2013 cch basic principles ch16 pii

Chapter 16

Partnerships, Corporations, and S Corporations

Part II: Partnerships

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CCH Federal Taxation Basic Principles 2 of 69

Chapter 16 Exhibits

1. Definition of Partnership

2. Types of Partnerships 3. Tax Years 4. Accounting Methods 5. Tax Formula 6. Code Section 702(a)(8) Income or Loss 7. Separately Stated Items 8. Formation of Partnerships—Overview of Code Section 721 9. Contribution of Part Property/Part Services10. Part Property/Part Services—Example11. Disguised Sales—General Rules12. Disguised Sales—Example13. Contribution of Encumbered Property14. Contribution of Encumbered Property—Example

Chapter 16, Exhibit Contents A

CCH Federal Taxation Basic Principles 3 of 69Chapter 16, Exhibit Contents B

15. Contribution of “Know-How”16. Goodwill Contributions in a Code Section 721 Exchange—Example17. Inside Basis Computations18. Outside Basis Computations19. Special Basis Rules20. What Is a Partner’s Holding Period (HP) in the Outside Basis?21. Outside Basis Computations—Example22. Code Section 465 At-Risk Rules23. Code Section 469 Passive Activity Loss Rules 24. At-Risk and Passive Activity Loss Rules—Example25. Partners Providing Infrequent, Nonessential Services to Partnerships for

Compensation26. Partners Providing Ongoing, Integral Services to Partnerships for

Compensation

Chapter 16 Exhibits


Definition of Partnership

An unincorporated association with two or more persons who associate for a profit motive.

For income tax purposes, partnerships are generally treated as pass-through entities, i.e., the partnership pays no taxes, and partnership income (loss) and separately stated items are allocated to each partner according to the partnership’s profit sharing agreement.

The partners receive separate K-1 schedules from the partnership. Each K-1 reports each partner’s share of the partnership net profit and separately reported income and expense items. Partners report these items on their own 1040 tax returns, even if none of the items have been distributed to them.

Chapter 16, Exhibit 1


General partnership [GP]. A GP has one or more general partners who is personally liable for partnership debts; a general partner can be bankrupted by a malpractice judgment brought against the partnership, even though the partner was not personally involved in the malpractice.

Limited liability partnership [LLP]. An LLP is similar to a general partnership, except that an LLP partner is not liable for any malpractice committed by the other LLP partners.

Chapter 16, Exhibit 2a

Types of Partnerships


Types of Partnerships

Limited partnership [LP]. An LP is comprised of at least one general partner and often many limited partners. Limited partners may not participate in the management of the LP, and their risks of loss are restricted to their equity investments in the LP.

Limited liability company [“LLC”]. An LLC is a state-registered association generally taxed as a partnership if it “checks the box.” LLC members, like corporate shareholders, are not personally liable. Unlike limited partners, LLC members may participate in management without risking personal liability. However, guaranteed payments are subject to self-employment tax, along with the members’ share of ordinary income or loss from the LLC.

Chapter 16, Exhibit 2b


Tax Years

Majority Interest Taxable Year. Partnerships are generally required to elect the same taxable year as their partners who represent a majority interest on the first day of the partnership’s first tax year. Code Sec. 706(b).

Five Percenters’ Common Tax Year. If there is no majority interest taxable year, the partnership must use the same year as that of the principal partners, i.e., those owning five percent or more interest in either profits or capital.

Calendar Tax Year. If there is no majority interest tax year and the principal partners do not have the same taxable year, the partnership generally must use the calendar year. There are two exceptions, (1) minimum deferral rules and (2) business purpose rules. Details regarding these exceptions are covered in the text.



Accounting Methods

Cash method. The cash method is available to partnerships that do not have a C corporation partner. The cash method however, MAY be used by partnerships with C corporation partners if the partnership’s average annual gross receipts are $5 million or less in the three preceding years. The determination is made annually.

Accrual Method. Once the partnership’s three-year average exceeds $5 million, it must use the accrual basis thereafter.



Tax Formula

Separately Stated Items (These are items that may result in different tax treatment by different partners. Examples include capital gain or loss and charitable contributions.)

+ or -

Code Sec. 702(a)(8) Ordinary Income–

Operating Expenses-

Gross Income from Business Operations=

Exclusions and Cost of Goods Sold–

Ordinary Income “From Whatever Source Derived” (including Code Sec. 1245 recapture)

[Taxation at Owner Level]



Code Section 702(a)(8) Income or Loss

Definition. Earned income from operations generally follows the same rules as for individuals (i.e., all income from whatever source derived, unless specifically excluded). It is offset by cost of goods sold and operating expenses to produce a single reporting item.



The following items are included in the Code Sec. 702(a)(8) computation because they always get ordinary treatment. Code Sec. 1245 depreciation recapture Cost of goods sold Depreciation and other operating expenses Organizational expenditures.

(1) Amortizable expenditures. Organizational expenses qualify for amortization (and reduce Code Sec. 702(a)(8) income) if:

(a) = incurred incidental to formation of the partnership. (e.g., legal fees for drafting the partnership agreement, cost of state filings, cost of required notice publications and organizational meeting costs), and

(b) = incurred before the end of the tax year in which the partnership commences business.

The amortization period must be over at least 60 months, starting withthe month that the corporation commences business.




(2) Nonamortizable expenditures. Organizational expenses DO NOT qualify for amortization if related to issuing and marketing partnership interests. Examples are prospectus preparation costs and commissions on sales of limited partnership interests. They are written off when the partnership is terminated.


Chapter 16, Exhibit 6c


Items other than partnership operating income and expenses must be separately stated. The reason for showing these items separately is that their ultimate tax treatment may vary from partner to partner.


Separately Stated Items


Separately Stated Items Separately stated items are first computed at the partnership level

(same computation method as with individuals).

Next, each partner’s distributive share of each separately stated item is reported on his Schedule K-1 of the partnership return.

Finally, the K-1 is sent to each partner who transfers his

distributive share of Code Sec. 702(a)(8) taxable income, and each separately stated item listed, from the K-1 to the appropriate section of his individual return. For example, a distributive share of charitable contributions reported on K-1 is transferred to Schedule A of Form 1040. There, it is subject to certain AGI limitations of the partner, which will differ from that of the other partners.



Items that must be separately stated include the following: Code Sec. 1231 gain and loss Code Sec. 1250 depreciation recapture (Code Sec. 1250, unlike Code Sec. 1245, must

be separately stated because corporate partners may be subject to an additional recapture adjustment under Code Sec. 291)

Capital gains and losses Dividends eligible for a corporate dividend-received deduction Tax-exempt income and related expense Investment income and related expense Passive income and losses from rental and other nonoperating activities Recovery items (e.g., tax refunds, recovery of bad debts) Distributions of unrealized receivables or inventory that have substantially appreciated Tax credits Charitable contributions Foreign income taxes paid or accrued Depletion on oil and gas wells Alimony payments Other nonbusiness expenses


Separately Stated Items


Formation of Partnerships—Overview of Code Section 721

What is the general rule for transferring property to a partnership (P/S) in exchange for a P/S interest?

The rules are similar to Code Sec. 351 for corporations, except (1) there is no 80% control requirement, and (2) debt assumption does increase partners’ bases, while it does not affect shareholders’ stock basis.


CCH Federal Taxation Basic Principles 17 of 69Chapter 16, Exhibit 8b

No gain or loss. Generally, Code Sec. 721 requires that no gain or loss is recognized if property is transferred to a partnership in exchange for a partnership interest. It does not matter whether the transfer is during partnership formation or after the partnership had already been formed. Similar nonrecognition rules govern corporate shareholders in a Code Sec. 351 contribution, except for the 80% control requirement.

Mandatory non-recognition. Notwithstanding the exceptions in the following slide, nonrecognition treatment for qualified transactions under Code Sec. 721 is mandatory, not elective for partners. Similarly, nonrecognition treatment under Code Sec. 351 is mandatory for corporate shareholders.


CCH Federal Taxation Basic Principles 18 of 69Chapter 16, Exhibit 8c

Three exceptions to non-recognition. Gain is recognized in either event below:

1. Services. A partner’s contribution of services in exchange for a P/S interest creates OI to the partner.

2. Disguised sale. A partner’s contribution of property to a P/S followed by a P/S’s distribution of property (other than a partnership interest) to a partner within 2 years is presumed by IRS to be a disguised sale.

3. XS of P’s debt relief over P’s basis. XS debt relief enjoyed by a partner over the basis of contributed property is treated as capital gain. Similar treatment holds for corporate shareholders. Recall that a shareholder relieved of debt by a corporation has taxable boot if the debt relief exceeds that shareholder’s basis in contributed property.



No 80% control requirement. The 80% control requirement for corporate shareholders is not required of partners contributing property to a P/S.

Chapter 16, Exhibit 8d



Partner’s outside basis increases with P/S debt assumption. A partner’s outside basis increases by his pro rata share of a P/S’s increase in both recourse and nonrecourse debt. The debt may include debt transferred by a contributing partner. (In contrast, a corporate shareholder’s stock basis is not affected by corporate debt assumption.)

Chapter 16, Exhibit 8e



Partner’s outside basis decreases with debt relief. Debt transferred by a contributing partner to the P/S results in debt relief to the contributing partner. The partner must reduce his basis in the P/S by the amount of debt relief. (Similarly, shareholders must reduce their basis in stock for the amount of their debt assumed by the corporation.)

Chapter 16, Exhibit 8f



What was Congress thinking when it enacted Code Sec. 721?

Same reason as with Code Sec. 351 for corporate shareholders. First, as partners receive only a partnership (P/S) interest, they may not have the wherewithal to pay taxes. Second, the formation of a partnership is not an economic transaction rather, a change in legal form only.

Chapter 16, Exhibit 8g


CCH Federal Taxation Basic Principles 23 of 69Chapter 16, Exhibit 8h

Does the partnership recognize gain or loss in a Code Sec. 721 exchange?

No.


CCH Federal Taxation Basic Principles 24 of 69Chapter 16, Exhibit 8i

What is “property”?

“Property” includes just about everything except services. (i.e., cash, inventory, receivables, land, other tangible assets, nonexclusive licenses and industry know-how.)

[Note: Since neither Congress nor the Treasury Dept. have offered a definition of property, the courts have been guided by analogous interpretations under Code Sec. 351. Recall that Code Sec. 351 provides for nonrecognition treatment on the transfer of “property” to an 80% controlled corporation in exchange for stock.]


CCH Federal Taxation Basic Principles 25 of 69Chapter 16, Exhibit 8j

Why are “services” NOT “property’?

Reg. §1.721-1(b)(1) provides that services are NOT property to ensure that a person who provides services to a partnership will be taxed either:

1. Immediately, on the FMV of the P/S capital interest received: With a contribution of services, the FMV of the P/S capital interest received is taxed to the partner as compensation (i.e., OI). [Recall that a shareholder’s contribution of services gets similar ordinary treatment.]

2. Eventually, on the receipt of income from an income only P/S interest: If services are performed in exchange for an income interest, (not a capital interest), then income recognition is DEFERRED until income is received. The reason for deferring the recognition of income is because of the difficulty in determining a market value of the speculative future profits.



Contribution of Part Property/Part Services

How does Code Sec. 721 apply if a person contributes both property and services?

The receipt of a partnership (P/S) interest attributable to services will generally be treated as a separate transaction outside the scope of Code Sec. 721. The transfer of property remains protected from income recognition within the scope of Code Sec. 721.



Part Property/ Part Services—Example

Services: $35,000 OI as compensation.

Land: $0. The $40,000 [50,000 - 10,000 = 40,000] realized gain on transfer of land is NOT recognized, consistent with Code Sec. 721; rather, it is a built-in gain.

SOLUTION

QUESTION: How much income is recognized on the transfer?

$0$35,000 Services

$10,000 $50,000 Land

Basis FMV Asset

FACTS

“A” transfers the following items to XYZ Partnership in exchange for a capital interest:



Disguised Sales—General Rules

What is a disguised sale?

Code Sec. 707(a)(2)(B) and Reg. §1.707-3 provide that any exchange of property (other than a capital interest) between partner and partnership (P/S) within 2 years of each other is presumed to be a disguised sale. The burden is on the taxpayers to prove otherwise. If a contribution of property by a partner to a P/S followed by a distribution by the P/S to the partner is a disguised sale, then it is treated as if:

The partner sold the contributed property to an unrelated 3rd party; and . . .



The P/S sold the distributed property to an unrelated 3rd party.

Gains or losses are recognized by partners and partnerships on disguised sales, based on the difference between fair market value (FMV) and adjusted basis (AB). However, recognition of losses depends on the partner’s % ownership interest. If the partner has a “ > 50% capital interest,” NEITHER may recognized losses. Instead, the related party rules must be applied. Code Sec. 707(b)(1).

[Compare these rules with the rules for corporations. C corporations recognize gain but NEVER LOSS on transfers of nonstock property to any shareholder, regardless of ownership %.]




Yes, % of total transfers that get Code Sec. 721 nonrecognition treatment, are: [(a) – (b)] (a), where:

(a) = FMV of property contributed by the partner to the P/S; and

(b) = FMV of property other than a capital interest distributed by the P/S to the partner.

If a disguised sale involves the transfer by a partnership of a capital interest, does part of the transaction qualify for Code Sec. 721 nonrecognition treatment? If so, how much?




FACTS: Fred transfers land [$400 fair market value (FMV), $120 adjusted basis (AB), held long-term for investment purposes] to a partnership (P/S) in exchange for:

1. A capital interest worth $100;

2. $300 cash.

QUESTIONS:

A. What portion of the exchange represents a disguised sale?

B. What portion of the exchange represents a Code Sec. 721 contribution?

C. What is the tax treatment to Fred?

D. What is the tax treatment to P/S?


Disguised Sales—Example



Code Sec. 721

Nonrecognition on transfer of property for a P/S interest.

Reg. §1.707-3(a) Recognition of realized gain from disguised sale.

Reason for tax treatment:

(400 - 300) 400) = 25% 100% - 25% = 75% Computation

Not recognized LTCG Character of gain

0210Recognized gain

70210280Realized gain

30 [25%] 90 [75%] 120Basis in land

100300400Amount realized

75225300Cash

2575100FMV of cap. int.

Contribution (25%): Disguised Sale (75%): Total

The transfer is treated as a partial disguised sale and a partial partnership contribution:

SOLUTION



SOLUTIONFred’s basis in the partnership interest: $30 [25% of the basis of land is attributable to a “contribution.”P/S’ basis in the land: $330 [Fred’s 30 basis of land “contributed” + 300 “sale” price.]

COMMENTS Even if Fred had received the $300 cash 2 years after receipt of a P/S interest, the IRS would still presume that Fred’s contribution was partially a disguised sale as per above. Fred would have to prove otherwise.




Contribution of Encumbered Property

What is the tax effect to partner (P) and partnership (P/S) from contributing encumbered property to a P/S?

When a partnership assumes the debt of a contributing partner, the partner relieved of debt is treated as if having received a distribution of money from the partnership in the amount of the debt relief. Code Sec. 752(b).




The P’s debt relief is the P/S’s debt burden. That burden is shared by ALL Ps, in accordance with their ownership percentages. The term “ALL Ps” includes the partner relieved of 100% of the debt. In essence, he is relieved of 100% of the debt, then assumes his pro rata share of that same debt assumed by the P/S. The P’s “net” debt relief (total debt relief minus pro rata debt burden) is nontaxable to the relieved P to the extent of his basis in the P/S.




Any net debt relief in excess of basis is capital gain (i.e., same effect as if the amount of excess net debt relief were cash proceeds from the sale of a partnership interest.) The capital gain is short-term or long-term depending on the holding period of the partnership interest.



Contribution of Encumbered Property—Example

Does this transfer of assets qualify for Code Sec. 721 treatment?

What is each partner’s gain or loss on contributions to the partnership?

What is the resulting basis of each partner in the P/S (“outside basis”)?

What is the P/S’s basis in the assets received (“inside basis”)?

Bob’s land is subject to a $10,000 mortgage that the partnership assumes.

The FMV of the P/S is $100,000 [$110,000 FMV assets - $10,000 debt assumed.]

100% $110,000TOTALS

10% 11,000 10,000EquipmentCal

60% 20,000 70,000LandBob

30% $ 0 $ 30,000 Services Ann

P’s % int. in P/S: AB to P FMV Contribution Partner

FACTS:

Ann, Bob and Cal decide to pool their efforts and form a partnership. They make the following contributions to the partnership:



SOLUTION

Ann’s transfer of services falls outside the scope of Code Sec. 721. However, Bob and Cal’s transfers still qualify for Code Sec. 721 treatment, since they represent property contributions. Note that Bob and Cal, get nonrecognition treatment under Code Sec. 721, even though they do not have 80% control immediately after the exchange. As previously pointed out, the 80% control rule applies only to corporations.




Basis of the land to the P/S: $20,000. (Ellworth’s AB of $20,000 + $0 gain recognized by Bob)

11,000 12,000 0 (since Sec. 721 nonrecog. applies.)

(1,000)

(10,000 - 11,000)

Cal

(Equip.)

20,000 16,000 0 (since no XS debt relief)

50,000

(70,000 - 20,000)

Bob

(Land)

30,000 33,000 30,000 (since services income)

30,000

(30,000 - 0)

Ann

(Service)

(C)

Inside Basis of P/S

(B)

Outside Basis of P (See computations in next

table)

(A)

Recog. Gain/Loss

Realized G/L

(FMV - AB)

Partner (P):

Solution to Questions (A), (B), and (C):




COMMENTS

The results in this partnership problem differ from a similar corporate problem in two ways:

1. No 80% control requirement for nonrecognition treatment under Code Sec. 721 (Not so for shareholders under Code Sec. 351.)

2. Debt assumption is added to a partner’s basis in the P/S. (Not so with a shareholder’s stock basis. However, note that debt relief does reduce the basis of both partner and shareholder.)





Sec. 721

(Nonrecog. rule)

Sec. 721

(Nonrecog. rule)

Sec. 83(a)

(Services cont’d are OI to extent of FMV of P/S interest.)


0030,000Ordinary income recognized on service contribution:

(d) = (c) from services

(1,000)40,00030,000Realized gain (loss):

(c) = (a) – (b)

(11,000)(20,000)0Basis in asset contributed:

(b)

10,00060,00030,000FMV, P/S interest rec’d:

(a)

Cal

(Equipment)

Bob

(Land)

Ann

(Services)

Formula

Chapter 16, Exhibit 14e


04,0000Net debt relief: (g) = (e) – (f)

N/A0N/AXS debt relief: (i) = (g) – (h)

(11,000)(20,000)0Basis in asset contributed:

(h) = (b)

1,0006,0003,000Less: Share of debt assumption

(f) = P/S debt assumption x 1/3

010,0000Gross debt relief: (e)

Cal

(Equipment)

Bob

(Land)

Ann

(Services)

Formula

Chapter 16, Exhibit 14f



Sec. 731(a)(1) (No XS debt relief, so no capital gain)

Sec. 731(a)(1)

(No XS debt relief, so no cap. gain)

Sec. 731(a)(1)

(No XS debt relief, so no capital gain)


000Capital gain recognized on excess debt relief

(j) = (i)

Cal

(Equipment)

Bob

(Land)

Ann

(Services)

Formula

Chapter 16, Exhibit 14g



Sec. 732

P/S basis in assets is same as P’s before contribution

Sec. 732

P/S basis in assets is same as P’s before contribution

Sec. 732

P/S basis in assets is same as P’s before contribution + any Sec. 83(a) gain


11,00020,00030,000P/S inside basis

(m) = (k) + (l)

0030,000Gain on service cont’n:

(l) = (d)

000Basis in asset contributed:

(k) = (b)

Cal

(Equipment)

Bob

(Land)

Ann

(Services)

Formula

Chapter 16, Exhibit 14h



0(10,000)0Debt relief (p) = (e)

1,0006,0003,000Share of debt assumption

(o) = (f)

000Gain on XS debt relief

(n) = (j)

Cal

(Equipment)

Bob

(Land)

Ann

(Services)

Formula

Chapter 16, Exhibit 14i



Sec. 752(a): Debts assumed by P/S are treated as contributions by Ps.

Sec. 752(b): A P’s debt relief is treated as a P/S distribution to that P.

Sec. 731(a) and 722: XS debt relief over basis of assets cont’d is gain and such gain increases a P’s basis in the P/S.

Sec.752(a)

Debts assumed by P/S are treated as contributions by Partner

Sec.752(a)

Debts assumed by P/S are treated as contributions by Ps


Partner’s outside basis

12,00016,00033,000(q) =

(m) + (n) + (o) – (p)

Cal

(Equipment)

Bob

(Land)

Ann

(Services)

Formula

Chapter 16, Exhibit 14j



Contribution of “Know-How”

What is the tax effect on a partner who acquires a P/S interest without contributing property or services?

A person may be valued by a partnership (P/S) for her client contacts, or unique ability to do certain things (“know-how”). If admitted into the P/S without contributing property or services, the P/S credits the partner’s capital account, based on her % share of the fair market value (FMV) of P/S assets, net of her % share of P/S debt. The offset is to goodwill, which is treated as property in a Code Sec. 721 exchange (i.e., nonrecognition treatment when contributed to the P/S in exchange for an outside interest).



Goodwill Contributions in a Code Section 721 Exchange—Example

15,000 (15 + 0)15,000 (10 + 5)Capital balance of each partner

05,000P/S inside basis in the assets

15,00010,000Built-in gains

05,000P’s outside basis in P/S int.

0

(Code Sec. 721)

0

(Code Sec. 721)

Recognized gain on contribution:

15,00010,000Realizable gain on contribution:

05,000Basis

15,00015,000Agreed upon FMV

GoodwillLandProperty Contributed:

JillJack

FACTS: Jack and Jill form a P/S by contributing the property listed below. QUESTION: What are the tax consequences to Jack, Jill and the P/S?



SOLUTION:If both Jack and Jill were to sell their partnership interests for $15,000 each, assuming no other transactions, the partnership would have no distributive gain, [since post-contribution-date values do not change] but Jack and Jill would recognize their respective built-in gains:

Jack: $10,000 capital gain [15,000 FMV at contribution - 5,000 basis at contribution]

Jill: $15,000 capital gain [15,000 FMV at contribution - 0 basis at contribution].


Goodwill Contributions in a Code Section 721 Exchange—Example


Inside Basis Computations

How is a partnership’s inside basis in property contributed by partners determined?Code Sec. 763 provides that the basis of property received by a partnership will be Partner’s basis in contributed property;+ Ordinary income recognized by a partner on contributions of services= Partnership’s inside basis in property Note that gain recognized by a partner on excess debt relief (i.e., debt relief - debt assumption - basis in assets contributed) does not increase the partnership’s inside basis in the contributed assets, even though it DOES increases the outside basis of the contributing partner in her partnership interest.



Outside Basis Computations


Partner’s outside basis of partnership interest.=

Basis of property distributions, including cash–

Debt relief–

Share of P/S losses–

Share of debt assumption (if recourse debt, % share is based on % share of P/S loss, if nonrecourse debt, % share is based on % share of P/S profits). Both % are usually the same.

+

Gain recognized by partner on excess debt relief+

Gain recognized by partner on services contributed+

Share of “separately stated items”+/–

Share of P/S’s taxable income or loss under Code Sec. 702(a)(8) (i.e., earned income/loss, both active and Passive)

+/–

Basis in contributed property+

How is the partner’s outside basis in the partnership (P/S) determined?

Code Sec. 722 and related regulations provide the following formula:


Special Basis Rules

1. Losses may not reduce basis below zero. Instead, they remain suspended under the at-risk rules until sufficient basis arises to pass the at-risk hurdle.

2. At-risk basis is reduced by the amount of any released losses previously suspended under the at-risk rules.

3. No separate adjustment to basis is made for guaranteed payments received by a partner from his P/S. The reason: Guaranteed payments to partners are deductible by the P/S against Code Sec. 702(a)(8) operating income (since they are not contingent upon P/S profits). When Code Sec. 702(a)(8) income is later allocated to the partner, he automatically gets a basis reduction reflecting the guaranteed payment deduction taken by the P/S.



What Is a Partner’s Holding Period (HP) in theOutside Basis?

[Note that an outside basis can have a split holding period if multiple assets are contributed.]

Begins on day after contribution. Services

Begins on day after contribution. Other property (e.g., receivables and inventory)

Tacks on to property contributed. Investment or business property

HP of Partnership Interest Type of Contribution

The HP depends on the type of property contributed by the partner:



Outside Basis Computations—Example


Basis: 10,000; FMV: 15,000 Distribution of land to Mary

800Charitable contribution to Girl Scouts

250Short-term capital loss

100Long-term capital loss

500Long-term capital gain

6,200Code Sec. 1231 gain

4,000Code Sec. 1245 gain (this is a smoke screen)

5,000Tax-exempt interest income

48,000Code Sec. 702(a)(8) income

FACTS: Mary and Joe are equal partners in the accrual basis MJ partnership. At the beginning of the current year, Mary’s capital account has a balance of $10,000 and the partnership has debts of $30,000 payable to unrelated parties.The following information about MJ’s operations for the current year is obtained from the partnership’s records:


ASSUMPTIONS: None of the property was contributed by the partners (therefore no

built-in gains). Year-end partnership debt payable to unrelated parties is $24,000.

QUESTIONS: What is Mary’s outside basis at the beginning of the year? What is Mary’s outside basis at the end of the year? What is Mary’s capital account balance at the end of the year?




Note: The Code Sec. 1245 gain was a “smoke screen” because it is already included in Code Sec. 702(a)(8) taxable income. Recall that Code Sec. 1245 gain gets ordinary treatment and is not part of the netting process. With its “automatic” ordinary treatment, there is no need for it to be “separately stated.” Doing so in this problem would have resulted in its being counted twice.

29,275 =[41,275 - (1/2 x 24,000 debt] MARY’S ENDING CAPITAL ACCT BAL. (C)

41,275 MARY’S ENDING BASIS (B)

(10,000) = [100% x 10,000] Basis of land distributions to Mary –

(3,000) =[1/2 x (30,000 - 24,000)] Share of debt relief –

5,275 =[1/2 x (5 + 6.2 + .5 - .1 - .25 - .8)] Share of “separately stated items” +

Share of P/S’s TI under Sec. 702(a)(8)

MARY’S BEGINNING BASIS (A)

24,000 =[1/2 x 48,000] +

+

(C): $29,275 [see below]

(B): $41,275 [see below]

(A): $25,000 [10,000 capital account + (1/2 x 30,000 P/S debt)]




Code Section 465 At-Risk RulesA partner’s distributive share of partnership losses and deductions from both business and investment activities are “at-risk.” Code Sec. 465(b)(1) and (2). Using classroom vernacular, such losses are allowed to “jump Hurdle 1” only to the extent of the partner’s at-risk amount at the end of the partnership’s tax year.

(a) The at-risk amount is generally the partner’s outside basis defined at Code Sec. 704(d).(i) Nonrecourse loans from “nonqualified”

lenders are generally excluded from the at-risk basis amount but included in the Code Sec. 704(d) outside basis.

(b) If a partnership has more than one “activity,” then the at-risk rules must be applied to each activity separately (i.e., each activity must have its own “at-risk” basis). Code Sec. 465(c)(2)(A) and (3)(A).



(c) If only a portion of losses are allowed to “jump Hurdle 1,” how does a partner decide which losses jump Hurdle 1? Prop. Reg. §1.465-38 answers this question by requiring the following order of deductions:

(1) Capital losses must first jump Hurdle 1;

(2) Code Sec. 1231 losses are applied next;

(3) Deductions that do NOT reduce AMT tax preferences.

(4) Deductions that DO reduce AMT tax preferences.

(5) All other losses in whatever order the partner chooses. These are generally Code Sec. 702(a)(8) losses that get ordinary treatment.


Code Section 465 At-Risk Rules


(d) What about alimony paid, charitable contributions and other nonbusiness/noninvestment expenses? Prop. Reg. §1.465-13 addresses this question by providing that,

“ ...allowable deductions allocable to an [passive] activity are those otherwise allowable deductions incurred in a trade or business or for the production of income from the activity.”

(In other words, alimony and charitable contributions paid by a partnership are generally NOT subject to the at-risk rules since they do not ordinarily serve a business or investment purpose to the passive activity incurring these expenses. However, facts and circumstances govern “purpose”.)


Code Section 465 At-Risk Rules


Code Section 469 Passive Activity Loss RulesAs with the at-risk rules, the passive activity loss (PAL) rules are applied on a partner-by-partner basis, not at the partnership level. However, unlike the at-risk rules, the PAL rules apply only to business income and losses [i.e., Code Sec. 702(a)(8) taxable income or loss.] PALs are deductible (i.e., allowed to “jump Hurdle 2”) to the extent of Code Sec. 702(a)(8) income from all passive activities in the aggregate.

“Portfolio income” (interest, dividends, annuities, royalties not derived from the ordinary course of business and gains or losses from assets that produce such income, less related expenses) shall not be considered as arising from a passive activity. Code Sec. 469(e)(1). Partnership ordinary loss is generally passive to a partner unless the partner materially participates in the partnership activity.



At-Risk and Passive Activity Loss Rules—Example

FACTS:

1/1/x1: Rhonda’s outside basis in her 25% partnership interest is $24,000.

20x1: The partnership incurred a $100,000 Code Sec. 702(a)(8) operating loss.

20x2: The partnership earned $12,000 Sec. 702(a)(8) operating income.

Rhonda does not materially participate.

QUESTION:

Determine the tax effect on Rhonda for 20x1 and 20x2.



(21)

0 + (24) - (3) = (21)

(3)

Lesser of:

[0 + (24) = (24)]; or neg. [0 + 3 + /- 0] = (2); Lesser = (2).

03 0 x2

(1)

(25) + 0 - (24) = (1)

(24)

Lesser of:

[(25) + 0 = (25)]; or neg. [24 + 0 + /- 0] = (24); Lesser = (24).

0 (25) 24 x1

(f) =

[(c) + (f) from prior period] - (e)

(e) =

Lesser of:

[(c) + (f) from prior yr.] or

[(a)+(b)+/-(d)], expressed as a negative number.

(d) (c) (b) (a) = (i) from prior

yr.

Loss “Blocked” By H1

Amt. of Loss “Jumping” H1 Contrib.

(Distr.)

Passive

(Loss)

Passive Income

Beg. At-Risk Basis

Yr

At-Risk Hurdle (H1)




(3)30

[0 + 3 + 0 + (2) = 0]

(24)

[(3) + (24) - (3) = (24)]

(3)

[(3) + (24) = (27];

neg. 3 = (3);

Lesser = (3)

x2

0

(g) = 0 (b) = 0

0

[24 + 0 + 0 + (24) = 0]

(24)

[(24) + 0 - 0 = (24)]

0x1

(k) = (g) (j) =

(b) from all passive activities

(i) =

(a) + (b) +/- (d) + (e)

(h) =

[(e) + (h) from prior period] - (g)

(g) =Lesser of:[(e) + (h) from prior yr.]; or[(b) from all passive activities, expressed as a neg. number.

DeductIncomeEnding At-Risk Basis

Loss “Blocked” By H2

Amt. of Loss “Jumping” H2

Yr

Passive Hurdle (H2)




Partners Providing Infrequent, Nonessential Services to Partnerships for Compensation

What rules govern transactions between partners and partnerships (P/Ss)?

Infrequent, nonessential services. Code Sec. 707(a)(1) allows nonpartner status when a partner acts in an independent capacity, rendering services that are neither ongoing nor integral to the operations of the partnership. [For example, a partner who is a licensed CPA prepares the partnership’s tax returns for his customary fee.] Code Sec. 707(a)(1) encompasses both “outbound” (partnership pays partner) and “inbound” (partner pays partnership) payments. The payments may be for services, interest on loans, leases or purchase of property.


CCH Federal Taxation Basic Principles 65 of 69Chapter 16, Exhibit 25b

Tax treatment:

Partner: Ordinary income, no adjustment to outside basis. Payments received by partner are treated as if the transaction took place between two unrelated parties.

Partnership: Deductible. The value of the services is deductible by the P/S (or capitalizable if appropriate, e.g., a partner’s fee for replacing the roof of the P/S’s office building is capitalized by the P/S under Code Sec. 263.)

Partners Providing Infrequent, Nonessential Services to Partnerships for Compensation


Partners Providing Ongoing, Integral Services to Partnerships for Compensation

Ongoing, integral services that are guaranteed. Code Sec. 707(c) allows nonpartner status with regard to ongoing, integral services performed by partners in exchange for guaranteed payment. Payments are guaranteed if they are determined without regard to partnership income. For example, a partner drives the delivery truck of a pizza delivery partnership in exchange for a guaranteed payment of $1,000 per month. The monthly payment resembles a salary and is treated as such.



Tax treatment: Generally, the same as before, except:

Early recognition. Partner may have to report ordinary income whether or not received. This would occur if the P/S used the accrual method and took an accrual deduction one year and paid the partner in the next.

Not-salary in QRP context. In the context of qualified retirement plans, guaranteed payments are not the same as salary. Therefore, a partnership-employer’s contributions into qualified self-employment retirement plan, such as a Keogh or SEP IRA, that match guaranteed payments, are not deductible by the partnership, nor tax deferred by the partner.




Ongoing, integral services that are NOT guaranteed. The courts have required “partner status” when a partner performed services that were ongoing and integral to the business of the partnership and remuneration was NOT guaranteed. For example, driving the delivery truck of a pizza delivery partnership in exchange for 25% of the profits.




Tax treatment (worst case treatment):

Partner: Ordinary income, adjustment to outside basis. An ongoing, integral, non-guaranteed payment received by a partner is treated as a distribution of profits rather than compensation. The partner’s outside basis must be reduced by the amount of the partnership’s inside basis in the property distributed.

Partnership: Not deductible. The P/S’s payment for services is not deductible by the P/S.



2013 cch basic principles ch16 pii

Business

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