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)]. 1 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. 3 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. 4 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 5 $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 6 $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). 7 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. 8 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 9 Basis $15,000 15,000 FMV $ 90,000 90,000 Interest, Reece $120,000 $270,000 *$75,000 LLC interest plus $15,000 gain 10 90,000* 90,000 $120,000 $270,000