34
SPRING 2013
CHAPTER 10: ANSWERS TO HOMEWORK
Lecture. The “inside basis” is the partnership’s tax basis for the assets it owns. The
“outside basis” is a given partner’s tax basis in the partnership interest. On formation of a
partnership, the total of all partners’ outside bases will equal the partnership’s inside
bases of all of its assets.
Lecture.
A partner’s capital account is a mechanical determination of the partner’s
financial interest in the partnership, as determined using one of several possible
accounting methods, including tax basis, GAAP, § 704(b) book basis, or some other
method defined by the partnership.
The capital account reflects contributions and distributions of cash or other
property to or from the partner. In addition, it accumulates the partner’s share of increases
and decreases from operations, including amounts that are otherwise tax-exempt or
nondeductible. Even if capital accounts are determined on a tax basis, a partner’s capital
account usually will differ from the partner’s basis in the partnership interest because
(among other reasons) the capital account does not include the partner’s share of
partnership liabilities.
9. As a general rule, both §§ 721 and 351 provide that no gain or loss is recognized
when property is transferred on the formation of a partnership or corporation. However,
§ 351 applies only if those persons transferring property to a corporation are in control of
the corporation immediately after the exchange, whereas § 721 does not include a control
requirement. Section 721 not only applies to initial transfers in forming the partnership
but to all subsequent contributions from any partner.
Similarities exist between §§ 721 and 351 in that these nonrecognition provisions
do not apply to all transfers made by the owners. Under § 721, the contributor must
receive an interest in the partnership, while under § 351, the transferor must receive stock
in the corporation. Under both §§ 721 and 351, if the transfer of property involves the
receipt of money or other consideration, the transaction may be deemed a sale or exchange
rather than a tax-free transfer.
11. In general, on formation of a partnership, no gain or loss will be recognized by either
the partnership or the contributing partners [§ 721]. Kelsey will not recognize the realized
gain related to the land she is contributing. Similarly, KC will not recognize a gain or
loss. Kelsey’s basis in the land will carry over to KC. Kelsey’s basis in KC will be a
substituted basis equal to her basis in the contributed land. If the land Kelsey contributes
is ever sold by KC, the precontribution gain must be allocated to Kelsey [§ 704(c)].
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20.
Under § 722, a partner’s initial basis is determined by reference to the amount of
money and the basis of other property contributed to the partnership. This basis is
increased by any gain recognized under § 721(b) and the partner’s share of any
partnership liabilities. Basis is decreased by any partner liabilities assumed by the
partnership.
Basis is also adjusted to reflect the effect of partnership operations: it is increased by the
partner’s share of taxable and nontaxable income and is decreased by the partner’s share
of loss and nondeductible/noncapitalizable expenses. Certain adjustments for depletion
are also made.
Finally, a partner’s basis is increased by additional contributions to the partnership and by
increases in the partner’s share of partnership debt. Basis is decreased by distributions
from the partnership and decreases in the partner’s share of partnership debt.
A partner’s basis is adjusted any time it may be necessary to determine the basis for the
partnership interest, for example, when a distribution was made during the taxable year,
or at the end of a year in which a loss arises. A partner’s basis may never be reduced
below zero (i.e., no negative basis).
21. OPTIONAL. The partnership’s debts are allocated to the partners in
determining the partners’ bases in their partnership interests. Any increase in
partnership liabilities is treated as cash contribution to the partnership, thereby
increasing the partners’ bases. Any decrease in partnership liabilities is treated as a
distribution from the partnership to the partners and decreases their bases.
Partnership debt is allocated differently depending on whether it is recourse to the
partners or nonrecourse. Recourse debt is allocated in accordance with the constructive
liquidation scenario. Under this test, all partnership assets are deemed to be worthless.
The losses that would arise are allocated to the partners according to the partnership
agreement. The losses would create negative capital accounts for at least some of the
partners; those partners are deemed to contribute that amount of cash (equal to the
negative capital balance) to the partnership in settlement of the obligation to repay
partnership’s recourse liabilities. The amount of that deemed capital contribution is the
amount of the partner’s share of the recourse liabilities.
Student Can ignore. Nonrecourse debt is allocated in a three-tier system. First,
allocate any gain related to assets where the debt exceeds the partnership’s “book” basis
in the assets. This is called minimum gain and is allocated according to the partnership
agreement. Next, any debt related to any remaining precontribution gain is allocated to
the partner who contributed the encumbered property to the partnership. Finally, any
remaining debt is allocated in accordance with the method specified in the partnership
agreement.
24.
A guaranteed payment is an amount paid to a partner for the performance of
services or for the use of the partner’s capital. These payments are in the nature of salary
or interest payments that are made by other entities, but the tax treatment of guaranteed
payments is somewhat different. Like payments made by other entities, guaranteed
payments are generally deductible by the partnership, and can result in a loss to the
entity. Guaranteed payments are taxed as ordinary income to the recipient partner.
2
Unlike salary and interest payments made by other entities, guaranteed payments
are treated as if they were received by the partner on the last day of the partnership’s tax
year. If the partner and partnership have different tax years, there will be a deferral
between the time the partnership claims the deduction and the time the partner reports the
income. Guaranteed payments are treated as self-employment income by the recipient
partner.
25.
An individual partner who is a general partner must pay self-employment
tax on his or her distributive share of partnership income. Any partner
(general or limited) must also pay self-employment tax on any guaranteed
payments for services. Proposed regulations outline situations in which a
partner will be treated as a general partner.
OPTIONAL QUESTIONS:
19.
The three rules of the economic effect test are designed to ensure that a partner
bears the economic burden of a loss or deduction allocation and receives the economic
benefit of an income or gain allocation. By increasing the partner’s capital account by the
gain or income allocated to the partner, the rule ensures that a positive capital account
partner will receive an allocation of assets equal to the balance in the partner’s capital
account when the partner’s interest is eventually liquidated. If the partner has a negative
capital account, an allocation of gain or income to the partner reduces the amount of the
negative capital account and, therefore, the amount of the deficit capital contribution that
is required from the partner upon liquidation. In short, a dollar of income or gain
increases the partner’s capital account by a dollar and, everything being equal, the partner
should receive a dollar more upon liquidation (or contribute a dollar less to restore a
deficit in the capital account).
Allocations of losses and deductions affect the partner in the opposite manner as
income or gain. Therefore, the allocation of a dollar of loss or deduction reduces the
partner’s capital account by a dollar and, everything being equal, reduces the amount the
partner will receive upon liquidation (or increases by a dollar the partner’s deficit capital
restoration requirement).
26. A partnership is advantageous under any of the following conditions:
 The entity owners wish to make Special allocations of income, expenses, cash
flows, etc.
 The entity has taxable losses which the owners can utilize on their individual
tax returns.
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 The partnership generates net passive income which offsets passive losses of
the owners.
 The entity operated as a Subchapter C corporation and would be required to
report taxable income since other means of reducing such income (e.g.,
interest, rents, salaries to owners) have been maximized and are not available.
(In this situation, the tax cost of converting to a partnership could be
prohibitive.)
 The entity cannot qualify under the requirements for a Subchapter S election
(e.g., too many shareholders, nonqualifying shareholders, more than one
outstanding class of stock, etc.)
 The entity will exist for only a short period of time and, if a corporation, its
liquidation will result in a large tax due to the appreciation in its assets.
 Several other advantages may exist.
The disadvantages of the partnership entity form arise when:
 The entity income is significant and will be taxed at higher individual rates than
if accumulated in the corporation.
 The entity is in a high risk business and the owners require protection from
personal liability. An LLC or LLP may be useful in such situations.
 Several other disadvantages may exist.
PROBLEMS:
27.
a.
Under § 721, neither the partnership nor the partners recognizes any gain
on formation of the entity.
b.
Emma will take a cash basis of $100,000 in his partnership interest.
c.
Laine will take a substituted basis of $40,000 in her partnership interest
($40,000 basis in the property contributed to the entity).
d.
The partnership will take a carryover basis in the assets it receives
($100,000 basis in cash, and $40,000 basis in property).
29.
a.
Liz realizes a gain of $15,000 on contribution of the land. John realizes a gain of
$150,000 on contribution of the equipment. The partnership realizes a gain equal
to the value of the property it receives (it has a $0 basis in the partnership interests
it issues).
b.
Under § 721, neither the partnership nor either of the partners recognizes any gain
on formation of the entity.
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c.
Liz will take a substituted basis of $155,000 in her partnership interest ($80,000
cash plus $75,000 basis in land). John will take a substituted basis of $20,000 in
his partnership interest ($20,000 basis in the equipment).
d.
The partnership will take a carryover basis in all the assets it receives ($80,000
basis in cash, $75,000 basis in land, and $20,000 basis in equipment).
e.
The partners’ outside bases in their partnership interests total $175,000: Liz’s
basis of $155,000 plus John’s basis of $20,000. This is the same as the
partnership’s basis in assets of $175,000 ($80,000 cash plus $75,000 land plus
$20,000 equipment).
f.
The partnership will ‘‘step into John’s shoes” in determining its depreciation
expense. It will use the remaining depreciable life and the same depreciation rates
John would have used.
30.
Both partners are contributing assets valued at $100,000. One property has a builtin gain; the other has a built-in loss. Jared and Chelsea recognize no gain or loss
on contribution of their respective properties to the partnership. Jared takes a
substituted basis of $85,000 in his partnership interest ($20,000 cash plus $65,000
basis in land). The partnership takes a $65,000 carryover basis in the contributed
land. The “built-in gain” on the land must be tracked and allocated to Jared if the
property is ever sold at a gain [§ 704(c)].
Section 721 applies to losses as well as gains and prevents Chelsea from
recognizing the $25,000 loss on her contribution to the partnership. She will have
a $125,000 basis in a partnership interest worth $100,000. Similarly, the
partnership will have a $125,000 basis in assets valued at $100,000. The
partnership will “step into Chelsea’s shoes” in determining depreciation
deductions. As this is “built-in loss” property, § 704(c) applies, and amounts
related to the built-in loss must be allocated to Chelsea. Depreciation must be
allocated in accordance with Reg. § 1.704-3 (not discussed in detail in this
chapter). [Basically, a large portion of the depreciation deductions would be
allocated to Chelsea to reduce the difference between her basis and the fair market
value of her partnership interest as quickly as possible. (If the property basis was
less than its fair market value, depreciation would first be allocated to the other
partner.)]
44.
a.
Assuming that Andrea’s capital account reflects an accurate number for
basis purposes, her beginning basis is determined as follows:
Capital account balance, beginning of year
Share of AM’s debt ($100,000 × 1/2)
Andrea’s basis, beginning of year
b.
$200,000
50,000
$250,000
Andrea’s basis at the end of the year is determined as follows:
Capital account balance, beginning of year
Add Andrea’s share of:
Taxable income
Tax-exempt interest income
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$200,000
$160,000
3,000
§ 1231 gain
4,500
Less:
Short-term capital loss
Political contribution
Charitable contribution
Cash distribution to Andrea
167,500
$367,500
$ 1,000
500
1,000
50,000
(52,500)
$315,000
Plus: Share of AM’s debt ($140,000 × 1/2)
Andrea’s basis, end of year
70,000
$385,000
Note that the political contribution decreases her basis even though
Andrea cannot deduct the expense.
45.
a.
The partnership’s ordinary taxable income is determined as follows:
Sales revenue
Cost of sales
Depreciation expense
Utilities
Rent
Total ordinary income
$150,000
(80,000)
(20,000)
(14,000)
(18,000)
$ 18,000
Separately stated items:
Long-term capital gain
$6,000
The distribution to Lisa is not deductible by the partnership. The payment
to Mercy Hospital for Kayla’s medical expenses is treated as a distribution
to Kayla in the amount of $12,000. Kayla may be able to claim a
deduction for medical expenses on her personal tax return.
b.
Kayla’s basis in her partnership interest at the end of the tax year is
determined as follows, using the ordering rules in Figure 10.3:
Beginning basis
Share of partnership income
Share of separately stated income items:
Long-term capital gain
Distribution (payment for medical expenses)
Ending basis in interest
$20,000
9,000*
3,000*
(12,000)
$20,000
*These items are reported on Kayla’s personal income tax return for the
year.
c.
Lisa’s basis in her partnership interest at the end of the tax year is
determined as follows:
Beginning basis
Share of partnership income
Share of separately stated income items:
Long-term capital gain
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$16,000
9,000*
3,000*
Distribution to Lisa
Ending basis in interest
(15,000)
$13,000
*These items are reported on Lisa’s personal income tax return for the
year.
55.
OPTIONAL
a.
A partner’s basis in the partnership interest must be adjusted in the order
shown in Figure 10.3: income items and contributions first increase basis,
then basis is reduced by distributions from the partnership. Finally, losses
may be deducted under § 704(d) to the extent of any remaining basis.
However, this allowed loss may be further limited under the at-risk and
passive loss rules.
b.
In Brad’s case, the $20,000 distribution reduces his basis in the
partnership interest to $0 and Brad must recognize a $5,000 gain (probably
a capital gain) in the amount of the distribution that exceeds his $15,000
basis.
c.
Since his basis is reduced to $0, none of the loss can be deducted. The full
$10,000 is suspended under § 704(d) and must be carried forward until
Brad has adequate basis to absorb the loss.
d.
If the partnership can make the distribution at the beginning of the
following tax year, Brad could deduct the loss in the current year. The
partnership expects to report earnings in future years, so Brad’s share of
that income would increase his basis before the cash is distributed, and he
will probably not be required to report a capital gain on the distribution.
Alternatively, the partnership could incur additional (short-term) debt at
the end of the year. This approach would be treated as a contribution of
capital that increases Brad’s basis in his partnership interest. With
adequate basis, the cash could be distributed without gain recognition, and
the losses would be fully deductible.
59.
In addition to recognizing the differences between the entities with respect to the
timing of Nicole’s gross income, it is important to use the proper terminology for
each item.
a. Nicole is taxable on none of the corporation’s taxable income for the year,
although the entity is subject to its own income tax. She includes the $55,000
salary ($5,000  11 months) in her 2012 gross income. An employee includes a
salary in gross income on the date that he or she receives it.
b. Nicole is taxable on none of the partnership’s income in 2012. Her share of
income flows through to her on 1/31/2013, regardless of when the partnership
generates the income. She includes none of the guaranteed payments in her
2012 income. These also are allocated to her on the last day of the entity’s tax
year, regardless of when payments are made. In 2013, she reports her $60,000
(30%) share of partnership income, plus the $60,000 of guaranteed payments
she receives from February 2012 to January 2013 ($5,000  12).
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OPTIONAL PROBLEMS:
57.
38.
a.
In its April 30, 2013, tax return, Burgundy, Inc., must report income from
BV, LLC of $140,000. This includes Burgundy’s $100,000 guaranteed
payment, and its 50% distributive share of the partnership’s $80,000 of
taxable income for the tax year ended December 31, 2012.
b.
In her December 31, 2013, tax return, Violet must report income from BV
of $45,000. This is her 50% share of the partnership’s $90,000 of taxable
income for the tax year ended December 31, 2013.
a.
The legal and accounting fees totaling $8,000 are organizational costs. The
$10,000 to secure limited partnership investments are nonamortizable,
nondeductible syndication costs. The $51,500 for advertising and the preopening event are startup expenses.
b.
The partnership may deduct $5,000 of the organizational costs, plus $50
amortization [($8,000 total – $5,000 deducted)/180 months × 3 months],
for a total of $5,050. None of the syndication costs is deductible. The
partnership may deduct $3,500 of the startup costs [$5,000 maximum
permitted – ($51,500 total – $50,000 phaseout)], plus $800 amortization
[($51,500 total – $3,500 deducted)/ 180 months × 3 months].
c.
The organizational and startup costs that are not deducted currently are
amortized and deducted over 180 months, beginning with the month in
which the partnership begins business. The syndication costs are not
deductible.
Lecture. To determine the required tax year of a partnership under the least
aggregate deferral method, perform the following steps:
 Select one partner’s tax year as a test year.
 Calculate the number of months from the end of the test year to the next year-end
for each partner (i.e., determine the number of deferral months for each partner).
 Multiply the number of income deferral months for each partner by each partner’s
profit percent.
 Add the products to determine the aggregate number of deferral months for the
test year.
 Repeat the process until each partner’s tax year has been used as a test year.
 Compare the aggregate number of deferral months for each test year.
The test year that has the smallest number of aggregate deferral months is the
required tax year.
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Assume three partners, CourtneryCo whose year end is 3/31, CassandraCo’s whose year
end is 1/31 andClemCo’s whose year end is 2/28. THE ANSWER IS 1/31.
TEST FOR 3/31 YEAR-END (CourtneyCo’s year-end)
Partner
Year Ends
Profit Interest
Months of Deferral
CassandraCo. 1/31
1/4
x
10
=
2.50
ClemCo.
2/28
1/4
x
11
=
CourtneyCo.
3/31
1/2
x
0
=
Aggregate number of deferral months 5.25
Product
2.75
0.00
TEST FOR 1/31 YEAR-END (CassandraCo’s year-end)
Partner
Year Ends
Profit Interest
Months of Deferral
CassandraCo.
1/31
1/4
x
0
=
ClemCo.
2/28
1/4
x
1
=
CourtneyCo.
3/31
1/2
x
2
=
Aggregate number of deferral months 1.25
Product
0.00
0.25
1.00
TEST FOR 2/28 YEAR-END (ClemCo’s year-end)
Partner
Year Ends
Profit Interest
Months of Deferral
CassandraCo.
1/31
1/4
x
11
=
ClemCo.
2/28
1/4
x
0
=
CourtneyCo.
3/31
1/2
x
1
=
Aggregate number of deferral months 3.25
Product
2.75
0.00
0.50
Since 1.25 (for 1/31) is smaller than 3.25 or 5.25 (for 2/28 and 3/31, respectively), the
required tax year for the partnership is January 31, under the least aggregate deferral
method.
42. a. Reece’s basis is $75,000. Under § 722, the basis of an LLC’s membership’s interest
equals the adjusted basis of contributed property at the time of contribution. Since Reece
paid $75,000 for the property, her basis in her partnership interest is $75,000.
b. The LLC’s holding period includes the period during which Reece owned
the investment property; thus, Phoenix’s holding period began five years ago.
c. $15,000 gain. Under § 704(c), all unrealized gain or loss at the contribution date on
property contributed for an LLC interest belongs to the contributing partner. On
the land sale, the LLC realized a gain of $15,000 ($90,000 selling price minus
$75,000 adjusted basis). This gain is allocated entirely to Reece, since this was the
amount of the unrealized gain on the land at the contribution date.
d.
Cash
Land
Basis
$ 90,000
30,000
FMV
$ 90,000
180,000
Interest, Phoebe
Interest, Parker
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Basis
$15,000
15,000
FMV
$ 90,000
90,000
Interest, Reece
$120,000
$270,000
*$75,000 LLC interest plus $15,000 gain
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90,000*
90,000
$120,000 $270,000