1 Chapter 1 What Is a Partnership? Reading: Paragraphs What is a partnership? 2. Define each of the following in terms of the liability of the partners: General partnership Limited partnership Limited liability partnership Limited liability limited partnership
2 3. If a partnership wants to be taxed as a corporation, how would it go about doing so? If a corporation (incorporated under state laws) wants to be taxed as a partnership, how would it go about doing so? If an unincorporated multi-owner organization doesn t select a tax entity, how will it be taxed? 4. Compare the tax treatment of the formation of a partnership to the formation of a corporation. Compare the tax treatment of partnership distributions to the tax treatment of corporate distributions.
3 5. If one expected a business to (1) incur heavy initial losses and (2) be highly leveraged, for tax purposes would it be better to operate as a corporation or a partnership? Why?
4 Chapter 2 Partnership Interest Received for Contribution of Property Reading: Paragraphs If a partner contributes appreciated property to a partnership, and the partnership later sells the property, how will the deferred gain be allocated between the partners? 2. Suppose a partner contributes appreciated property to a partnership and then later sells his partnership interest for a gain. Is there any way for the partnership to adjust the basis of the partnership property upward? 3. What is the one transaction which will cause an inside-outside basis disparity, but does not allow a Code Sec. 754 election? 4. What amount is a contribution of property recorded at for tax purposes and what amount is it recorded at for book purposes? 5. How does a partner determine the holding period of his partnership interest?
5 6. How does a partnership determine the holding period of assets contributed by the partners? 7. If depreciable property is contributed to the partnership, what depreciation method should the partnership use to depreciate it? 8. If a partner contributes encumbered property and has net debt relief (a net decrease in her liabilities) as a result, it is treated as a deemed distribution to the partner of what? 9. Under what circumstances will a partner contributing encumbered property to a partnership have to recognize a gain? 10. Does the depreciation recapture potential of contributed property carry over to the partnership?
6 11. Partners W, X, Y, and Z form the Ace partnership, contributing the following: Interest Basis FMV Liability W 40% Prop. 1 $40,000 $200,000 $160,000 X 40% Prop. 2 $120,000 $60,000 $20,000 Y 10% Prop. 3 $10,000 $70,000 $60,000 Z 10% Prop. 4 $30,000 $20,000 $10,000 How much is each partner s basis in their partnership interest? How much is each partner s capital account? What is each property s basis to the partnership, assuming that a Code Sec. 754 election is not in effect? 12. On April 6, Cathy contributes the following to the ABC Partnership: Inventory (FMV = $10,000, basis = $7,000) purchased on December 10 of last year. Land (FMV = $160,000, basis = $250,000) purchased on January 15 of last year. Cash = $30,000. What will Cathy s holding period for her partnership interest be on April 6?
7 Chapter 3 Receipt of a Partnership Interest for Services Reading: Paragraphs If a capital interest in a partnership is received for services, what are the tax effects to the service partner, the continuing partners, and the partnership? 2. If the capital interest is not vested, when will the service partner recognize the income from the receipt of the partnership interest? 3. What are the tax effects if a 83(b) election is made by a service partner if they get a partnership capital interest that is not vested? 4. What are the two benefits of making a 83(b) election in the case of a nonvested capital interest exchanged for services? 5. By when does the 83(b) election have to be made?
8 6. The XYZ partnership has the following balance sheet: Assets Tax Basis FMV Real estate $120,000 $180,000 Liabilities $0 $0 Capital X $40,000 $60,000 Y $40,000 $60,000 Z $40,000 $60,000 $120,000 $180,000 If Q provides $45,000 of services in exchange for a $25% interest in the partnership, what is the tax effect to Q, X, Y, Z, and XYZ? Assume all of the partners are individuals. How much income does Q recognize? How much gain do X, Y, and Z recognize? How much of a deduction do they get? What basis will XYZ have in the Real estate? What is the balance sheet afterward? If the property is later sold for $180,000, how much gain will each partner recognize? What if it is later sold for $200,000? What would your answer to the above questions be under the Proposed Regulations?
9 7. The XYZ partnership has the following balance sheet: Assets Tax Basis FMV Real estate $300,000 $210,000 Liabilities $0 $0 Capital X $100,000 $70,000 Y $100,000 $70,000 Z $100,000 $70,000 $300,000 $210,000 If Q provides $52,500 of services in exchange for a $25% interest in the partnership, what is the tax effect to Q, X, Y, Z, and XYZ? Assume all of the partners are individuals. How much income does Q recognize? How much gain do X, Y, and Z recognize? How much of a deduction do they get? What basis will XYZ have in the Real estate? What is the balance sheet afterward? If the property is later sold for $210,000, how much gain will each partner recognize? What if it is sold for $180,000?
10 Chapter 4 Calculation of Partnership Taxable Income Reading: Paragraphs What types of items should be separately stated on Schedules K and K-1? 2. Where do all of the nonseparately stated items go on the Form 1065? Where is the net of all of those items reported on Form 1065? 3. Which of the following are examples of the entity approach to partnership taxation, and which are examples of the aggregate approach? Passive activity loss limits At-risk limits Most elections Income tax return preparation Tax return filing requirement includes partner s share of partnership gross income Pass-through of income character to the partners Depreciation elections 4. When there is an involuntary conversion of partnership property, can the partners get deferral of gain if the proceeds of the involuntary conversion are distributed to the partners, who then invest in replacement property? 5. Code Section 1244 allows for ordinary losses on the sale of stock, as long as the stock is sold by its original owner. If a partnership buys stock and distributes it to its partners, who then sell it for a loss, will the sale qualify for ordinary loss treatment under Code Sec. 1244?
11 6. What three categories do payments to partners fall into? 7. How is a Sec. 707(a) payment to a partner for services treated by the partner and the partnership? When will it be recognized by a cash basis partner? When will it be deducted by a partnership? 8. Partner A performs $5,000 of contract-type Code Sec. 707(a) services for the ABC partnership in December of 2009, but does not get paid until January of A and ABC are both calendar-year taxpayers, but A is on the cash basis and ABC is on the accrual basis. When will A recognize it, and when will ABC deduct it? Is your answer any different if ABC has to capitalize the expense for services, and must amortize it? Is your answer any different if A is accrual basis and ABC is on the cash basis, and the expense is not capitalized?
12 9. How is a guaranteed payment for services treated by the partner and the partnership? When is it recognized or deducted? 10. Partner D (a calendar-year, cash basis taxpayer) performs services for the DEF partnership (a FYE 10/31, accrual basis taxpayer) in October, In return, D is to get a guaranteed payment of $10,000. DEF pays D the guaranteed payment in January, When is it deducted by DEF? When is it included in D s income? Assume that DEF is an equal partnership and earns $100,000 of income before considering the guaranteed payment. How much income will D have from the partnership in 2009? 11. Partner Z of the EZ partnership provides services to the partnership in exchange for 30% of the profits, but not less than $150,000. The partnership had $300,000 of taxable income before the guaranteed payment. How much is Z s guaranteed payment, and how much is his total income for the year from EZ?
13 12. The ABCD partnership agreement provides that D will receive 25% of partnership ordinary income before taking into account any guaranteed payment, but not less than $100,000, and he will receive 25% of the ordinary losses after taking into account the guaranteed payment. All capital gains will be split equally among the partners. For the year the partnership has $200,000 of ordinary income (before the guaranteed payment) and $80,000 of long term capital gains. How much is D s guaranteed payment? How much is her share of ordinary income? How much is her share of long term capital gains? How much, in total, of the ordinary income and long term capital gain will the other partners be allocated? What would your answer to the above questions be if D is to receive 25% of total partnership income before any guaranteed payment, but not less than $100,000, and the capital gains are not separately allocated? 13. Are guaranteed payments for capital treated as interest income for purposes of the investment interest expense limitation? Are guaranteed payments for capital active income, passive income, or portfolio income, according to the passive loss rules?
14 Reading: Paragraphs In what taxable year must a partner recognize her share of partnership income? 2. The months of deferral of partnership income that a partner gets is the number of months from when to when? 3. If a partnership can not come up with an acceptable business purpose for a taxable year, how must it determine its taxable year (what three methods, in order)? 4. If no group of partners with the same taxable year own, in the aggregate, more than 50% of the partnership, how will the partnership taxable year be determined? 5. A principal partner must own at least what percent of the partnership? 6. Under the de minimis rule, a partnership will not be required to change its taxable year, even though the taxable year of least aggregate deferral changes, if what happens? 7. Even if it is unlikely, could a partnership potentially be required to change its taxable year end every year?
15 8. One way for a partnership to demonstrate a business purpose taxable year is to show that there is a natural business year. How does it show that? 9. The CDE partnership has the following: Partner Partner s Interest Year end C 5/31 35% D 6/30 10% E 10/31 55% What is the required year end, assuming a business purpose year end can t be shown? What is the year end with the least aggregate deferral?
16 10. The CDE partnership has the following: Partner Partner s Interest Year end C 5/31 30% D 6/30 40% E 10/31 30% What is the required year end, assuming a business purpose year end can t be shown? What is the year end with the least aggregate deferral?
17 11. The DEF partnership had the following gross receipts for the past three years: Year 2003 FYE 11/30 120,000 Oct, Nov. 40,000 FYE 6/30 110,000 May, June 30, FYE 11/30 150,000 Oct, Nov. 35,000 FYE 6/30 160,000 May, June 42, FYE 11/30 170,000 Oct, Nov. 45,000 FYE 6/30 160,000 May, June 50,000 What natural business year(s) can they adopt?
18 Reading: Paragraphs If a partnership has organizational expenses of $53,000, how much of the expenses can the partnership deduct (not including amortization)? 2. What are three examples of partnership organizational expenses? 3. When must expenses be incurred in order to be organizational expenses? 4. If the election to expense or amortize is not made, then how will organizational expenses be treated by the partnership? 5. In what month does the amortization of the organizational expenses begin? 6. What are five examples of nondeductible syndication costs?
19 7. In 2007 the XYZ partnership incurs $35,000 of expenses that qualified as organizational expenses. They are a calendar year partnership, and begin business in July of How much is their deduction and amortization of the organizational expenses in 2007, assuming they elect the maximum of each? 8. In 2007 the GHI partnership incurs $60,000 of expenses that qualified as organizational expenses. GHI is a calendar year partnership and begins business in November of How much is GHI s deduction and amortization of the organizational expenses in 2007, assuming it elects the maximum of each? 9. Does Section 195 apply to the cost of investigating and deciding whether or not to buy a store or outlet in a different location, but in the same line of business as the taxpayer already was in? How would such expenses generally be treated? 10. Are the actual costs of acquiring a business in a new trade or business subject to Code Section 195 treatment?
20 11. Section 195 applies to both investigation expenses and start-up expenses. Name four examples of start-up expenses. 12. Section 709 allows amortization of organizational expenses beginning when the partnership is ready to begin doing business (for 709 purposes that is the definition of when the trade or business begins). When can amortization begin under Section 195? 13. In 2005 the PQR partnership, a clothing wholesaler, incurs $60,000 of expenses as follows: $10,000 advertising for the grand opening of a retail clothing outlet PQR just built. $5,000 in legal fees involved in purchasing the land the outlet is located on. $30,000 for a market study to see if a retail clothing outlet in that location would have sufficient demand. $15,000 in advertising to publicize a new, more efficient, wholesale clothing distribution center to its customers, PQR is a calendar year partnership, and they actually open the doors of the retail clothing outlet in November of 2005, even though they were ready to open in September. How much is PQR s deduction and amortization of the above expenses in 2005, assuming it elects to deduct the maximum?
21 14. In the current year the Taylor Partnership, a calendar-year partnership, was organized and began a new business. It had the following expenditures in the current year: $10,000 Accounting fees for preparations of offering materials $20,000 Printing costs of the brochures used in selling the partnership interests $15,000 Legal fees for drafting the partnership agreement $38,000 Local and state filing fees $25,000 Pre-opening wages paid to employees being trained and their instructors $20,000 Pre-opening travel and other expenses incurred to line up prospective customers $6,000 Expenditures to get property (for store site) appraised during purchase. How much deduction and amortization will it be able to take in the current year, if it is ready for and begins business in October?
22 Chapter 5 Character and Presentation of Partnership Taxable Income Reading: Paragraphs Does a partnership have a limitation on the charitable contribution deduction, like an individual does? What line of Schedule K do charitable contributions go on? Does a partnership get to deduct oil and gas depletion? What box of the K-1 does the information necessary for the partners to compute depletion go in? 2. What type of income and expenses go on line 2 of Schedule K? What type of income and expense goes on line 3? Why are they separated this way? Do all rental activities (such as a hotel, for instance) go on these lines? 3. Guaranteed payments to partners go on what two lines of the Form 1065? What type of interest goes on line 5 of Schedule K? What types of dividends go on line 6a of Schedule K? What type goes on line 6b? Does line 6a include those on line 6b? 4. What line of Schedule K do specially allocated items of ordinary income and deductions go on? What line do Code Sec. 179 expenses go on? Is there a limitation on these at the partnership level?
23 5. Look at the Worksheet for Figuring Net Earnings (Loss) from Self-Employment (p. 31 for 2008) of the Form 1065 instructions. What lines from Schedule K are, in general, involved in the calculation of Self-Employment income? What guaranteed payments are included in a partner s self-employment income? However, look at Rev. Rul and Technical Advice Memorandum What do they tell you about using the Worksheet? 6. Identify which of the following fringe benefits are deductible to the partnership and excludible by the partner: Child and dependent care assistance Qualified employee discounts Exclusion for meals and lodging De minimis fringe benefits Qualified moving expenses
24 Chapter 6 Allocation of Partnership Income Among the Partners: The Substantial Economic Effect Requirement Reading: Paragraphs What requirements must be met in order for an allocation of income or loss to have economic effect? 2. A, B, and C form the equal ABC partnership. Capital accounts are properly maintained. Depreciation is allocated completely to C, but any distributions in liquidation will be made equally to each partner, although partners are required to restore deficit capital accounts upon liquidation. Does the allocation of depreciation have economic effect? 3. A, B, and C form the equal ABC partnership. Capital accounts are properly maintained. Depreciation is allocated completely to C, and any distributions in liquidation will be made according to the capital accounts of each partner. However, under local law any excess of liabilities over assets at the time of liquidation must be made up equally by each partner. Does the allocation of depreciation have economic effect? 4. A, B, and C form the equal ABC partnership. Depreciation is allocated completely to C, and any distributions in liquidation will be made according to the capital accounts of each partner. Partners are required to restore deficit capital accounts upon liquidation. The capital accounts of each partner are kept on a tax basis, so contributions and distributions of property are recorded in the capital accounts at the properties bases. Does the allocation of depreciation have economic effect?
25 5. A, B, and C form the equal ABC partnership by contributing $100,000 each, and purchasing some equipment for $300,000. The equipment has a depreciable life of six years, and all depreciation (straight line) is allocated to A. Capital accounts are properly maintained. Any distributions in liquidation will be made according to the capital accounts of each partner. Partners are required to restore deficit capital accounts upon liquidation. Income aside from depreciation is $60,000 each year. If the partnership were liquidated at the end of year three, how much would each partner get? What would your answer be if the liquidation occurred at the end of year four? 6. A, B, and C form the equal ABC partnership by contributing $100,000 each, and purchasing some equipment for $300,000. The equipment has a depreciable life of six years, and all depreciation (straight line) is allocated to A. Capital accounts are properly maintained. Any distributions in liquidation will be made according to the capital accounts of each partner. No partners are required to restore deficit capital accounts upon liquidation, but if partner A s capital account ends up with a deficit balance, A is to be allocated income sufficient to offset the difference as soon as possible. Income aside from depreciation is $60,000 each year. How much depreciation will be allocated to each partner in year 3? How much will be allocated to each partner in year 4?
26 7. Partner A of the AB partnership has $100,000 of NOLs, and partner B has $100,000 of long term capital losses. The partnership is expected to earn $100,000 of ordinary income and $100,000 of long term capital gains during the year. The partnership agreement is amended to allocate this year s ordinary income to A and long term capital gain to B. Assume that the three tests for economic effect are met. Is this allocation substantial? Why or why not? What type of allocation is it, a shifting allocation or a transitory allocation? Would the allocation be substantial if A did not have a net operating loss carryforward? 8. The ABCD Partnership owns an office building. In a special allocation that has economic effect, partner D is allocated all of the depreciation from the building, and all of the gain from any sale of the building, up to the amount of depreciation taken. Any gain in excess of depreciation taken is to be split equally among the partners. The building is expected to be sold for a substantial gain within four years. Is this allocation substantial? Why or why not?
27 Reading: Paragraph Who bears the risk of loss where nonrecourse debt is concerned? 2. What is the most fundamental requirement concerning allocations of deductions derived from nonrecourse financing? 3. Allocations of deductions attributable to nonrecourse debt will be deemed to be valid if what four conditions are met? 4. How would you calculate minimum gain for a particular asset, and why is it called minimum gain? Why is it significant for determining the economic effect of deduction allocations?
28 5. Partners A, B, C and D each contribute $100,000 for 25% of the ABCD partnership. The partners all meet the three tests for economic effect, and the four tests for allocation of nonrecourse deductions are met as well. They use the $400,000 cash and $3,600,000 of nonrecourse financing to buy a building that is depreciable over 20 years on a straight line basis. Income equals expenses in all years, except for depreciation, which is allocated completely to D. How much of the depreciation deduction in each year (from year 1 to year 3) will D be allowed to take? 6. Assume the same facts as the prior problem. If the building is sold at the end of year three for $4,100,000, how much gain would each partner have to recognize?
29 7. Partners A and B each contribute $100,000 for 50% of the AB partnership. The partnership allocations meet the three tests for economic effect, and the four tests for a valid allocation of nonrecourse deductions are met as well. They use the $200,000 cash and $1,800,000 of debt to buy a building that is depreciable over 20 years on a straight line basis. $200,000 of the debt is nonrecourse, and is subordinate to the other $1,600,000 of recourse debt. Income equals expenses in all years, except for depreciation, which is allocated completely to B. How much of the depreciation deduction in each year (from year 1 to year 5) will B be allowed to take?
30 8. Assume that in Problem 7 above B does not have a deficit capital account restoration requirement (A still does), but with respect to B the alternate test for economic effect is met. The partnership agreement still allocates all depreciation to B. How would the depreciation be allocated in years 1-5?
31 9. What would your answer to Number 8 be if the nonrecourse debt had priority over the recourse debt? 10. LP is a limited partner and GP is a general partner of the LG partnership. LP contributes $90,000 and GP contributes $10,000 to the partnership, which then gets a $400,000 nonrecourse loan and purchases a building for $500,000. GP is required to make up any capital account deficit, but LP is not. However, the partnership agreement has a qualified income offset provision for LP and also a minimum gain chargeback provision. The partnership allocates 90% of all partnership items to LP and 10% to GP, until the partnership generates minimum gain. At that point they will be allocated 50/50. Is this allocation reasonably consistent with the allocation of items that do have substantial economic effect? What would your answer be if, after the partnership generates minimum gain, items of income and loss are allocated 99% to LP and 10% to GP?
32 Reading: Paragraph In order for special allocations of items of income or deduction to have substantial economic effect, the capital accounts of the partnership must be properly maintained under the rules of Code Sec. 704(b). Under those rules, when someone contributes property, is their capital account increased by its FMV or its basis? 2. When appreciated or depreciated property is distributed, what is the effect on the capital accounts? 3. Suppose that a partner s capital account balance and tax basis in her partnership interest is $200, and the FMV of her partnership interest is $300. In liquidation of her interest she gets distributed property with a FMV of $300 and a book value of $200. She had a 25% interest, so this leaves her with a capital account of $200 + $25 - $300 = -$75. She is no longer a partner, so what can the partnership do to make this deficit capital account go away? 4. If a partner contributes encumbered property to a partnership, what are the effects on his capital account for book purposes? How is this different from the effects on his basis when he contributes encumbered property?
33 5. If a partnership distributes encumbered property to a partner, what are the effects on her capital account? How is this different from the effects on her basis when she is distributed encumbered property? 6. Partner A is a 25% partner, and has a basis in her interest and capital account balance of $200,000. She contributes some land (FMV = $100,000, basis = $60,000, liability attached = $40,000) to the partnership. How much are her book capital account and basis afterward? 7. Partner A is a 25% partner, and has a basis in her interest and capital account balance of $200,000. She is distributed some land (FMV = $100,000, basis = $60,000, book value = $60,000, liability attached = $40,000) by the partnership. How much are her book capital account and basis afterward?
34 Chapter 7 Allocation of Income and Losses from Contributed Property: Code Sec. 704(c) Reading: Paragraphs T and K formed new partnership TK to operate a charter boat service in Florida. T contributed a boat with a tax basis of $210,000 and a fair market value of $350,000. K contributed $350,000 cash. The partnership agreement allocates profits, losses, and capital 50% to each partner. The agreement satisfies the requirements of Code Sec. 704(b). a. Assume the fishing boat is depreciated using the straight-line method over 7 years. Further assume that the partnership deducts a half-year of depreciation expense in its first year of operations. How will year 1 book and tax depreciation be allocated between the partners? b. Assume the partners agreed to dissolve the partnership at the end of year 1. The partnership sold the boat for $400,000 and liquidated. How much gain will it recognize on sale of the boat for book and tax? How will this gain be allocated between the partners?
35 2. Assume the same facts as above, except that the tax basis of the fishing boat was only $140,000, rather than $210,000. If the partnership uses the traditional method under Code Sec. 704(c), how will year 1 tax depreciation be allocated between the partners? 3. Assume the tax basis of the fishing boat was $140,000 as above. Further assume that the partnership used the traditional method to allocate tax depreciation in year 1, and that at the end of year 1, it sold the boat for $400,000 and liquidated. How will it allocate book and tax gain between the partners? Will this allocation offset the distortion caused by the ceiling rule in allocating year 1 depreciation between the partners?
36 4. A and B form the equal AB partnership. A contributes property (FMV = $100,000, basis = $60,000) and B contributes $100,000 cash. The property is depreciated straight line over a 10 year life for both book and tax purposes. Using the traditional method under Code Sec. 704(c), how much of the tax depreciation in the first year will A get? How much will B be allocated? How much of the gain would be allocated to A if the asset is sold for $110,000 at the beginning of year 2?
37 Reading: Paragraph Daisy Tree Partnership owns and operates two apartment complexes in the metropolitan area. The first complex was contributed to the partnership by partner L. The other two partners (M and N) contributed cash which, together with borrowed funds, was used to purchase the second complex. The three partners share partnership income, loss, gain and deduction equally. The tax basis and book value of the partnership s assets at the end of the current year are as follows: Tax Book Cash and equivalents $60,000 $60,000 Receivables 0 45,000 Apartment Complex 1 600,000 1,500,000 Accumulated depreciation, complex 1 (120,000) (300,000) Apartment Complex 2 2,475,000 2,475,000 Accumulated depreciation, complex 2 (180,000) (180,000) Land and other assets 200, ,000 Total assets $2,035,000 $4,070,000 Assume that the partnership uses the traditional method with curative allocations to make allocations under Code Sec. 704(c). Further assume that complex 1 has a remaining useful life of 8 years for book and tax. Complex 2 has a remaining useful life of 25.5 years. Both are depreciated using the straight line method for both book and tax. Show how book and tax depreciation will be allocated among the partners.
38 c. Does the curative allocation of depreciation on complex 2 from L to M and N completely cure the discrepancy caused by the ceiling rule with respect to the allocation of depreciation on complex 1? d. How can the partnership eliminate the remaining discrepancy? 2. Assume the partnership in the above problem sells apartment complex 1 in January next year for $1,000,000. a. What will be its gain or loss for book and tax?
39 b. How will the tax gain be allocated between the partners? c. Does the application of the ceiling rule create any book/tax distortions under Code Sec. 704(c)? Can this discrepancy be cured this year? 3. A and B form the equal AB partnership. A contributes property (FMV = $100,000, basis = $40,000) and B contributes $100,000 cash. The property is depreciated straight line over a 10 year life for both book and tax purposes. The partnership also has other property (FMV = $200,000, basis = $200,000) that is depreciated straight line over 10 years. Under Code Sec. 704(c), how much of the tax depreciation of the contributed property in the first year will B get? Assuming a curative allocation is made, how much will it be? If there were no other depreciable assets, what type of curative allocation could be made?
40 Reading: Paragraph A and B form the equal AB partnership. A contributes property (FMV = $100,000, basis = $30,000) and B contributes $100,000 cash. The property has three years remaining on its 10 year life. The partnership uses the remedial allocations method to eliminate ceiling rule disparities. Under Code Sec. 704(c), how much of tax depreciation with respect to the contributed property in the first year will be allocated to B? Assuming a remedial allocation is made, how much will it be? What will be its character? 2. K, G and L form a new partnership to operate a charter airplane company. K contributes a plane with a tax basis of $400,000 and fair market value of $1,200,000 in exchange for a one-third interest. The plane is subject to a $600,000 liability, for which the partnership assumes responsibility. G contributes a second plane with a tax basis of $450,000 and a book value of $600,000 in exchange for a one-third interest. L contributes $600,000 cash in exchange for the remaining one-third interest. Assume that both planes have remaining useful lives for book and tax purposes of 10 years and that the partnership uses the straight-line method to compute depreciation. a. Show how the partnership will allocate tax depreciation among the partners using the traditional method under Code Sec. 704(c). Assume that the partnership agreement allocates all items of income, deduction, gain and loss equally among the partners.
41 b. How would depreciation expense be allocated if the partnership uses the traditional method with curative allocations under Code Sec. 704(c)? (Assume the partnership had gross rental income of $120,000 from its charter activity in the current year). c. How would depreciation be allocated if the partnership uses the remedial allocations method under Code Sec. 704(c)?
42 Reading: Paragraph J contributed rental real estate to JD Partners with a tax basis of $525,000 and a fair market value of $825,000. The property is 27.5-year property with 15 years left in its depreciable life for tax purposes. The partnership uses the straight-line method to compute depreciation expense for book and tax purposes. a. Compute tax and book depreciation for year 1 assuming the partnership uses the traditional method with curative allocations under Code Sec. 704(c). b. Compute tax and book depreciation for year 1 assuming the partnership uses the remedial allocations method under Code Sec. 704(c). 2. Johnson Partners admitted Tina Smith as an equal 25% partner at the beginning of this year. The partnership s only asset was a hotel with a tax basis of $600,000 and a fair market value of $1,500,000. The hotel had 15 years remaining in its useful life when Tina joined the partnership. The partnership opted to revalue the hotel for book purposes under Code Sec. 704(b) following the admission of Tina as a new partner. If the partnership uses the traditional method to make allocations under Code Sec. 704(c), how will tax and book depreciation be allocated in the first year following Tina s admission to the partnership?
43 Assume the partnership uses the remedial allocations method to make allocations under Code Sec. 704(c), rather than the traditional method. Further assume that the partnership depreciates the hotel over 39 years for book purposes. How will book and tax depreciation be allocated in year 16? (Recall that the hotel has 15 years remaining in its useful life for tax purposes).
44 Chapter 8 Other Limitations on Partnership Allocations Reading: Paragraph Partner A owns a 10% interest in the ABCD partnership. If partner A sells her partnership interest, will the partnership taxable year have to close on that date? If A only sells ½ of her interest in the partnership, will the partnership taxable year have to close on that date? Is there any effect on the timing of the partnership income to A if there is a sale of only part, versus all, of A s partnership interest? 2. What are the two methods of income allocation with respect to the income of a partner who sells all or part of his partnership interest? 3. On September 30 Partner C buys ½ of partner A s interest in the equal AB calendar-year partnership, so A and C each own 25% after the sale. For the year, the partnership earns income of $2,000 a month for January through August, and $6,000 a month for September through December. How much income will A and C each have from the partnership under (a) the interim closing method and (b) the proration of partnership income method?
45 4. What are the allocable cash-basis items that must be prorated by cash-basis partnerships when partnership interests vary during the year? 5. The ABC partnership is a cash-basis, calendar-year partnership. A sells his 1/3 interest to D on September 31. Revenue to the partnership is $4,500 per month, and expenses are $1,200 per month, except for (1) rent expense for the year of $6,000, paid on October 15, (2) real estate taxes of $9,000 for the year, paid on November 1, and (3) a long term capital gain of $15,000 from the sale of property on December 1. (a) How much income and expenses would A be allocated under the interim closing method? (b) How would your answer be different under the interim closing method if the real estate taxes were for the period from November 1 of this year to October 31 of the next year, and the rent expense was for the 12 months from November 1 of the prior year to October 31 of the current year?
46 Reading: Paragraph Under Code Sec. 704(e), what relatives are considered family for purposes of the family partnership rules? 2. If a partner was given (by her mother) her interest in a partnership in which capital is a material income-producing factor, will she be treated as a valid partner for tax purposes? 3. Partner A was given (by her mother) her 10% interest in a partnership in which capital is a material income-producing factor. The income of the partnership is $200,000 before consideration of any guaranteed payment to her mother. Her mother performs services for the partnership worth $80,000, but only takes a guaranteed payment of $30,000 in return. How much income will A be allocated from the partnership? Would your answer be any different if A had purchased her 10% from her mother?
47 4. Partner D was given (by his mother) his 20% interest in a business in which capital is a material income-producing factor, resulting in a partnership in which D and his mother are the only partners. The partnership agreement states that D will get a distributive share of 20% of the partnership income, but his mother has capital of $360,000 in the partnership, and D s capital (given to him by his mother) was $40,000. The income of the partnership before consideration of any guaranteed payment is $300,000. His mother performs service es for the partnership worth $100,000, but only takes a guaranteed payment of $40,000 in return. D performs no services for the partnership, and any distribution in liquidation or withdrawal is based on capital account balances. How much should D s distributive share of partnership income be? 5. When is capital a material income-producing factor under Code Sec. 704(e)? 6. Partner D was given (by his mother) his 20% interest in a business in which capital is not a material income-producing factor, resulting in a partnership in which D and his mother are the only partners. The partnership agreement states that D will get a distributive share of 20% of the partnership income, but his mother has capital of $360,000 in the partnership, and D s capital (given to him by his mother) was $40,000. The income of the partnership before consideration of any guaranteed payment is $300,000. His mother performs services for the partnership worth $100,000, but only takes a guaranteed payment of $40,000 in return. D performs no services for the partnership, and any distribution in liquidation or withdrawal is based on capital account balances. How much should D s distributive share of partnership income be?
48 Chapter 9 Partner s Share of Partnership Debt Reading: Paragraphs Partner A of the equal general ABCD partnership contributes property (FMV = $200,000, basis = $20,000, associated liability = $120,000), to the partnership. A s basis in her partnership interest before the contribution (including A s share of partnership liabilities) is $30,000, and the partnership has liabilities of $80,000. The other partners also contribute property, so A s interest in the partnership does not change. What is A s gain or loss, if any, on the contribution, and what is A s basis in the partnership after the contribution? What would your answer be if the contribution increased her interest to 40%? 2. C is owed $100,000 by the equal AB partnership. C s note indicates that the interest rate will vary depending on the performance of the partnership, and the note can be rolled over indefinitely as long as the partnership wishes it to be rolled over. The note is subordinated to any other liabilities of the partnership, except that it is secured by property with a current value of $120,000. A and B s capital accounts total $2,000, and the terms of the note allow C to have a say in certain business decisions of the partnership. The partnership is in the real estate rental business, and its properties are rented virtually 100% of the time. At the current time, C s debt is the only debt the partnership has. What factors indicate that the note is debt, and what indicate that it is equity? Which should it be classified as?
49 3. Do a partnership s contingent liabilities and cash-method trade payables increase any partner s basis? 4. The constructive liquidation test for allocation of partnership recourse liabilities involves which five hypothetical events? 5. At the end of the hypothetical liquidation scenario, how do you know if a limited or general partner bears the economic risk of loss for a liability? 6. If a partner would be obligated to contribute to the partnership at the end of the constructive liquidation, but the partner is already in bankruptcy and would therefore not be making any payments under any circumstances, would the partner still be allocated any of the liabilities of the partnership for purposes of computing basis? 7. At the end of a hypothetical constructive liquidation, partner A would be obligated to pay $100,000. However, under the partnership agreement she is not obligated to pay it for ten years, and at a below-market interest rate. The present value of her payment obligation, assuming a constructive liquidation, is $45,000. How much of the partnership liabilities would she be allocated?
50 8. The equal AB partnership had $100,000 of recourse liabilities. At the end of a hypothetical constructive liquidation, partner A would be obligated to pay $100,000, and B would be obligated to pay nothing. Because of the nature of A s obligation, B had to guarantee to pay it if A could not. How much of the partnership liabilities should each partner be allocated? 9. Partner D in the equal ABCD partnership guarantees 40% of the interest on $300,000 of the partnership nonrecourse debt. It is reasonable to expect that D will have to pay this interest for the partnership. The present value of the interest payments that D will have to make is $30,000. How much of the debt will be allocated to D because of the guarantee? 10. The equal DEF partnership has the following balance sheet: Cash and other assets $400,000 Recourse liabilities $100,000 Capital D $100,000 Capital E $100,000 Capital F $100,000 The profits and losses are allocated 40% to D, and 30% each to E and F. Under the partnership agreement there is a capital account deficit restoration provision. How should the liability be allocated?
51 What would your answer be if E had guaranteed F that she would not be required to pay any money if the partnership liquidates? What would your answer be if E had guaranteed the lender that if F did not pay, E would pay F s share?
52 Reading: Paragraph Partners G and H form the GH partnership, with G contributing $200,000 cash and H contributing some land with a basis of $600,000 and a FMV of $900,000, subject to a nonrecourse liability of $700,000. They agree to share profits and losses 60% to G and 40% to H. What is H s share of the liability? 2. Partners X and Y own the XY partnership. XY owns a building with a book value/tax basis of $800,000 and an associated nonrecourse debt of $900,000. All of the depreciation on the building has been allocated to Y, and the original cost of the building was $1,100,000. X is allocated 65% of the partnership gains and losses, and Y gets the other 35%. How much of the nonrecourse debt is allocated to each partner? 3. Partnership KBCD owns a building with a tax basis of $1,250,000 and a book value of $1,800,000. The building is encumbered by a nonrecourse mortgage of $2,000,000. The property was recently appraised at $2,500,000. a. What is the Code Sec. 704(b) minimum gain (if any) with respect to this property? b. What is the Code Sec. 704(c) minimum gain (if any) with respect to this property?
53 4. V contributed real estate to JVX Partners several years ago. At the date of V s contribution, the tax basis of the real estate was $750,000 and its fair market value was $1,000,000. The property was encumbered by a $900,000 nonrecourse mortgage at the date of contribution. At the end of the current year, the property s tax basis is $600,000 and its book value is $800,000. The principal balance of the nonrecourse note is $850,000. If V s share of partnership profits is 20% and her share of partnership depreciation expense is 10%, how much of the nonrecourse mortgage will be allocated to her under the general rule? 5. Krypton Partnership owns and operates an office building in the medical district of a large city. The property was contributed to the partnership several years ago by partner K. Under the terms of the partnership agreement, K is allocated 20% of the partnership s profits, gains, losses and deductions, other than depreciation. Depreciation is allocated 50% to K and 50% to the other partners. The office building is encumbered by a nonrecourse mortgage of $750,000. Its tax basis is $650,000 and its book value is $875,000. a. Under the general rules governing the allocation of partnership nonrecourse liabilities, how much of the nonrecourse liability will be allocated to K? b. Would an allocation of $475,000 of the nonrecourse liability to K be acceptable under the regulations? Explain.
54 c. What about an allocation of $330,000? d. Could the partnership allocate $475,000 of the liability to K this year and change the allocation to $330,000 next year (adjusted for changes in the tax basis and book value of the property)? 6. Triple J Partners has the following balance sheets for book and tax at year end: Tax Basis Book Value Cash & equivalents $50,000 $50,000 Property 1 1,200,000 1,500,000 Property 2 1,250,000 1,250,000 Other Assets 800, ,000 $3,300,000 $3,600,000 Nonrecourse Mortgage, Property 1 $1,500,000 $1,500,000 Recourse Mortgage, Property 2 1,200,000 1,200,000 Capital, James 0 300,000 Capital, Johnson 300, ,000 Capital, Jackson 300, ,000 $3,300,000 $3,600,000 Property 1 was contributed by partner James. The partnership agreement allocates profits equally, but losses are allocated 25% to James, 25% to Johnson, and 50% to Jackson. a. How will the partnership allocate the nonrecourse mortgage?
55 b. How will it allocate the recourse mortgage? c. What will be the partners tax bases in their partnership interests?
56 Reading: Paragraph Q contributed property to Quake Partners in exchange for a 1/3 rd partnership interest. The tax basis and fair market value of the property were $500,000 at the date of the contribution. It was subject to a contingent liability, however, in the amount of $300,000. a. What will be Q s initial tax basis in her partnership interest (assuming the partnership has no other liabilities)? b. Assume that Q subsequently sold her partnership interest to an unrelated buyer for $250,000 cash. How much gain or loss will she recognize in connection with the sale?
57 Chapter 10 Limitations on the Deductibility of Partnership Losses Reading: Paragraphs In year 1 A and B form the AB equal partnership, with A contributing property with a FMV of $100,000 and a basis of $60,000, and B contributing $100,000 cash. In year 1 the partnership had ordinary income of $30,000, municipal bond interest of $2,000, made a $500 political contribution to a presidential campaign, and paid A s property taxes on his residence of $9,000. In addition, A was distributed some property with a FMV of $10,000 and a basis of $12,000 (assume there is no disguised sale in this problem). What is A s basis in the partnership at the end of the year? 2. What are the three common limitations on the deductibility of a partner s share of partnership losses, in the order in which they are applied? 3. Partner X of the XYZ equal partnership has a total basis in her partnership interest of $30,000. The partnership has $21,000 of nonqualified nonrecourse debt, and no recourse debt. XYZ has a current ordinary loss of ($120,000). X does not materially participate in XYZ, and also has another passive activity for which her share of the income for the year is $5,000. How much X s share of the XYZ loss is deductible, and how much and at what level (basis, at-risk amount, passive activity loss) are X s carryovers to the next year?
58 4. If partner X in the previous example sold her interest in XYZ at the beginning of the next year for $50,000, by how much would the sale increase her taxable income?
59 Reading: Paragraphs Great West Boating Ventures is a limited partnership formed to purchase and operate a fishing boat. The partnership was formed by two partners, I and L, who each contributed $150,000 cash to form the partnership. The partnership then borrowed $800,000 on a nonrecourse loan from an unrelated bank, and purchased a boat. The two partners share all items of partnership income, gain, loss and deduction equally. a. Over the partnership s first 3 years of operations, it reported net losses of ($580,000), allocated equally between the two partners. It also made principal payments against the nonrecourse loan of $50,000. Assuming no distributions or additional contributions were made to or by the partners over that period, what will be the partners tax bases in their partnership interests at the end of year 3? b. Assume that at the beginning of year 4, I sells her interest in the partnership to L for $25,000 cash (plus assumption of I s share of the partnership s nonrecourse debt). How will the sale affect I s taxable income for year 4? c. How would your answer to part b change if the nonrecourse loan had been used to purchase real estate rather than a fishing boat?
60 2. R is a 25% general partner in Forlorn Partners. Her K-1 from the partnership reports the following: Net rental real estate income (loss) ($45,000) Guaranteed payments 20,000 Interest income 1,500 Unrecaptured Sec gain 18,000 Other deductions: Charitable deductions 750 Investment interest expense 800 R is not a real estate professional. She received the guaranteed payment from the partnership for legal services provided. The Sec gain reported by the partnership is attributable to the partnership s sale of one of its rental real estate properties during the year. a. Compute R s net passive loss from Forlorn Partners. b. What is her net portfolio income? c. How will the guaranteed payment be classified? d. Assuming R has no passive income or loss from any other source, by how much will the information reported on this K-1 increase her taxable income?
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