Problem Area 7
Question 1
Upon contribution:
Capital Account
Tax Basis
Partner Q
$30,000
$30,000
Partner R
$30,000
$30,000
Loss may be allocated to R if allocation meets the
substantial economic effect test (Sec. 704(b) / Regs):
Economic effect exists if:
1) Capital accounts must be created/maintained in
the manner set forth in the Regulations
2) Liquidating distributions must be made in
accordance with the partner’s positive capital
account balances
3) Deficit capital account balances following
liquidation must be restored
Substantiality:
Requires that the allocation “substantially” affect the
dollar amounts to be received by the partners upon
liquidation, independent of tax consequences
Substantiality is questioned:
1) Allocations are designed to shift tax
consequences (capital gain v. ordinary treatment)
2) Transitory allocations – allocations likely to be
offset in future years
In this case – R’s receipt of Q’s portion of the loss
($5,000) carries an economic burden. R has
relinquished rights to $5,000 in liquidation proceeds
through the reduction of his capital account.
Thus – substantial economic effect criteria have been
met and the transaction is allowed.
Question 2.
Sold for $85,000:
Proceeds:
$85,000
Adj. Basis
(85,000): $100,000-$15,000 (acc. depr)
----------Loss
($0)
Cash available to distribute: $85,000
A
B
Capital
Depr
Loss
$50K
$50K
($15K) ($0K)
0
($0K)
Capital
12/31/Y2
$35K
$50K
Cash
Distr.
$35
$50
If the cash is distributed based on the capital accounts, then A bears the entire
economic cost of the depreciation for which she received the tax benefit.
Substantial economic effect has been met.
Question 2: Sold for $100,000
Proceeds:
Adj. Basis
Gain
$100,000
(85,000): $100,000-$15,000 (acc. depr)
----------$15,000
Cash available to distribute: $100,000
A
B
Capital
Depr
Gain
$50K
$50K
($15K) 7.5K
0
7.5
Capital
12/31/Y2
$42.5K
$57.5K
Cash
Distr.
$42.5
$57.5
If the cash is distributed based on the capital accounts, then A bears the entire
economic cost of the depreciation for which she received the tax benefit.
Substantial economic effect has been met.
Question 2.
Sold for $70,000:
Proceeds:
$70,000
Adj. Basis
(85,000): $100,000-$15,000 (acc. depr)
----------Loss
($15,000)
Cash available to distribute: $70,000
Capital
A
B
$50K
$50K
Depr
Loss
Capital
12/31/Y2
($15K) ($7.5K) $27.5K
0
($7.5K) $42.5K
Cash
Distr.
$27.5
$42.5
If the cash is distributed based on the capital accounts, then A bears the entire
economic cost of the depreciation for which she received the tax benefit.
Substantial economic effect has been met.
Question 3:
Proceeds:
Adj. Basis
Loss
A
B
Liability: $90,000 / Sold for $85,000
$85,000
(85,000): $100,000-$15,000 (acc. depr)
----------($0)
Capital
Depr
Loss
$5K
$5K
($15K) ($0K)
0
($0K)
Capital
12/31/Y2
($10K)
$5K
Def.
Paid
$10K
0
Cash
Distr.
$0
$5
Cash Available for distribution: 85,000 + 10,000 = 95,000
Cash Distributed: $90,000 liability , $5,000 to Partner B
If the partners are required to replenish negative capital accounts and the cash is
distributed based on the capital accounts, then A bears the entire economic cost
of the depreciation for which she received the tax benefit. Substantial economic
effect has been met.
Question 3:
Proceeds:
Adj. Basis
Gain
Capital
A
B
$5K
$5K
Liability: $90,000 / Sold for $100,000
$100,000
(85,000): $100,000-$15,000 (acc. depr)
----------$15,000
Depr
Gain
Capital
12/31/Y2
($15K) $7.5K (2.5k)
0
$7.5K $12.5K
Deficit Cash
Paid
Distr.
$2.5
$0
0
$12.5K
Cash Available for distribution: 100,000+2,500 = 102,500
Cash Distributed: $90,000 liability , $12,500 to Partner B
If the partners are required to replenish negative capital accounts and/or the cash
is distributed based on the capital accounts, then A bears the entire economic
cost of the depreciation for which she received the tax benefit. Substantial
economic effect has been met.
Question 3:
Proceeds:
Adj. Basis
Loss
Capital
A
B
$5K
$5K
Liability: $90,000 / Sold for $70,000
$70,000
(85,000): $100,000-$15,000 (acc. depr)
----------($15,000)
Depr
Loss
Capital
12/31/Y2
($15K) ($7.5K) ($17.5K)
0
($7.5K) ($2.5K)
Def.
Cash
Paid
Distr.
$17.5K $0
$2.5K
$0
Cash Available for distribution: 70,000 + 20,000 = 90,000
Cash Distributed: $90,000 liability , $0 to Partners A&B
If the partners are required to replenish negative capital accounts and the cash is
distributed based on the capital accounts, then A bears the entire economic cost
of the depreciation for which she received the tax benefit. Substantial economic
effect has been met.
Question 4:
Sec. 761(c) – partnership agreement includes
modifications made at or prior to the due date (not
including extensions of time) for filing the return.
However – the later period, the more potential
scrutiny.
Economic effect – will exist as long as the capital
accounts are adjusted properly, deficits must be paid
back, and liquidations are in accordance with capital
accounts.
Substantiality – will lack if there is shifting of tax
consequences and/or transitory allocations.
In this situation, more than likely substantiality is
lacking and will result in the failure to meet the Sec.
704(b)(2) requirement. Let’s read Reg. Sec. 1.7041(b)(2)(iii)(a).
Question 5:
Part a:
Wildcat drilling is very risky. Thus, there is not a
strong likelihood at the time the allocations become
part of the agreement that the economic effect of the
allocations of deductions and losses to B would be
offset by allocations of partnership income. Thus,
the economic effect of these allocations is substantial.
Reg Sec. 1.704-1(b)(2)(iii) and 1.704-1(b)(5)
example 3.
Part b:
Nature of business makes the future cash flows
relatively certain.
A strong likelihood exists that the economic effect of
the allocations of deductions and losses to B will be
offset within 5 years means the arrangement is not
substantial. Reg. Sec. 1.704-1(b)(2)(iii)(c)(2) and
1.704-1(b)(5) example 2.
Part c:
Not likely that offset will occur within 5 years, the
arrangement would be substantial. Reg. Sec. 1.7041(b)(2)(iii)(c)(2) and 1.704-1(b)(5) example 2.
Question 6:
Gain chargeback only occurs if the property is sold at a gain. Therefore, selling
the property at $85K or 70K will result in a either no gain or a loss.
Gain chargeback to the extent of depreciation taken is considered substantial –
Reg. Sec. 1.704-1(b)(2)(iii)(C) and Reg. 1.704-1(b)(5) example 1(xi).
Proceeds:
Adj. Basis
Gain
A
B
$100,000
(85,000): $100,000-$15,000 (acc. depr)
----------$15,000
Capital
Depr
$50K
$50K
($15K)
0
Gain
15K
0K
Capital
12/31/Y2
$50K
$50K
Cash
Distr.
$50
$50
Question 7
Part a:
Reg 1.704-1(b)(4)(vii) – allocations to reflect
revaluations.
Refer to Reg. Sec. 1.1245-1(e)(i),
1.125(e)(2)(ii)(C)(1).
These regs indicate that depreciation recapture must
be allocated to the partner who had the benefit of
depreciation.
Thus, A has depreciation recapture of $6,400.
The remaining gain of $2,000 is split evenly between
A &B.
Question 7, Part b
Debt is nonrecourse – partners bear no risk of loss for the decrease in the
buildings value. Bank bears the risk of loss. Partners are only at risk for their
initial investments.
Allocations of non-recourse deductions (i.e., those attributable to the decrease in
value below the amount of the liability) do not have economic effect.
Amount of depreciation for which partners are at risk: $10,000
Depreciation allocated to A= 10,000
Value of property = 85,000, Book value=90,000.
If given up, no gain/loss on partnerships books.
Bank loses $5,000
A
B
Capital
Depr
Loss
$5K
$5K
($10K) ($0K)
0
($0K)
Capital
12/31/Y2
($5K)
$5K
Def.
Paid
$5.0K
0
Cash
Distr.
$0
$5.0
If depreciation taken were $15,000
Amount of depreciation for which partners are at risk: $10,000
Depreciation allocated to A= 15,000
Value of property = 85,000, Book value=85,000, Liability amount 90,000.
If given up, no gain/loss on partnerships books.
Bank loses $5,000, Minimum gain 90K-85K=5K
Minimum gain must be charged back to Partner A for allocations to have
substantial economic effect.
Capital
A
B
$5K
$5K
Depr
Min
Gain
($15K) $5K
0
($0K)
Capital
12/31/Y2
($5K)
$5K
Def.
Paid
$5.0K
0
Cash
Distr.
$0
$5.0
Requirments for nonrecourse deductions:
1. Capital accounts are employed and govern liquidation rights
2. Allocations of nonrecourse deductions are consistent with allocations of some
other significant item which has substantial economic effect.
3. A minimum gain chargeback is provided, and
4. All other material allocations and capital account adjustments are recognized
under Regs, 1.704-1(b).