must Partnership adopt under 706(b) in each of the following alternatives? Unless stated to the contrary, assume Partnership is a newly formed partnership. 1. (a) All partners of Partnership are calendar year taxpayers. a. Pship would use the calendar year b. 706(b)(1)(B)(i),706(b)(1)(4)(B) : majority interest taxable year is calendar year (b/c 100% aggregate interest uses calendar year). 2. If partners believe that the partnership will have substantial income and they are free to choose, what taxable year should they select for the partnership? a. Pship would choose January 31. The 2008 tax return would include pship items for the period Feb. 1, 2007 Jan. 31, 2008. In effect, its an interest free loan on tax liability. 3. What if they expect the partnership to have substantial losses? a. Pship would choose December 31. The partners would be able to use all losses accumulated that year. 4. (b) Partnership has a 20% corporate general partner which uses a July 31 fiscal year and 20 individual 4% limited partners all of whom are on a calendar year? a. Pship would use the calendar year b. 706(b)(1)(B)(i),706(b)(1)(4)(B) : majority interest taxable year is calendar year i. 20 partners * 4% = 80% aggregate interest uses calendar year 5. (c) What result in (b), above, if, on the first day of year four, 10 of the limited partners sell their interests to the corporate general partner? a. Pship would use July 31 fiscal year b. 706(b)(1)(B)(i),706(b)(1)(4)(B) : majority interest taxable year is July 31 fiscal year i. 20% original interest + [10 * 4%] = 60% interest uses July 31 fiscal year

40

6. (d) What result in (b), above, if 10 of the limited partners use a September 30 fiscal year and the other 10 use a calendar year? a. Pship would use July 31 fiscal year b. 706(b)(1)(B)(i),706(b)(1)(4)(B): no majority interest taxable year c. 706(b)(1)(B)(ii), 706(b)(3): taxable year of all of the principal partners of the partnership (i.e., all partners who owns at least a 5% interest) i. Corp. general partner is only principal partner; uses July 31 fiscal year 7. (e) What result in (b), above, if Partnership wants to adopt a September 30 fiscal year under 706(b) in order to have sufficient time to gather tax information for its calendar year partners? May Partnership adopt a September 30 fiscal year in some other manner? If so, with what cost? a. Under part (b), the pship is reqd to use the majority interest taxable year as its required taxable year. b. Rev. Rul. 85-57: the reason for using the different taxable year is one of convenience, not a business purpose. c. Pship could elect under 444 to choose a Sept. 30 fiscal year if it makes pmts to the govt under 7519. i. 444(b)(2): deferral period must be 3 months ii. 444(b)(4): Oct. 1Dec. 31 = 3 months 8. (f) What result in (b), above, if over the prior five years Partnership has been in the retail business and does 20% of its annual business in December and 10% of its business in January in post-Christmas sales. Partnership has been using a calendar year. It wishes to change to a January 31 fiscal year. May it do so? If so, is a 444 election and a 7519 required payment necessary? a. Pship could establish a natural business year under the business purpose exception. i. Rev. Proc. 2006-46: here, 30% of gross receipts are earned in the last 2 months b. Pship doesnt have to make a 444 election. Section 444 was designed when pship cannot establish a business purpose. 9. (g) What result if Partnership has two partners, A and B, each of whom has a 50 percent interest in partnership profits, if A uses a fiscal year ending June 30 and B uses a fiscal year ending July 31? a. 706(b)(1)(B)(i),706(b)(1)(4)(B): no majority interest taxable year b. 706(b)(1)(B)(ii), 706(b)(3): no taxable year of all of the principal partners of the partnership c. Least Aggregate Deferral6/30 Assuming the adoption of ABs June 30 fiscal year: Months Interest Taxable Profits of X Partner Year Interest Deferral Deferral A 6/30 50% 0 0 B 7/31 50% 1 0.5 Aggregate Deferral 0.5 d. Least Aggregate Deferral7/31

41

Assuming the adoption of ABs July 31 fiscal year: Months Interest Taxable Profits of X Partner Year Interest Deferral Deferral A 6/30 50% 11 5.5 B 7/31 50% 0 0 Aggregate Deferral 5.5 e. Pship will have June 30 taxable year II. Tax Consequences to the Partners a. General Rules i. Partnership Return. A pship must file an informational return. See 6031(a). This return is due by the 15th day of the 4th month after the close of the pships taxable year. Reg. 1.60031-1(e)(2). 1. Copies to Partners. The pship also informs the partners of its tax items on a Form K1. See 6031(b). ii. Partners Return 1. Included Partnership Items. Pship items for the pships taxable year that ends w/in the partners taxable year are included in the partners taxable income. 706(a). 2. Character Determined at Partnership Level. Character of pship items included in a partners distributive share under 702(a)(1)(7) is determined at the pship level. See 702(b). 3. Gross Income. Partners GI includes his distributive share of pship GI (+ distributive share of separately stated items). See 702(c). iii. Partnership Taxable Income. Pship taxable income is computed in the same manner as an individual except (1) items described in 702(a) are separately stated, and (2) a pship cannot take certain deductions. See 703(a). 1. Policy for 703(a)(1). The items in 702(a) are separately stated b/c they may affect partners tax liability differently, depending on their tax profiles. When the partner sees this separately stated item on Form K1, she will combine that item with other sources of that income to determine the overall tax effect. 2. Policy for 703(a)(2). Some of the deductions are for individuals only. Many of the deductions listed are subject to limitations. The limitations should apply at the individual partner level. 3. Computing Taxable Income. Generally, taxable income = gross income deductions. 63(a). iv. Categorizing Tax Items. A pships tax items will fall into one of three categories: Combined (a.k.a. Bottom Line) Items, Separately Stated Items, or Other Items. 1. Separately Stated Items. Per 703(a)(1), the following items are separately stated: a. 702(a)(1)(6) i. STCG and STCL. Gains/losses from sales/exchanges of capital assets held for not more than 1 year. 702(a)(1). ii. LTCG and LTCL. Gains/losses from sales/exchanges of capital assets held for more than 1 year. 702(a)(1).

42

1. NLTCG/L. Partners take into account

their distributive share of net LTCG and LTCL of the pship. Reg. 1.702-1(a)(2). iii. 1231 Gain/Loss. Gains/losses from sales/exchanges of 1231 property. 702(a)(3). iv. Charitable Contributions. 702(a)(4). v. Qualified Dividends. 702(a)(5). b. 702(a)(7). Other items provided by the Regs: i. More Separately Stated Items. Reg. 1.7021(a)(8)(i) lists additional items to be separately stated. ii. Broad Catch-all. A pship must separately state any item which, if separately taken into account by a partner, would result in an income tax liability for that partner, or for any other person, different from that which would result if that partner did not take the item into account separately. Reg. 1.702-1(a)(8)(ii). 1. Investment Interest. B/c deductions for investment interest is limited to the amount of net investment income, this is separately stated under Reg. 1.702-1(a) (8)(ii). See 163(d)(1). 2. Combined (Bottom Line) Items. A pship must separately state taxable income or loss, exclusive of the separately stated items in 702(a)(1)(7). 702(a)(8). a. Examples. Gross receipts from inventory sales and COGS (think AR and AB of inventory); 1245 gain. 3. Other Items. Other Items include charitable contributions and tax-exempt interest. v. Adjusting Outside Basis 1. Policy. To ensure a single level of tax, partners outside basis in pship interests are adjusted for income/loss. This makes outside basis conform to FMV. 2. STEP ONE: Make Increases to Basis. Reg. 1.704-1(d)(2). Outside basis is increased by a partners distributive share of partnership income and tax-exempt income. 705(a)(1)(A), (B). 3. Make Decreases to Basis. Reg. 1.704-1(d)(2). Outside basis in decreased by pship distributions and a partners distributive share of pship losses and nondeductible pship expenditures not chargeable to the capital account. a. STEP TWO: Decrease Basis by Distributions. See Reg. 1.703-1(d)(2) (silent as to the order of basis decreases except that losses are taken last); Reg. 1.1367-1(f) (providing that among basis decreases in subchapter S corp stock, distributions are taken first). b. STEP THREE: Decrease Basis by Noncapital Nondeductible Expenses. See Reg. 1.703-1(d)(2) (silent as to the order of basis decreases except that losses are taken last); Reg. 1.1367-1(f) (providing that among basis decreases in subchapter S corp stock, noncapital nondeductible expenses are taken second).

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c. STEP FOUR: Decrease Basis by Losses. Reg. 1.7031(d)(2). i. 702(a) Deductible Items. Note losses refers to items listed in 702(a) that are deduction items. This includes: 1. STCL. 702(a)(1). 2. LTCL. 702(a)(2). 3. 1231 losses. 702(a)(3). 4. Other items of loss. 702(a)(7). 5. Taxable items not separately stated. 702(a)(8). vi. Problem (pp. 10607). A and B, both calendar year noncorporate taxpayers, are equal partners in the AB Partnership, which had the following income and expenses during its (business purpose) taxable year that ended on July 31 of the current year: Gross receipts from inventory sales $100,000 Cost of goods sold 30,000 Salaries paid to nonpartners 10,000 Depreciation 12,000 Advertising expenses 8,000 Interest expense paid on investment margin account maintained by AB (see 163(d)) 6,000 Gain from the sale of machine held for two years: 1245 gain 8,000 1231 gain 2,000 Dividends 7,000 Charitable contributions 800 Tax-exempt interest 500 STCG on a sale of stock 6,000 LTCG on a sale of stock held for two years 4,000 LTCL on a sale of stock held for two years 2,000 1231 gain on casualty to machine held for two years 1,000 1. (a) How and when will AB, A and B report the income and who will be liable for the taxes? a. What and when will AB, A and B file with the IRS? i. 6031: pship files an informational return and informs partners of their shares of pship tax items ii. 706(a): partners taxable income includes pship items for the pship taxable year that ends w/in the partners taxable year Combined Items. 702(a)(8). Income Deductions Gross receipts 100k Salaries 10k (inventory) COGS (30k) Depreciati 12k on 1245 gain 8k Advertisin 8k g 78k 30k 48k Combined Net Income

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Separately Stated Items Income Deductions 1231 gain 2k Investmen 6k t Interest Dividends 7k STCG 6k Net LTCG 2k 1231 gain on 1k machine casualty 18k Other Items Charitable 800 Contributions Tax-Exempt Interest 500 b. ABs taxable income is $48k combined income and the listed separately stated items. c. 702(c): A and B would include their distributive share of $78k + distributive share of separately stated items. 2. (b) Assume this is the first year of partnership operations, As basis in his partnership interest is $70,000 and Bs basis in her partnership interest is $40,000. What will be the tax consequences of ABs first year of operations to A and B? a. STEP ONE: Increases to Basis i. 24k bottom line income. 705(a)(1)(A). ii. 9k separately stated income. 705(a)(1)(A). iii. 250 tax exempt income. 705(a)(1)(B). b. STEP TWO: Decrease Basis by Distributions i. 400 charitable contribution. 705(a)(2)(B). c. STEP THREE: Decrease Basis by Losses (incl. 702(a) deductible items) i. 3k separately stated deductions (investment interest). 705(a)(2)(A). A B Initial Basis 70k 40k Bottom line income 24k 24k Separately Stated income 9k 9k Tax exempt income 250 250 Charitable contribution (400) (400) Investment interest (3k) (3k) Ending outside basis 99,850 69,850

3. (c) What would be the result in (b), above, if the partnership distributed $20,000 in cash to each partner at the end of the year?
Initial Basis Bottom line income Separately Stated income Tax exempt income Distribution Charitable contribution A 70k 24k 9k 250 (20k) (400) B 40k 24k 9k 250 (20k) (400)

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Investment interest

(3k)

(3k)

Ending outside basis

79,850

49,850

4. (d) Would it matter if the 1231 gain on the sale of the machine would have been ordinary income if A had sold it individually? a. No, character is determined at the pship level. 702(b). b. Electing Large Partnerships i. Effect of ELP Election. If a pship is an ELP, most limitations that effect the computation of income apply at the pship level. See 773(a)(3). E.g., an ELP can deduct charitable contributions, and applies limitations at the pship level. ii. 100 partners. Pships with 100 members may elect to have ELP rules apply. iii. No Service Partnerships. Service pships cannot take advantage of ELP rules. 775(b). III. Limitations on Partnership Losses a. Basis Limitations i. Policy: Only Deduct Losses on Previously Taxed Investment. The partnership loss limitations attempt to allow T only to deduct losses to the extent that T has basis in those losses. Essentially they are specific applications of 165(b) (basis for determining the amount of a deduction for any loss is the AB of property). ii. Loss Limitation. A partners distributive share of partnership loss is allowed to the extent of a partners outside basis at the end of the pship year in which such loss occurred. 704(d). 1. Excess Carried Forward. Any excess of losses over outside basis are carried forward and allowed as a deduction when the partner has sufficient basis. See 704(d). iii. Allocate Basis to Distributive Share of Losses. If a partners distributive share of aggregate items of loss exceed outside basis, the limitation on loss must be allocated to his distributive share of each such loss. Allocate basis by the proportion that each loss bears to the total losses. See Reg. 1.704-1(d)(2), III.a.v. Problem (p. 110), part (d), infra. iv. Transfer of Suspended Loss 1. Terminates on Sale. If a partner sells his partnership interest, the sellers previously deferred losses will disappear and do not carry over to the buyer. Sennett v. Commissioner. 2. Gift: Unclear. Where a partner gives his partnership interest to a 3d party, it is unclear if the suspended loss transfers. See III.a.v. Problem (p. 110), part (e), infra. v. Problem (p. 110). C and D are partners who share income and losses equally. C has an outside basis of $5,000 in his partnership interest and D has an outside basis of $15,000 in his partnership interest. 1. (a) During the current year the partnership has gross income of $40,000 and expenses of $60,000. What are the tax results to C and D? a. $20k loss = $10k distributive share of loss per partner b. 704(d): distributive share of loss allowed is allowed to the extent of outside basis; any excess of loss over basis is carried forward to deduct when theres sufficient basis i. C takes $5k deduction; $5k carried forward ii. D can deduct $10k

46

2.

3.

4.

5.

c. 705(a)(2)(A): outside basis is decreased by losses of pship i. Cs basis decreased to zero ii. Ds basis decreased to $5k iii. Note: these losses are considered last in the order of increases/decreases to outside basis (b) What are the results to C and D in the succeeding year when the partnership has $20,000 of net profits? a. $20k net profits = $10k each b. 705(a)(1): outside basis increased by distributive share of pship income i. Cs basis increased from 0 to $10k ii. Ds basis increased from $5k to $15k c. 704(d): Cs $5k loss carry over is allowed as a deduction d. 705(a)(2)(A): outside basis decreased by losses of pship i. Cs basis decreased from $10k to $5k (c) How might C have alleviated his problem in the first year? a. C could have contributed $5k cash or property w/ AB of $5k i. 722: contributions of money/property increase basis b. Not clear whether C could write a p/note i. Parachi v. U.S. (in corporate context): promising to pay corp. increases basis ii. But 722 says basis = money + property contributed, and a p/note has a zero basis c. Partnership could borrow money i. 752: an increase in partners share of pship liabilities is treated as a cash contribution to pship ii. But, if there no business purpose for borrowing, the IRS may disallow a basis increase and deduction (d) What result in (a), above, if the net $20,000 loss consists of $15,000 of ordinary loss and $5,000 of long-term capital loss? a. Partnership Taxable Income i. 703: calculated like individual, except 702(a) items are separately stated ii. 702(a)(8): $7.5k distributive share of ordinary loss iii. 702(a)(2): $2.5k distributive share of LTCL (separately stated) b. Allocate Cs $5k Basis i. $5k basis * [$7.5k ordinary loss/$10k total loss] = $3,750 ordinary loss deductible ii. $5k basis * [$2.5k LTCL/$10k total loss] = $1,250 LTCL deductible (e) What result to S, Cs son, in (a), above, if C gives his interest in the partnership to S on the first day of a year in which the partnership has profits of $20,000? a. If C sells the pship interest to a 3d party: i. Sennett v. Commr: the suspended loss terminates

47

ii. C effectively benefits from the suspended loss by not having to reduce his basis to negative $5k b. If C gives the pship interest to S: i. Arg to Shift the Loss 1. If we dont allow S to deduct the suspended loss; nobody will realize it 2. There will be a permanent disconnect btwn inside and outside basis ii. Arg to Not Shift the Loss 1. 1015 generally permits the shifting of gains, but not losses b. At-Risk Limitations i. Policy. After Crane v. Commissioner, promoters marketed tax shelters so that investors would be limited partners of pships that took on a lot of NR debt to buy depreciable assets. The resulting losses would flow through to the partners to offset income from other sources. In response, Congress added the at-risk limitations to losses in 465. ii. General Rule. For individuals engaged in an activity to which this section applies, any loss from such activity for the taxable year shall be allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk for such activity at the close of the taxable year. 465(a)(1). 1. Carry Forward Extra Losses. Excess (not allowed) losses are treated as a deduction allocable to such activity in the next taxable year (if the partner has a sufficient amount at risk). 465(a)(2). 2. Adjustments to Amount At Risk. Similar to the effect of losses and gains on outside basis, a partners amount at risk will increase to the extent of income and cash contributions, and will decrease to the extent of losses allowed. iii. Activities to Which 465 Applies 1. Enumerated List. Section 465 applies to a taxpayer engaged in the activity of: a. (A) holding, producing, or distributing motion picture films or video tapes, b. (B) farming, c. (C) leasing any section 1245 property, d. (D) exploring for, or exploiting, oil and gas resources, or e. (E) exploring for, or exploiting geothermal deposits. 465(c)(1). 2. Carrying on a Trade or Business or for the Production of Income. Section 465 applies to each activity engaged in by T in carrying on a trade or business or for the production of income. 465(c)(3)(A). iv. Amount At Risk 1. General Rule. T is at risk for an activity w/ respect to amounts including a. (A) amounts of money and AB of property contributed by T to the activity, and b. (B) borrowed with respect to such activity. 465(b)(1). 2. Borrowed Amounts. T is at risk for amounts borrowed for use in an activity to the extent he a. (A) is personally liable for repayment, or

48

b. (B) has pledged property, other than property used in such activity, as security for such borrowed amount (to the extent of net FMV). 465(b)(2). 3. Qualified Nonrecourse Financing a. General Rule. T is at risk for Ts share of qualified nonrecourse financing which is secured by real property. 465(b)(6)(A). b. Defined. Qualified nonrecourse financing means financing i. (i) borrowed by T w/ respect to the activity of holding real property, ii. (ii) borrowed by T from a qualified person or govt, iii. (iii) if no person is personally liable for re-pmt, and iv. (iv) thats not convertible. 465(b)(6)(B). c. Qualified Person. A qualified person is a person in the business of lending money which is not i. (I) a related person w/ respect to T, ii. (II) a person from which T acqd the property (or a related person to such person), iii. (III) a person who receives a fee w/ respect to Ts investment in the property (or a related person to such person). 49(a)(1)(D)(iv); see 465(b)(6) (D)(i). d. Related Person with Respect to T i. Related Person. Related person includes brothers, sisters, spouse, ancestors and lineal descendants. 49(a)(1)(D)(v), 465(b)(3)(C)(i), 267(b)(1), (c)(4). ii. Exception: Commercially Reasonable Loan. Section 49(a)(1)(D)(iv)(I) doesnt apply if the financing is commercially reasonable and on substantially the same terms as loans involving unrelated persons. 465(b)(6)(D)(ii). v. Problem 1 (p. 114). LP is a limited partner in a newly formed partnership which is engaged in the following activities: 1. (i) A research and development activity to which LP contributed $10,000 cash; LPs share of partnership nonrecourse liability attributable to this activity is $10,000. LPs share of loss from the research and development activity is $12,000 for the current year. 2. (ii) A motion picture production activity to which LP contributed $20,000 cash; LPs share of income from this activity for the current year is $25,000. 3. LPs outside basis at the beginning of the year was $40,000, and his share of net gain for the year was $13,000. What are the tax consequences to LP under 465? 4. R&D Activity a. Activity to which 465 Applies i. 465(c)(3)(A): section 465 applies to all activities engaged in by T in carrying on a trade/business or for the production of income b. Amount At Risk

49

i. 465(b)(1)(A): money + AB property contributed by T to the activity 1. $10k cash contributed ii. 465(b)(1)(B): amounts borrowed 1. 465(b)(2): if personally liable or pledged property other than property used in such activity as security 2. Here, LP has no personal liability on NR debt iii. Amount At Risk = $10k c. Deduction i. LP can only deduct $10k of the $12k loss ii. 465(a)(2): extra $2k carries forward d. Basis Original Basis $40k + Share of Income $25k Share of Loss ($12k) Outside Basis $53k e. Reduce Amount At Risk i. Amount at risk decreases from $10k to zero 5. Motion Picture Activity a. 465 limits losses, not gains b. 465(b)(1): LPs amount at risk = $20k c. $25k share of income increases that amount to $45k vi. Problem 2 (pp. 11415). The ABC equal limited partnership (in which A is a general partner and B and C are limited partners) purchased an apartment building for $540,000, paying $90,000 cash (contributed equally by the partners to the partnership) and financing the balance with a $450,000 nonrecourse loan secured by the building. Assume that A, B and C are all unrelated and that the partnership holds no other assets. To what extent are each of the partners at risk if the loan is: 1. (a) From a commercial bank in which none of the parties owns an interest. a. 465(b)(6)(A): T is at risk w/ respect to qualified nonrecourse financing secured by real property b. 465(b)(6)(B): qualified nonrecourse financing means financing i. (i) borrowed by T w/ respect to the activity of holding real property, ii. (ii) borrowed by T from a qualified person or govt, iii. (iii) no person is personally liable for re-pmt, and iv. (iv) not convertible. c. 49(a)(1)(D)(iv); 465(b)(6)(D)(i): qualified person is a person in the business of lending money which is not i. (I) a related person w/ respect to T, ii. (II) a person from which T acqd the property, iii. (III) a person who receives a fee w/ respect to Ts investment in the property. d. Here, the loan meets the 465(b)(6)(B) reqs; commercial lender is a qualified person under 49(a) (1)(D)(iv). e. Amount At Risk = $180k

50

i. 465(b)(1): $90k/3 = $30k contribution of money ii. 465(b)(6)(A): $450k/3 = $150k share of liability 2. (b) From the seller of the apartment complex. a. 49(a)(1)(D)(iv)(II): seller is not qualified person b. NR loan is not qualified nonrecourse financing c. Partners are not at-risk for the NR loan d. 465(a)(1), (2): loss not allowed; carried forward e. Amount At Risk = $30k each (money contributed) 3. (c) From Bs brother, who is in the money lending business and makes the loan at a rate of interest 25% below comparable rates charged to unrelated borrowers. a. 49(a)(1)(D)(iv)((I): qualified person is in the bus. of lending money and not a related person to w/ respect to T b. 49(a)(1)(D)(v), 465(b)(3)(C)(i), 267(b)(1), (c)(4): related person includes brothers, sisters, spouse, ancestors and lineal descendants. c. Here, Bs brother is a related person w/ respect to B d. 465(b)(6)(D)(ii): Section 49(a)(1)(D)(iv)(I) doesnt apply if the financing is commercially reasonable and on substantially the same terms as loans involving unrelated persons e. Here, the loan was made at an interest rate thats 25% below comparable rates f. Bs brother is not a qualified person w/ respect to B i. Bs amount at risk = $30k g. A and C may argue that related person w/ respect to T should be read to mean a person related to Partner A and C i. Answer is not clear ii. Even if Bs brother loans the money at this interest rate, it may be qualified nonrecourse financing to A and C 4. (d) The same as (c), above, except the loan is at regular commercial rates of interest. a. Here, the exception in 465(b)(6)(D)(ii) applies b. The loan is qualified nonrecourse financing c. Passive Loss Limitations i. Section 469 Policy. Section 469 attempts to cut off passive investors ability to take tax benefits from activity in a partnership and use them to shelter income from other activities. ii. Taxpayers Subject to 469. Section 469 passive loss limitations apply to, inter alia, individuals (e.g., partners). See 469(a)(2). iii. General Rule. Passive activity loss is not allowed. 469(a)(1)(A). 1. Disallowed Losses: Carry Forward. Disallowed losses are carried forward the next year and deducted to the extent theres passive activity income. See 469(b). 2. Dispositions of Entire Interest in Passive Activity. If a partner disposes of his entire interest or if the pship disposes of the passive activity, disallowed losses may be deducted in full. 469(g)(1)(A). iv. Passive Activity Loss. Passive activity loss means the amount by which the aggregate losses from all passive activities for the taxable

51

year, exceed the aggregate income from all passive activities. 469(d). 1. Passive Activity. Passive activity means any activity a. (A) which involves the conduct of any trade or business, and b. (B) in which the taxpayer does not materially participate. 469(c)(1). 2. Material Participation. T materially participates in an activity if: a. > 500 Hours. T participates in the activity for more than 500 hours during such year. Temp. Reg. 1.4695T(a)(1). b. Substantially All Participation. Ts participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including non-owners) for such year. Temp. Reg. 1.469-5T(a)(2). c. More Participation than Others + 100 Hours. T participates for more than 100 hours during the taxable year, and such participation is not less than the participation of others (including non-owners). Temp. Reg. 1.469-5T(a)(3). d. Significant Participation Activity + Aggregate 500 Hours. The activity is a significant participation activity for the taxable year and Ts aggregate participation in all significant participation activities > 500 hours. Temp. Reg. 1.469-5T(a)(4). i. Significant Participation Activity. A significant participation activity is one: 1. (i) that is a trade/business in which T significantly participates, and 2. (ii) where T does not materially participate under the other tests. See Temp. Reg. 1.469-5T(c)(1). 3. 100 Hours. T significantly participates in an activity if T participates for > 100 hours. Temp. Reg. 1.469-5T(c)(2). e. Material Participation for 5/10 Previous Years. T materially participated in the activity for any five taxable years during the previous ten taxable years. Temp. Reg. 1.469-5T(a)(5). f. Personal Service Activity + Material Participation for 3 Previous Years. The activity is a personal service activity and T materially participated in the activity for any three previous taxable years. Temp. Reg. 1.469-5T(a)(6). i. Personal Service Activity. An activity is a personal service activity if it involves the performance of personal services in 1. (1) the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; or

52

2. (2) any other trade/business in which capital is not a material income-producing factor. Temp. Reg. 1.469-5T(d). g. Facts/Circumstances. Based on facts/circumstances, Ts participation in the activity is regular, continuous, and substantial. 469(h)(1); Temp. Reg. 1.469-5T(a) (7). 3. Limited Partnership Interests. T shall not be treated as materially participating in any activity of a limited partnership. Temp. Reg. 1.469-5T(e)(1). a. Exception if Materially Participates. Temp. Reg. 1.469-5T(e)(1) does not apply where T is treated as materially participating under Temp. Reg. 1.469-5T(a) (1), (5), or (6). b. Exception for General Partners. Ts partnership interest shall not be treated as a limited pship interest if the individual is a general partner in the pship. Temp. Reg. 1.469-5T(e)(3)(ii). v. Portfolio Income. In determining income/loss from an activity, portfolio income (e.g., dividends, losses from sale of marketable securities) is not taken into account. 469(e)(1). vi. Rental Activity 1. Rental Activity = Passive Activity. Passive activity includes rental activity. 469(c)(2). 2. Exceptions for Rental Real Estate Activity a. 469(c) i. 469(c)(2) Doesnt Apply. If the reqs in 469(c)(7)(B) are met, 469(c)(2) doesnt apply. 469(c)(7)(A). ii. Requirements 1. > of Personal Services. More than one-half of the personal services performed in trades or businesses by T must be performed in real property trades or businesses in which T materially participates. 469(c)(7)(B)(i). 2. > 750 Hours. T performs more than 750 hours of services during the taxable year in real property trades or businesses in which T materially participates. 469(c) (7)(B)(ii). b. 469(i) i. 469(a) Doesnt Apply. Section 469(a) does not apply (up to $25k) to passive activity loss for rental real estate activities where T actively participated in such taxable year. 469(i)(1), (2). 1. Phase out. This $25k limitation is phased out based on AGI. See 469(i)(3). ii. Limited Partners Do Not Actively Participate. No interest as a limited partner in a limited partnership will be treated as an interest where T actively participates. 469(i)(6)(C). vii. Working Interests in Oil and Gas Property. Passive activity does not include any working interest in any oil and gas property which

53

T holds directly or through an entity which does not limit the liability of T with respect to such interest. 469(c)(3)(A). viii. Problem 1 (pp. 12122). Producer owns both a 40% interest as a general partner and a 20% interest as a limited partner in PG-13 Associates, a motion picture production partnership which also pays Producer a $100,000 annual salary for her service as a full-time (1,500 hours per year) producer. After deducting Producers salary, the partnership has a $300,000 net loss in the current year. Producers aggregate outside basis for her partnership interests at the beginning of the year is $350,000. Producers outside basis is attributable to cash contributed to PG-13 Associates. 1. Share of Partnership Loss = $180k a. 40% * 300k = $120k as general partner b. 20% * 300k = $60k as limited partner 2. Effect of Loss a. 705(a)(2)(A): losses decrease basis b. $350k original outside basis $180k loss = $170k ending outside basis 3. Loss Limitations a. 704(d): loss limited to outside basis i. $180k loss allowed by $350k basis b. 465: loss limited to amount at risk i. $180 loss allowed by $350k amount at risk (cash contributed) c. Note: loss limitations do not affect ending outside basis! 4. (a) What are the tax consequences to Producer from her interests in PG-13 Associates for the current year? a. 469(a)(2): section 469 applies to producer (individual) b. 469(a)(1): passive activity loss not allowed c. 469(c): passive activity is an activity which involves conduct of a trade/business and where T d/n materially participate i. Motion picture production = trade/business ii. General Partner Interest 1. Temp. Reg. 1.469-5T(a)(1): materially participates b/c participated for > 500 hours iii. Limited Partner Interest 1. Temp. Reg. 1.469-5T(e)(1): T is not treated as materially participating in any activity of a limited partnership. 2. Temp. Reg. 1.469-5T(e)(3)(ii): a pship interest is not treated as a limited partnership interest if general partner 3. Since Producer materially participates under Temp. Reg. 1.469-5T(a)(1), his limited pship interest has no effect. iv. Producer materially participates in activity v. Activity is not a passive activity d. Loss is allowed 5. (b) What result in (a), above, if Producer spends most of her time farming and only devotes 300 hours during the year to PG13? a. Maybe materially participates under Temp. Reg. 1.469-5T(a)(4) (significant participation activity).

54

b. May materially participate under Temp. Reg. 1.4695T(a)(2), (3), or (7) if we had more facts. c. If this fails all the materially participate tests, it is a disallowed passive activity loss i. 469(b): the loss would be suspended and deductible in the future when the pship has passive activity income d. Assume for the rest of the problem that partner does not materially participate in part (b). 6. (c) What result in (b), above, if Producer had devoted 1,500 hours to PG-13 during each of the previous five years? a. Temp. Reg. 1.469-5T(a)(5): materially participates b/c materially participated in 5 of last 10 years i. Temp. Reg. 1.469-5T(a)(6): may be a personal service activity b. Not passive activity loss; allowed 7. (d) What result in (b), above, if the partnerships loss for the year is only $200,000 because it also realizes $60,000 of dividend income and $40,000 of net gains from sales of marketable securities? a. 469(e)(1): this portfolio income is treated as a separate activity b. Passive activity loss stays at $300k 8. (e) What result in (b), above, if Producer also has $75,000 of income from an interest in a burned out real estate limited partnership interest? a. Note: a burned out partnership is one whose assets are fully depreciated and is currently generating income for its partners b. 469(a): passive activity loss not allowed c. 469(d)(1): passive activity loss = loss from passive activities income from passive activities d. 469(c): passive activity = trade/bus in which T does not materially participate e. Temp. Reg. 1.469-5T(e) i. (1): if limited partner, not materially participating ii. (2): exception if materially participates under Temp. Reg. 1.469-5T(a)(1), (5) or (6). 1. Not satisfied here f. Assuming its a rental real estate activity: i. 469(c)(2): rental activity is passive activity ii. 469(c)(7) exception 1. 469(c)(7)(A): effect: 469(c)(2) d/n apply 2. 469(c)(7)(B): reqs: > of personal services performed by T are performed in real property trades or businesses in which T materially participates, and T performs > 750 hours during the taxable year in real property trades/businesses in which T materially participates 3. No facts to indicate this exception applies iii. 469(i) exception

55

1. 469(i)(1), (2): effect: 469(a) d/n apply to (up to $25k) losses for rental real estate activities in which T actively participated 2. 469(i)(6)(C): no interest as a limited partner in a LP shall be treated as an interest w/ respect to which T actively participates 3. No facts to indicate this exception applies iv. 469(d)(1): passive activity loss = loss from passive activities income from passive activities 1. $180k disallowed loss $75k passive income from LP = $105k carry forward 9. (f) What result in (b), above, if Producer also has a $25,000 loss from a rental real estate limited partnership interest? a. 469(a): passive activity loss not allowed b. 469(d)(1): passive activity loss = loss from passive activities income from passive activities c. 469(c): passive activity = trade/bus in which T does not materially participate d. Temp. Reg. 1.469-5T(e) i. (1): if limited partner, not materially participating ii. (2): exception if materially participates under Temp. Reg. 1.469-5T(a)(1), (5) or (6). 1. Not satisfied here e. 469(c)(2): rental activity is passive activity f. 469(c)(7) exception i. 469(c)(7)(A): effect: 469(c)(2) d/n apply ii. 469(c)(7)(B): reqs: > of personal services performed by T are performed in real property trades or businesses in which T materially participates, and T performs > 750 hours during the taxable year in real property trades/businesses in which T materially participates iii. No facts to indicate this exception applies g. 469(i) exception i. 469(i)(1), (2): effect: 469(a) d/n apply to (up to $25k) losses for rental real estate activities in which T actively participated ii. 469(i)(6)(C): no interest as a limited partner in a LP shall be treated as an interest w/ respect to which T actively participates iii. No facts to indicate this exception applies h. Disallowed loss = $180k original disallowed loss + $25k passive loss from LP = $205k carry forward 10. (g) What result in (b), above, if Producer also has a $50,000 loss from an investment in a general partnership that owns a working interest in an oil and gas property? a. 469(c)(3)(A): passive activity does not include any working interest in any oil and gas property which the taxpayer holds directly or through an entity which does not limit the liability of T w/ respect to such interest. i. Here, T is a general partner ii. Loss is not passive b. $50k loss is not limited by 469

56

11. (h) Same as (g), above, except Producer holds her interest in
the oil and gas partnership as a limited partner? a. 469(c)(3)(A): passive activity does not include any working interest in any oil and gas property which the taxpayer holds directly or through an entity which does not limit the liability of T w/ respect to such interest. i. Here, T is a limited partner in a pship ii. Exception not met b. Temp. Reg. 1.469-5T(e)(1), (2): limited partnership interest is not materially participating unless materially participate under Temp. Reg. 1.469-5T(a)(1), (5), or (6). i. T does not materially participate ii. Loss is passive c. Disallowed loss = $180k original + $50k LP loss = $230k ix. Problem 2 (p. 122). During the current year LP has investments in four limited partnerships as follows: 1. (i) A motion picture production limited partnership in which LP has an outside basis of $10,000 attributable to LPs cash contribution to the partnership. LPs distributive share of loss in this partnership for the current year is $25,000. 2. (ii) An equipment leasing limited partnership in which LP has a $100,000 outside basis (attributable to a $15,000 cash contribution and an $85,000 nonrecourse liability). LPs share of loss for the year is $20,000. 3. (iii) A real estate limited partnership in which LP has a positive outside basis and his share of partnership income is $30,000 for the year. 4. (iv) A research and development limited partnership in which LP has an outside basis of $60,000, attributable to his $60,000 cash contribution to the partnership. LPs share of the partnerships loss for the year is $40,000. 5. Consider to what extent LP may deduct his share of losses from these partnerships for the current year, assuming he has no carryovers under Sections 704(d), 465 or 469. Share of Basis 465 Passive Loss/Inco in Amount at Activity me Pship Risk Loss/ Interes Income t ($25k) $10k $10k (cash ($10k) Motion $15k $10k contr) picture suspended 0 ($10k) (b/c of LP 704(d) ded.) Equipme nt Leasing LP Real Estate LP R&D LP
($20k) $5k suspended 465 $30k $100k ($20k) $80k N/A 0 $15k (cash contr) ($15k) 0 N/A ($15k)

$30k

($40k)

$60k ($40k) $20k

$60k (cash contr) ($40k) (ded.) $20k

($40k)

57

6. Passive Activity Loss (Carry Forward) = ($35k)

a. Loss from Passive Activity = ($65k) i. Activity (i) = ($10k) ii. Activity (ii) = ($15k) iii. Activity (iv) = ($40k) b. Income from Passive Activity = $30k 7. Allocate $35k disallowed amount to passive activities a. Activity (i): $10k/$65k * $35k = $5,385 b. Activity (ii): $15k/$65k * $35k = $8,077 c. Activity (iv): $40k/$65k * $35k = $21,538 8. Reg. 1.469-1T(f)(2): w/in each activity, disallow a portion of each deduction a. In activity (i): $5,385/$10k of each deduction is disallowed b. In activity (ii): $8,077/$15k of each deduction is disallowed c. In activity (i): $21,538/$40k of each deduction is disallowed

58

PART 4: PARTNERSHIP ALLOCATIONS I. Introduction a. Partnerships vs. Corporations

i. Corporations. In corporations, rights associated with shares of stock

determine voting power, rights to distributions and rights upon liquidation. In order to vary the rights among the SHs, shares would have to be transferred or more stock issued.

ii. Partnerships. In partnerships, the rights of the partners generally are

determined by the partnership agreement. Varying the rights of partners is as easy as amending the agreement. Partners are generally free to divide tax items among whomever they want. b. Subchapter Ks Approach to Allocations of Income and Deductions

i. General Rule. A partners distributive share of income, gain, loss

deduction and credit is determined by the partnership agreement. See 704(a).

ii. Limitation. Each partners distributive share of the items above is

determined in accordance with the partners interest in the partnership if: 1. The partnership agreement does not allocate these items among the partners, or

2. The partnership agreement does allocate them, but the

allocation does not have substantial economic effect. See 704(b). II. Special Allocations Under Section 704(b) a. Background: The Substantial Economic Effect Concept

i. Special Allocations. Special allocations are allocations which are

disproportionate to the amount of capital each partner has put in. ii. Section 704(b) Applicability

1. Specific Items. Section 704(b) applies to allocations of

specific items of partnership income, gain, loss, deduction or credit, i.e., those listed in 702(a)(1)(7).

2. Bottom Line Items. Section 704(b) also applies to

allocations of bottom line, nonseparately stated income or loss of the partnership, i.e., the income or loss listed in 702(a) (8). b. The Section 704(b) Regulations: Basic Rules i. Economic Effect

59

1. General Rules

a. General Principles and Organization of the

704(b) Regulations. Under Reg. 1.704-1(b)(1)(i), if the partnership agreement allocates a tax item to a partner, there are three ways for the allocation to be respected under 704(b):

i. The allocation can have substantial economic

effect under Reg. 1.704-1(b)(2).

ii. The allocation can be in accordance with the

partners interest in the partnership, as determined by taking into account all facts and circumstances, under Reg. 1.704-1(b)(3).

iii. The allocation can be deemed to be in

accordance with the partners interest in the partnership under special rules in Reg. 1.704(b) (4) and 1.704-2.

b. Two Part Test. A two-part analysis must be applied at

the end of each partnership taxable year to allocations made for that year. Reg. 1.704-1(b)(2)(i).

i. Does the allocation have economic effect? Reg.

1.704-1(b)(2)(ii)

ii. If it has economic effect, is the economic effect

substantial? Reg. 1.704-1(b)(2)(iii).

c. Economic Effect General Principle. Generally, an

allocation has economic effect if it is consistent with the underlying economic arrangement of the partners. Reg. 1.704-1(b)(2)(ii)(a).

d. Basic Test (The Big Three). Allocations of income,

gain, loss, or deduction (or item thereof) to a partner will have economic effect if the partnership agreement provides for: i. Maintenance of capital accounts in accordance with Reg. 1.704-1(b)(2)(iv); ii. Liquidating distributions to be made in accordance with the partners positive capital account balances; and iii. An unconditional deficit restoration obligation. Reg. 1.704-1(b)(2)(ii)(b). e. Capital Account Maintenance

i. See II.a.ii.3. Maintaining Capital Accounts, supra. 60

ii. Contribution of Promissory Notes. If a

promissory note is contributed to a partnership by partner who is the maker of such note, such partners capital account will be increased with respect to such note only when there is a taxable disposition of such note by the partnership or when the partner makes principal payments on such note. This shall not apply if the note is readily tradable on an established securities market. Reg. 1.704-1(b)(2)(iv)(d)(2); see Reg. 1.704-1(b)(5) Example 1(ix). f. Alternate Test for Economic Effect

i. Requirements. Reg. 1.704-1(b)(2)(ii)(d)(1)

(3). 1. The first two requirements of the basic test for economic effect are met. 2. The partner has no/limited deficit restoration obligation. 3. The partnership agreement contains a qualified income offset (QIO)

ii. Effect. An allocation will be considered to have

economic effect to the extent such allocation does not cause or increase a deficit balance in such partners capital account (in excess of any limited dollar amount of such deficit balance that such partner is obligated to restore). Reg. 1.704-1(b)(2)(ii)(d).

g. Obligations to Restore a Deficit. If a partner is not

expressly obligated to restore the deficit balance in his capital account, such partner nevertheless will be treated as obligated to restore the deficit balance in his capital account to the extent of the outstanding principal balance of any promissory note (of which such partner is the maker) contributed to the partnership by such partner. Reg. 1.704-1(b)(2)(ii)(c)(1).

h. Expected Distributions. In determining the extent to

which an allocation causes/increases a deficit balance in excess of any deficit restoration obligation, the partners capital account will be reduced for expected distributions and increases to the partners capital account. Reg. 1.704-1(b)(2)(ii)(d)(6).

i.

Qualified Income Offset. A QIO provides that where unexpected distributions create an impermissible deficit, she will be allocated items of income or gain sufficient to

61

eliminate such deficit balance as quickly as possible. Reg. 1.704-1(b)(2)(ii)(d) (flush language after (6)).

j.

Problem 1 (pp. 16162). A and B each contribute $100,000 upon formation of a limited partnership. A is a general partner and B is a limited partner. The partnership purchases an office building on leased land for $200,000 and elects straight-line cost recovery. Assume (for simplicity) that the property has a 10-year recovery period. The partnership agreement allocates all items of income and loss equally with the exception of the cost recovery deductions, which are allocated entirely to B. Assume (perhaps unrealistically) that both partners are unconditionally obligated to restore a deficit to their capital accounts upon a liquidation of the partnership. i. (a) Assume that apart from cost recovery deductions, the partnerships rental income is equal to its operating expenses. What must the partners respective capital account balances be at the end of year one if the allocation of cost recovery deductions is to have economic effect? 1. Reg. 1.704-1(b)(2)(iv): increase capital accounts by cash contributed a. Beginning capital account balances = $100k cash contributed 2. Reg. 1.704-1(b)(2)(iv): decrease capital accounts by allocations of partnership loss and deduction a. Bs capital account decreases by $20k depreciation deduction Assets Liability and Capital Accounts Buildi $200k Liab: 0 ng Depr. ($20k) Capital Accounts A $100k B $100k $20k $80k $180k $180k ii. (b) Assume the partnership sells the building on January 1 of year two and immediately liquidates. Again, with an eye toward qualifying the allocation, how must the proceeds be distributed if the building is sold for $180,000? 1. Reg. 1.704-1(b)(2)(ii)(b)(2): liquidating distributions made according to partners positive capital account balances

62

2. A: $100k 3. B: $80k iii. For $200,000? 1. $200k AR $180k AB = $20k RG 2. Reg. 1.704-1(b)(2)(iv)(b): increase capital accounts by allocations to him of partnership gain a. Allocate $20k RG according to the pship agreement ($10k to each)

63

Assets Cas h $200k

Liability and Capital Accounts Liab: 0 Capital Accounts A

$100k + $10k $110k B $80k +$10k $90k $200k $200k 3. Reg. 1.704-1(b)(2)(ii)(b)(2): liquidating distributions made according to partners positive capital account balances 4. A: $110k 5. B: $90k iv. (c) Assume the agreement further provides that gain on disposition will be allocated to B to the extent of the cost recovery deductions specially allocated to her. What result when the partnership sells the building on January 1 of year two for $200,000? Assets Liability and Capital Accounts Cas $200k Liab: 0 h Capital Accounts A $100k B $80k +$20k $100k $200k $200k 1. Reg. 1.704-1(b)(2)(ii)(b)(2): liquidating distributions made according to partners positive capital account balances 2. A: $100k 3. B: $100k v. (d) Assume that B is not required to restore a deficit in her capital account, but the partnership agreement includes a qualified income offset. If the partnership continues to operate the building, what is the result to A and B in year one? Assets Liability and Capital Accounts Buildi $200k Liab: 0 ng Depr. ($200) Capital Accounts

64

$100k $80k $180k $180k 1. Reg. 1.704-1(b)(2)(ii)(b)(3): fails basic economic effect test b/c no unconditional deficit restoration obligation 2. Reg. 1.704-1(b)(2)(ii)(d): if (1) first two reqs in basic economic effect test are met, and (2) has no or limited deficit restoration obligation, and (3) the pship agreement contains a QIO, the allocation is considered to have economic effect to the extent it does not cause/increase a deficit balance in excess of any limited deficit restoration obligation a. Meets all requirements for the alternative test for economic effect vi. In year six? Assets Buildi ng Depr. $200k ($120) Liability and Capital Accounts Liab: 0 Capital Accounts A B

A B

$100k ($20k) $80k $80k 1. Reg. 1.704-1(b)(2)(ii)(d): this violates the third prong of the alternative test for economic effect 2. Reg. 1.704-1(b)(1)(i): must reallocate in accordance with the partners interests in the partnership vii. (e) What results in both years under the facts of (d), above, if in addition B has contributed her promissory note for $100,000 to the partnership? 1. Reg. 1.704-1(b)(2)(iv)(d)(2): if a promissory note is contributed to a partnership by a partner, such partners capital account will be increased only when there is a taxable disposition of such note by the partnership or when the partner makes principal payments on such note a. P/note has no effect on capital accounts 2. Reg. 1.704-1(b)(2)(ii)(d): if alternative test for economic effect is met, the allocation will be considered to have economic effect to the extent such allocation does not cause or increase a

65

deficit balance in excess of any limited dollar amount of such deficit balance that such partner is obligated to restore a. Reg. 1.704-1(b)(2)(ii)(c)(1): a partner is treated as obligated to restore a deficit balance to the extent of the outstanding principal balance of any promissory note contributed to the partnership by the partner b. Thus, allocations to B will have economic effect to the extent of $100k (the amount of the promissory note) 3. Note: this isnt really helpful b/c by the end of year 5, Bs outside basis = 0. 704(d) suspends further deductions. viii. Suppose in year 7, the partnership expects to make a distribution of $100k to each partner. 1. Reg. 1.704-1(b)(2)(ii)(d): if alternative test for economic effect is met, the allocation will be considered to have economic effect to the extent such allocation does not cause or increase a deficit balance in excess of any limited dollar amount of such deficit balance that such partner is obligated to restore 2. Reg. 1.704-1(b)(2)(ii)(d)(6): in determining the extent of deficit capital accounts caused or increased, a partners capital account is reduced for expected distributions and expected increases in capital accounts 3. If B gets a $100k distribution, Bs capital account decreases from $0 to ($100k). 4. Thus, B cannot take the $20k depreciation deduction ix. Suppose instead in year 7 the partnership makes an unexpected $100k distribution to each partner. 1. Bs capital account decreases from $0 to ($120) (impermissible). 2. Reg. 1.704-1(b)(2)(ii)(d): QIO provides that if a partner unexpectedly receives a distribution that creates an impermissible deficit, she will be allocated items of income or gain sufficient to eliminate such deficit balance as quickly as possible. 3. Here, the partnership would allocate income items of $20k to eliminate the impermissible excess deficit 2. Reallocations When an Allocation Lacks Economic Effect Because of the Absence of a Deficit Restoration Obligation

66

a. Partners Interest in the Partnership. If a

partnership agreement provides for an allocation of income, gain, loss, deduction, or credit to a partner but such allocation does not have substantial economic effect, then the partners distributive share of such tax item shall be determined in accordance with such partners interest in the partnership. Reg. 1.704-1(b) (1)(i).

b. Agreement to Share Economic Benefits/Burdens.

Partners interest in the partnership signifies the manner in which the partners have agreed to share the economic benefit or burden corresponding to the tax item allocated. Reg. 1.704-1(b)(3)(i).

c. Facts and Circumstances. The determination of a

partners interest in a partnership shall be made by taking into account all facts and circumstances relating to the economic arrangement of the partners. Reg. 1.704-1(b)(3)(i).

d. Per Capita Presumption. All partners interest in the

partnership are presumed to be equal (determined on a per capita basis). However, the presumption may be rebutted by T or the IRS by establishing facts/circumstances that show that the partners interests in the partnership are otherwise. Reg. 1.7041(b)(3)(i).

e. Factors Considered. In determining a partners

interest in the partnership, the following factors are among those that will be considered:

i. (a) The partners relative contributions to the

partnership,

ii. (b) The interests of the partners in economic

profits and losses (if different than that in taxable income or loss), iii. (c) The interest of the partners in cash flow and other non-liquidating distributions, and

iv. (d) The rights of the partners to distributions of

capital upon liquidation. Reg. 1.704-1(b)(3)(ii).

f. Certain Determinations. If the first two requirements

of the basic test are met, and all or a portion of an allocation of income, gain, loss, or deduction does not have economic effect, the partners interests in the partnership with respect to the portion of the allocation that lacks economic effect will be determined by comparing the manner in which distributions (and contributions) would be made if all partnership property

67

were sold at book value and the partnership liquidated (1) in the year of the allocation, with (2) the result if the partnership liquidated in the prior year. Reg. 1.7041(b)(3)(iii).

g. Problem. In Problem 1(d) (p. 161) above, what

reallocation, if any, is necessary in year 6?

i. Year 5
Assets Buildi ng Depr. $200k ($100) Liability and Capital Accounts Liab: 0 Capital Accounts A B

$100k ii. Year 6 Assets Buildi ng Depr. $200k ($120)

$100k $0 $100k

Liability and Capital Accounts Liab: 0 Capital Accounts A B

$80k iii. Reg. 1.704-1(b)(1)(i): if a partnership agreement provides for an allocation of income, gain, loss, deduction, or credit to a partner but such allocation does not have substantial economic effect, then the partners distributive share of such tax item shall be determined in accordance with such partners interest in the partnership.

$100k ($20k) $80k

iv. Reg. 1.704-1(b)(3)(iii): If the first two

requirements of the basic test are met, and an allocation of deduction does not have economic effect, the partners interests in the partnership is determined by comparing what distributions (and contributions) would be made if all partnership property were sold at book value and the partnership liquidated (1) in the year of the allocation, with (2) the result if the partnership liquidated in the prior year. 1. Constructive Liquidation at Year 5 A B Distributions 100 0 Contributions 0 0 2. Constructive Liquidation at Year 6 A B Distributions 80 0

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Contributions 0 0* *b/c no deficit restoration obligation v. Since A bears the economic burden associated with the depreciation; allocate all year 6 depreciation to A

h. What would be the result in year 6 if the partnership

agreement did not contain a qualified income offset? i. Reg. 1.704-1(b)(2)(ii)(3): cannot satisfy the 3d prong of the basic economic effect test ii. Reg. 1.704(b)(2)(ii)(d)(3): cannot satisfy the 3d prong of the alternate economic effect test iii. Reg. 1.704-1(b)(1)(i): if a partnership agreement provides for an allocation of income, gain, loss, deduction, or credit to a partner but such allocation does not have substantial economic effect, then the partners distributive share of such tax item shall be determined in accordance with such partners interest in the partnership.

iv. Reg. 1.704-1(b)(3)(iii): If the first two

requirements of the basic test are met, and an allocation of deduction does not have economic effect, the partners interests in the partnership is determined by comparing what distributions (and contributions) would be made if all partnership property were sold at book value and the partnership liquidated (1) in the year of the allocation, with (2) the result if the partnership liquidated in the prior year. 1. Years 15 a. B bears the economic burden associated with the depreciation deductions b. Respect the allocations 2. Year 6 a. Reallocate to A 3. Even though its the same result as with the QIO, its a good idea to have the QIO so you can use the alternate economic effect test ii. Substantiality

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1. Generally. The substantiality requirement asks whether

partners are merely shifting items with different tax characteristics among themselves without changing the economic result.

2. Order of Substantiality Tests. First, (depending on the

timing of the allocations) apply either the Shifting Tax Consequences Test or the Transitory Allocation Test. Then, apply the After Tax Test. Finally, apply the General Test.

3. Shifting Tax Consequences Test. The economic effect of an

allocation is not substantial if, at the time the allocation becomes part of the partnership agreement, there is a strong likelihood that

a. (1) the net increases/decreases recorded in the partners

capital accounts will not differ substantially than what they would be in the absence of the allocations, AND

b. (2) the total tax liability of the partners will be less than
if the allocations were not contained in the partnership agreement. Reg. 1.704-1(b)(2)(iii)(b).

4. Transitory Allocation Test. If a partnership agreement

provides for the possibility that one or more allocations (original allocation) will be largely offset by one or more other allocations (offsetting allocation), the economic effect of these allocations are not substantial if at the time the allocations become part of the partnership agreement there is a strong likelihood that

a. (1) the net increases/decreases recorded in the partners

capital accounts will not differ substantially from what it would have been in the absence of the allocations, AND

b. (2) the total tax liability of the partners will be reduced

from what it would otherwise be. Reg. 1.704-1(b)(2) (iii)(c).

5. After Tax Test. The economic effect of an allocation is not

substantial if, at the time the allocation becomes part of the partnership agreement,

a. (1) the after-tax economic consequences of at least one

partner may, in present value terms, be enhanced compared to such consequences if the allocation were not contained in the partnership agreement, and

b. (2) there is a strong likelihood that the after-tax

economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation were not contained in the partnership agreement. Reg. 1.704-1(b)(2)(iii) (a) (second sentence).

70

6. General Test. The economic effect of an allocation is

substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Reg. 1.704-1(b)(2)(iii)(a) (first sentence).

7. Problem 2 (p. 162). C and D are equal partners in a general

partnership formed to design and produce clothing for sale to retailers located throughout Europe and the United States. D is a nonresident alien. At the beginning of the tax year, the relative dollar amounts of United States and foreign source income cannot be predicted. Any foreign source income allocated to D is exempt from United States taxation. Assume that all of the following allocations have economic effect. a. (a) What result if the partnership agreement provides that all U.S. source income will be allocated to C, and all foreign source income will be allocated to D? i. Shifting Tax Consequences Test 1. There is no strong likelihood that the net increases/decreases in capital accounts would not differ substantially b/c income cannot be predicted.

2. See Reg. 1.704-1(b)(5) Example 10(i).

ii. After Tax Test 1. The after-tax consequences of D may be enhanced b/c D is tax exempt on foreign income.

2. There is not a strong likelihood that the

after-tax economic consequences of no partner will be substantially diminished b/c we cannot predict the amounts of foreign and U.S. income. iii. General Test 1. There is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners. b. (b) What result if the agreement provides that all income will be shared equally but that D will be allocated all the foreign source income up to the dollar amount of her 50% share of income? i. Shifting Tax Consequences Test

71

1. There is a strong likelihood that net increases/decreases in capital accounts would not differ substantially 2. Example

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Foreign US

With Allocation Total C $50k 0 $100k $75k $150k $75k

D $50k $25k $75k

Without Allocation: $150k * = $75k each 3. There is a strong likelihood that the total tax liability is reduced b/c of the allocation. (Although we probably need to know more about the partners tax profiles.) ii. Thus, the economic effect of the allocations is not substantial iii. See Reg. 1.704-1(b)(5) Example 10(ii). iv. Allocate in accordance with the partners interests in the partnership. Allocate of the foreign source income to C and D each; allocate of the U.S. income to C and D each. c. (c) Assume, instead, that at the beginning of the tax year it can be predicted that the relative dollar amounts of U.S. and foreign source income will be roughly equal. What result if the agreement provides, as in (a), above, that all U.S. source income shall be allocated to C, and all foreign source income shall be allocated to D? i. Shifting Tax Consequences Test 1. There is a strong likelihood that net increases/decreases in capital accounts will not differ substantially. This is b/c the amounts of foreign and U.S. source income are roughly the same. 2. Example Foreig n US With Allocation Total C $75k 0 $75k $150k $75k $75k D $75k 0 $75k

Without Allocation: $150k * = $75k each 3. There is a strong likelihood that the total tax liability is reduced b/c of the allocation. This is b/c D wont pay taxes on foreign source income. (Although wed probably want additional facts about the tax profiles of the partners.)

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ii. Thus, the economic effect of the allocation is not

substantial. iii. Allocate in accordance with the partners interest in the partnership. Each gets half of the foreign and US income. c. Allocations Attributable to Nonrecourse Debt

i. General Rule. Nonrecourse deductions must be allocated in

accordance with the partners interests in the partnership. Reg. 1.704-2(b)(1).

ii. Safe Harbor. Allocations of nonrecourse deductions are deemed to

be in accordance with the partners interests in the partnership if: 1. (1) throughout the full term of the partnership, the basic or alternate test for economic effect is met; 2. (2) the partnership agreement provides for allocations of NR deductions in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liabilities; 3. (3) the partnership agreement contains a minimum gain chargeback provision; 4. (4) all other material allocations and capital account adjustments under the partnership agreement are recognized under 1.704-1(b). Reg. 1.704-2(e).

iii. Nonrecourse Deductions. The amount of nonrecourse deductions

equals the net increase in partnership minimum gain during the year, reduced (but not below zero) by the aggregate distributions made during the year of proceeds of a nonrecourse liability that are allocable to an increase in partnership minimum gain. Reg. 1.704-2(c).

1. Partnership Minimum Gain. The partnership minimum gain

is any gain the partnership would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability. Reg. 1.704-2(d)(1).

a. Net Increase/Decrease. The net increase/decrease in

partnership minimum gain is determined by comparing the partnership minimum gain on the last day of the immediately preceding taxable year with the partnership minimum gain on the last day of the current taxable year. Reg. 1.704-2(d)(1).

iv. Minimum Gain Chargeback. If there is a net decrease in partnership

minimum gain, the minimum gain chargeback requirement applies and each partner must be allocated items of partnership income and gain for that year equal to that partners share of the net decrease in partnership minimum gain. Reg. 1.704-2(f)(1).

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1. Share of Net Decrease in Partnership Minimum Gain. A

partners share of partnership minimum gain equals the sum of nonrecourse deductions allocated to that partner allocable to an increase in partnership minimum gain . . . . Reg. 1.704-2(g)(1) (i).

a. Add to Limited Deficit Restoration Obligation. For

purposes of the alternate economic effect test, a partners share of partnership minimum gain is added to the partners limited deficit restoration obligation. Reg. 1.704-2(g)(1) (flush language).

v. Study Guide for Assignment 4F. Developer and Investor form a

limited partnership in which Developer is the general partner and Investor is the limited partner. Neither partner makes a contribution to the partnerships capital. The partnership purchases an office building for $100,000 using the $100,000 of loan proceeds that it borrows on a nonrecourse basis. The loan is secured by the building. The partnership depreciates the building on a straight-line basis over ten years. If we ignore the applicable convention, the partnership will have a $10,000 depreciation deduction each year. The partnership agreement allocates all items of income and deduction 10% to Developer and 90% to Investor. The partnership agreement contains a minimum gain chargeback provision.

1. (1) Who will bear the economic burden of the depreciation? In

considering this question, assume that the partnership sells the building for its book value immediately after the partnerships first taxable year. Who will receive the proceeds of the sale, and what does this tell you concerning who bears the economic burden of the depreciation? a. If the partnership sells the building after the first taxable year, the lender gets the proceeds of the sale (i.e., $90k). i. $100k AR $90k AB = $10k RG

b. Since the loan is nonrecourse, the lender bears the

economic burden of the depreciation. 2. (2) What is the general rule in the regulations concerning how nonrecourse deductions must be allocated, and what safe harbor do the regulations provide? a. Reg. 1.704-2(b)(1): NR deductions must be allocated in accordance with the partners interests in the partnership

b. Reg. 1.704-2(e) provides a safe harbor. See II.c.ii. Safe

Harbor, supra. 3. (3) Is the partnership eligible for the safe harbor set forth in the regulations?

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4. (4) In its first taxable year, what is the amount of the partnerships nonrecourse deductions? In answering this question, consider: a. What is the general rule concerning how to determine the amount of the partnerships nonrecourse deductions? i. Reg. 1.704-2(c): net increase in pship minimum gain reduced by aggregate distributions of proceeds of a NR liability allocable to an increase in pship minimum gain b. Is there any partnership minimum gain at the beginning of the partnerships first taxable year? Immediately after the end of the partnerships first taxable year?

i. Reg. 1.704-2(d)(1): pship minimum gain is any

gain the pship would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability ii. Beginning of Year 1 1. $100k AR $100k AB = 0 iii. End of Year 1 1. $100k AR $90k AB = $10k iv. Net increase in partnership minimum gain = $10k v. Partnership nonrecourse deductions = $10k (i.e., the depreciation deduction is a NR deduction) c. Suppose you took out an additional $5k in NR debt and took a distribution i. Reg. 1.704-2(c): pship NR deductions = net increase in pship minimum gain reduced by aggregate distributions of proceeds of a NR liability allocable to an increase in pship minimum gain ii. $15k increase in pship minimum gain iii. ($5k) distribution of proceeds of NR liability allocable to an increase in pship minimum gain iv. Thus, partnerships NR deductions = $10k 5. (5) What is a minimum gain chargeback provision, and what does it require? To test your understanding of the provisions effect, assume that, immediately after the close of the

76

partnerships first taxable year (i.e., at the beginning of year 2), the partnership transfers the building to a purchaser who pays no cash, but who takes the property subject to the nonrecourse liability. How much gain must be allocated to each partner?

a. Reg. 1.704-2(f): if there is a net decrease in

partnership minimum gain, the minimum gain chargeback requirement applies and each partner must be allocated items of partnership income and gain for that year equal to that partners share of the net decrease in partnership minimum gain i. If the partnership transfers the building to a purchaser who takes property subject to NR liability, $10k gain must be allocated to the partners 1. $100k AR $90k AB = $10k RG

b. Reg. 1.704-2(g)(1)(i): a partners share of partnership

minimum gain equals the sum of nonrecourse deductions allocated to that partner allocable to an increase in partnership minimum gain i. Depreciation deductions allocated: 1. Developer: $1k 2. Investor: $9k ii. Partners will get these amounts of the $10k RG iii. Partners capital accounts will be brought up to zero 6. (6) Do a balance sheet for the partnership (that shows only book accounts) as of the beginning of its first taxable year, and as of the end of its first taxable year. What is Investors book capital account at the end of the first year? Is the agreed allocation of the depreciation to Investor in the first year permissible under either the primary or alternate economic effect test? a. Beginning of Year 1 Assets Buildin g $100k Liability and Capital Accounts Liabilities Note Payable Capital Accounts Dev. Inv. $100k $100k 0 0 $100k

77

b. End of Year 1 Assets Buildin g Dep. $100k ($10k)

Liability and Capital Accounts Liabilities Note Payable Capital Accounts Dev. Inv. $100k

($1k) ($9k) $90k $90k c. If the safe harbor requirements are met, the allocation will be deemed to be in accordance with the partners interests in the partnership. See Reg. 1.704-2(e). d. Basic Test for Economic Effect i. Reg. 1.704-1(b)(2)(ii)(b): Investor unlikely to agree to an unconditional deficit restoration obligation e. Alternate Test for Economic Effect: if requirements are met, an allocation has economic effect if it does not cause or increase a deficit balance in excess of any limited deficit restoration obligation i. Reg. 1.704-2(g)(1) (flush language): for purposes of the alternate economic effect test, a partners share of partnership minimum gain is added to the partners limited deficit restoration obligation ii. Investors capital account does not decrease below ($9k); thus, the depreciation deduction allocation has economic effect 7. Suppose the partners contributed an additional $10,000 at the beginning of Year 1.

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Liability and Capital Accounts Cash $20k Liabilities Building $100k Note Payable $100k Capital Accounts Dev. $10k Inv. $10k $120k $120k a. Assume that during the year, the partnership paid $2,000 in wages (deductible). According to the partnership agreement, allocate 10% to Developer, 90% to Investor. i. Developers Capital Account 1. Begins at $10k 2. Allocate depreciation of $1k 3. Allocate wage deduction of $200 4. Ends at $8.8k ii. Investors Capital Account 1. Begins at $10k 2. Allocate depreciation of $9k 3. Allocate wage deduction of $1.8k 4. Ends at ($800) Assets Liability and Capital Accounts Cash $18k Liabilities Buildin $100k Note Payable $100k g Dep. ($10k) Capital Accounts Dev. $8.8k Inv. ($800) $108k $120k b. Can we allocate wage deductions to investor? i. Basic Test for Economic Effect: Investor is unlikely to agree to an unconditional deficit restoration obligation. ii. Alternate Test for Economic Effect: if requirements are met, an allocation has economic effect if it does not cause or increase a deficit balance in excess of any limited deficit restoration obligation 1. Reg. 1.704-2(g)(1) (flush language): for purposes of the alternate economic effect test, a partners share of partnership minimum gain is added to the partners limited deficit restoration obligation iii. Investors capital account does not decrease in excess of his limited deficit restoration obligation of $9k. Thus, the negative capital account balance does not trigger the QIO (b/c doesnt go negative impermissibly). III. Allocations With Respect to Contributed Property

Assets

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a. Introduction i. Subchapter Ks Approach to Allocations of Income and Deductions

1. General Rule. Under 704(a), a partners distributive share of

income, gain, loss, deduction and credit is determined by the partnership agreement.

2. Limitation. Under 704(b), each partners distributive share

of the items above is determined in accordance with the partners interest in the partnership if: a. The partnership agreement does not allocate these items among the partners, or b. The partnership agreement does allocate them, but the allocation does not have substantial economic effect

3. Another Limitation. Another limit is provided in 704(c). ii. Contributed Property. Under the regulations, "income, gain, loss,
and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. 704(c)(1)(A).

iii. Methods of Allocation. Allocations with respect to 704(c) property

must be made using a reasonable method that is consistent with the purpose of 704(c). Reg. 1.704-3(a)(1). Methods that are generally reasonable are: the traditional method, the traditional method with curative allocations, and the remedial method. See Reg. 1.704-3(b) (d).

iv. Property-by-Property Basis. Section 704(c) generally applies on a

property-by-property basis. Reg. 1.704-3(a)(2).

v. Section 704(c) Property. Property is 704(c) property if at the time

of contribution its book value differs from the contributing partners adjusted tax basis. Reg. 1.704-3(a)(3)(i).

vi. Application to Contributed Property. Section 704(c) applies only if

the partners contribution of property is governed by 721. Reg. 1.704-3(a)(5).

vii. Small Disparity Exception. The partnership can ignore 704(c) if

the disparity between the propertys book value and its adjusted tax basis is a small disparity. Reg. 1.704-3(e)(1)(i).

1. Small Disparity. A disparity between book value and

adjusted tax basis is a small disparity if: a. The book value of all properties contributed by one partner during the partnership taxable year does not

80

differ from the adjusted tax basis by more than 15% of the adjusted tax basis, and b. The total gross disparity does not exceed $20,000. Reg. 1.704-3(e)(1)(ii). b. Sales and Exchange of Contributed Property

i. Traditional Method 1. Allocate Built-In Gain/Loss to Contributor. If the

partnership sells section 704(c) property and recognizes gain or loss, built-in gain or loss on the property is allocated to the contributing partner. Reg. 1.704-3(b)(1).

a. Built-In Gain/Loss. The built-in gain on section 704(c)

property is the excess of the propertys book value over the contributing partners adjusted tax basis upon contribution. Reg. 1.704-3(a)(3)(ii).

2. Ceiling Rule. The total [tax] income, gain, loss or deduction

allocated to the partners for a taxable year with respect to a property cannot exceed the total partnership income, gain, loss, or deduction with respect to that property for the taxable year. Reg. 1.704-3(b)(1). ii. Remedial Allocation Method

1. Generally. First, the partnership determines the partners

distributive share of book items. The partnership then allocates the corresponding tax items recognized by the partnership, if any, using the traditional method. If the ceiling rule causes the book allocation of a noncontributing partner to differ from the tax allocation, the partnership creates a remedial item of income, gain, loss, or deduction equal to the full amount of the difference and allocates it to the noncontributing partner. The partnership simultaneously creates an offsetting remedial item in an identical amount and allocates it to the contributing partner. Reg. 1.704-3(d)(1).

2. Type of Allocations. Remedial allocations have the same tax

attributes as the tax item limited by the ceiling rule. Reg. 1.704-3(d)(3).

3. No Effect on Partnership. Remedial items do not affect the

partnerships computation of its taxable income or inside bases. Reg. 1.704-3(d)(4)(i).

4. Effect on Partners. Remedial items have the same effect as

actual tax items on a partners tax liability. Reg. 1.704-3(d)(4) (ii).

iii. Traditional Method with Curative Allocations. To correct

distortions created by the ceiling rule, a partnership using the

81

traditional method may make reasonable curative allocations. A curative allocation is an allocation of tax item that differs from the corresponding book item. Reg. 1.704-3(c)(1). iv. Character of Certain Tax Items

1. General Rule. Generally, character of gain/loss is determined

at the partnership level. But 724 provides some exceptions.

2. Contribution of Unrealized Receivables. In the case of

property that was an unrealized receivable in the hands of the partner before it was contributed to the pship, any gain/loss recognized by the pship on disposition is treated as ordinary income/loss. 724(a).

a. Unrealized Receivable. Unrealized receivables

includes, to the extent not previously includible in income, any rights to payment for goods delivered (if inventory) or services rendered. 724(d)(1), 751(c).

3. Contribution of Inventory Items. In the case of property

that was an inventory item in the hands of the partner before it was contributed to the pship, any gain/loss recognized by the pship on a disposition within 5 years after contribution is treated as ordinary income/loss. 724(b).

a. Inventory Item. inventory items means:

i. (1) property of the pship described in 1221(a) (1), ii. (2) property of the pship which, on sale or exchange by the partnership, would be considered property other than a capital asset and other than property described in 1231, and

iii. (3) property held by the pship which, if held by

the selling or distrbutee partner, would be considered property of the type described in (1) or (2). 724(d)(2), 751(d). 4. Contribution of Capital Loss Items

a. Loss treated as Capital Loss. Any loss recognized by

the pship on the disposition of capital loss property within 5 years of contribution is a capital loss. 724(c) (flush language).

b. Capital Loss Property. This rule applies to property

contributed by a partner that was a capital asset in his hands immediately before the contribution. 724(c)(1), (2).

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v. Problem 1 (p. 195). A, B and C form an equal partnership. A

contributes accounts receivable for services rendered (A.B.$0, F.M.V. $10,000); B, a real estate dealer, contributes lots held primarily for sale (A.B.$5,000, F.M.V.$10,000); and C, an investor, contributes land (A.B.$20,000, F.M.V.$10,000). Unless otherwise stated, the partnership is not a dealer in receivables or land, all contributed assets have been held long-term by the partners prior to contribution, and the traditional method of allocation is applied with respect to all contributed property. What tax results in the following alternative transactions:

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Liability and Capital Accounts Tax Book A/R Liabilities: none Lots $5k $10k Capital (land) Accounts Land $20k $10k A 0 $10k B $5k $10k C $20k $10k 1. (a) The partnership sells the receivables contributed by A for $10,000? a. Book Gain: $10k AR $10k AB = 0 b. Tax Gain: $10k AR 0 AB = $10k i. Reg. 1.704-3(b)(1): allocate built-in gain to contributing partner ii. Reg. 1.704-3(a)(3)(ii): built-in gain = $10k c. Ceiling Rule i. The ceiling rule does not apply the amount were allocating, $10k, does not exceed the pship tax gain. d. Character of the Tax Gain i. 724(a): any gain/loss recognized by a disposition of a contributed unrealized receivable is ordinary income ii. 724(d)(1), 751(c): unrealized receivable includes rights to payment for services rendered iii. Thus, the income that flows to A is ordinary Assets Liability and Capital Accounts Tax Book Tax Book Cash $10k $10k Liab: none Lots $5k $10k Capital (land) Account Land $20k $10k A $10k $10k B $5k $10k C $20k $10k 2. (b) The partnership sells the lots contributed by B for $10,600? a. Book Gain: $10.6k AR $10k AB = $600 i. Allocate according to the pship agreement ($200 each) b. Tax Gain: $10.6k AR $5k AB = $5.6k i. Built-In Gain 1. Reg. 1.704-3(b)(1): allocate built-in gain to contributing partner 2. Reg. 1.704-3(a)(3)(ii): built-in gain = $5k ii. Remaining Gain 1. $5.6k tax gain $5k built-in gain = $600 2. Allocate equally among partners c. Ceiling Rule i. The ceiling rule does not apply; the amount were allocating, $5.6k, does not exceed the pship tax gain. Book $10k

Assets Tax 0

84

d. Character of the Tax Gain i. 724(b): any gain/loss recognized by a disposition of a contributed inventory item within 5 years of contribution is ordinary income/loss ii. Thus, the income that flows to the partners is ordinary

85

Assets A/R Cash Land Tax 0 $10.6 k $20k Book $10k $10.6 k $10k

Liability and Capital Accounts Tax Book Liab: none Capital Accts A $200

$10.2 k B $10. $10.2 2k k C $20. $10.2 2k k 3. (c) The partnership sells the lots contributed by B for $9,100? a. Book Loss: $9.1k AR $10k AB = ($900) i. Allocate according to the pship agreement (equally) b. Tax Gain: $9.1k AR $5k AB = $4.1k i. Reg. 1.704-3(b)(1): allocate built-in gain to contributing partner c. Ceiling Rule i. Reg. 1.704-3(b)(1): tax gain/loss allocated cannot exceed total gain/loss ii. A and C 1. Since we allocated a $300 book loss to A and C, wed like to allocate a $300 tax loss. But, we cannot do this under the ceiling rule b/c there is no pship tax loss. iii. B 1. B has a claim on $9.7k (after the book loss allocation) 2. Bs basis contributed was $5k 3. Thus, Bs true tax gain is $4.7k 4. But, under the ceiling rule, we can only allocate $4.1k of gain to B. Assets Liability and Capital Accounts Tax Book Tax Book A/R 0 $10k Liab: none Lots $5k $10k Capital Acct (land) Land $20k $10k A 0 $9.7k B $9.1 $9.7k k C $20k $9.7k 4. (d) Same as (c), above, except that partnership elects to use the remedial method of allocation. a. Reg. 1.704-3(d)(1): under the remedial method, create offsetting tax allocations to negate the ceiling rule i. A and C: ($300) allocation ii. B: $600 allocation Assets Liability and Capital Accounts Tax Book Tax Book

86

($30 $9.7k 0) B $9.7 $9.7k k C $19. $9.7k 7k 5. (e) The partnership is a real estate dealer and sells the land contributed by C for $17,000? a. Book gain = $7k i. Allocate according to pship agreement ($2,333 each) ii. Increase book capital accounts b. Tax loss = ($3k) i. Built-in loss allocated to C c. Ceiling Rule i. A and B: We would like to give $2,333 of tax gain to match book allocation (but cant do that b/c of the ceiling rule) ii. C: We would like to allocate 3k of book loss (but cant b/c of the ceiling rule) 1. Now, C has a claim on 12,333 2. Amount C contributed was 20k 3. We would like to allocate a 7,667 tax loss to C (12,33320k) (but can only allocate 3k tax loss b/c of the ceiling rule) d. Character of 3k Loss i. General rule: determine character at pship level 1. Loss would be ordinary under this rule ii. Exception: 724(c): contributions of capital loss property 1. Capital loss to the extent of the built-in loss 2. Thus, 3k is a capital loss that flows through to C, even though the pship is a dealer in real estate 6. (g) Would the result in any of the above transactions change if all sales had occurred six years after the property was contributed? a. Yes b. 724(b), (c): special characterization rules for contributed inventory and capital loss property only apply if the property was disposed of within 5 years of contribution i. After 5 years, determine character at the pship level ii. Disposition of inventory item: loss would be capital iii. Disposition of land: loss would be ordinary c. Note: contributed unrealized receivables (724(a)) doesnt have a 5-year window IV. Allocations of Partnership Liabilities a. Introduction

A/R Lots (land) Land

0 $5k $20k

$10k $10k $10k

Liab: none Capital Acct A

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i. Increase in Partners Liabilities. Any increase in a partners share

of partnership liabilities (or the partners assumption of partnership liabilities) is treated as a contribution of money by the partner. 752(a). 1. Increases Basis. A partners outside basis shall be the amount of money and AB of property contributed. See 722. ii. Decrease in Partners Liabilities. Any decrease in a partners share of partnership liabilities (or the partnerships assumption of the partners liabilities) is treated as a distribution of money to the partner. 752(b). 1. Distributions Decrease Basis. Outside basis is decreased (but not below zero) by cash/property distributions by the pship. 705(a)(2), 733. 2. Distributions in Excess of Basis. A distribution results in a gain to a partner to the extent that the distribution exceeds outside basis. 731(a)(1). iii. Policy. The policy of 752 is to try to give each partner enough basis in the partnership to take deductions that result from the liability. iv. Liability Defined. An obligation is a liability for purposes of 752 to the extent the obligation: 1. Creates or increases the obligors basis in any of its assets (including cash), 2. Gives rise to an immediate deduction to the obligor, or a. E.g., accrued wages payable for an accrual method taxpayer 3. Gives rise to an expense that is not deductible in computing taxable income and is not a capital expenditure (i.e., 705(a)(2) (B) amounts). a. E.g., if a pship accrues tax liability to a foreign country b. Recourse Liabilities i. Recourse vs. Nonrecourse Liabilities 1. Recourse. A partnership liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability under 1.752-2. Reg. 1.752-1(a)(1). 2. Nonrecourse. A partnership liability is a nonrecourse liability to the extent that no partner bears the economic risk of loss for that liability under 1.752-2. Reg. 1.752-1(a)(2). ii. Economic Risk of Loss. A partners share of a recourse partnership liability equals the portion of that liability for which the partner bears the economic risk of loss. Reg. 1.752-2(a). 1. Constructive Liquidation. A partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner would not be entitled to reimbursement from another partner. Reg. 1.752-2(b)(1). a. What Hypothetically Happens. Upon a constructive liquidation: i. All of the partnerships liabilities become payable in full; ii. With the exception of property contributed to secure a partnership liability, all of the

88

partnerships assets, including cash become worthless; iii. The partnership disposes of all of its property for no consideration (except relief from liabilities for which the creditors right to repayment is limited solely to one or more assets of the partnership); iv. All items of income, gain, loss, or deduction are allocated among the partners; and v. The partnership liquidates. Reg. 1.752-2(b)(1). 2. Property Contributed to Secure a Partnership Liability a. Has Value in Constructive Liquidation. In the constructive liquidation, all pship property becomes worthless, except property contributed to secure a pship liability. Reg. 1.752-2(b)(1)(ii) b. Indirect Pledges. A partner bears the economic risk of loss for a partnership liability to the extent of the value of any property that the partner contributes to the partnership solely for the purpose of securing a partnership liability. Reg. 1.752-2(h)(2). i. Must Allocate to Contributor. Contributed property is not treated as contributed solely for the purpose of securing a partnership liability unless substantially all items of income, gain, loss, and deduction attributable to the contributed property are allocated to the contributing partner. Reg. 1.752-2(h)(2). ii. Greater than Share of Other Items. Contributed property is not treated as contributed solely for the purpose of securing a partnership liability unless the allocation is generally greater than the partners share of other significant items of partnesrhip income, gain, loss, or deduction. Reg. 1.752-2(h)(2). c. No Promissory Notes. For purposes of (h)(2), a promissory note of the partner or related person that is contributed to the partnership shall not be taken into account unless the note is readily tradeable on an established securities market. Reg. 1.752-2(h)(4). 3. Reimbursement. A partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person . . . and the partner would not be entitled to reimbursement from another partner. Reg. 1.752-2(b)(1). A partners obligation to make a payment is reduced to the extent that the partner is entitled to reimbursement. Reg. 1.752-2(b)(5). 4. Deemed Satisfaction of Obligation. It is assumed that all partners who have obligations to make payments actually perform those obligations. Reg. 1.752-2(b)(6). iii. Problem 1 (p. 214). A, B and C each contribute $20,000 to form the ABC general partnership. The partnership agreement satisfies the primary test for economic effect under Section 704(b). Partnership profits and losses are allocated 40% to A, 40% to B and 20% to C. The

89

partnership uses its $60,000 cash and borrows an additional $40,000 on a recourse basis and purchases land for $100,000. Assets Liability and Capital Accounts Land $100k Liabilities: $40k note/payable Capital Accounts A $20k B $20k C $20k 1. (a) How will the $40,000 liability be allocated and what will be each partners outside basis? a. Reg. 1.752-1(a)(1): a pship liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability under 1.752-2 b. Reg. 1.752-2(b)(1): a partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner would be obligated to make a payment i. The $40k is due right now ii. The land becomes worthless iii. Pship disposes of land for no consideration 1. $0 AR $100k AB = $100 RL iv. $100k loss allocated among the partners 1. Special allocation satisfies primary test for economic effectallocate loss according to the agreement Partner Beg. Share of Ending Capital Loss Capital Account Account A 20k (40k) (20k) B 20k (40k) (20k) C 20k (20k) 0 2. Note: negative capital accounts are OK b/c of the unconditional deficit restoration obligation v. The partnership liquidates c. Since A and B are under an obligation to restore their negative capital accounts of ($20) back to zero, they have a payment obligation d. Thus, at least one partner bears the economic risk of loss for this liability e. Thus, this is a recourse liability f. Reg. 1.752-2(a): a partners share of recourse pship liability equals the portion of that liability for which the partner bears the economic risk of loss i. 752(a): increase in partners share of pship liability is considered as a contribution of money to the pship ii. 722: partners basis in his partnership interest = money + AB of property contributed iii. A has a $20k share of liability iv. B has a $20k share of liability

90

v. C has a 0 share of liability Partner Beg. Increased/Decre End. Outside ased Share of Outside Basis Liability Basis A $20k $20k $40k B $20k $20k $40k C $20k 0 $20k 2. (b) What result in (a), above, if A, B and C had contributed $10,000, $20,000 and $30,000 respectively, to the ABC partnership? a. B/c special allocation satisfies basic test for economic effect, $100k loss allocated according to pship agreement Partner Beg. Capital Share of End. Capital Account Loss Account A $10k ($40k) ($30k) B $20k ($40k) ($20k) C $30k ($20k) 10k b. $50k is paid in to restore capital accounts, but $10k goes to C on constructive liquidation c. Total paid in = $50k i. A contributes $30k/$50k = 60% ii. B contributes $20k/$50k = 40% d. 60% of As and 40% of Bs contribution goes to pay off the pship liability i. A: 60% * 40k = 24k (risk of loss) ii. B: 40% * 40k = 16k (risk of loss) e. Share of Liability Partner Beg. Increased/Decre End. Outside ased Share of Outside Basis Liability Basis A $10k $24k $34k B $20k $16k $36k C $30k $0 $30k 3. (c) What result in (a), above, if A and B are limited partners who are not obligated to restore a capital account deficit but the partnership agreement includes a qualified income offset? a. Same $100k loss to pship b. Constructive Liquidation

91

Beg. Share of Loss End. Capital Capital Account Account A $20k ($40k) ($20k) B $20k ($40k) ($20k) C $20k ($20k) $0 i. Reg. 1.704-1(b)(2)(ii)(d): to have economic effect under the alternate test, the allocation cannot cause or increase a deficit capital account in excess of a partners limited deficit restoration obligation 1. As limited partners, A and B have no deficit restoration obligation 2. Thus, these allocations do not have economic effect 3. Reg. 1.704-1(i): reallocate in accordance with the partners interests in the pship c. Reallocate in Accordance with Interests in the Pship i. Reg. 1.704-1(b)(3)(iii): if first 2 parts of the basic test are met, compare the manner in which distributions and contributions would be made if the pship liquidated at the end of the current year and at the end of the previous year 1. Since there is no previous year, look at the situation just before the partnership assets were deemed worthless Distribution To A B C (Contribution By) Previous Year $20k $20k $20k End of Current 0 0 ($40k) Year Difference = Share $20k $20k $60k of $100k Loss ii. Capital Accounts Partner Beg. Share of Loss End. Capital Capital Account Account A $20k ($20k) $0 B $20k ($20k) $0 C $20k ($60k) ($40) iii. Share of Liability 1. 752(a): increase in partners share of pship liability is considered as a contribution of money to the pship 2. 722: partners basis in his partnership interest = money + AB of property contributed Partner Beg. Increased/Decre End. Outside ased Share of Outside Basis Liability Basis A $20k $0k $20 B $20k $0k $20 C $20k $40k $60k

Partner

92

d. Note: limited partners normally dont have any share of recourse liabilities of the partnership 4. (d) What result in (c), above, if A contributes $15,000 of stock to the partnership as security for the liability and all income, gain or loss on the stock is allocated to A? a. Note: were assuming As basis in stock = $15k Assets Liability & Capital Accounts Land $100k Liab: note payable $40k Stoc $15k Capital Accounts k A $35k B $20k C $20k $115k $115k b. Constructive Liquidation i. Reg. 1.752-2(b)(1)(ii): all pship assets are worthless, except property contributed to secure a partnership liability (see 1.752-2(h)(2)) ii. Reg. 1.752-2(h)(2): a partner is considered to bear the economic risk of loss for a partnership liability to the extent the partner contributes property to secure a partnership liability 1. Reg. 1.752-2(h)(2): must allocate tax items attributable to contributed property to contributing partner a. Here, all income, gain or loss on the stock is allocated to A 2. Reg. 1.752-2(h)(2): allocation must be generally greater than the partners share of other significant items of partnership income, gain, loss or deduction a. Here, the allocation is greater than As normal 40% of pship items 3. Thus, partner bears economic risk for $15k iii. Allocate $100k loss Partner Beg. Share of End. Capital Loss Capital Account Account A $35k ($40k) ($5k) B $20k ($40k) ($20k) C $20k ($20k) 0 1. Reg. 1.704-1(b)(2)(ii)(d): since the allocation creates deficit capital accounts and A and B have no deficit restoration obligation, this allocation does not have economic effect 2. Reallocate in accordance with partners interests in the pship c. Reallocate in Accordance with Interests in Pship i. Reg. 1.704-1(b)(3)(iii): if first 2 parts of the basic test are met, compare the manner in which distributions and contributions would be made if

93

the pship liquidated at the end of the current year and at the end of the previous year 1. Since there is no previous year, look at the situation just before the partnership assets were deemed worthless

94

Distribution A B C To (Contribution By) Note: not Previous $35k $20k $20k verified Year End of 0 0 ($25k) Current Year Difference = $35k $20k $45k Share of $100k Loss ii. Capital Accounts Partner Beg. Share of End. Capital Loss Capital Account Account A $35k ($35k) $0 B $20k ($20k) $0 C $20k ($45k) ($25) iii. Share of Liability 1. 752(a): increase in partners share of pship liability is considered as a contribution of money to the pship 2. 722: partners basis in his partnership interest = money + AB of property contributed Partn Beg. Increased/Decre End. er Outsid ased Share of Outsid e Liability e Basis Basis A $35k $15k* $50 B $20k $0k $20 C $20k $25k $45k *Reg. 1.752-2(h)(2): partner bears the economic risk of loss for a partnership liability to the extent of the value of any property that the partner contributes to the partnership solely for the purpose of securing a partnership liability 5. What result if A contributes his $15,000 note as security for the liability? Assets Liability & Capital Accounts Land $100k Liability: $40k note/payable P/note $15k Capital Accounts A $20k* B $20k C $20k $115k $100k *Reg. 1.704-1(b)(2)(iv)(d)(2): a contributed promissory note does not increase the contributors capital account until there is a taxable disposition of the note or when the partner makes principal payments on such note a. Constructive Liquidation

95

i. Reg. 1.752-2(b)(1)(ii): all pship assets are

worthless, except property contributed to secure a partnership liability (see 1.752-2(h)(2)) ii. Reg. 1.752-2(h)(2): a partner is considered to bear the economic risk of loss for a partnership liability to the extent the partner contributes property to secure a partnership liability iii. Reg. 1.752-2(h)(4): for purposes of (h)(2), a contributed promissory note shall not be taken into account unless the note is readily tradeable on an established securities market iv. Thus, A doesnt bear the economic risk of loss of the p/note under Reg. 1.752-2(h)(2) 1. But, under Reg. 1.704-2(b)(2)(ii)(b), (c) (1) the p/note is a limited restoration obligation of A v. Allocate $100k loss Partner Beg. Share of End. Capital Loss Capital Account Account A $35k ($40k) ($5k) B $20k ($40k) ($20k) C $20k ($20k) 0 1. Reg. 1.704-1(b)(2)(ii)(d): since the allocation creates a deficit capital account for B and B has no deficit restoration obligation, this allocation does not have economic effect 2. Reallocate in accordance with partners interests in the pship b. Reallocate in Accordance with Interests in Pship i. Reg. 1.704-1(b)(3)(iii): if first 2 parts of the basic test are met, compare the manner in which distributions and contributions would be made if the pship liquidated at the end of the current year and at the end of the previous year 1. Since there is no previous year, look at the situation just before the partnership assets were deemed worthless Distribution A B C To (Contribution By) Previous $20k $20k $20k Year End of ($15k) 0 ($25k) Current Year Difference = $35k $20k $45k Share of $100k Loss ii. Capital Accounts Partner Beg. Share of End. Capital Loss Capital Account Account

This is a guess

Note: not verified

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A $20k ($35k) ($15k)* B $20k ($20k) $0 C $20k ($45k) ($25k) *note: the negative capital account is OK b/c of the limited deficit restoration obligation iii. Share of Liabilities 1. 752(a): increase in partners share of pship liability is considered as a contribution of money to the pship 2. 722: partners basis in his partnership interest = money + AB of property contributed Partn Beg. Increased/Decre End. er Outsid ased Share of Outsid e Liability e Basis Basis A $20k $15k $35k B $20k $0k $20k C $20k $25k $45k 6. (e) What result in (c), above, if A personally guarantees the $40,000 liability? a. Reimbursement Issue i. Reg. 1.752-2(b)(1): a partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person . . . and the partner would not be entitled to reimbursement from another partner ii. Reg. 1.752-2(b)(5): a partners obligation to make a payment is reduced to the extent that the partner is entitled to reimbursement iii. If A has subrogation rights (i.e., he steps into the shoes of the lender, and can go after pship assets and Cs assets), A does not bear the economic risk of loss for the $40k liability iv. A would have to waive these subrogation rights to bear the economic risk of loss b. Deemed Satisfaction of Obligation i. Reg. 1.752-2(b)(6): it is assumed that all partners who have obligations to make payments actually perform those obligations ii. If the terms of the guarantee make the lender exhaust the pship assets and Cs assets, its assumed the lender will get satisfaction from these sources and will not have to go after A 1. We assume that C will make payment on the liability (even if hes insolvent) iii. To get around this, A would have to give the direct right to go after himself, irrespective of whether hes exhausted the pship assets or Cs assets c. Nonrecourse Liabilities

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i. Partners Share of Nonrecourse Liabilities. A partners share of

nonrecourse liabilities equals the sum of: 1. Partnership Minimum Gain. The partners share of partnership minimum gain under 704(b). Reg. 1.752-3(a)(1). a. Defined. The amount of PMG is the aggregate amounts of any gain the pship would realize if it disposed of property subject to a NR liability for no consideration other than full satisfaction of the liability. Reg. 1.7042(d)(1). b. Book Value. If pship property subject to a NR liability has a book/tax disparity, the PMG determination is made w/ reference to the propertys book value. Reg. 1.7042(d)(3). 2. Section 704(c) Gain. Gain that would be allocated to the partner under 704(c) if the pship disposed of all pship property subject to one or more NR liabilities of the pship in full satisfaction of the liabilities and for no other consideration. Reg. 1.752-3(a)(2). 3. Excess Nonrecourse Liabilities. Nonrecourse liabilities not allocated under Reg. 1.752-3(a)(1), (2) as determined in accordance with the partners share of partnership profits. Reg. 1.752-3(a)(3). a. Partnership Agreement. The pship agreement may specify the partners interests in pship profits for purposes of allocating excess NR liabilities provided the interests so specified are reasonably consistent with allocations (that have SEE) of some other significant item of pship income or gain. Reg. 1.752-3(a)(3). ii. Problem 2 (p. 21415). G and L form a limited partnership. G, the general partner, contributes $10,000 and L, the limited partner, contributes $90,000. The partnership purchases a building on leased land, paying $100,000 cash and borrowing $900,000 on a nonrecourse basis from a commercial lender, securing the loan with a mortgage on the building. The terms of the loan require the payment of market rate interest and no principal for the first ten years. Assume for convenience that the building is depreciable at the rate of $50,000 per year for twenty years, and that other partnership income equals expenses for the years in question. The partnership agreement contains a qualified income offset, and G is required to make up any capital account deficit. Except as otherwise required by a minimum gain chargeback provision, the agreement allocates profit and loss 90% to L and 10% to G until such time as the partnership recognizes items of income and gain that exceed the items of deduction and loss that it has recognized over its life. Subsequent partnership income and losses are allocated equally between G and L. Assume that it is reasonably anticipated that the equal allocation will begin after ten years. The partnership agreement states that G and L each has a 50% interest in partnership profits for purposes of 752. Assets Liabilities and Capital Accounts Building $1M Liab.: note $900k payable Capital Accounts

98

G L

$1M 1. (a) How is the $900,000 liability allocated in year one? a. Reg. 1.752-3(a)(1)(3): partners share of NR liabilities = i. Partners share of partnership minimum gain ii. Gain allocated to the partner under 704(c) if pship disposed of all pship property in full satisfaction of the liabilities and for no other consideration iii. Partners share of excess NR liabilities as determined in accordance with the partners share of pship profits b. Beginning of Year 1 i. No PMG 1. Reg. 1.704-2(d)(1): pship minimum gain is gain the pship would realize if it disposed of the property for no consideration other than the full satisfaction of the liability 2. Reg. 1.704-2(d)(3): if pship property subject to NR liabilities has a tax-book disparity, use the propertys book value for PMG 3. Here, if the pship sold the building, it would have a $100k RL ii. No 704(c) Gain 1. There is no contributed property iii. Excess NR Liability Allocated in Accordance with Partners Share of Profits 1. Reg. 1.752-3(a)(3): pship agreement may specify the partners interests in pship profits for purposes of allocating excess NR liabilities provided the interests are reasonably consistent w/ allocations (that have SEE) of some other significant item of pship income or gain 2. Here, the pship agreement provides that the partners have a 50% interest in pship profits for purposes of 752 a. This is consistent with the anticipated profits sharing arrangement iv. Note: unlike recourse liabilities, limited partners normally have a share in the pships NR liabilities Assets Liab. & Capital Accounts Buildin $1M Liab: note/p $900k g Capital Accounts G $10k L $90k $1M $1M

$10k $90k $1M

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v. Outside Basis Partn er G L

Beg. Outsid e Basis $10k $90k

Increased/Decre ased Share of Liability $450k $450k

End. Outsid e Basis $460k $540k

c. End of Year 1 i. No PMG 1. Reg. 1.704-2(d)(1): pship minimum gain is gain the pship would realize if it disposed of the property for no consideration other than the full satisfaction of the liability 2. Reg. 1.704-2(d)(3): if pship property subject to NR liabilities has a tax-book disparity, use the propertys book value for PMG 3. Here, if the pship sold the building, it would have a $50k RL ii. No 704(c) Gain 1. There is no contributed property iii. Excess NR Liability Allocated in Accordance with Partners Share of Profits 1. Reg. 1.752-3(a)(3): pship agreement may specify the partners interests in pship profits for purposes of allocating excess NR liabilities provided the interests are reasonably consistent w/ allocations (that have SEE) of some other significant item of pship income or gain 2. Here, the pship agreement provides that the partners have a 50% interest in pship profits for purposes of 752 a. This is consistent with the anticipated profits sharing arrangement Assets Liab. & Capital Accounts Building $1M Liab: $900k note/p Dep. ($50k) Capital Accounts G $5k L $45k $950k $950k iv. Outside Basis Partne Beg. Inc/De Loss End. r Outsid c (from Outsid e Basis Share dep.) e Basis of Liabilit y G $460k 0 ($5k) $455k

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d. End of i.

ii. iii.

iv.

($45k $495k ) 1. 705(a)(2): share of loss increases basis Year 2 No PMG 1. Reg. 1.704-2(d)(1): pship minimum gain is gain the pship would realize if it disposed of the property for no consideration other than the full satisfaction of the liability 2. Reg. 1.704-2(d)(3): if pship property subject to NR liabilities has a tax-book disparity, use the propertys book value for PMG 3. Here, if the pship sold the building, it would have no gain or loss No 704(c) Gain 1. There is no contributed property Excess NR Liability Allocated in Accordance with Partners Share of Profits 1. Reg. 1.752-3(a)(3): pship agreement may specify the partners interests in pship profits for purposes of allocating excess NR liabilities provided the interests are reasonably consistent w/ allocations (that have SEE) of some other significant item of pship income or gain 2. Here, the pship agreement provides that the partners have a 50% interest in pship profits for purposes of 752 a. This is consistent with the anticipated profits sharing arrangement Assets Liab. & Capital Accounts Building $1M Liab: $900k note/p Dep. ($100k) Capital Accounts G 0 L 0 $900k $900k Outside Basis

$540k

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Partne r

Beg. Outsid e Basis

($5k) $450k ($45k $450k ) 2. (b) How will the liability be allocated at the end of year three? a. $50k PMG i. Reg. 1.704-2(d)(1): pship minimum gain is gain the pship would realize if it disposed of the property for no consideration other than the full satisfaction of the liability ii. Reg. 1.704-2(d)(3): if pship property subject to NR liabilities has a tax-book disparity, use the propertys book value for PMG iii. Here, if the pship sold the building, it would have a $50k RG 1. Allocate according to other profits/losses (90%/10%) b. No 704(c) Gain i. There is no contributed property c. Excess NR Liability Allocated in Accordance with Partners Share of Profits i. Excess NR liability = $900k $50k = $850k ii. Reg. 1.752-3(a)(3): pship agreement may specify the partners interests in pship profits for purposes of allocating excess NR liabilities provided the interests are reasonably consistent w/ allocations (that have SEE) of some other significant item of pship income or gain iii. Here, the pship agreement provides that the partners have a 50% interest in pship profits for purposes of 752 1. This is consistent with the anticipated profits sharing arrangement iv. Share of excess liability = $425k each G L PMG $5k $45k Excess $425k $425k Liability $430k $470k d. Compared to the end of year 2: i. G has a $20k decrease in liabilities ii. L has a $20k increase in liabilities Partn Beg. Increased/Decre Loss End. er Outsi ased Share of (fro Outsid de Liability m e Basis dep.) Basis G $405k ($20k) ($5k) $425k L $465k $20k ($45 $425k

G L

$455k $495k

Inc/De c Share of Liabilit y 0 0

Loss (from dep.)

End. Outsid e Basis

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k) V. Allocations Where Partners Interests Vary During the Year a. Look to Regulations. If there is a change in any partners interest in the partnership, each partner's distributive share of partnership tax items for the taxable year must be determined using any method prescribed by regulations. 706(d)(1). b. Methods Prescribed by Regulations. Reg. 1.706-1(c)(2)(ii). i. Interim Closing of the Books Method (default). At the time the change in interests occurs, the partnership closes its books, i.e., treats the date of change as if it were the end of a taxable year, and allocates tax items accordingly. ii. Proration Method (elective method). Tax items are treated as arising ratably throughout the year. c. Example

i. Allocation of the $120,000 Loss (Interim Closing of the Books Method) A B C D $72k $24k $24k $24k 0 (January June) $48k (July $12k $12k $12k $12k December) Total $36k $36k $36k $12k ii. Allocation of the $120,000 Loss (Proration Method) A B C D $60k $20k $20k $20k 0 (January June) $60k (July $15k $15k $15k $15k December) Total $35k $35k $35k $15k * Under the proration method, the $120,000 loss is allocated equally throughout the year ($10,000 per month in this example), and is allocated among the outstanding interests. d. Historical Abuse of Section 706(d)(1) i. Partnerships using the cash method of accounting would defer paying deductible items, such as interest, until the end of the partnership taxable year.

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ii. A new partner would be admitted just before the payment, and the partnership would allocate the deductible item using the interim closing of the books method. iii. This had the effect of giving the new partner a significant share of the deductible item, although only a small portion of it was attributable to the period after the new partners admission. e. Congresss Response: Section 706(d)(2)(3) i. 706(d)(2)(A): if the partnership has an allocable cash basis item, then the item must be assigned to each day during the period in which it arose, and allocated in accordance with the partners' interests on those days. 1. In effect, it makes a cash-method taxpayer use the accrual method for these items ii. 706(d)(2)(B): an allocable cash basis item is any of the following for which the partnership uses the cash method of accounting: 1. Interest 2. Taxes 3. Payments for services or the use of property 4. Any other item specified in regulations

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PART 5: TRANSACTIONS BETWEEN PARTNERS AND PARTNERSHIPS I. Payments for Services and the Use of Property a. Introduction i. Transactions Between Partners and Partnerships 1. Partners sometimes deal with the partnership other than in their capacity as partners. 2. Transactions in which a partner might act in a non-partner capacity in a transaction with the partnership include the partners: a. provision of services b. loan of money, or c. rental or sale of property 3. Before Congress enacted subchapter K in 1954, there was uncertainty concerning whether, for federal tax purposes, a partner could engage in a transaction with his partnership in a nonpartner capacity, i.e., as if the partner were a third party. 4. In 1954, Congress enacted subchapter K, including 707, which was meant to clarify the law in this area. ii. Three Categories of Transactions. Congress has created three categories of transactions between a partner and a partnership: 1. Partner provides services or use of property while acting in his capacity as a partner, and the amount the partner receives is determined with reference to partnership income. a. 702, 704: partner takes into account his distributive share b. Timing determined by 706(a) c. Distributions to partner governed by 731 2. Transactions between a partner and the partnership in which the partner is acting other than in his capacity as a partner. a. Treat this transaction as btwn the pship and an outsider. 707(a)(1). 3. Same as #1, but the amount the partner receives is determined without reference to partnership income. a. Hybrid approach of guaranteed payments under 707(c) b. Partner Acting in Nonpartner Capacity i. A partner is likely to be regarded as acting in a partner capacity if the partner provides services that are ongoing and integral to the partnerships business. 1. A partners provision of general managerial services would fall into this category. See Pratt v. Commr (concluding that general partners who managed shopping center owned by partnership were acting in their capacity as partners). ii. A partner is more likely to be found not to be acting as a partner when the partner provides services that require the partner's special expertise, e.g., as a lawyer, accountant, or investment advisor. See Rev. Rul. 81-301 (concluding that partner acted in a non-partner capacity in providing investment advisory services to partnership). iii. Hypothetical Differences Between Partners and Non-Partners

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1. Affects Character a. If A is not acting as a partner (under 707(a)(1)), the amount paid to A becomes a deductible expense to the pship (deductible against OI). i. $6k OI $1k ded. = $5k OI ii. Allocable Income = $5k OI and $4k LTCG A (50%) B (50%) $5k OI $2.5k OI $2.5k OI $4k LTCG $2k LTCG $2k LTCG $1k GI (compensation ) b. If A is acting as a partner (1st category above), A gets $1k allocation; split $9k equally. This effectively makes the sharing arrangement 55%/45%. i. Allocable Income = $6k OI and $4k LTCG A (55%) B (45%) $6k OI $3.3k OI $2.7k OI $4k LTCG $3.2k LTCG $1.8k LTCG 2. Affects Timing a. If A is not acting as a partner: i. 267(a)(2), (e): a deduction may not be taken prior to the year in which the amount is includible in GI of the payee ii. Assuming the pship makes the pmt, its includible in GI by A and deductible by pship in the current year b. If A is acting as a partner: i. 706(a): items are taken into account in partners tax year where the pships tax year ends, whether or not received ii. 731: if pship makes pmt to A, its a distribution 3. Affects Allowance of a Partner to be Classified as an Employee a. If A is not acting as a partner, he could claim hes an employee and is entitled to tax benefits. See Armstrong v. Phinney.

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i. E.g., exclusions on group term life insurance, health insurance benefits ( 105, 106), meals and lodging ( 119), fringe benefits ( 132) c. Disguised Payments i. Problem 1 (p. 240). A (a cash method taxpayer) is an equal partner in the ABCD partnership (an accrual method taxpayer) and has a $10k outside basis in her partnership interest. A owns depreciable personal property (adjusted basis$2,000; fair market value$15,000; fair rental value$1,000 per year) which the partnership will use in its business. Before any of the transactions described below, the partnership has $10,000 of net income each year. What result in the following alternatives? 1. (a) A leases the property to the partnership for three years. The partnership will pay A $1,000 per year for three years for the use of the property. a. A is not acting as a partner. He is renting property to the pship. b. 707(a)(1): treat as if the transaction is btwn the pship and an outsider. Business expenses to partnership. c. When the pship pays the $1k rent: i. $10k net income $1k rent ded. = $9k net income to divide among the partners A B C D $2.25k $2.25k $2.25k $2.25k $1k rental income 2. (b) What result in (a), above, if the rental payments are made on January 31 of the year following accrual? a. 267(a)(2), (e): pship cant take the deduction until the partner includes the pmt in GI b. $10k net income to allocate among partners A B C D $2.25k $2.25k $2.25k $2.25k c. When pship pays $1k rent in year 2: i. Partner includes in GI (b/c hes a cash method taxpayer) ii. Pship takes $1k deduction iii. Same result as in part (a) 3. (c) A transfers the property to the partnership, which will use it for three years and transfer it back to A at the end of that period. The partnership makes a special allocation of its first $1,000 of net income to A. What result to A? a. Whats the entrepreneurial risk to A? i. If the pmt is pretty certain, tends to look like a disguised pmt under 707(a)(2)(A); 707(a)(1). Payment is pretty certain so likely a disguised payment. Benefit to PR only, not the PNS. No deduction to the PNS. ii. If there is entrepreneurial risk, treat it as pmt to a partner acting as a partner w/ reference to pship income (1st category above) b. 707(a)(2)(A): disguised paymenttreat as a transaction in 707(a)(1) i. Same result as in parts (a) and (b), disguised payment

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ii. If pship makes pmt this year: 1. Pship takes $1k deduction 2. A has $1k GI 3. Remaining is allocated among partners iii. If defers pmt, defers deduction c. If there is a level of entrepreneurial risk; treat A as a partner i. First $1k is allocated to A. The remaining is allocated equally among A, B, C, and D A B C D $2.25k $2.25k $2.25k $2.25k $1k allocation ii. Character is determined at pship level iii. Timing is governed by 706(a) iv. As basis is increased by $3,250, then decreased by $1k when pship makes the pmt to A 4. What if instead, the first $3,000 of the first years net income and no subsequent income in excess of her one-quarter share is allocated to A? a. If A is acting in his capacity as partner: i. Allocate $10k 1. $3k goes to A 2. $7k allocated equally among partners A B C D $3k $1.75k $1.75k $1.75k $1.75k b. If A is not acting as a partner (disguised pmt) i. $3k pmt paid to A is pre-paid rent ii. 263: capital expenditure; take deduction ratably each year iii. Year 1 1. $10k income $1k deduction = $9k income to allocate A B C D $3k $2.25k $2.25k $2.25k $2.25k c. Advantage of A acting as a partner: i. Has the effect of giving pship a current deduction for what is really a capital expenditure d. Note: 3 years of rent has a greater risk of being a disguised pmt ii. Problem 2 (p. 240). Consider the following example adapted from the legislative history of 707(a)(2)(A): 1. A commercial office building constructed by a partnership is projected to generate gross income of at least $100,000 per year indefinitely. Architect, whose normal fee for architectural services is $40,000, contributes cash for a 25% interest in the partnership and receives both a 25% distributive share of net income for the life of the partnership and an allocation of $20,000 of partnership gross income for the first two years of partnership operations after the property is leased. The partnership expects to have sufficient cash available to

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distribute $20,000 to Architect in each of the first two years, and the agreement requires such a distribution. 2. What factors are most important in determining whether the $20,000 allocation of gross income to Architect is a share of profits or a 707(a)(2)(A) payment? 3. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. Factors to determine whether a partner receives pmt as a partner are: a. Entrepreneurial risk (risk of payment) i. Here, theres little risk b. Whether the partner status of the recipient is transitory c. Whether the allocation and distribution are close in time to the partners performance of services for or transfer of property to the partnership i. Here, the allocation is pretty close to the services d. Whether the recipient became a partner to obtain tax benefits for himself or the partnership which would not have been available if he had rendered services to the partnership in a third party capacity e. Whether the value of the recipients interest in general and continuing partnership profits is small in relation to the allocation in question i. Here, the pmt is a fairly high allocation ($20k of $100k net income) + 25% share f. Whether the requirement that capital accounts be respected under 704(b) makes income allocations which are disguised pmts for capital economically unfeasible and therefore unlikely to occur d. Guaranteed Payments i. Problem 1 (p. 250). The AB equal partnership is in a highly speculative business in which profits fluctuate widely. For the current year the partnership has profits of $20,000, of which $12,000 is ordinary income and $8,000 is long-term capital gain. A and B share profits and losses equally unless otherwise provided. A renders services to the partnership which are continuous, related to the function of the partnership and not in the nature of a capital expenditure. 1. (a) What result to A, B, and AB if A worked for the partnership and was required to be paid $15,000 per year for his services regardless of the income of the partnership? a. A is acting as a partner i. Activity is integral and ongoing ii. Here, this is a guaranteed pmt under 707(c) b. Pship has $3k loss i. $12k OI $15k guaranteed pmt to A = $3k loss A (50%) B (50%) Ordinary Income $15k* Ordinary loss ($1.5k) ($1.5k) LTCG $4k $4k c. *Reg. 1.707-1(c) (2d sentence): partner must include guaranteed pmt as ordinary income for his taxable year within or with which ends the pship taxable year in which the partnership deducted such pmts as paid or accrued under its method of accounting

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i. If pship used the accrual method and accrues the deduction in year 1, but doesnt make pmt until year 2, partners includes the pmt in GI in year 1 2. (b) What result in (a), above, if As services relate to the improvements on land owned by the partnership? a. As pmt is a capital expenditure; not deductible by pship b. Ordinary income = $12k c. LTCG = $8k d. A includes the pmt in GI when its made (assuming hes a cash method taxpayer) A (50%) B (50%) Ordinary Income $15k Ordinary loss ($6k) ($6k) LTCG $4k $4k 3. (c) What results if A renders the services under an agreement that he will receive $15,000 or 50% of the profits before taking into account any guaranteed payments, whichever is greater, and the profits are $20,000, consisting of $12,000 of ordinary income and $8,000 of long-term capital gain? a. As distributive share of pship income = $20k * 50% = $10k b. As guaranteed pmt is the extra $5k c. Pship ordinary income = $12k $5k guaranteed pmt ded. = $7k d. LTCG = $8k e. Total pship income = $15k f. A is entitled to $10k/$15k = 2/3; B is entitled to 1/3 A (2/3) B (1/3) Guaranteed pmt $5k $7k Ordinary $4,667 $2,333 Income $8k LTCG ($5,333) ($2,667) g. See Rev. Rul. 69-180 (using this method to solve a similar problem) 4. (d) What result in (a) and (c), above, if As compensation is not for services but is received as a guaranteed return on As contributed capital to the partnership? a. Same result b. 707(c): guaranteed pmts include pmts for use of capital

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PART 6: SALES AND EXCHANGES OF PARTNERSHIP INTERESTS I. Consequences to the Selling Partner a. STEP ONE: Determine total gain or loss realized. i. AR AB = RG (RL). 1001. ii. Amount Realized 1. Cash and Property. AR = money + FMV of property received. 1001(b). 2. Liability Relief. If a pship interest is sold, the reduction in the transferor partners share of pship liabilities is treated as an amount realized under 1001. 752(d); Reg. 1.752-1(h). iii. Adjusted Basis 1. Cash and Property. Outside basis = money + AB property contributed. 722. 2. Share of Partnership Liability. Any increase in a partners share of pship liabilities shall be considered as a contribution of money to the pship. 752(a). Outside basis [is increased] by contributions of money. 722. 3. Share of Partnership Income. Where a partner sells her entire interest, the partners outside basis is increased by her share of pship taxable income. Reg. 1.706-1(c)(2)(ii); 705(a)(1)(A). b. STEP TWO: Determine portion of gain (loss) that is ordinary under 751. i. STEP 2(A): Determine partners capital gain (loss) in absence of 751. This is going to be the same answer as STEP ONE. See 741. ii. STEP 2(B): Determine partners share of ordinary income under 751 by doing a hypothetical sale. 1. Hypothetical Sale. Ordinary income/loss under 751 is the income/loss from 751 property allocated to the partner if the pship sold its property for an amount equal to FMV. 2. 751 Property a. Unrealized Receivables i. Defined. Unrealized receivable includes, to the extent not previously includible in income under the pships method of accounting, any right to payment for: 1. (1) goods delivered, or to be delivered, to the extent theyre not capital assets, or 2. (2) services rendered, or to be rendered. 751(c). ii. 1245 and 1250 Property. Unrealized receivables also include section 1245 property and section 1250 property. 751(c) (flush language). b. Inventory Items. Inventory items means: i. (1) pship property described in 1221(a)(1), ii. (2) property thats not a capital asset and not section 1231 property, and iii. (3) pship property which, if held by the selling partner, would be considered property of the type described in (1) or (2). 751(d).

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c. Tiered Partnerships. In determining whether pship

property is 751 property, the pship is treated as owning its proportionate share of the property of any other pship in which it is a partner. 751(f). iii. Capital Gain = STEP 2(A) STEP 2(B). In the case of a sale/exchange of an interest in a partnership, gain/loss is capital, except as provided in 751. 741. c. Problem 1 (pp. 27576). Partner A owns a one-third interest in the ABC cash method, calendar year general partnership, which manufactures and sells inventory. A, B and C, the original partners, each made initial cash contributions of $75,000. All income has been distributed as earned. On January 1st, A sells his interest in the partnership to D. Consider the tax consequences of the sale to A, assuming he has owned his partnership interest for several years. The balance sheet of the ABC partnership (which is to be used in all parts of this problem unless the facts indicate to the contrary) is as follows: Assets Liabilities and Partners Capital AB FMV AB FMV Cash $45k $45k Liab: none Inventory $75k $90k Capital: A/R 0 $45k A $75k $135k Capital $105k $225k B $75k $135k Asset C $75k $135k $225k $405k $225k $405k i. Consider the tax consequences to A on his sale in each of the following alternative situations: ii. (a) A sells his interest for $135,000 cash. 1. STEP ONE a. $135k AR $75k AB = $60k gain b. If theres no liabilities, tax capital accounts should equal partners basis in the partnership 2. STEP TWO(A) a. Capital gain (loss) in absence of 751 = $60k i. 741: gain/loss from sale of a pship interest is capital 3. STEP TWO(B) a. Hypothetical Sale of 751 Property Inventory Accounts Receivable AR $90k AR $45k AB ($75k) AB (0) Gain $15k Gain $45k b. Total Gain = $60k c. As share = $20k d. A has 751 ordinary income of $20k 4. 741: $60k gain $20k OI = $40k capital gain a. Since A held the pship interest for several years, its LTCG 5. Note: if A had contributed the accounts receivable, the built-in gain of $45k would be allocated to A in the hypothetical sale under 704(c) iii. (b) Each partner originally contributed $150,000 cash (and assume each has an outside basis of $150,000), and the capital asset has a

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basis to the partnership of $330,000. A sells his interest to D for $135,000 cash. 1. STEP ONE a. $135k AR $150k AB = $15k loss 2. STEP TWO(A) a. Capital gain (loss) in absence of 751 = $15k 3. STEP TWO(B) a. Hypothetical Sale of 751 Property Inventory Accounts Receivable AR $90k AR $45k AB ($75k) AB (0) Gain $15k Gain $45k i. Note: 751 property does not include capital assets b. Total Gain = $60k c. As share = $20k d. A has 751 ordinary income of $20k 4. 741: $15k loss $20k OI = $35k LTCL iv. (c) Each partner originally contributed only $45,000 cash instead of $75,000, and the capital asset was purchased and held subject to a $90,000 liability. A sells his interest to D for $105,000 cash. 1. STEP ONE a. $135k AR $75k AB = $60k gain b. AR i. 1001(b): $105k cash received ii. 752(d); Reg. 1.752-1(h): $30k liability relief c. AB i. 722: $45k cash contributed ii. 752; 722: $30k share of liability 2. STEP TWO a. Same result as part (a) v. (d) The sale occurs on March 31, one quarter of the way through the year, at a time when As share of partnership income through March 31 (all ordinary income) is $30,000. It is agreed that D will pay A $165,000 for his interest and also will acquire As right to income. Asked under the interim closing method how will we calculate. 1. STEP ONE a. $165k AR $105k AB = $60k gain b. AR i. 1001(b): $165k cash received c. AB i. $75k original outside basis ii. $30k income through March 31 1. 706(c)(2)(A): pship taxable year closes w/ respect to a partner upon sale of her entire interest 2. Reg. 1.706-1(c)(2)(ii): where a partner sells her entire interest, the partner shall include . . . his distributive share of items in 702(a) a. 702(a)(7) includes OI 3. 705(a)(1)(A): outside basis is increased by partners share of pship taxable income 2. STEP TWO

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a. Same result as part (a)

d. Problem 2 (p. 276). Assume the same basic facts as in Problem 1, except
the ABC partnership is an accrual method partnership so that the accounts receivable have an adjusted basis of $45,000 and A has an outside basis of $90,000. i. Assume Partner A sell his pship interest for $135k 1. STEP ONE a. $135k AR $90k AB = $45k gain 2. STEP TWO(A) a. Capital gain (loss) in absence of 751 = $45k ii. (a) A sells his interest to D on January 1. 1. STEP TWO(B) a. Hypothetical Sale of 751 Property Inventory Accounts Receivable AR $90k AR $45k AB ($75k) AB ($45k) Gain $15k Gain 0 i. Accounts Receivable 1. A/R not an unrealized receivable b/c it is includible in income under pships method of accounting. Because PNS is on the accrual method, therefore PNS will have a basis in the assets. 2. A/R is an inventory item b/c it is a noncapital asset. For purposes of our constructive sale. b. Total Gain = $15k c. As share = $5k d. A has 751 ordinary income of $5k 2. $45k gain $5k OI = $40k LTCG iii. (b) What result in (a), above, if the partnership held the inventory as a capital asset, but A is a dealer in that type of property? 1. Same result as part (a) 2. 751(d)(3): inventory item includes pship property that would be considered property described in (1) or (2) if held by the partner a. If held by A, the property would be property described in 1221(a)(1) ( 751(d)(1)) iv. (c) What result in (a), above, if the partnership owns no inventory but has a 50% interest in another partnership (partnership #2), whose only assets are inventory with a basis of $150,000 and a value of $180,000? 1. Same result as part (a), calculation is the same. 150k (90k) 180k (90k) 2. 751(f): in determining whether pship property is 751 property, the pship is treated as owning its proportionate share of the property of any other pship in which it is a partner. a. Pship #1 owns 50% of Pship #2 b. Pship #2 owns inventory$150k AB; $180k FMV c. Treat Pship #1 as owning inventory w/ $75k AB and $90 FMV i. Same as in part (a) v. (d) What result in (a), above, if in addition the partnership had a contract worth $30,000 to perform real estate management services for the next ten years? 1. STEP TWO(B)

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a. The contract is a 751 asset i. See Ledoux v. Commissioner (contract to operate dog track was an unrealized receivable under 751(c)(2) b/c it was a right to pmt for services to be rendered)Treated as an accounts receivable b. Hypothetical Sale of 751 Property Inventory Accounts Contract Receivable AR $90k AR $45k (prof AR $30k AB ($75k) added 30k here, AB 0 Gain $15k no separate K) Gain $30k AB ($45k) Gain 0 (30k) c. Total Gain = $45k d. As share = $15k e. A has 751 ordinary income of $15k 2. $45k gain $15k OI = $30k capital gain II. Consequences to the Buying Partner a. General Rule: Basis in Pship Property Unadjusted. If there is a transfer of a partnership interest, no adjustment can be made to the basis of partnership property unless: i. A 754 election is in effect, or ii. The partnership has a substantial built-in loss immediately after the transfer. 743(b). 1. Substantial Built-In Loss. A partnership has a substantial built-in loss if the partnerships adjusted basis in partnership property exceeds by more than $250,000 the fair market value of the property. 743(d)(1). iii. Income to Partner. Since the bases in pship assets are not adjusted, upon disposition of assets, the partner will recognize her distributive share of income/loss, even though she paid for it in buying the pship interest. b. The 754 Election i. Effect of Election. A 754 election adjusts inside basis of pship assets. See 754, 743. When the pship disposes of the asset, New Partner does not have flow-through income. Reg. 1.743-1(j)(3)(i). 1. Personal to Partner. The basis adjustment only adjusts the basis of the transferee. No adjustment is made to the common basis of pship property. Reg. 1.743-1(j)(1). ii. Procedure of Making the Election 1. Partnership makes the election. 754. 2. Written Statement. Election is made in a written statement filed w/ the partnership return for the taxable year during which the distribution or transfer occurs. The stmt shall (i) set forth the name and address of the pship, (ii) be signed by any one of the partners, and (iii) contains a declaration that the pship elects under 754. Reg. 1.754-1(b)(1). 3. Applies Until Revocation. A 754 election applies to property distributions and transfers of pship interests in the taxable yr in which the election is made and in all subsequent pship taxable years unless the election is revoked. Reg. 1.754-1(a). a. How to Revoke. Pship may revoke w/ the approval of the district director for the internal revenue district in

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which the pship return is reqd to be filed. Reg. 1.7541(c). iii. Subsequent Transfers. A transferees basis adjustment is determined w/o regard to any prior transferees basis adjustment. Reg. 1.743-1(f). 1. Book Capital Accounts Transfer. The book capital account of the transferor carries over to the transferee. Reg. 1.7041(b)(2)(iv)(l), (m). c. Basis Adjustment under 754 i. Determine Total Basis Adjustment Under 743(b)(1). Increase AB of pship property by the excess of: 1. Transferees basis in pship interest, over a. Cost Basis. The basis in a partnership interest acquired other than by contribution is determined by 1011 and 1012 (cost basis rules). 742. 2. Transferees Proportionate Share of AB of Partnership Property a. Transferees interest in previously taxed capital, plus i. Previously Taxed Capital. Reg. 1.743-1(d)(1). 1. Distribution of cash in hypothetical liquidation 2. Increased by tax loss allocated 3. Decreased by tax gain allocated b. Transferees share of pship liabilities. Reg. 1.743-1(d) (1). ii. Allocate Basis Adjustment Among Partnership Assets Under 755. Reg. 1.755(a)(1). 1. (1) Determine FMV of pship assets under Reg. 1.755-1(a)(2) (5) 2. (2) Allocate basis adjustment among two classes: a. (A) Capital gain property b. (B) Ordinary income property c. Order. First determine the amount of basis adjustment allocated to ordinary income property. The amount of basis adjustment to capital gain property is generally the remaining basis adjustment. Reg. 1.755-1(b)(2)(i). 3. (3) Allocate basis adjustment among assets in each class d. Problem 1 (pp. 29192). On January 1 on year one, Nupartner purchased a one-third interest in a partnership for $40,000. At the time of purchase the partnership had the following assets:

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A.B. F.M.V. Accounts Receivable $0 $30,000 Land 60,000 90,000 i. (a) If 754 had not been elected by the partnership, what is the result to Nupartner upon collection of the receivables? First look for big substantial loss, no loss here, gain on both. 1. Pship has $30k ordinary income 2. Nupartners has a $10k distributive share (PRs share of OI, Distribution is something very different) of ordinary income ii. (b) What result to Nupartner in (a), above, if the partnership had made a 754 election? 1. Determine Total Basis Adjustment Under 743(b)(1). Increase AB of pship property by excess of: a. Transferees basis in pship interest, over i. Here, cost basis of $40k b. Transferees proportionate share of AB of pship property i. Reg. 1.743-1(d)(1): transferees interest in previously taxed capital (plus 0 liabilities) ii. Distribution of cash in hypothetical liquidation 1. Here, $30k cash from A/R + $90k cash from land = $120k total / 3 = $40k iii. Increase by tax loss allocated 1. Here, thats 0 iv. Decrease by tax gain allocated 1. Allocated gain = $20k a. A/R: 30k AR 0 = 30k b. Land: 90k AR 60k AB = 30k c. $30k + $30k = 60k / 3 = 20k c. Increase AB of pship property by: 40k [$40k 20k] = 20k d. So 10k AB in Accounts Receivable for new partner, and 30k AB in land for the new partner. (60k/3 = 20 +10k) 2. Allocate the Basis Adjustment Among Pship Assets under 755 a. (1) Determine FMV of pship assets under 1.755-1(a)(2) (5) i. Here, were told what the value is b. (2) Allocate basis adjustment among two classes: i. (A) Capital gain property 1. Land falls under this, assuming its not a dealer in land ii. (B) Ordinary income property 1. A/R is ordinary income property iii. Reg. 1.755-1(b)(2)(i): Order of Allocation: first determine allocation to OI property, then total basis adjustment allocation to OI property = allocation to capital gain property 1. Here, 10k would be allocated to OI property 2. $20k $10k = $10k allocated to capital gain property c. (3) Allocate basis adjustment among assets in each class i. Here, only one asset per class

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iii. (c) Who makes a 754 election? When and how must the election be made? 1. 754: pship make the election 2. Reg. 1.754-1(b)(1) a. Election is made in a written statement filed w/ the partnership return for the taxable year during which the distribution or transfer occurs i. The stmt shall (i) set forth the name and address of the pship, (ii) be signed by any one of the partners, and (iii) contains a declaration that he pship elects under 754. b. The return must be filed by the 15th day of the 4th month after the taxable yr ends 3. Reg. 1.754-1(a): a 754 election applies to property distributions and transfers of pship interests in the taxable yr in which the election is made and in all subsequent pship taxable years unless the election is revoked 4. Reg. 1.754-1(c): pship may revoke w/ the approval of the district director for the internal revenue district in which the pship return is reqd to be filed. iv. (d) Should Nupartner have conditioned his purchase of the partnership interest upon a 754 election? 1. Yes, as long as the assets are appreciated 2. Where the assets FMV < AB, the incoming partner would not want the pship to take the 754 election (special basis decrease) v. (e) Will Nupartners purchase and the 754 election have any immediate tax impact on the remaining old partners? May affect later distributions, will talk about later. 1. No, it will not have an immediate effect 2. Reg. 1.743-1(j)(1): the basis adjustment is personal to Nupartner 3. If the old partners sell their interests: a. Their transferees may be affected by a 754 election b. The election may make the interests less desirable if the assets are depreciated 4. A 754 election requires the pship to adjust the basis of assets distributed to the partners (more later) vi. (f) Will the 743(b) basis adjustment affect Nupartner in situations other than on collection of partnership income or sales of partnership property? 1. Reg. 1.743-1(j)(4): basis adjustments affect depreciation deductions 2. Reg. 1.743-1(g): basis adjustments affect the basis in assets distributed from the pship 3. New PRs basis in property for most purposes. vii. (g) At the end of year three, the partnership had earnings, all of which had been distributed, and it continued to hold the identical accounts receivable and land, each of which had the same basis and fair market value. Assuming no 754 election, what result to Nupartner if, before the receivables are collected, he sells his partnership interest to Buyer for $40,000? 1. STEP ONE: Determine total gain/loss to selling partner a. $40k AR $40k AB = $0

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2. STEP TWO: Determine portion of gain (loss) that is ordinary under 751. a. STEP 2(A): Determine partners capital gain (loss) in absence of 751. i. This is $0 b. STEP 2(B): Determine partners share of ordinary income under 751 by doing a hypothetical sale. i. Hypothetical Sale. Ordinary income/loss under 751 is the income/loss from 751 property allocated to the partner if the pship sold its property for an amount equal to FMV. 1. 751(c): A/R are unrealized receivables 2. $30k $0 = $30k / 3 = $10k allocated gain from A/R 3. $10k ordinary income c. Capital Gain = STEP 2(A) STEP 2(B). In the case of a sale/exchange of an interest in a partnership, gain/loss is capital, except as provided in 751. i. $0 $10k = $10k capital loss viii. (h) What result to Nupartner in (g), above, if the partnership had made a 754 election? 1. STEP ONE: Determine total gain/loss to selling partner a. $40k AR $40k AB = $0 2. STEP TWO: Determine portion of gain (loss) that is ordinary under 751. a. STEP 2(A): Determine partners capital gain (loss) in absence of 751. i. This is $0 b. STEP 2(B): Determine partners share of ordinary income under 751 by doing a hypothetical sale. i. Because of the 754 election, Nupartner realizes no income on the sale of the A/R. Nupartner has 10k new basis, 10k gain-10k basis = 0, Gets to use basis allocation. ii. Ordinary income = $0 c. Capital Gain = STEP 2(A) STEP 2(B). In the case of a sale/exchange of an interest in a partnership, gain/loss is capital, except as provided in 751. i. $0 $0 = $0 capital gain/loss 741 ix. (i) What is Buyers inside basis in (h), above? 1. Reg. 1.743-1(f): a transferees basis adjustment is determined w/o regard to any prior transferees basis adjustment 2. Thus, Buyer would go through the same analysis in part (b). All the numbers are the same, so it will be the same inside basis. x. (j) If the partnership properly maintained capital accounts and the selling partners capital account prior to the sale of his interest was $20,000, what is Nupartners capital account upon purchase of his onethird interest for $40,000 if: 1. (i) a 754 election were in effect; (ii) a 754 election were not in effect. 2. The answer is the same under either scenario 3. Reg. 1.704-1(b)(2)(iv)(l), (m): book capital account of the transferor carries over to the transferee

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a. Thus, Nupartners capital account is the same as the selling partners: $20k b. 754 election only relates to the basis, it does not affect the capital account. (Capital account: ledger of how much money the PNS owes to the PR). xi. (k) If a 754 election is in effect, will each new purchasing partner create havoc for the partnerships accountant? 1. Yes. It will be burdensome if the pship has a lot of assets or a lot of transfers in pship interests. 2. Reg. 1.754-1(c)(1): may permit revocation of a 754 election when it becomes an administrative burden

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PART 7: OPERATING DISTRIBUTIONS I. Introduction a. Operating (Current) Distributions are distributions to someone who continues to be a partner after distribution. Cf. liquidating distributions. II. Consequences to the Distributee Partner a. Nonrecognition Rules on the Distribution i. Nonrecognition by Partner. Generally, in distributions by a pship to a partner, gain/loss is not recognized. 731(a)(1). 1. Exception: Distribution of Money. Gain or loss is recognized to the extent that any money distributed exceeds the AB of the partners interest in the pship immediately before distribution. 731(a)(1). a. Marketable Securities Treated as Money. Money in 731(a)(1) includes marketable securities. 731(c). b. Advances and Draws. Advances or drawings of money or property are treated as current distributions made on the last day of the pship taxable year for the distributee partner. Reg. 1.731-1(a)(1)(i). 2. Capital Gain. Any gain/loss recognized under 731(a)(1) is considered gain/loss from sale/exchange of the pship interest from the distributee partner. 731(a) (flush language). ii. Transferred Basis in Land. The basis of property (other than money) distributed by a pship to a partner (in operating distribution) is its AB to the pship immediately before such distribution. 732(a)(1). 1. Limited to Basis in Pship Interest After Cash Distribution. The basis a partner takes in distributed property cannot exceed AB of such partners interest in the pship reduced by any money distributed in the same transaction. 732(a)(2). See 732(c) (how to allocate basis in pship interest in distribution of multiple assets). 2. New Transferee Partners. For a partner who acquired his interest by transfer where a 754 election was not in effect, w/in 2 years of the transfer, the partner can elect to treat AB of distributed property as if a 754 election was in effect. 732(d). a. Example. Nupartner joins ABC pship. Pship has A/R: AB = $0, FMV = $90k. W/in 2 yrs of Nupartner joining, pship distributes 1/3 of the A/R to Nupartner. Here, Nupartner could elect to treat his AB in the A/R as if a 754 election was in place. Under the adjustments to basis under 743, Nupartners basis in the A/R = $30k. iii. Effect on Partners Interest in the Partnership. For operating distributions, the AB of a partners interest in the pship is reduced (but not below zero) by 1. (1) money distributed to the partner, and 2. (2) AB to such partner of distributed property other than money. 733. iv. Nonrecognition by Partnership. Pship does not recognize gain/loss on distribution of property, including money. 731(b). v. Problem 1 (p. 304). On July 1, the ABC Partnership, a calendar year partnership, distributes to each of its equal partners $10,000 in cash and land with a value of $10,000 and a basis of $5,000. A, B and C

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have outside bases of $20,000, $10,000 and $5,000 respectively. The partnership has the following assets prior to the distribution:

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Assets A.B. F.M.V. Cash $50,000 $50,000 Accounts Receivable 0 20,000 Inventory 20,000 30,000 Land 30,000 60,000 Building 10,000 50,000 1. (a) Discuss the tax consequences of the distribution to A, B, and C, each of whom has owned his partnership interest for several years. a. Partner A i. Cash Distribution 1. 731(a)(1): gain/loss not recognized unless cash distributed > AB of partners interest in pship before distribution a. Here, $10k cash < $20k AB in pship interest b. Nonrecognition 2. 733(1): in operating distributions, AB of partners interest in pship is reduced by money distributed a. Basis in pship interest = $20k $10k = $10k ii. Land Distribution 1. 731(a)(1): nonrecognition (b/c not cash) 2. 732(a)(1): partners basis in distributed property = pships AB immediately before the distribution a. Basis in land = $5k 3. 733(2): in operating distributions, AB of partners interest in pship is reduced by partners AB in distributed property a. Basis in pship interest = $10k $5k = $5k b. Partner B i. Cash Distribution 1. 731(a)(1): gain/loss not recognized unless cash distributed > AB of partners interest in pship before distribution a. Here, $10k cash = $10k AB in pship interest b. Nonrecognition 2. 733(1): in operating distributions, AB of partners interest in pship is reduced by money distributed a. Basis in pship interest = $10k $10k = $0 ii. Land Distribution 1. 731(a)(1): nonrecognition (b/c not cash) 2. 732(a)(1): partners basis in distributed property = pships AB immediately before the distribution 3. 732(a)(2): partners basis in distributed property cannot exceed AB of such

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c. Partner C i. Cash Distribution 1. 731(a)(1): gain/loss not recognized unless cash distributed > AB of partners interest in pship before distribution a. Here, $10k cash > $5k AB in pship interest b. C recognizes $5k gain c. 731(a)(1) (flush language): capital gain d. LTCG b/c C owned pship interest for several years 2. 733(1): in operating distributions, AB of partners interest in pship is reduced (but not below zero) by money distributed a. Basis in pship interest = $0 ii. Land Distribution 1. Same result as Partner B 2. (b) What result to C if he receives the land first and the cash in a subsequent separate distribution on October 1? a. Land Distribution i. 731(a)(1): nonrecognition (b/c property, not cash) ii. 732(a)(1): partners basis in distributed property = pships AB immediately before the distribution 1. Basis in land = $5k iii. 732(a)(2) limitation d/n apply b/c the distributions are not in the same transaction iv. 733(2): in operating distributions, AB of partners interest in pship is reduced (but not below zero) by partners AB in distributed property 1. Basis in pship interest = $5k $5k = $0 b. Cash Distribution i. 731(a)(1): gain/loss not recognized unless cash distributed > AB of partners interest in pship before distribution 1. Here, $10k cash > $0 AB in pship interest 2. C recognizes $10k gain ii. 733(1): in operating distributions, AB of partners interest in pship is reduced (but not below zero) by money distributed

partners interest in the pship reduced by any money distributed in the same transaction a. Basis in pship interest reduced by cash distribution = $0 b. Basis in land = $0 4. 733(2): in operating distributions, AB of partners interest in pship is reduced (but not below zero) by partners AB in distributed property a. Basis in pship interest = $0 $0 = $0

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1. Basis in pship interest = $0 3. (c) What result to C in (b), above, if the cash distribution on October 1 is a draw against his share of partnership income, which is $20,000 for the year? a. Land Distribution i. Same result as part (b) b. Cash Distribution i. Reg. 1.731-1(a)(ii): advances/draws treated as current distributions on last day of pship taxable yr ii. 705(a): at the end of the pship taxable year, AB of partners interest in the pship is (1) increased by his distributive share of income, and (2) decreased by distributions. 1. $5k original AB in pship interest + $20k distributive share of income $5k land distribution $10k cash distribution = $10k AB in partnership interest iii. 731(a)(1): no gain recognition b. Consequences on Subsequent Sales of Distributed Property i. Sale/Exchange of Certain Distributed Property 1. Unrealized Receivables. A partner who disposes of distributed unrealized receivables has ordinary income/loss. 735(a)(1). 2. Inventory items. A partner who disposes of distributed inventory items, if within 5 years from the date of distribution, recognizes ordinary income/loss. 735(a)(2). ii. Holding Period for Distributed Property. For distributed property (other than for the inventory 5-yr window), the partner tacks the pships holding period. 735(b). iii. Problem (in syllabus). Return to Problem 1 on page 304 and, assuming that the partnership makes the following pro rata operating distributions rather than the distributions described in the problem, and that the distributed assets would be capital assets in As hands, consider the following alternative questions: 1. What result if the partnership distributes to Partner A all of its accounts receivable, which A collects six years later? a. Distribution of A/R i. 731(a)(1): nonrecognition (b/c property, not cash) ii. 732(a)(1): basis in A/R = pships AB = $0 iii. 733(2): AB of partners interest in pship is reduced by partners AB in distributed property 1. Basis in pship interest = $20k $0 = $20k b. Holding Period i. 735(b): for distributed property, partner tacks the holding period of the pship c. When Partner A collects the receivables: i. 735(a)(1): A recognizes $30k ordinary income 2. What result if the partnership distributes to Partner A all of its inventory, which A sells six years later? a. Distribution of Inventory

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i. 731(a)(1): nonrecognition (b/c property, not cash) ii. 732(a)(1): basis in inventory = pships AB = $20k iii. 733(2): AB of partners interest in pship is reduced by partners AB in distributed property 1. Basis in pship interest = $20k $20k = $0 b. When Partner A sells the inventory: i. If Partner A sold the inventory 4 years after distribution: 1. 735(a)(2): A recognizes $10k ordinary income ii. If Partner A sold the inventory 6 years after distribution: 1. Use general tax principles 2. If the inventory is inventory in Partner As hands, then A recognizes $10k ordinary income 3. If the inventory is a capital asset in Partner As hands, then A recognizes $10k LTCG III. Consequences to the Distributing Partnership a. Impact on Inside Basis i. General Rule. Generally, the basis of pship property is not adjusted b/c of a distribution of property. 734(a). ii. Exception: Section 754 Election. If the pship made a 754 election, increase the AB of undistributed property on the pship books as follows. 1. STEP ONE: Determine Total Basis Adjustment Under 734(b). Increase AB of pship property by a. Any gain recognized to the distributee partner under 731(a)(1) b. If 732(a)(2) applies, the excess of i. Pships basis in distributed property over ii. The distributee partners basis in that asset 2. STEP TWO: Allocate Basis Adjustment Among Partnership Assets Under 755. See Reg. 1.755-1(a)(1). a. (1) Determine FMV of pship assets under Reg. 1.7551(a)(2)(5) b. (2) Allocate basis adjustment between classes: Capital Gain Property and Ordinary Income Property i. Distributed Cash. Where a distribution under 734(b)(1)(A) results in an adjustment to undistributed pship property, the adjustment is allocated only to capital gain property. Reg. 1.755-1(c)(1)(ii). ii. Distributed Property. Where a distribution under 734(b)(1)(B) results in an adjustment to undistributed pship property, the adjustment is allocated to remaining pship property of a similar character. Reg. 1.755-1(c)(1)(i). 1. Carryover Adjustment. If an increase in the basis of undistributed property cannot

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be made b/c the pship owns no property of the character required to be adjusted, or b/c the basis of all the property of a like character has been reduced to zero, the adjustment is made when the pship subsequently acquires property of a like character to which an adjustment can be made. Reg. 1.755-1(c)(4). c. (3) Allocate the basis adjustment to assets in each class i. Property with Unrealized Appreciation. An increase in basis must be allocated to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation (but only to the extent of each propertys unrealized appreciation). Reg. 1.755-1(c)(2)(j). ii. Remaining Increase. Any remaining increase must be allocated among the properties w/in the class in proportion to their FMVs. Reg. 1.7551(c)(2)(j). b. Problem (p. 313). The ABC partnership has three equal partners, A, B, and C, and the following balance sheet: Assets Liabilities and Capital Accounts A.B. F.M.V. A.B. F.M.V. Cash $60,000 $60,000 Liab: none Capital Asset 90,000 60,000 Capital #1 Accounts Capital Asset 40,000 60,000 A $70,000 $80,000 #2 Capital Asset 20,000 60,000 B 70,000 80,000 #3 C 70,000 80,000 $210,00 $240,00 $210,00 $240,00 0 0 0 0 i. A receives capital asset #1 in an operating distribution. A has a oneninth interest worth $20,000 in the partnership capital and profits after the distribution. ii. (a) What results to A and the partnership if there is no 754 election? Reconstruct the balance sheet after the distribution. 1. Partner A a. See II. Consequences to the Distributee Partner, supra. b. 731(a)(2): gain/loss is not recognized on the transfer of property c. Basis in Capital Asset #1 i. 732(a)(1): general ruleA takes a transferred basis ii. 732(a)(2): limitationbasis shall not exceed partners basis in pship 1. Here, A has $70k basis in his pship interest 2. As basis in Capital Asset #1 = $70k d. Basis in Pship Interest i. 733: reduce by AB partner takes in distributed property

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ii. $70k original AB in pship interest $70k As AB in Capital Asset #1 = 0 e. Book Capital Account i. Reg. 1.704-1(b)(2)(iv)(b): partners capital account is decreased by FMV property distributed to him ii. $80k original book capital account $60k FMV Capital Asset #1 = $20k 2. Partnership a. 731(b) no gain/loss recognition 3. Balance Sheet Assets Liabilities and Capital Accounts A.B. F.M.V. A.B. F.M. V. Cash $60k $60k Liab: none Capital Asset $40k $60k Capital #2 Accounts Capital Asset $20k $60k A $0 $20k #3 B $70k $80k C $70k $80k $120 $180k $140 $180 k k k 4. The Problem a. $20k of basis associated w/ Capital Asset #1 has disappeared, 754 election would avoid this. b. If the pship sold off Capital Assets #2 and #3 i. The pship would realize $60k gain ii. Capital accounts only have $40k gain to allocate iii. A is undertaxed; B and C are overtaxed Partner Outside Basis Share of $60k Gain A (1/9) $0 $6,667 B (4/9) $70k $26,667 C (4/9) $70k $26,667 c. If the pship is liquidated, the partners are correctly allocated gain: Partner Outsid Share Ending Distributi Gain/ e of Outsid on (Loss) Basis $60k e Gain Basis A (1/9) $0 $6,667 $6,66 $20k $13,33 7 3 B (4/9) $70k $26,66 $96,6 $80k ($16,66 7 67 7) C (4/9) $70k $26,66 $96,6 $80k ($16,66 7 67 7) iii. (b) What results to A and the partnership if the partnership has made a 754 election? Reconstruct the balance sheet after the distribution. 1. Partner A a. Same result as part (a). 2. Partnership a. Same result as part (a).

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3. Adjustment to Undistributed Property a. STEP ONE: Determine Total Adjustment Under 734(b) i. Increase AB of pship property by 1. Any gain recognized to the distribtee partner under 731(a)(1) a. Here, there is no gain recognized to Partner A under 731(a)(1). 2. If 732(a)(2) applies, the excess of pships basis in distributed property over the distributee partners basis in that asset a. $90k $70k = $20k b. STEP TWO: Allocate Basis Adjustment Among Partnership Assets Under 755 i. (1) Determine FMV of pship assets under Reg. 1.755-1(a)(2)(5) 1. Here, FMV is given ii. (2) Allocate basis adjustment between classes: Capital Gain Property and Ordinary Income Property 1. Reg. 1.755-1(c)(1)(i): where a distribution under 734(b)(1)(B) results in an adjustment to undistributed pship property, the adjustment is allocated to remaining pship property of a similar character 2. Here, this is Capital Assets #2 and #3 iii. (3) Allocate the basis adjustment to assets in each class 1. Reg. 1.755-1(c)(2)(j): an increase in basis must be allocated to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation (but only to the extent of each propertys unrealized appreciation) 2. Unrealized Appreciation a. Capital Asset #2: $60k FMV $40k AB = $20k b. Capital Asset #3: $60k FMV $20k AB = $40k c. Total Appreciation = $60k 3. Allocate Adjustment a. Capital Asset #2 i. $20k basis adjustment * ($20k/$60k) = $6,667 ii. $40k original basis + $6,667 adjustment = $46,667 b. Capital Asset #3 i. $20k basis adjustment * ($40k/$60k) = $13,333 ii. $20k original basis + $13,333 adjustment = $33,333 4. Balance Sheet

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Liabilities and Capital Accounts A.B. F.M.V. A.B. F.M. V. Cash $60k $60k Liab: none Capital Asset $46,6 $60k Capital #2 67 Accounts Capital Asset $33,3 $60k A $0 $20k #3 33 (80k60k) B $70k $80k C $70k $80k $140 $180k $140 $180 k k k iv. (c) How should any basis adjustment be allocated among the partners? 1. If pship sold Capital Assets #2 and #3 a. Total gain = $40k i. A (1/9): 4,444 ii. B (4/9): 17,778 iii. C (4/9): 17,778 b. But, A should be allocated 20k; B and C should be allocated 10k each 2. How could the partners fix this? a. Change pship agreement b. Special allocation of the gain from assets #2 and #3 i. Gain on assets of #2 and #3 are allocated: 1. A: 20k 2. B: 10k 3. C: 10k c. BUT, does this special allocation has substantial economic effect? i. Economic Effect 1. Mechanical test; just need the right provisions in pship agreement and comply w/ them ii. Substantiality 1. Will the allocation affect substantially the dollar amounts the partners will receive? a. No b/c the book/tax disparity is corrected on liquidation 2. But, the allocation may be respected b/c its not based on tax-avoidance motivations IV. Mixing Bowl Transactions a. Distributions of Contributed Property to Another Partner i. Contributing Partner 1. Gain/Loss Recognition. If contributed property is distributed to another partner w/in 7 years of contribution, contributing partner is treated as recognizing gain/loss under 704(c)(1)(A) if property had been sold for FMV. 704(c)(1)(B)(i). 2. Character of Gain/Loss. If contributed property is distributed to another partner w/in 7 years of contribution, the character of the gain/loss is the character of gain/loss that results if the

Assets

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property was sold by the pship to the distributee. 704(c)(1) (B)(ii). a. Partnership Level. Character of gain/loss is determined at the pship level. 702(b). 3. Basis in Contributing Partners Interest in the Partnership. If contributed property is distributed to another partner w/in 7 years of contribution, contributing partners basis in his interest in the pship is adjusted to reflect any gain/loss recognized. 704(c)(1)(B)(iii). ii. Distributee Partner. See II. Consequences to the Distributee Partner, supra. 1. Nonrecognition. Generally, in distributions by a pship to a partner, gain/loss is not recognized. 731(a)(1). a. Exception: Distribution of Money. Gain or loss is recognized to the extent that any money distributed exceeds the AB of the partners interest in the pship immediately before distribution. 731(a)(1). b. Exception: Distribution of Other Property to Contributing Partner. See IV.b. Distributions of Other Property to the Contributing Partner, infra. 2. Basis in Distributed Property. The basis of property (other than money) distributed by a pship to a partner (in operating distribution) is its AB to the pship immediately before such distribution. 732(a)(1). a. Adjust Basis Before Distribution. Adjustments to the basis of a partners interest the partnership are made before the distribution. 704(c)(1)(B)(iii). 3. Basis in Partnership Interest. For operating distributions, the AB of a partners interest in the pship is reduced (but not below zero) by a. (1) money distributed to the partner, and b. (2) AB to such partner of distributed property other than money. 733. b. Distributions of Other Property to the Contributing Partner i. Gain/Loss Recognition. In the case of any distribution by a pship to a partner, such partner is treated as recognizing gain in an amount equal to the lesser of 1. (1) the excess of (A) FMV of property distributed over (B) AB of partners interest in the pship, OR 2. (2) the net pre-contribution gain of partner. 737(a). a. Net Precontribution Gain. Net precontribution gain means any gain the distributee partner would have recognized under 704(c)(1)(B) if all the property he contributed w/in 7 years of the distribution was distributed to another partner. 737(b). ii. Character of Gain/Loss. The character of such gain is determined by reference to the proportionate character of the net precontribution gain. 737(a) (flush language). iii. Basis Adjustments 1. Basis in Pship Interest. AB of partners interest in the pship is increased by the amount of any gain recognized by such partner under (a). 737(c)(1). a. Increased Before Distribution. For purposes of determining the basis of the distributed property, such

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increase shall be treated as occurring immediately before the distribution. 737(c)(1). 2. Basis in Asset Distributed. The basis of property (other than money) distributed by a pship to a partner (in operating distribution) is its AB to the pship immediately before such distribution. 732(a)(1). a. Distribution Decreases Basis. AB of distributees interest in the pship is reduced (but not below zero) by AB partner takes in the property. 733(2). 3. Partnerships Basis in Contributed Property. Adjustments made to pships basis in contributed property referred to in subsection (b) to reflect gain recognized under subsection (a). 737(c)(2). c. Problem (pp. 31819). A, B, and C form the equal ABC partnership by contributing the following real properties, all of which are held as an investment by both the partners and the partnership: Partner Property A.B. FMV. A #1 $2,000 $10,000 B #2 $5,000 $10,000 C #3 $10,000 $10,000 i. Assume that ABC uses the traditional method of allocation under Reg. 1.704-3(b). What are the tax consequences to the partners in the following transactions, assuming the partners outside bases and ABCs inside basis in the land are unchanged at the time of each transaction, if the ABC partnership: ii. (a) Sells property #1 for $10,000. 1. Partner A a. Gain/Loss Recognition i. Reg. 1.704-3(b)(1): traditional method of making 704(c) allocations reqs that built-in gain/loss is attributed to the contributing partner ii. 704(c)(1)(A): gain from contributed property shall be shared so as to take into account the variation btwn AB of property to the pship and its FMV at time of contribution iii. $10k FMV $2k AB = $8k built-in gain iv. A recognizes $8k gain b. Character of Gain i. 702(b): determine character at the pship level ii. Pship holds the property as investment iii. Assume pship held the property for many years iv. Gain is LTCG c. As Basis in Pship Interest i. 705: increase basis in pship interest ii. As basis in pship interest = $2k + $8k = $10k iii. (b) Distributes property #1 to C six years after formation of the partnership. 1. Partner A a. Gain/Loss Recognition i. 704(c)(1)(B)(i): if contributed property is distributed to another partner w/in 7 years of contribution, contributing partner is treated as recognizing gain/loss under 704(c)(1)(A) if property had been sold for FMV

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ii. Here, built-in gain = $8k iii. A recognizes $8k gain b. Character of Gain i. 704(c)(1)(B)(ii): if contributed property is distributed to another partner w/in 7 years of contribution, the character of the gain/loss is the character of gain/loss that results if the property was sold by the pship to the distributee ii. Here, gain = LTCG 1. See part (a) c. Basis in Contributing Partners Interest in the Pship i. 704(c)(1)(B)(iii): if contributed property is distributed to another partner w/in 7 years of contribution, contributing partners basis in his interest in the pship is adjusted to reflect any gain/loss recognized ii. Here, A recognized $8k gain iii. As basis in pship interest = $2k + $8k = $10k 2. Partner C a. Gain/Loss Recognition i. 731(a)(1): in the case of distributions, partner does not recognize gain/loss, except to the extent money distributed > AB of the partners interest in the pship ii. Here, C does not recognize gain/loss b. Basis in Distributed Property i. 732(a)(1): partner takes transferred basis ii. 704(c)(1)(B)(iii): adjustments to propertys basis are made before the distribution iii. Basis of Property #1 = $2k + $8k = $10k iv. C takes a $10k basis in the property c. Basis in Pship Interest i. 733(2): AB in partners interest in the pship is reduced by basis the partner takes in the distributed property ii. Cs basis in partnership interest = $10k $10k = 0 iv. (c) Distributes property #3 to A six years after formation of the partnership. 1. Partner C a. The property Partner C contributed does not have a built-in gain b. 704(c)(1)(B) is not triggered (i.e., it results in zero gain for C) 2. Partner A a. Gain Recognition i. 737(a): partner is treated as recognizing gain in an amount equal to the lesser of 1. (1) the excess of (A) FMV of property distributed over (B) AB of partners interest in the pship, OR a. Here, $10k $2k = $8k 2. (2) the net pre-contribution gain of partner a. 737(b): net precontribution gain means gain the distributee

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partner would recognize under 704(c)(1)(B) if all the property he contributed w/in 7 years of the distribution was distributed to another partner b. Here, contributed asset had a builtin gain of $8k c. A wouldve recognized $8k gain ii. A recognizes $8k gain b. Character of Gain/Loss i. 737(a): character is determined by reference to the proportionate character of the net precontribution gain ii. Here, gain is LTCG c. Basis Adjustments i. Basis in Pship Interest 1. 737(c)(1): AB of partners interest in the pship is increased by the amount of any gain recognized by such partner under (a) a. Basis in pship interest = $2k + $8k = $10k 2. 733(2): AB of distributees interest in the pship is reduced by AB partner takes in the property a. Basis in pship interest = $10k $10k = 0 ii. Basis in Asset Received 1. 732(a)(1): distributee takes transferred basis a. As basis in Property #3 = $10k v. (d) Distributes property #2 to A six years after formation of the partnership. 1. Partner B a. Gain/Loss Recognition i. 704(c)(1)(B)(i): if contributed property is distributed to another partner w/in 7 years of contribution, contributing partner is treated as recognizing gain/loss under 704(c)(1)(A) if property had been sold for FMV ii. Here, built-in gain = $5k iii. B recognizes $5k gain b. Character of Gain i. 704(c)(1)(B)(ii): if contributed property is distributed to another partner w/in 7 years of contribution, the character of the gain/loss is the character of gain/loss that results if the property was sold by the pship to the distributee ii. 702(b): character is determined at the pship level iii. Here, gain = LTCG c. Basis in Contributing Partners Interest in the Pship i. 704(c)(1)(B)(iii): if contributed property is distributed to another partner w/in 7 years of contribution, contributing partners basis in his

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interest in the pship is adjusted to reflect any gain/loss recognized ii. Here, B recognized $5k gain iii. Bs basis in pship interest = $5k + $5k = $10k d. Basis in Property Distributed i. 704(c)(1)(B)(iii): if contributed property is distributed to another partner w/in 7 years of contribution, AB of distributed property is adjusted to reflect any gain/loss recognized ii. Basis in Parcel #2 = $5k + $5k = $10k 2. Partner A a. Gain Recognition i. 737(a): partner is treated as recognizing gain in an amount equal to the lesser of 1. (1) the excess of (A) FMV of property distributed over (B) AB of partners interest in the pship, OR a. Here, $10k $2k = $8k 2. (2) the net pre-contribution gain of partner a. 737(b): net precontribution gain means gain the distributee partner would recognize under 704(c)(1)(B) if all the property he contributed w/in 7 years of the distribution was distributed to another partner b. Here, contributed asset had a builtin gain of $8k c. A wouldve recognized $8k gain ii. A recognizes $8k gain b. Character of Gain/Loss i. 737(a): character is determined by reference to the proportionate character of the net precontribution gain 1. Determine character at pship level w/ reference to contributed property ii. Here, gain is LTCG c. Basis Adjustments i. Basis in Pship Interest 1. 737(c)(1): AB of partners interest in the pship is increased by the amount of any gain recognized by such partner under (a) a. Basis in pship interest = $2k + $8k = $10k 2. Basis in Distributed Property a. 732(a)(1): distributee takes transferred basis b. As basis in Property #2 = $10k 3. 733(2): AB of distributees interest in the pship is reduced by AB partner takes in the property a. Basis in pship interest = $10k $10k = 0 ii. Pships Basis in Contributed Property

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1. 737(c)(2): pships basis in contributed property is adjusted to reflect gain recognized under (b) a. Basis in Property #1 = $2k + $8k = $10k

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PART 8: LIQUIDATING DISTRIBUTIONS AND TERMINATIONS I. Introduction a. Alternatives for a Partner Leaving a Partnership i. Liquidation of the partners interest in the partnership. See 736. ii. Sale of the partners partnership interest. See 741, 751(a). See PART 6: SALES AND EXCHANGES OF PARTNERSHIP INTERESTS, supra. 1. Sale could be to other partners, or to a third party. II. Liquidation of a Partners Interest a. Classification of Payments to a Retiring Partner i. Payments from the partnership to a retiring partner can be classified as either: 1. Payment for the partners interest in partnership property, or a. Such payments are treated as distributions to the partner under 731, 732. 736(b)(1). 2. Pmt for something else (e.g., for a partners services, or as a departing bonus) a. Such payments are treated either as a distributive share of partnership income or as guaranteed payments under 704(c). 736(a). b. Determining Whether Payments are Subject to 736(b) or 736(a) i. If capital is a material income producing factor for the partnership: 1. A liquidating payment falls under 736(b)(1) to the extent of the FMV of that partners share of partnership assets, and a. The partners can agree on the FMV of the partners interest in partnership assets (including goodwill). As long as its an arms-length agreement, the Service will respect it. See Reg. 1.736-1(b)(1). 2. The portion of the payment in excess of that FMV falls under 736(a). 3. E.g., in businesses with large inventories capital is a material income producing factor, whereas it is not in a service partnership. 4. Example. Partner A retires from a pship where capital is a material income producing factor. Assets Liabilities and Capital Accounts AB FMV Tax FMV Cash $33,000 $33,000 Liabilitie $0 $0 s Goodwill $0 $30,000 Capital Account s Land $3,000 $30,000 A $12,000 $31,000 B $12,000 $31,000 C $12,000 $31,000 $36,00 $93,00 $36,00 $93,00 0 0 0 0 a. If A gets $31k, its treated as a distribution under 736(b) b. If A gets $32k: i. $31k is treated as a distribution under 736(b) ii. $1k is treated as a guaranteed payment under 736(a)

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ii. If capital is not a material income producing factor for the partnership,
and if the retiring partner is a general partner, then the special rules of 736(b)(2) apply. See 736(b)(3). 1. Section 736(b)(1) does not apply (i.e., 736(a) applies) to amounts paid for: a. Unrealized receivables, and b. Goodwill of the partnership, unless the pship agreement provides for a payment for goodwill (unstated goodwill). 726(b)(2). 2. Example. Using the balance sheet from the last example, assume the capital is not a material income producing factor. A is a general partner. a. Here, there is unstated goodwill b. If A gets a $31k payment: i. $10k is unstated goodwill; subject to 736(a) ii. $21k is treated as a distribution; subject to 736(b) c. If the pship agreement provided for pmt of goodwill (stated goodwill), its subject to 736(b) c. Distributions. See PART 7. OPERATING DISTRIBUTIONS, supra. i. Partnership: Nonrecognition. No gain/loss is recognized to a partnership on a distribution to a partner of property, including money. 731(b). ii. Distributee Partner 1. Gain/Loss Recognized a. Gain Recognition. A distributee partner does not recognize gain, except to the extent that any money distributed exceeds the partners interest in the pship. 731(a)(1). b. Loss Recognition. Where a distributee partner only receives money or unrealized receivables or inventory ( 751 assets), loss is recognized to the extent the AB of his pship interest exceeds the sum of money and 751 assets received. 731(a)(2). 2. Basis of Distributed Assets. Basis in distributed property is equal to AB of partners interest in the pship reduced by any money distributed. 732(b). 3. Allocation of Basis a. 751 Property. First allocate basis in distributed property to AB unrealized receivables and inventory items. 732(c)(1)(A)(i). b. Other Distributed Property. Then, assign remaining basis to other distributed property. 732(c)(1)(B)(i). c. Increase/Decrease. To the extent any increase/decrease in basis is reqd to have AB of other distributed properties equal remaining basis, increase/decrease as appropriate. 732(c)(1)(B)(ii). i. Increasing Other Distributed Propertys Bases 1. Unrealized Appreciation. First allocate any increase to property w/ unrealized appreciation in proportion to (and to the extent of) their unrealized appreciation. 732(c)(2)(A).

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2. FMV. Then, allocate the increase in

proportion to their respective FMVs. 732(c)(2)(B). 4. Character of Gain/Loss a. Inventory: Ordinary Income/Loss W/in 5 Years. Gain/loss on the sale/exchange of distributed inventory, within 5 years of distribution is ordinary income/loss. 735(a)(2). b. Tacked Holding Period. A partner includes the pships holding period in determining his holding period of distributed property. 735(b). d. Problem 1 (p. 336). The ABC partnership, which has not made a 754 election, has the following balance sheet: Assets Liabilities and Capital Accounts A.B. F.M.V. A.B. F.M.V. Cash $90,000 $90,000 Liab: none Inventory 15,000 30,000 Capital Accounts Land (Parcel 100,000 60,000 A $85,000 $70,000 #1) Land (Parcel 50,000 30,000 B 85,000 70,000 #2) C 85,000 70,000 $255,00 $210,00 $255,000 $210,00 0 0 0 i. (a) In liquidation of his interest, A receives one-third of the inventory and Parcel #1. What are the tax consequences of this distribution to A and the partnership? 1. Partner A a. Capital is a material income producing factor for the pship i. There is a lot of inventory and land ii. Liquidating payment is treated as a distribution under 736(b)(1) to the extent of the FMV of that partners share of partnership assets 1. $10k inventory + $60k land = $70k As FMV in interest in pship property b. Gain/Loss Recognized i. Gain Recognition 1. 731(a)(1): no gain recognized (b/c not cash) ii. Loss Recognition 1. 731(a)(2): no loss recognition (b/c received property other than cash and 751 assets) iii. Basis of Distributed Assets 1. 732(b): basis in distributed property is an amount equal to AB of partners interest in the pship reduced by any money distributed a. $85k 0 = $85k 2. 732(c)(1)(A)(i): first allocate basis in distributed property to extent of AB of 751 property in the PNS

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a. Allocate $5k to inventory 3. 732(c)(1)(B)(i): then, assign remaining basis to other distributed property a. Allocate $80k to Parcel #1 AB FMV Inventory $5k $10k Land #1 $80k $60k c. Character of Gain/Loss i. 735(a)(2): if A sold the inventory w/in 5 years of the distribution, it would treated as ordinary gain/loss ii. If A sold Parcel #1, his use would determine the character iii. 735(b): A takes a tacked holding period 2. Partnership a. 731(b): nonrecognition 3. Checking Your Work a. $70k distributed property $85k AB in pship interest = $15k loss, because property consists of only cash and 751 property. b. A did not recognize any loss, so he should have $15k loss built-in to the distributed assets i. Inventory: $10k FMV $5k AB = $5k built-in gain ii. Land #1: $60k FMV $80k AB = $20k built-in loss iii. $5k $20k = $15k net built-in loss 4. Ending Balance Sheet Assets Liabilities and Capital Accounts A.B. F.M.V. A.B. F.M. V. Cash $90k $90k Liab: none Inventory $10k $20k Capital Accounts Land (Parcel $50k $30k B $85k $70k #2) C $85k $70k $150 $140k $170 $140 k k k ii. (b) In liquidation of his interest, A again receives one-third of the inventory and also receives $60,000 cash. What are the tax consequences of this distribution to A and the partnership? 1. Partner A a. Capital is a material income producing factor for the pship i. There is a lot of inventory and land ii. Liquidating payment is treated as a distribution under 736(b)(1) to the extent of the FMV of that partners share of partnership assets 1. $10k inventory + $60k cash = $70k As FMV in interest in pship property b. Gain/Loss Recognized i. Gain Recognition

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1. 731(a)(1): no gain recognized (b/c cash received does not exceed AB in pship interest) ii. Loss Recognition 1. 731(a)(2): where a distributee partner only receives cash or 751 assets, loss is recognized to the extent the AB of his pship interest exceeds the sum of money and 751 assets received a. Basis A Takes in Distributed Property i. 732(b): basis in distributed property = AB of partners interest in the pship money distributed ii. $85k $60k = $25k b. Allocate Basis i. 732(c)(1)(A)(i): first allocate to inventory in amount of pships AB ii. Allocate $5k to inventory 2. $85k [$60k + $5k] = $20k loss iii. If the pship made a 754 election, adjust AB in pship property down by $20k 2. Partnership a. 731(b): nonrecognition iii. (c) Why is recognized loss under 731(a)(2) limited to liquidating distributions and further restricted with regard to the nature of the distribution? 1. Loss is not recognized in operating distributions b/c the distributions do not represent a closed and completed transaction. The distributee partner still remains a partner after the distribution. In liquidating distribution there is no up-side potential. 2. Restricting losses to distributions where partner receives cash and 751 property: a. Congress tried to prevent gain/loss recognition, except when theres no other choice i. E.g., where partner receives cash distribution and has zero basis in pship interest b. Congress permits losses when it cannot or does not want to build-in losses to distributed property i. Suppose Partner has AB in pship interest of $100; receives $60 cash in liquidating distribution 1. Partner recognizes $40 loss 2. Cant defer loss ii. Suppose partner receives $60 in inventory instead 1. Here, Congress chose not to build-in the loss and preserve the capital gain/loss character in the property iv. (d) What result to A in (b), above, if the inventory were worth $120,000 rather than $30,000, As interest were worth $100,000 and A received $60,000 of cash and his one-third of the inventory? 1. Gain/Loss Recognized

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a. Gain Recognition i. 731(a)(1): no gain recognized (b/c cash does not exceed AB in pship interest) b. Loss Recognition i. Same result as part (b) ii. A realizes $20k loss c. Basis in Distributed Assets (1/3 of the inventory) AB FMV Gain Inventory $5k $40k $35k 2. Checking Your Work a. $100k FMV distributed property $85k AB in pship interest = $15k gain b. A recognized $20k loss c. $15k gain ($20k loss) = $35k built-in gain i. Inventory has a $35k built-in gain e. Problem 2 (p. 336). Partnership distributes Capital Asset #1 (inside basis $5,000, f.m.v.$40,000) and Capital Asset #2 (inside basis$10,000, f.m.v. $10,000) to Partner A in liquidation of As interest in Partnership. Prior to the distributions, A has a $55,000 outside basis. Determine partner As basis in the two capital assets following the liquidation distribution. i. 732(b): basis in distributed property is an amount equal to AB of partners interest in the pship reduced by any money distributed 1. $55k 0 = $55k ii. 732(c)(1)(A)(i): first allocate basis in distributed property to AB unrealized receivables and inventory items 1. Here there are no 751 assets iii. 732(c)(1)(B)(i): then, assign remaining basis to other distributed property 1. Capital Asset #1: allocate $5k basis 2. Capital Asset #2: allocate $10k basis iv. 732(c)(1)(B)(ii): then, to the extent any increase/decrease in basis is reqd to have AB of other distributed properties equal remaining basis, increase/decrease as provided in 732(c)(2), (3) v. 732(c)(2)(A): first allocate any increase to property w/ unrealized appreciation in proportion to their unrealized appreciation (to the extent of each propertys unrealized appreciation) 1. Here, Capital Asset #1 has unrealized appreciation of $35k vi. 732(c)(2)(B): then, allocate the increase in proportion to their respective FMVs 1. $55k basis $5k $10k $35k = $5k basis remaining 2. Capital Asset #1: $5k * ($40k/$50k) = $4k 3. Capital Asset #2: $5k * ($10k/$50k) = $1k Pships AB Unrealized FMV Total Basis Appreciation Capital Asset $5k $35k $4k $44k #1 Capital Asset $10k $1k $11k #2

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PART 9: S CORPORATIONS AND THEIR SHAREHOLDERS I. Introduction a. Development of Subchapter S i. Congress enacted Subchapter S in 1958 ii. Congresss stated purpose: 1. To create a regime like subchapter K, so that businesses could choose either the corporate form of doing business or the partnership form without major differences in tax consequences. 2. However, there are significant differences between subchapters K and S that business participants should consider in choosing between these regimes. iii. Subsequent legislation has made significant changes to Subchapter S. Generally, this legislation has: 1. Made subchapter S more closely resemble subchapter K, and 2. Relaxed the eligibility rules for status as an S corporation. b. The Future of Subchapter S i. Business participants typically desire: 1. Limited liability 2. Pass-through tax treatment ii. Traditional options: 1. Limited partnership (subchapter K) 2. Subchapter S corporation (subchapter S) iii. Newer options: 1. Limited liability company (LLC) 2. Limited liability partnership (LLP) iv. Today, under the check-the-box regulations, domestic, unincorporated business organizations with two or more members can choose to be subject to: 1. Subchapter S (or subchapter C) 2. Subchapter K v. Is there still a need to maintain two different passthrough regimes (subchapter K and subchapter S) in the Code? II. Eligibility for S Corporation Status a. S Corporation vs. C Corporation. An S corporation is a small business corporation which elects under 1362. 1361(a)(1). A C corporation means all other corporations. 1361(a)(2). b. Small Business Corporation. A small business corporation is a: i. Domestic corporation ii. Which is not an ineligible corporation iii. Which has 1. No more than 100 shareholders 2. Only shareholders who are individuals, estates, and certain types of trusts and tax-exempt organizations a. See 1361(c)(2). 3. No nonresident alien shareholders, and 4. Not more than one class of stock. 1361(b)(1). c. Ineligible Corporation. Ineligible corporation means a corporation which is [in the list of corporations subject to their own tax schemes.] 1361(b)(2). d. 100 Shareholders i. Husband and Wife = One Shareholder. For purposes of the 100 shareholder limit, husband and wife are treated as one shareholder. 1361(c)(1)(A)(i).

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1. Form of Ownership Irrelevant. Stock owned by a H and W is

treated as if owned by one shareholder, regardless of the form in which they hold the stock. Reg. 1.1361-1(e)(2). ii. Members of a Family = One Shareholder. For purposes of the 100 shareholder limit, members of a family are treated as one shareholder. 1361(c)(1)(A)(ii). 1. Members of a Family. Members of a family means a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendant. 1361(c)(1)(B)(i). 2. Common Ancestor. An individual is not a common ancestor if, on the applicable date, the individual is more than 6 generations removed from the youngest generation of shareholders who would be members of the family. 1361(c) (1)(B)(ii). e. Types of Shareholders i. Wholly Owned Subsidiaries 1. Q-Sub Requirements. A qualified subchapter S subsidiary (Q-sub) means any domestic corporation which is not an ineligible corporation, if a. (i) 100% of the stock is held by the S corporation, and b. (ii) the S corporation elects to treat such corporation as a qualified subchapter S subsidiary. 1361(b)(3)(B). 2. Effect a. Not Separate. A corporation which is a qualified subchapter S subsidiary shall not be treated as a separate corporation. 1361(b)(3)(A)(i). b. Tax Items Absorbed. Assets, liabilities, and items of income, deduction and credit of the Q-sub are treated as such items of the S corporation. 1361(b)(3)(A)(ii). ii. Estate Includes Individual Bankruptcy Estate. 1361(c)(3). f. One Class of Stock i. Identical Distribution/Liquidation Rights. A corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Reg. 1.1361-1(l)(1). 1. Look to Governing Documents. The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law and binding agreements relating to distribution and liquidation proceeds. Reg. 1.1361-1(l)(2)(i). ii. Voting/Nonvoting Irrelevant. For purposes of the eligibility requirements, a corporation is not treated as having more than 1 class of stock solely b/c there are differences in voting rights among the shares of common stock. 1361(c)(4). iii. Straight Debt Safe Harbor 1. Historical Reclassification. Before the safe debt safe harbor, the IRS reclassified nominal S corporation debt owed to shareholders as a second class of stock, causing the corporation to lose its S status. 2. Straight Debt Second Class of Stock. An obligation that satisfies the straight debt safe harbor is not treated as a second class of stock even if it is considered equity under general

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principles of Federal tax law. 1361(c)(5)(A); Reg. 1.1361-1(l) (5)(iv). a. Recharacterization for Unreasonably High Debt. If a straight debt obligation bears a rate of interest that is unreasonably high, an appropriate portion of the interest may be recharacterized and treated as a payment that is not interest. Reg. 1.1361-1(l)(5)(iv). 3. Straight Debt. Straight debt means any written unconditional promise to pay on demand or on a specified date a sum certain in money if a. (i) the interest rate is not contingent on profits, the borrowers discretion, or similar factors, b. (ii) there is no convertibility into stock, and c. (iii) the creditor is an individual (other than a nonresident alien), an estate, certain trusts, or a person which is actively and regularly engaged in the business of lending money. 1361(c)(5)(B). 4. Subordination Not Dispositive. The fact an obligation is subordinated to other debt of the corporation does not prevent the obligation from qualifying as straight debt. Reg. 1.13611(l)(5)(ii). g. Problem 1 (handout). Z Corporation is a corporation organized under Texas law that, except as otherwise provided below, has 115 share of voting common stock outstanding. In each of the following alternative situations, determine whether Z is eligible to elect S corporation status: i. (a) Z has 99 individual shareholders, each of whom owns one share of Z stock. The remaining 16 shares are owned by A and her husband, B. Of their 16 shares, they own 10 shares as community property and each spouse owns 3 shares as separate property. 1. 1361(b)(1)(A): corporation cannot have more than 100 shareholders 2. 1361(c)(1)(A)(i): husband and wife are treated as one shareholder 3. Reg. 1.1361-1(e)(2): stock owned by a H and W is treated as if owned by one shareholder, regardless of the form in which they hold the stock 4. Z Corporation can elect S corporation status ii. (b) Same as (a), above, except that A and B are brothers who own their 16 shares as joint tenants with right of survivorship. 1. 1361(b)(1)(A): corporation cannot have more than 100 shareholders 2. 1361(c)(1)(A)(ii): members of a family are treated as one shareholder a. 1361(c)(1)(B)(i): members of a family means a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendant b. 1361(c)(1)(B)(ii): an individual is not a common ancestor if, on the applicable date, the individual is more than 6 generations removed from the youngest generation of shareholders who would be members of the family 3. Here, A and B are lineal descendants of their parents (a common ancestor) 4. Z Corporation can elect S corporation status

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iii. (c) Z has 100 shares of Class A voting common stock and 50 shares of Class B nonvoting common stock outstanding. Apart from the differences in voting rights, the two classes of common stock have equal rights with regard to dividends and liquidation distributions. Z also has an authorized but unissued class of nonvoting stock that would be limited and preferred as to dividends. The Class A common stock is owned by four individuals and the Class B common stock is owned by E and F (a married couple) as tenants-in-common. 1. 1361(b)(1)(D): corporation cannot have more than one class of stock 2. Voting/Nonvoting a. 1361(c)(4): for purposes of eligibility requirements, a corporation is not treated as having more than 1 class of stock solely b/c there are differences in voting rights among the shares of common stock b. Thus, there the voting/nonvoting distinction is not treated as more than one class of stock 3. Unissued Shares a. Reg. 1.1361-1(l)(1): a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds b. Thus, we dont take unissued shares into account 4. Z Corporation can elect S corporation status iv. (d) Same as (c), above, except that Z enters into a binding agreement with its shareholders to make larger annual distributions to shareholders who bear heavier state income tax burdens. The amount of the distributions is based on a formula that will give the shareholders equal after-tax distributions. 1. 1361(b)(1)(D): corporation cannot have more than one class of stock 2. Reg. 1.1361-1(l)(1): a corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds a. Reg. 1.1361-1(l)(2)(i): the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on [governing documents and] binding agreements relating to distribution and liquidation proceeds b. Reg. 1.1361-1(l)(2)(vi) Example 6: the agreement alters the rights to distribution proceeds so that those rights are not identical 3. Z Corporation is treated as having more than one class of stock 4. Z Corporation cannot elect S corporation status v. (e) Z has four individual shareholders, each of whom owns 100 shares of Z common stock for which each paid $10 per share. Each shareholder also owns $25,000 of 15-year Z bonds. The bonds bear interest at 3% above the prime lending rate established by the Chase Manhattan Bank, adjusted quarterly, and are subordinated to general creditors of Z. 1. 1361(c)(5)(A): straight debt is not treated as a second class of stock

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2. 1361(c)(5)(B): straight debt means any written

unconditional promise to pay on demand or on a specified date a sum certain in money if a. (i) the interest rate is not contingent on profits, the borrowers discretion, or similar factors, b. (ii) there is no convertibility into stock, and c. (iii) the creditor is an individual (other than a nonresident alien), an estate, certain trusts, or a person which is actively and regularly engaged in the business of lending money 3. Here, the debt fits into the safe harbor 4. Reg. 1.1361-1(l)(5)(ii): the fact an obligation is subordinated to other debt of the corporation does not prevent the obligation from qualifying as straight debt 5. Z Corporation can elect S corporation status III. Election, Revocation and Termination a. Subchapter S Election i. Election Mechanics 1. Election Statement. An election stmt must identify the election being made, set forth the name, address, and taxpayer identification number of the corporation, and be signed by a person authorized under 6037. Reg. 1.1362-6(a)(1). 2. File Form 2553. A small business corporation makes an election under 1362(a) to be an S corporation by filing a completed Form 2553. Reg. 1.1362-6(a)(2)(i). 3. All Shareholders (At Time of Election) Consent. An election is valid only if all persons who are shareholders in such corporation on the day on which such election is made consent to such election. 1362(a)(2). a. Effect on Timely Election. A timely election is treated as made for the following year if 1 or more of the persons who held stock in the corporation during such taxable year and before the election was made did not consent to the election. 1362(b)(2)(B)(ii). ii. Filing Deadline. An election may be made by a small business corporation 1. (A) during the preceding taxable year, or 2. (B) on or before the 15th day of the 3d month of the taxable year. 1362(b)(1). iii. Effect of Late Filing. An election after the 15th day of the 3d month of the taxable year is treated as made for the following taxable year. 1362(b)(3). 1. Reasonable Cause. The Secretary may treat a late election as timely if it determines there was reasonable cause for the failure to timely make such election. 1362(b)(5). The form of the request is a private letter ruling. See Rev. Proc. 2004-48; 2007-62 for the procedure. b. Revocation i. > of Shares Must Consent. An election may be terminated by revocation if shareholders holding more than one-half of the shares of stock of the corporation on the day on which the revocation is made consent to the revocation. 1362(d)(1)(A), (B).

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1. Includes Non-Voting Stock. Non-voting stock is included in

c. Termination i. Ceases to be Small Business Corporation. An election is terminated when such corporation ceases to be a small business corporation. 1362(d)(2)(A). 1. Termination is Effective Immediately. 1362(d)(2)(B). ii. Inadvertent Termination. If 1. (1) an election a. (A) was not effective by reason of a failure to meet 1361(b) or to obtain shareholder consents, or b. (B) an election was terminated under 1361(d)(2) or (3), 2. (2) the Secretary determines that the termination was inadvertent, 3. (3) no later than a reasonable period of time after discovery of the circumstances resulting in such ineffectiveness or termination, steps were taken a. (A) so that the corporation is a small business corporation, or b. (B) to acquire the required shareholder consents, and 4. (4) the corporation and all shareholders consent to make adjustments required by the Secretary, 5. Then, such corporation shall be treated as an S corporation. 1367(f). 6. Procedure. The corporation would make a private letter ruling for relief. Reg. 1.1362-4(c). d. No Election for 5 Years. If a small business corporation made an election and such election was terminated or revoked, such corporation shall not be eligible to make an election for 5 taxable years after the termination is effective. 1362(g). e. Taxable Year of an S Corporation i. Calendar Year. Generally, S corporations must use a calendar taxable year. 1378(a), (b)(1). ii. Business Purpose. An S corporation can choose another taxable year if the corporation can establish a business purpose for using that other period. 1378(b)(2). iii. Different Taxable Year. If an S corporation cannot establish a business purpose for a different taxable year, then it can, within limits, choose a different taxable year pursuant to 444 if it pays an entitylevel tax calculated under 7519. f. Problem 2 (handout). On January 1 of Year 1, individuals A, B and C, who are unrelated, validly formed Corporation X under Texas law. The three individuals are equal shareholders. You can assume that A, B and C are all U.S. citizens. i. (a) How would Corporation X elect to be treated as a subchapter S corporation? 1. Reg. 1.1362-6(a)(1): an election stmt must identify the election being made, sets forth the name, address, and taxpayer identification number of the corporation, and be signed by a person authorized under 6037 2. Reg. 1.1362-6(a)(2)(i): a small business corporation makes an election under 1362(a) to be an S corporation by filing a completed Form 2553 the shareholder consent requirement. Reg. 1.1362-2(a)(1); 1.1362-6(a)(3)(i).

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ii. (b) If Corporation X is to be treated as a subchapter S corporation for Year 1, by what point in time must the election be made? 1. 1362(b)(1)(B): an election may be made any time during the taxable year on or before the 15th day of the 3d month of the taxable year 2. The election must be mailed by March 15. See 7502(a). iii. What happens if Corporation X fails to make a timely election? 1. 1362(b)(3): an election after the 15th day of the 3d month of the taxable year is treated as made for the following taxable year a. Corporation X would be a C corporation in the current taxable year 2. 1362(b)(5): the Secretary may treat a late election as timely if it determines there was reasonable cause for the failure to timely make such election iv. (c) Who must consent to the election? Would your answer be different if A and B held voting stock and C held nonvoting stock? 1. 1362(a)(2): an election is valid only if all persons who are shareholders in such corporation on the day on which such election is made consent to such election 2. Voting/nonvoting stock does not matter v. (d) Assume that Corporation X made a valid subchapter S election for Year 1. In Year 2, shareholder A wishes to revoke the S election. Can A do so? Would your answer be different if A held voting stock and B and C held nonvoting stock? 1. 1362(d)(1)(A), (B): an election may be terminated by revocation if shareholders holding more than one-half of the shares of stock consent a. Thus, A alone cannot revoke the S election 2. Reg. 1.1362-2(a)(1): non-voting stock is included in the shareholder consent requirement 3. Reg. 1.1362-6(a)(3)(i): non-voting stock is taken into account for the revocation statement vi. (e) Assume that Corporation X made a valid subchapter S election for Year 1. In Year 3, A died and As shares in the corporation passed to As son and only heir, F, who is a citizen and resident of France. 1. (i) What effect would Fs ownership of the shares have on Corporation Xs status as an S corporation? a. 1362(d)(2)(A): an election is terminated when such corporation ceases to be a small business corporation i. 1362(d)(2)(B): termination is effective immediately b. AAs estate i. 1361(b)(1)(B): a small business corporation cannot have as a shareholder a person (other than an estate, etc.) who in not an individual ii. Thus, Corporation X remains a small business corporation c. As estateF i. 1361(b)(1)(C): a shareholder cannot be a nonresident alien ii. Thus, Corporation Xs S election terminated 2. (ii) What measures could be taken to preserve Corporation Xs status as an S corporation?

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a. This should have been addressed as a planning matter

i. Buy-sell agreement 1. Upon a shareholders death, the decedents shares shall be bought by the remaining shareholders or the corporation ii. Restrictions on stock transfers 1. No shareholder can transfer shares w/o the consent of others 2. Or, shareholders can only transfer shares to permissible classes of people b. 1367(f)If i. (1)(B) an election was terminated under 1361(d)(2) or (3), ii. (2) the Secretary determines that the termination was inadvertent, iii. (3) no later than a reasonable period of time after discovery of the circumstances resulting in such termination, steps were taken 1. (A) so that the corporation is a small business corporation, and iv. (4) the corporation and all shareholders consent to make adjustments required by the Secretary, v. Then, such corporation shall be treated as an S corporation c. This likely entails (1) getting the shares out of Fs hands, (2) F agreeing to be taxed as a shareholder, and (3) treating F as a shareholder for the period he held the shares IV. Treatment of the Shareholders a. Taxable Income. The taxable income of an S corporation shall be computed in the same manner as in the case of an individual, except that i. (1) the items described in 1366(a)(1)(A) are separately stated, 1. Items that Affect Tax Liability. Items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect a shareholders tax liability. 1366(a)(1)(A). ii. (2) the deductions in 703(a)(2) are not allowed, iii. (3) 248 applies (referring to deducting organizational expenditures), iv. (4) 291 applies (referring to reductions of certain tax benefits). 1363(b). b. Shareholders Taxable Income. A shareholder takes into account her pro rata share of the corporations i. (A) items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect a shareholders tax liability, and ii. (B) nonseparately stated items. 1366(a)(1). iii. Pro Rata. Each shareholders pro rata share of any item is the sum of the amount determined 1. (A) by assigning an equal portion of such item to each day of the taxable year, and 2. (B) then by dividing that portion pro rata among the shares outstanding on such day. 1377(a)(1). c. Loss Limitations

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i. Basis Limitation. The aggregate amount of losses and deductions

taken into account by a shareholder shall not exceed the sum of 1. (A) the AB of the shareholders stock in the S corporation (determined with regard to 1367(a)(1), (2)(A)), and 2. (B) the shareholders adjusted basis of any indebtedness of the S corporation to the shareholder. 1366(d)(1). ii. Guarantees. S corp shareholders dont get a basis increase by personally guaranteeing liability. Harris v. United States. The court requires an economic outlay (e.g., if shareholders paid on the guarantee) in order to deem it a capital contribution. iii. If Allocated Basis Exceeds Limitation 1. Allocate Basis. If shareholders pro rata share of aggregate losses/deductions exceeds loss limitation, then the limitation is allocated in an amount that bears the same ratio to the amount of the limitation as the loss or deduction bears to the total of the losses and deductions. Reg. 1.1366-2(a)(4). 2. Carry Over Excess. Any loss/deduction which is disallowed is carried over indefinitely until theres sufficient AB in stock or indebtedness. 1366(d)(2)(A). d. Basis in Stock i. Increases. AB in stock is increased by: 1. (A) items in items of income in 1366(a)(1)(A), [and] 2. (B) nonseparately computed income under 1366(a)(1)(B). 1367(a)(1). ii. Decreases. Basis decreased (but not below zero) by: . . . 1. (B) items of loss in 1366(a)(1)(A), and 2. (C) nonseparately computed loss under 1366(a)(1)(B). 1367(a)(2). iii. Order of Adjustments. The order of adjustments is: 1. (1) increases in basis 2. (4) decreases for items of loss or deduction in 1367(a)(2)(B) and (C). Reg. 1.1367-1(f). e. Basis in Indebtedness i. Losses (In Excess of AB of Stock) Decrease Basis. Where items in 1367(a)(2)(B)(E) exceed the shareholders basis, such excess reduces the shareholders basis in indebtedness of the S corporation to the shareholder. 1367(b)(2)(A). ii. Restoration of Basis. If there is a reduction in the shareholders basis in the indebtedness of an S corporation to a shareholder, any net increase is applied to restore such reduction in basis before it increases the shareholders basis in the stock of the S corporation. 1367(b)(2)(B). f. Problem 3 (handout). Assume the same basic facts of Problem 2, above, i.e., Corporation X has three equal shareholders, A, B and C. Corporation X made a valid subchapter S election effective as of January 1, Year 1. At the beginning of Year 2, A, B and C had a basis in their Corporation X stock of $20,000, $10,000 and $5,000, respectively. In addition, during Year 2, shareholder C made a loan to Corporation X in the amount of $2,000. During Year 2, Corporation X had the following tax items: Tax-exempt interest: $3,000 Ordinary income: $40,000 Depreciation: $58,000 Long-Term Capital Gain: $10,000 Long-Term Capital Loss: $19,000

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i. (a) What is X Corporations taxable income for Year 2? 1. 1363(b): the taxable income of an S corporation shall be computed in the same manner as in the case of an individual, except that a. (1) the items described in 1366(a)(1)(A) are separately stated . . . 2. 1366(a)(1)(A): items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder Separate Items Combined Items Income Income Tax-exempt $3k Ordinary $40k income income Deductions Deductions Net LTCL* ($9k) Depreciation ($58k) Combined ($18k) loss *Reg. 1.1366-1(a)(2)(i): net capital gains and losses ii. (b) How will the shareholders take these items into account for Year 2? 1. 1366(a)(1): a shareholder takes into account her pro rata share of the corporations a. (A) separately stated items b. (B) nonseparately stated items. 2. 1377(a)(1): each shareholders pro rata share of any item is the sum of the amount determined a. (A) by assigning an equal portion of such item to each day of the taxable year, and b. (B) then by dividing that portion pro rata among the shares outstanding on such day. Separate Items Combined Items Income Combined ($6k)/partner Tax-exempt $1k/partner loss income Deductions Net LTCL* ($3k)/partn er iii. (c) Will each shareholder be able to take the full amount of these items into account? 1. 1366(d)(1): the aggregate amount of losses and deductions taken into account by a shareholder shall not exceed the sum of a. (A) the AB of the shareholders stock in the S corporation (determined with regard to 1367(a)(1), (2)(A)), and b. (B) the shareholders adjusted basis of any indebtedness of the S corporation to the shareholder. 2. See part (d). A B C Shareholders AB in stock (taking $21,000 $11,000 $6,000 into account 1367(a)(1)) Shareholders AB $2,000 in indebtedness Loss Limitation $21,000 $11,000 $8,000

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3. C: $9k allocated loss (see part (d)) exceeds $8k loss limitation a. Reg. 1.1366-2(a)(4): if shareholders pro rata share of aggregate losses/deductions exceeds loss limitation, then the limitation is allocated in an amount that bears the same ratio to the amount of the limitation as the loss or deduction bears to the total of the losses and deductions i. Net LTCL: ($3k/$9k) * $8k = $2,667 ii. Ordinary loss: ($6k/$9k) * $8k = $5,333 b. 1366(d)(2)(A): any loss/deduction which is disallowed is carried over indefinitely until theres sufficient AB in stock or indebtedness i. $9k loss allocation $8k loss limitation = $1k carried over 4. Note: the at risk limitation ( 465) and passive activity loss limitation also apply iv. Would your answer be any different if, during Year 2, Corporation X borrowed $100,000 from a bank to fund operations? 1. 1366(d)(1)(B): debt to a bank is not indebtedness of the S corporation to the shareholder v. Would your answer be any different if shareholder C personally guaranteed the bank loan? 1. Harris v. United States: S corp SHs dont get basis increase by personally guaranteeing liability a. An economic outlay (e.g., if shareholders paid on the guarantee) is deemed a capital contribution vi. (d) What adjustments to basis are necessary at the end of Year 2? 1. 1367(a)(1): basis increased by: a. (A) items in items of income in 1366(a)(1)(A), and b. (B) nonseparately computed income under 1366(a)(1) (B) . . . 2. 1367(a)(2): basis decreased by: . . . a. (B) items of loss in 1366(a)(1)(A), and b. (C) nonseparately computed loss under 1366(a)(1) (B) . . . 3. Reg. 1.1367-1(f): order of adjustments is: a. (1) increases in basis b. (2) decreases for distributions c. (3) decreases for noncapital, nondeductible expenses d. (4) decreases for items of loss or deduction in 1367(a) (2)(B) and (C) A B C Initial stock $20,000 $10,000 $5,000 basis Tax exempt $1,000 $1,000 $1,000 income $21,000 $11,000 $6,000 Net LTCL ($3,000) ($3,000) ($3,000) Ordinary loss ($6,000) ($6,000) ($6,000) AB in stock $12,000 $2,000 $0 4. Basis in indebtedness a. Cs AB in the $2k indebtedness = $0 i. 1367(b)(2)(A): where items in 1367(a)(2)(B) (E) exceed the shareholders basis, such excess

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reduces the shareholders basis in indebtedness of the S corporation to the shareholder ii. He has offset this basis by $2k of loss b. Restoration of basis i. 1367(b)(2)(B): if there is a reduction in the shareholders basis in the indebtedness of an S corporation to a shareholder, any net increase is applied to restore such reduction in basis before it increases the shareholders basis in the stock of the S corporation V. Distributions to Shareholders a. Application of Subchapter C. Subchapter C applies to an S corporation unless otherwise provided, or if subchapter C would be inconsistent with subchapter S. 1371(a). b. Accumulated Earnings and Profits? A S corporation accumulates earnings and profits if (1) it was a C corporation before, or (2) it acquired a C corporation and inherited earnings and profits. Rules on distributions of property depend on whether the S corporation accumulated earnings and profits. 1368(a). i. If No Earnings and Profits. Where theres no accumulated earnings and profits: 1. (1) the distribution is not included in GI to the extent it does not exceed AB of stock 2. (2) if the distribution exceeds AB of stock, such excess is gain from sale/exchange of property. 1368(b). ii. If Earnings and Profits 1. Portion up to AAATreat Under 1368(b). If an S corporation has accumulated earnings and profits, the portion of the distribution which does not exceed the accumulated adjustments account shall be treated in the manner provided by 1368(b). 1368(c)(1). a. AAA. AAA is an account of the S corporation which is generally adjusted in a manner similar to adjustments under 1367. 1368(e)(1). 2. Portion up to Accumulated Earnings and Profits = Dividend. The portion of the distribution that remains after 1368(c)(1) is treated as a dividend to the extent it does not exceed accumulated earnings and profits. 1368(c)(2). 3. Remaining Treated Under 1368(b). Any portion of the distribution remaining after the application of 1368(c)(2) is treated in the manner provided by 1368(b). 1368(c)(3). 4. Election to Distribute Accumulated Earnings and Profits First. An S corporation may, w/ the consent of all affected shareholders, elect to have 1368(c)(1) not apply. 1368(e) (3)(A). c. Distribution of Appreciated Property. If a corporation distributes appreciated property (other than an obligation of such corporation) to a shareholder, the corporation recognizes gain as if such property were sold to the distributee at its FMV. 311(b). Otherwise, the corporation recognizes no gain/loss. 311(a). i. Gain Flows Through. Basis increased by . . . nonseparately computed income under 1366(a)(1)(B). 1367(a)(1)(B).

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ii. Take Basis Adjustment Into Account for Distributions. In any

distribution, AB of stock is determined w/ regard to the adjustments provided in 1367(a)(1). 1368(d) (flush language). iii. Amount of the Distribution = FMV Received. 301(b). 1. FMV Basis. 301(d). d. Problem 1 (p. 446). Ajax Corporation is a calendar year taxpayer which was organized two years ago and elected S corporation status for its first taxable year. Ajaxs stock is owned one-third by Dewey and two-thirds by Milt. At the beginning of the current year, Deweys basis in his Ajax shares was $3,000 and Milts basis in his shares was $5,000. During the year, Ajax will earn $9,000 of net income from operations and have a $3,000 long-term capital gain on the sale of 100 shares of Exxon stock. What results to Dewey, Milt and Ajax in the following alternative situations? i. Basis in Stock 1. 1367(a)(1): AB in stock is increased by: a. (A) items in items of income in 1366(a)(1)(A), [and] b. (B) nonseparately computed income under 1366(a)(1) (B). Dewey (1/3) Milt (2/3) Initial stock basis $3k $5k Ordinary income $3k $6k LTCG $1k $2k AB in stock $7k $13k ii. (a) On October 15, Ajax distributes $5,000 to Dewey and $10,000 to Milt. 1. 1368(a): distribution of property is treated the manner provided in (b) or (c) 2. 1368(b): where theres no accumulated earnings and profits: a. (1) the distribution is not included in GI to the extent it does not exceed AB of stock 3. Dewey: $5k distribution does not exceed $7k basis in stock 4. Milt: $10k distribution does not exceed $13k basis in stock 5. Effect on Basis in Stock Dewey (1/3) Milt (2/3) Original AB in stock $7k $13k Distribution ($5k) ($10k) AB in stock $2k $3k iii. (b) On October 15, Ajax distributes $8,000 to Dewey and $16,000 to Milt. 1. 1368(a): distribution of property is treated the manner provided in (b) or (c) 2. 1368(b): where theres no accumulated earnings and profits: a. (1) the distribution is not included in GI to the extent it does not exceed AB of stock b. (2) if the distribution exceeds AB of stock, such excess is gain from sale/exchange of property 3. Dewey: $8k distribution $7k basis in stock = $1k gain 4. Milt: $16k distribution $13k basis in stock = $3k gain 5. Effect on Basis in Stock Dewey (1/3) Milt (2/3) Original AB in stock $7k $13k Distribution ($8k) ($16k) AB in stock $0 $0

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iv. (c) Ajax distributes a parcel of land with a basis of $9,000 and a fair market value of $8,000 to Dewey and a different parcel with a basis of $13,000 and fair market value of $16,000 to Milt. 1. 1371(a): Subchapter C applies to an S corporation unless otherwise provided, or if subchapter C would be inconsistent with subchapter S 2. Distribution of Parcel to Milt a. 311(b): if a corporation distributes appreciated property (other than an obligation of such corporation) to a shareholder, the corporation recognizes gain as if such property were sold to the distributee at its FMV i. $16k FMV $13k AB = $3k RG ii. Gain flows through to Milt and Dewey b. 1367(a)(1)(B): basis increased by nonseparately computed income under 1366(a)(1)(B) Dewey (1/3) Milt (2/3) Original AB in $7k $13k stock Gain on land $1k $2k distributed by Corporation X AB in stock $8k $15k c. 1368(d) (flush language): in any distribution, AB of stock is determined w/ regard to the adjustments provided in 1367(a)(1) d. 1368(b)(2): distribution in excess of basis in stock is gain from sale/exchange of property i. 301(b): amount of the distribution = FMV received 1. 301(d): Milt takes a FMV basis ii. $16k FMV basis in property $15k AB in stock = $1k LTCG 3. Distribution of Parcel to Dewey a. 311(b) does not apply (b/c not appreciated property) b. 311(a) (general rule): no gain or loss is recognized to a corporation on a distribution of stock/property c. Dewey has no gain/loss d. 301(b): amount of the distribution = FMV received = $8k Dewey (1/3) Milt (2/3) Original AB in stock $8k $15k Distribution ($8k) ($16k) AB in stock $0 $0 v. (d) On October 15, Ajax distributes its own notes to Dewey and Milt. Dewey receives an Ajax five year, 12% note with a face amount and fair market value of $8,000 and Milt receives an Ajax five year, 12% note with a face amount and fair market value of $16,000. 1. Ajax a. No gain from distribution b. 311(b): other than obligation of such corp 2. Same result as part (b), except there are no corporate tax consequences Dewey (1/3) Milt (2/3) Original AB in stock $7k $13k Distribution ($8k) ($16k)

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AB in stock

$0

$0

e. Problem 2 (pp. 44647). P Corporation was formed ten years ago by its two
equal shareholders, Nancy and Opal, and elected S corporation status at the beginning of the current year. On January 1, Nancy had a $1,000 basis in her P stock and Opal had a $5,000 basis in her stock. P has $6,000 of accumulated earnings and profits from its prior C corporation operations and has the following results from operations this year: Gross Income $32,000 Long-term capital gain 4,000 Salary Expense 18,000 Depreciation 8,000 i. What are the tax consequences to Nancy, Opal and P Corporation in the following alternative situations? ii. (a) On November 1, P distributes $5,000 to Nancy and $5,000 to Opal. 1. Taxable Income of S Corporation a. 1363(b): taxable income of an S corporation is computed in the same manner as in the case of an individual, except that i. (1) items described in 1366(a)(1) are separately stated b. Separate Items i. LTCG: 4k c. Combined Items i. $32k GI $18k salary ded. $8k depreciation ded. = $6k OI 2. 1368(c)(1): if an S corporation has accumulated earnings and profits, the portion of the distribution which does not exceed the accumulated adjustments account shall be treated in the manner provided by 1368(b) a. 1368(e)(1): AAA is an account of the S corporation which is generally adjusted in a manner similar to adjustments under 1367 b. $32k GI + $4k LTCG $18k salary ded. $8k depreciation ded. = $10k AAA c. Here, $10k distributions = $10k AAA d. Treat $10k distributions under 1368(b) e. 1368(b): distribution is not included in GI to the extent it does not exceed AB in stock i. 1368(d) (flush language): in any distribution, the AB of stock shall be determined w/ regard to adjustments provided in 1367(a)(1) ii. Reg. 1.1367-1(f): adjustments [to basis] are made in the following order(1) any increase in basis . . . (2) any decrease in basis attributable to a distribution . . . Nancy Opal Initial Stock Basis 1k 5k 6k ordinary 3k 3k income 4k LTCG 2k 2k AB in stock 6k 10k Distribution (5k) (5k) AB in stock 1k 5k

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f.

iii. (b) Same as (a), above, except that P distributes $10,000 to Nancy and $10,000 to Opal. 1. Total amount of distribution = $20k 2. 1368(c)(1): if an S corporation has accumulated earnings and profits, the portion of the distribution which does not exceed the accumulated adjustments account shall be treated in the manner provided by 1368(b) a. Here, AAA = $10k (see part (a)) b. The first $10k is treated under 1368(b) (no gain unless > AB in stock) 3. $20k $10k = $10k remaining 4. 1368(c)(2): the portion remaining after application of 1368(c)(1) is treated as a dividend to the extent it does not exceed accumulated earnings and profits a. Here, accumulated earnings and profits (given) = $6k b. The next $6k is treated as a dividend (gross income to Nancy and Opal) 5. $10k $6k = $4k remaining 6. 1368(c)(3): any remaining after application of 1368(c)(2) is treated under 1368(b) a. 1368(b): no gain unless > AB in stock b. See table below Nancy Opal Initial Stock Basis 1k 5k 6k ordinary 3k 3k income 4k LTCG 2k 2k AB in stock 6k 10k $10k Distribution (5k) (5k) 1368(c)(1) AB in stock 1k 5k $4k Distribution ($2k) ($2k) 1368(c)(3) AB in stock 0 0 c. 1368(b)(2): Nancy has $1k capital gain Problem 3 (p. 447). How do the tax rules governing distributions of appreciated property by an S corporation differ from the rules governing similar distributions by partnerships? Why? Which approach is preferable? S Corporation Partnership Distribution of 301: distributee takes 732(a)(1): distributee appreciated property FMV basis takes transferred basis 311(b): recognize gain Gain is deferred until immediately partner disposes of property Cash distributions 1368(b): no gain 731(a)(1): no gain unless exceeds AB in unless exceeds AB in stock pship interest Effect of liabilities on 1367: no effect 752, 722: increased basis share of pship liabilities increases AB in pship interest

VI. Taxation of the S Corporation

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a. S Corporation Not Taxed Unless Code Provides. [E]xcept as otherwise

provided in this subchapter, an S corporation shall not be subject to the taxes imposed by this chapter. 1363(a). b. Tax on Certain Built-in Gains i. Requirements. If for any taxable year beginning in the recognition period an S corporation has a net recognized built-in gain (NRBIG), a tax is imposed under 1363(b). 1374(a). 1. Recognition Period. Recognition period means the 10 year period beginning with the 1st day of the 1st taxable year for which the corporation was an S corporation. 1374(d)(7). 2. NRBIG. Net recognized built-in gain means, with respect to any taxable year in the recognition period, the lesser of a. (i) the amount which would be the taxable income of the S corporation for such taxable year if only recognized built-in gains and recognized built-in losses were taken into account, or b. (ii) such corporations taxable income for such taxable year (determined as provided in 1375(b)(1)(B)). 1374(d)(2). c. RBIG. Recognized built-in gain means any gain recognized during the recognition period on the disposition of any asset except to the extent that the S corporation establishes that i. (A) such asset was not held by the S corporation as of the beginning of the 1st taxable year for which it was an S corporation, or ii. (B) such gain exceeds the excess of 1. (i) FMV of such asset as of the beginning of such 1st taxable year, over 2. (ii) AB of the asset at that time. 1374(d) (3). 3. Carryover. If, the amount referred to in 1374(d)(1)(A)(i) exceeds the amount in 1374(d)(1)(A)(ii), such excess will be treated as a RBIG in the succeeding taxable year. 1374(d)(2) (B). ii. Computing Tax. The amount of tax imposed by (a) = 35% * NRBIG. 1374(b)(1). iii. Treat as a Loss. A tax imposed under 1374 is treated as a loss; the character of such loss is determined by allocating the loss proportionately among the recognized built-in gains giving rise to the tax. 1366(f)(2). c. Passive Activity Loss i. Requirements. If for the taxable year, an S corporation has 1. (1) accumulated earnings and profits at the close of such taxable year, and 2. (2) gross receipts more than 25% of which are passive investment income, then there is a tax imposed. 1375(a). 3. Gross Receipts. Gross receipts means the total amount received or accrued under the method of accounting used by the corporation in computing its taxable income. Reg. 1.13622(c)(4)(i). a. Net Capital Gains. In the case of dispositions of capital assets, gross receipts from such dispositions are taken

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into account to the extent of the capital gain net income therefrom. 1362(d)(2)(B)(i). 4. Passive Investment Income. Passive investment income means gross receipts derived from royalties, rents, dividends, interest, and annuities. 1362(d)(3)(C)(i). ii. Tax Imposed. If the requirements are met, tax is computed by multiplying the excess net passive income by 35%. 1375(a) (flush language). 1. Excess Net Passive Income. 1375(d)(1)(A). = net passive income * (passive investment income 25% gross receipts) passive investment income a. Net Passive Income. Net passive income means (A) passive investment income, reduced by (B) deductions which are directly connected w/ the production of such income. 1375(d)(2). iii. Losing S Corporation Eligibility. An S corporations subchapter S election is terminated if the corporation 1. Has accumulated E&P at the close of each of three consecutive tax years, and 2. Has gross receipts for each of these three years more than 25% of which are passive investment income. 1362(d)(3)(A). d. Problem 1 (p. 453). Built-in Corporation (B) was formed in 2000 as a C corporation. The shareholders of B elected S corporation status effective as of January 1, 2004, when it had no Subchapter C earnings and profits and the following assets: Asset Adjusted Basis F.M.V. Land $30,000 $20,000 Building 10,000 35,000 Machinery 15,000 30,000 i. For purposes of this problem, disregard any cost recovery deductions that may be available to B. Consider the shareholder and corporate level tax consequences of the following alternative transactions: 1. Gain on sale of property: $50k AR $10k AB = $40k RG ii. (a) B sells the building for $50,000 in 2005; its taxable income for 2005 if it were not an S corporation would be $75,000. 1. 1374(a): if for any taxable year beginning in the recognition period an S corporation has a NRBIG, a tax is imposed under 1363(b) 2. 1374(d)(7): recognition period means the 10 year period beginning with the 1st day of the 1st taxable year for which the corporation was an S corp a. Here, this is 2 years after the S corp election became effective 3. 1374(d)(2): net recognized built-in gain means, with respect to any taxable year in the recognition period, the lesser of a. (i) the amount which would be the taxable income of the S corporation for such taxable year if only recognized built-in gains and recognized built-in losses were taken into account, or i. 1374(d)(3): recognized built-in gain means any gain recognized during the recognition period

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on the disposition of any asset except to the extent that the S corporation establishes that 1. (B) such gain exceeds the excess of a. (i) FMV of such asset as of the beginning of such 1st taxable year, over b. (ii) AB of the asset at that time 2. $40k RG [$35k FMV at beginning of 1st taxable yr $10k AB] = $15k 3. RBIG = $40k $15k = $25k b. (ii) such corporations taxable income for such taxable year (determined as provided in 1375(b)(1)(B)) i. Here, this is $75k (given) c. NRBIG = $25k 4. 1374(b)(1): tax liability = 35% * NRBIG a. 35% * $25k = $8,750 5. 1366(f)(2): a tax imposed under 1374 is treated as a loss; the character of such loss is determined by allocating the loss proportionately among the recognized built-in gains giving rise to the tax. iii. (b) Same as (a), above, except that Bs taxable income for 2005 if it were not an S corporation would be $20,000. 1. Same analysis as part (a), except the corporations taxable income determined under 1375(b)(1)(B) is $20k instead of $75k 2. 1374(d)(2): NRBIG = $20k (lesser than $25k RBIG) 3. 1374(d)(2)(B): the extra $5k is carried over to the next year as a RBIG 4. 1374(b)(1): tax liability = 35% * NRBIG a. 35% * $20k = $7,000 e. Problem 2 (p. 453). S Corporation elected S corporation status beginning in 2001 and will have Subchapter C earnings and profits at the close of the current taxable year. This year, S expects that its business operations and investments will produce the following tax results: Gross income from operations $75,000 Business deductions 60,000 Tax-exempt interest 23,000 Dividends 12,000 Long-term capital gain from the sale of investment real property 35,000 i. (a) Is S Corporation subject to the 1375 tax on passive investment income? If so, compute the amount of tax. 1. 1375(a): if for the taxable year, an S corporation has a. (1) accumulated earnings and profits at the close of such taxable year, and b. (2) gross receipts more than 25% of which are passive investment income, then there is a tax imposed. 1375(a). 2. Here, there was subchapter C earnings and profits 3. Gross Receipts a. Reg. 1.1362-2(c)(4)(i): gross receipts means the total amount received or accrued under the method of accounting used by the corporation in computing its taxable income

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b. 1362(d)(2)(B)(i): take into account net capital gains

c. $75k GI + $23k tax-exempt interest + $12k dividends + $35k LTCG = $145 gross receipts 4. Passive Investment Income a. 1362(d)(3)(C)(i): passive investment income means gross receipts derived from royalties, rents, dividends, interest, and annuities b. $12k dividends + $23k tax exempt interest = $35k passive investment income 5. $35k passive investment income/$145k gross receipts = 24.14% 6. No tax imposed under 1375(a) ii. (b) Same as (a), above, except that S receives an additional $5,000 of tax-exempt interest. 1. Here, gross receipts = $150k and passive investment income = $40k a. $40k/$150k = 26.67% b. Tax is imposed under 1375(a) 2. 1375(a): tax imposed = excess net passive income * 35% 3. 1375(d)(1)(A): excess net passive income = net passive income * [(passive investment income 25% gross receipts)/passive investment income] a. 1375(d)(2): net passive income means (A) passive investment income, reduced by (B) deductions which are directly connected w/ the production of such income. i. $40k passive investment income 0 = $40k net passive investment income b. $40k * [($40k 25% * $150k)/$40k] = $2,500 excess net passive income 4. $2,500 * 35% = $875 tax imposed

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