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Chapter C10

Special Partnership Issues

Discussion Questions

C10-1 A liquidating distribution. A current distribution is a distribution that does not terminate the partner's interest in the partnership, nor is the payment one of a series of payments intended to terminate the partner's interest in the partnership. A liquidating distribution is made with the intention of terminating the partner's entire interest in the partnership either with this payment or with a planned series of payments including this one. The January distribution to Javier is the first in a series of distributions that will terminate his interest in the partnership and, therefore, is a liquidating distribution. p. C10-2.

C10-2 The basis of property in the hands of the distributee partner generally is a carryover of the property's adjusted basis in the partnership's hands immediately before the distribution. However, the basis of all property distributed to a partner cannot exceed the distributee partner's basis in his or her partnership interest immediately before the distribution, reduced by any cash or deemed cash payments (liability reduction) that she received as part of the distribution. Lia's basis will be $40,000 if the partnership's basis in the land prior to the distribution was $40,000 or more. Lia will take a carryover basis from the partnership if the partnership's basis for the parcel of land prior to the distribution was less than $40,000. pp. C10-4 through C10-7.

C10-3 The basis of a single asset received in a liquidating distribution is determined by two factors: the basis of the distributed property in the partnership's hands and the distributee partner's basis in his or her partnership interest prior to the distribution. However, the total basis to the distributee partner of the assets received generally will equal the partner's basis in the partnership interest immediately prior to the distribution. Because Mariel received a single asset that was not money, accounts receivable, or inventory, her basis will be $60,000 in the land regardless of what the partnership's basis in the land was prior to its distribution. pp. C10-12 through C10-14.

C10-4 Cindy's basis for the property she receives will be reduced to $4,000 from its $4,500 basis to the CDE Partnership because it is limited to Cindy's basis in her partnership interest before the distribution. Even though Cindy will hold the property as an investment, the sale of the inventory would generate ordinary income for five years from the date of the distribution. The sale of the capital asset would generate long-term capital gain that to most individual taxpayers is taxed at a maximum 15% marginal tax rate. pp. C10-4 through C10-7.

C10-5 The partnership's accounts receivable probably are not unrealized receivables because the partnership uses the accrual method of accounting. However, depreciation recapture potential under Secs. 1245 is treated as an unrealized receivable. The partnership has Sec. 1245 recapture potential on the machines used to produce the inventory (and presumably also from other machinery, furniture, and equipment the partnership owns). The building has no Sec. 1250

C10-1

recapture potential, and therefore does not produce an additional unrealized receivable because it was depreciated under MACRS, which requires straight-line depreciation. The building, however, does have Sec. 1250 gain potential, but Sec. 1250 gain is not an unrealized receivable. p. C10-8.

C10-6 a, b, c, e. p. C10-8.

C10-7 For Sec. 751 to come into play in a current distribution, the distributing partnership must have both Sec. 751 assets (unrealized receivables and/or substantially appreciated inventory) and non-Sec. 751 assets. In addition, the distributee partner must have given up some of his or her interest in one of the two classes of assets in exchange for an increased interest in the other class of assets. In other words, the distribution must be disproportionate. p. C10-9.

C10-8 A partner can recognize a loss on a distribution only if the distribution is a liquidating distribution that consists only of money, unrealized receivables, and/or inventory. The partner recognizes a loss if the amount of money and the carryover basis of the receivables and inventory are less than the partner's predistribution basis in his or her partnership interest. p. C10-12.

C10-9 No. The basis of unrealized receivables and inventory received by a distributee partner in a nonliquidating or liquidating distribution cannot be greater to the partner than to the partnership. If the partner receives only money, unrealized receivables, and inventory as part of a liquidating distribution, and the carryover basis of the receivables and inventory is less than the partner's predistribution basis in the partnership interest (reduced by money received or deemed to have been received in the distribution), the partner cannot step-up the basis in the receivables or inventory but instead must recognize a loss.

Yes. If the partner's predistribution basis in the partnership interest is smaller than the sum of money received and the carryover basis for the receivables and inventory, the basis of the receivables and inventory to the distributee partner is reduced. The basis to be allocated between the unrealized receivables and inventory equals the predistribution basis for the partnership interest reduced by any money or deemed money received in the distribution. pp. C10-12 through C10-14.

C10-10 Yes. In determining the character of gain and/or loss on the sale of a partnership interest, the partnership is deemed to sell all its assets in a hypothetical sale for their FMV. The selling partner is then allocated his or her share of the ordinary income or loss from the sale of Sec. 751 assets. The partner’s residual gain or loss on the sale is capital gain or loss. If the partnership owns loss assets in addition to Sec. 751 assets, the allocable ordinary income could exceed the partner’s total gain, in which case the residual amount would be a capital loss. This result occurs in Example C10-20 in the text. pp. C10-16 through C10-19.

C10-11 a. When Tyra's interest in the partnership terminates, she will be deemed to have received a money distribution in the amount of her interest in partnership liabilities. Because she

C10-2

has a zero basis, she must report gain equal to the money distribution. Any other property she receives in the distribution will have a zero basis.

b. The amount realized will equal the sum of the money received and any liabilities assumed by the purchaser. Because her basis is zero she will report a large gain. pp. C10-12 and C10-16 through C10-18.

C10-12 If the entire partnership terminates, the Sec. 736 provisions do not apply at all. Rather each partner is taxed under the liquidating distribution rules. Section 736 applies if one or more partners (but fewer than all the partners) dies or retires. Accordingly, Sec. 736 applies to the payments to Tom. pp. C10-19 and C10-20.

C10-13 Section 736 divides payments into two categories. Section 736(b) payments are for a partner's interest in partnership property, and these payments are taxed under the rules for liquidating distributions. The partner recognizes capital gain if she receives money exceeding basis in her partnership interest, so Lucia will report a capital gain of $3,000 ($23,000 - $20,000) on the payment she receives for partnership assets.

Section 736(a) payments will be taxed as a guaranteed payment (ordinary income) if the distribution is not based on partnership income. If the payment is based on partnership income, the partner will be taxed on a distributive share of partnership income with the character of the income determined at the partnership level. Accordingly, Lucia will report her share of partnership income as a distributive share. pp. C10-19 and C10-20.

C10-14 The advantages of terminating a partnership include the termination of tax accounting elections, which also may be disadvantageous, and the possibility of an accelerated loss flow through when the terminated partnership’s year closes. The disadvantages of a termination may include loss of a favorable tax year and the bunching of income for the partners. The advantage or disadvantage of changed asset bases no longer exists under current Treasury Regulations. See Reg. Sec. 1.708-1(b)(1)(iv). pp. C10-22 through C10-24.

C10-15 A publicly traded partnership (PTP) is defined as a partnership whose interests are either traded on an established securities exchange or are traded in a secondary market or the equivalent thereof. Two groups of PTPs are not taxed as corporations. A PTP that existed on December 17, 1987, and which has not added a substantial new line of business, was not taxed as a corporation until tax years beginning after December 31, 1997. These partnerships, which were grandfathered under the 1987 law for ten years, were granted a new election in the Taxpayer Relief Act of 1997 (TRA of 1997). The TRA of 1997 allows these PTPs to continue to be taxed as partnerships if they elect to do so and agree to pay an annual tax of 3.5% of gross income from the partnership’s trade or business. Partnerships that have 90% or more of their gross income being "qualifying income" (interest, dividends, real property rents, etc.) continue to be taxed as partnerships. pp. C10-28 and C10-29.

C10-16 From a legal standpoint, all the owners of a limited liability company (LLC) have limited liability for the firms debts. In a limited partnership, all general partners have significant liability for firm debts. Under the check-the-box regulations, an LLC can choose whether to be

C10-3

treated as a partnership or taxed as a corporation. If the LLC chooses partnership treatment, the LLC and the limited partnership are treated similarly except the limited partnership must have at least one general partner. p. C10-29.

C10-17 An electing large partnership is a partnership that is not a service partnership, is not engaged in commodity trading, has at least 100 partners, and files an election to be taxed as an electing large partnership. The primary advantage to the partnership of electing to be an electing large partnership is that the reporting of income to the large number of partners is simplified. Relatively few items are separately stated so that the reporting process is more difficult than for a corporation but easier than for a non-electing partnership. pp. C10-30 through C10-33.

Issue Identification Questions

C10-18 • Does Kayla recognize a gain or loss on the current distribution?• What is Kayla's basis in the office equipment?• When does Kayla's holding period begin for the property?• Does any depreciation recapture carryover to Kayla from the partnership?• What is Kayla's basis in her partnership interest following the distribution?

Kayla recognizes no gain or loss on the distribution. Her basis for the equipment would be a carryover basis from the partnership ($35,000) if that were possible, but it is limited to her basis in her partnership interest prior to the distribution ($30,000). Kayla's holding period for the office equipment includes the holding period the partnership had for the property. Her basis in the partnership interest is zero following the distribution. The depreciation recapture potential is an unrealized receivable that will generate ordinary income under Sec. 735 (a)(1) when Kayla sells the property. pp. C10-2 through C10-7.

C10-19 • How much is Joel’s distribution? • Does the partnership have Sec. 751 assets? • If the partnership has Sec. 751 assets, did Joel exchange any interest in Sec. 751

assets for cash? • How much ordinary income must Joel recognize if he exchanges Sec. 751 assets

for cash? • How must Joel treat any cash distribution received that exceeds the amount

deemed to be part of the Sec. 751 exchange?

The amount of the distribution includes both the cash and the relief from liabilities that he received when his interest in the partnership changed from one-third to one-fourth. The partnership probably has Sec. 751 assets because the partnership inventory is substantially appreciated. Furthermore, the cash basis partnership probably has unrealized accounts receivable, and the partnership may have recapture potential if it has any depreciable personality. Again, an exchange of Sec. 751 assets for cash probably occurred because Joel received only cash and probably gave up a portion of his interest (from one-third to one-fourth) in each Sec. 751 asset. The amount of ordinary income is the difference between the amount of cash Joel is deemed to have received for the Sec. 751 assets and the adjusted basis that Joel would have had

C10-4

in the Sec. 751 assets had the Sec. 751 assets been distributed to Joel immediately before the deemed Sec. 751 sale (usually a carryover from the partnership's basis in these Sec. 751 assets). Any cash or deemed cash exceeding the amount deemed to be part of the Sec. 751 exchange is treated as a current distribution. The current distribution will reduce his basis in his partnership interest. If the current distribution is greater than his basis in the partnership interest, Joel will recognize gain because he receives cash exceeding his basis. pp. C10-7 through C10-11.

C10-20 • Does the partnership have Sec. 751 assets?• What is the amount and character of the gain on the sale of Scott's partnership

interest?• Should the partnership make a Sec. 754 election so Sally can obtain an optional

basis adjustment?

The partnership has no unrealized receivables, but the partnership does have inventory. The results of the sale are determined as follows:

Application of step 1 yields the following gain on Scott’s sale of his partnership interest:

Amount realized on sale $43,000Minus: Adjusted basis of partnership interest ( 33,000)Total gain realized $10,000

Application of step 2 yields the following allocation to Sec. 751 property:

Deemed Sale of Assets

PartnershipGain

Scott’s Share (1/3)

Inventory $9,000 $3,000Building 15,000a 5,000b

Land 6,000 2,000a$5,400 of which is Sec. 1250 gain.b$1,800 of which is Sec. 1250 gain.

Thus, on the sale of his partnership interest, Scott recognizes $3,000 of ordinary income and $1,800 of Sec. 1250 gain.

Application of step 3 yields the following residual allocation to capital gain:

Total gain realized $10,000 Minus: Allocation to ordinary income and Sec. 1250 gain ( 4,800) Capital gain recognized $ 5,200

In summary, on the sale of his partnership interest, Scott recognizes $3,000 of ordinary income, $1,800 of Sec. 1250 gain, and a $5,200 capital gain.

C10-5

If the partnership made a Sec. 754 election, Sally’s optional basis adjustment would be calculated as follows:

Cash purchase price $43,000Minus: Sally’s share of partnership’s basis in assets (1/3 x $99,000) ( 33,000)Optional basis adjustment $10,000

The optional basis adjustment would be allocated $3,000 to the inventory, $5,000 to the building, and $2,000 to the land.

pp. C10-16 through C10-18 and C10-26 through C10-29.

C10-21 Drew and Dana should consider the following:• The sale as contemplated will terminate the partnership. Is termination of the

partnership desirable for Drew and Dana?• Will either individual have to recognize gain? The recognition of gain is

unlikely unless Drew and Dana have a small basis relative to the cash held by the partnership and deemed distributed in the liquidating distribution.

• What will be the basis for each of the assets? Under current Treasury Regulations, the termination will be deemed to result in the old partnership contributing the property directly to the new partnership so that no adjustment to asset bases is likely to occur.

• Will income be bunched into a single tax year if the partnership terminates? Termination of the partnership closes a tax year. If the partnership has the same tax year-end as Drew and Dana, no bunching of income will occur. If their tax years differ, however, some bunching will occur.

• When the partnership terminates, all elections are lost. Are there advantages or disadvantages from losing all existing elections? A few advantageous tax year-ends for old partnerships were grand fathered when Congress enacted the rules imposing required partnership tax year-ends. The loss of this tax benefit would be a significant disadvantage.

• Would liquidation by the partnership be more advantageous than a sale to the other partners? Liquidation by the partnership does not terminate the partnership.

David should consider:• How much of his gain from the sale would be considered sale from his interest in

Sec. 751 assets and, therefore, taxed as ordinary income? His sale will result in ordinary income to the extent of his share of ordinary income upon the hypothetical sale of underlying Sec. 751 assets.

• Will the sale cause a bunching of income from the partnership for David? Because the sale of the entire partnership interest closes the partnership

tax year for the selling partner, the sale will cause bunching of income if David's tax year-end is different from DDD's tax year-end.

C10-6

• Could the transaction be structured in such a way that a liquidation by the partnership would be more beneficial to David? Possibly. If Drew and Dana really do not want the partnership to terminate, they may be willing to pay David more in a liquidating distribution than they were willing to pay for an outright purchase. pp. C10-16 through C10-18, C10-22 through C10-25.

C10-22 • Does the partnership terminate for tax purposes?• If so, when does the termination occur?

The partnership terminates because only one partner remains. The partnership terminates when the final Sec. 736 payment occurs. pp. C10-22 through C10-25.

C10-23 • Is this gift going to make Haley a partner in the HotWheels LLC for tax purposes?

• If Alex restructures the gift so that Haley has true control over the interest, how will the LLC's income be allocated between Alex and Haley?

Haley probably will not be a partner. For Haley to be considered a partner, she must have control of the interest. For a minor, control includes the situation where the interest is placed in trust for the benefit of the minor but only if the trustee is someone who will act in the best interest of the trust beneficiary. It is not clear that Alex is giving up any control over this interest since he will continue to control the 15% share he placed into Haley's trust. Thus, Haley is unlikely to be considered a partner. A two-step allocation process will be used to allocate partnership income. First, Alex must be allocated a FMV salary. His current salary is described as small, and it may be too small to be considered equal to the FMV of his services. Once Alex is allocated a FMV salary, all other income allocated to Alex and Haley must be divided on a pro rata basis. Alex must receive three-fourths and Haley must receive one-fourth. In effect, the family partnership income allocation rules override the special allocation to Alex. pp. C9-30, C9-31, and C10-29.

C10-24 • Should Krypton choose to be taxed as a partnership or as a corporation?• How much will be kept in the business for growth, and how much will be

distributed to the owners each year? The larger the percentage of earnings that will be distributed, the more advantageous a flow-through entity such as a partnership can be.

• What is the marginal tax rate for Jeff, Susan, and Richard? If Jeff, Susan, and Richard have lower marginal tax rates than does Krypton, partnership status has advantages.

• How should Jeff's pay for operating the business be structured? If the business is taxed as a corporation, a generous but reasonable salary will decrease the amount of income subject to double taxation. However, given the 15% tax rate on dividend income, double taxation is not as detrimental as when dividends were

C10-7

taxed as ordinary income. If the business is structured as a partnership, the partners need to decide whether to structure the payment as distributive share, as an outright guaranteed payment, or whether to establish a guaranteed minimum that may be some combination of the two. pp. C2-3 through C2-8 and C10-30.

C10-25 What method should XYZ Limited Partnership choose to use to operate under the publicly traded partnership rules?

• Pay the annual 3.5% of gross income tax and continue to be taxed as a publicly traded partnership?

• Buy back enough interests (or restrict opportunities for trading) so the partnership is no longer publicly traded?

• Incorporate the entity and be taxed as a regular C corporation?• If the XYZ Limited Partnership chooses to continue as a partnership, should it

elect to come under the electing large partnership rules?

The best alternative will be a function of the amount of gross income, amount of taxable income, tax rates of the partners, amount of profits the firm wants to retain, and costs of buying back partnership interests, and/or restricting trading, or incorporating.

The election reduces the partnership’s annual cost of providing information to partners but will require some start-up cost to make the change. The election also has the advantage of making it more difficult to accidentally terminate the partnership because of trades. However, the election significantly reduces the partners’ reporting and audit options.

pp. C10-29 and C10-30.

Problems

C10-26 a. Partnership interest basis:Beginning basis $ 25,000 Minus: Cash received ( 4,000) Land basis ( 14,000) Ending basis $ 7,000

Lisa recognizes no gain. Her basis in the land is $14,000.

C10-8

b. Partnership interest basis:Beginning basis $ 25,000Minus: Cash received ( 4,000)Basis before distribution of land $ 21,000Minus: Basis of land to Lisa ( 21,000)Ending basis $ -0 -

Lisa recognizes no gain. Her basis in the land is limited to $21,000, which is the basis of her partnership interest reduced by the cash distributed.

c. Partnership interest basis:Beginning basis $ 25,000 Minus: Cash received ( 28,000) Basis before distribution of land (but not less than zero) $ -0-Minus: Basis of land to Lisa -0 - Ending basis $ -0 -

Lisa recognizes a $3,000 gain, the amount by which cash distributed exceeds her partnership basis before the cash distribution. Her basis in the land is limited to zero, which is the basis of her partnership interest reduced by the cash distributed.

d. Partnership interest basis:Beginning basis $ 25,000Minus: Cash received ( 4,000)Basis before distribution of property $ 21,000Minus: Basis of receivables and inventory ( 10,000)Basis before distribution of land $ 11,000Minus: Basis of land to Lisa ( 11,000)

Ending basis $ -0-

Lisa recognizes no gain. Her basis in the receivables is zero, and her basis in the inventory is $10,000. Her basis in the land is limited to $11,000, which is the basis of her partnership interest reduced by the cash distributed and by the basis of receivables and inventory distributed.

e. FMV of land distributed $ 30,000Minus: Basis of land distributed ( 14,000)Gain recognized by the corporation (Sec. 311(b)) $ 16,000

In addition, the corporation increases its E&P by the E&P gain (which also is $16,000), decreases E&P by taxes on the tax gain, and decreases E&P by the $34,000 ($4,000 cash + $30,000 FMV of land) dividend distribution to Lisa (Sec. 312).

Lisa recognizes a $34,000 ($4,000 cash + $30,000 FMV of land) dividend (Sec. 301(c) and Sec. 316). Her basis in the land is its $30,000 FMV (Sec. 301(d)), and her basis in her

C10-9

corporate stock remains at $25,000.

f. FMV of land distributed $ 30,000Minus: Basis of land distributed ( 14,000)Gain recognized by the corporation (Sec. 311(b)) $ 16,000

One-half the $16,000 gain passes through to Lisa.

Lisa’s basis in S corporation stock:Beginning basis $ 25,000Plus: Gain pass-through 8,000Basis before distributions $ 33,000Minus: Distributions excluded from Lisa gross income ( 33,000)Ending basis $ -0 -

Lisa received a $34,000 ($4,000 cash + $30,000 FMV of land) distribution, which exceeded her stock basis before the distribution. Thus, in addition to the $8,000 pass-through gain, Lisa recognizes a $1,000 capital gain on the excess distribution (Sec. 1368(b)(2)). Her basis in the land is its $30,000 FMV (Sec. 301(d)).

pp. C10-2 through C10-7, C4-2 through C4-11, and C11-24 through C11-28

C10-27 Partner's

Postdistribution BasisGain/Loss basis Property to Partner

a. -0- $7,000 Land $4,000Machinery 3,000

b. -0- $4,000 Land 6,000Inventory 7,000

c. $9,000 -0- Land - Parcel 1 -0-Land - Parcel 2 -0-

d. -0- $14,000 Land - Parcel 1 4,000Land - Parcel 2 6,000Land - Parcel 3 4,000

pp. C10-2 through C10-7.

C10-10

C10-28 a. Because Mario does not receive cash exceeding his partnership basis, he recognizes no gain under the current distribution rules of Sec. 731. However, Sec. 737 requires an additional step when some precontribution gain remains unrecognized. Mario must recognize gain equal to the lesser of:

1. Remaining precontribution gain ($8,000 = $18,000 - $10,000) or2. The excess of the FMV of the property distributed over the adjusted basis of the

partnership interest immediately preceding the distribution ($3,000 = $23,000 - $20,000 partnership basis).

Under Sec. 737, Mario must recognize a $3,000 gain, which takes its character from the land Mario contributed to the partnership having the precontribution gain.

b. Under Sec. 731, his basis in his partnership interest is reduced by the carryover basis of the property distributed to him.

Mario's basis in partnership interest before the distribution $20,000 Plus: Sec. 737 gain recognized on the distribution 3,000 Minus: Carryover basis of property distributed (15,000) Basis in partnership interest after the distribution $ 8,000

Because Mario recognized gain under Sec. 737, he must increase the basis of his partnership interest by the $3,000 amount of the Sec. 737 gain. His basis is increased before reducing the basis for the distribution.

c. Because Mario recognizes $3,000 of gain under Sec. 737, the partnership must increase its basis in the property related to the precontribution gain that Mario recognized. The partnership's basis in the land is increased to $13,000 ($10,000 carryover basis from Mario at the time of the contribution + $3,000 Sec. 737 gain recognized on this distribution).

Students may note that $5,000 of precontribution gain related to this land remains, which could be recognized under Sec. 737 if Mario receives other distributions that trigger the recognition of this gain within seven years of the original contribution of the land to the partnership. pp. C10-2 through C10-7.

C10-29 a. Andrew must recognize the gain that would have been allocated to him had the partnership sold the land for its FMV instead of distributing it to Bob.

Amount deemed realized $21,000 Minus: Adjusted basis ( 18,000) Capital gain on deemed sale $ 3,000

b. and c. All $3,000 of the gain would have been allocated to Andrew because his pre-contribution gain was $4,000, so Andrew must recognize a $3,000 gain. He increases his basis in the partnership interest by the $3,000 gain he recognizes to $24,000. Bob's basis in his partnership interest is not affected by the gain recognition. The partnership's basis in the land is deemed increased by the $3,000 gain to $21,000 immediately before the land is distributed. Accordingly, the basis of the land to Bob is $21,000, and Bob's basis in his partnership interest is

C10-11

reduced to $9,000 ($30,000 - $21,000) by the distribution. Andrew's basis in his partnership interest is not affected by the distribution. pp. C10-2 through C10-7.

C10-30 First, Beth and Cathy must recognize precontribution gains on the distributed property.

1. Land: Amount deemed realized $10,000 Minus: Adjusted basis ( 4,000) Gain on deemed sale $ 6,000

The precontribution gain allocated to Beth on the deemed sale is $4,000 ($8,000 FMV - $4,000 basis at contribution). Beth's basis in her partnership interest after the deemed sale is $19,000 ($15,000 + $4,000 gain recognized). The land's basis to the partnership immediately before the distribution is $8,000 ($4,000 basis + $4,000 gain recognized).

2. Inventory: Amount deemed realized $10,000 Minus: Adjusted basis ( 1,000) Gain on deemed sale $ 9,000

The precontribution gain allocated to Cathy on the deemed sale is $3,000 ($4,000 FMV - $1,000 basis at contribution). Cathy's basis in the partnership interest after the deemed sale is $21,000 ($18,000 + $3,000 gain recognized). The inventory's basis to the partnership immediately before the distribution is $4,000 ($1,000 + $3,000 gain recognized).

Then, the current distributions must be analyzed using the normal rules.Alonzo's distribution:

Basis in partnership interest before distribution $19,000 Minus: Carryover basis in land (see 1 above) ( 8,000) Basis in partnership interest after distribution $11,000

Beth's distribution:Basis in partnership interest before distribution (see 1 above) $19,000 Minus: Carryover basis in inventory (see 2 above) ( 4,000) Basis in partnership interest after distribution $15,000

Cathy's distribution:Basis in partnership interest before distribution (see 2 above) $21,000 Minus: Cash received in distribution ( 10,000) Basis in partnership interest after distribution $11,000


C10-31 a. Accounts receivable and depreciation recapture on the equipment.

C10-12

b. Yes. The inventory's $76,000 FMV ($16,000 + $52,000 + $1,500 equipment depreciation recapture + $6,500) exceeds 120% of its adjusted basis [1.20 x ($0 + $50,000 + $0 + $6,000) = $67,200].

c.

BeginningPartnership Amount

(1)Kay's Interest

Before Distribution

(1/3)

(2)Kay's Interest

AfterDistribution

(1/4)

(3)Fictional

ProportionateDistribution(3)=(1)-(2)

(4)

ActualDistribution

(5)

Difference(5)=(4)-(3)

Sec. 751 Assets:ReceivablesInventorySuppliesRecaptureTotal

$16,000 52,000

6,500 1,500 $76,000

$ 5,333 17,333

2,167 500 $25,333

$ 4,000 13,000

1,625 375 $19,000

$ 1,333 4,333

542 125 $ 6,333

$-0- -0- -0- -0-

$-0-

($1,333) ( 4,333) ( 542) ( 125) ($6,333)

Other Assets:Cash EquipmentLandTotal

$ 30,000 9,000

65,000 $104,000

$10,000 3,000

21,667 $34,667

$ 2,500 2,250

16,250 $21,000

$ 7,500 750

5,417 $13,667

$20,000 -0- -0-

$20,000

$12,500 ( 750) ( 5,417) $ 6,333

Kay's sale:Amount realized $ 6,333 Minus: Adjusted basis ( 4,666)a Recognized gain (ordinary income) $ 1,667

Kay’s basis in partnership interest:Beginning basis $33,750 Minus: Sec. 751 transaction:

Inventory ($50,000/$52,000 x $4,333) ( 4,166) Supplies ($6,000/$6,500 x $542) ( 500)

Basis after Sec. 751 transaction $29,084 Minus: Non-Sec. 751 distribution (13,667)b Ending partnership interest basis $15,417

a$0 receivables + $4,166 inventory + $500 supplies + $0 depreciation recaptureb$20,000 total - $6,333 Sec. 751 exchange.


C10-32 a. Sec. 1245 recapture on machinery.b. Yes. The inventory's $86,000 FMV ($12,000 + $24,000 + $50,000 machinery

depreciation recapture) exceeds 120% of its adjusted basis [1.20 x ($12,000 + $21,000 + $0) = $39,600].

C10-13

c.


(1)Jack's

Interest Before Distribution

(1/4)

(2)Jack's Interest

AfterDistribution

(1/5)

(3)Fictional


(4)

ActualDistribution

(5)


Sec. 751 Assets:ReceivablesInventoryRecaptureTotal

$12,000 24,000

50,000 $86,000

$ 3,000 6,000

12,500 $21,500

$ 2,400 4,800

10,000 $17,200

$ 600 1,200

2,500 $4,300

$-0- -0-

-0- $-0-

($ 600) ( 1,200) ( 2,500)

($4,300)

Other Assets:Cash MachineryLandTotal

$ 48,000 190,000 76,000

$314,000

$12,000 47,500

19,000 $78,500

$ 4,600 38,000

15,200 $57,800

$ 7,400 9,500

3,800 $20,700

$25,000 -0-

-0- $25,000

$17,600 ( 9,500) ( 3,800) $ 4,300

Jack's sale:Amount realized $ 4,300 Minus: Adjusted basis ( 1,650)a Recognized gain (ordinary income) $ 2,650

Jack's basis in partnership interest:Beginning basis $76,875 Minus: Sec. 751 transaction Accounts receivable ( 600) Inventory ($21,000/$24,000 x $1,200) ( 1,050) Basis after Sec. 751 transaction $75,225 Minus: Non-Sec. 751 distribution (20,700)b Ending basis $54,525

a$600 receivables + $1,050 inventory + $0 recapture.b$25,000 total - $4,300 Sec. 751 exchange.


C10-14

C10-33


(1)Paula’s

Interest Before Distribution

(1/4)

(2)Paula's Interest

AfterDistribution

(1/5)

(3)Fictional


(4)

ActualDistribution

(5)


Sec. 751 Assets:ReceivablesInventoryTotal

$ 40,000 100,000

$140,000$86,000

$10,000 25,000 $35,000

$ 8,000 18,000

$36,000

$2,000 7,000 $9,000

$ -0- 10,000 $10,000

($2,000) 3,000 $1,000

Other Assets:Cash $ 20,000

$ 5,000

$ 4,000

$ 1,000

$ -0-

($1,000)

($1,000)

Deemed cash distribution $1,000

Partnership’s sale of inventory for cash:Amount realized $1,000Minus: Adjusted basis of inventory (0.80 x $1,000) ( 800)a

Partnership’s recognized gain $ 200b

aBecause the total basis for the inventory is $80,000 and the total FMV is $100,000, the basis of this portion of the inventory is assumed to be 80% of its FMV.

bThe $200 gain is allocated one-third to each of the other three partners (Reg. Sec. 1.751-1(b)(2)(ii)). Thus, each other partner recognizes $67 of ordinary income.

Basis in partnership interest:Paula Partner

QPartner R Partner S

Beginning basis $25,000 $25,000 $25,000 $25,000Plus: Share of partnership income 67 67 67Minus: Deemed distribution of cash ( 1,000) Distribution of remaining inventory (adjusted basis = 0.80 x $9,000) ( 7,200) _______ _______ _______Ending basis $16,800 $25,067 $25,067 $25,067

Paula’s basis in inventory: Portion deemed purchased from partnership (cost) $1,000 Remaining distribution (adjusted basis) 7,200 Total $8,200


C10-15

C10-34 Partner'sPostdistribution Basis

Gain/Loss Basis Property to Partnera. -0- None Land $11,000a

Machinery 3,000b. -0- None Land 10,000b

Inventory 7,000c. $9,000 None Land - 1 -0-c

Land - 2 -0-d. -0- None Land - 1 6,462d

Land - 2 10,769Land - 3 10,769

aPredistribution basis $20,000Less: Cash distribution ( 6,000)Basis to allocate $14,000

Basis of property to partners: Land Machinery

First allocate to property basis $ 4,000 $ 3,000Then allocate to property appreciation 7,000 -0-Total $11,000 $ 3,000

bPredistribution basis $20,000Less: Cash distribution ( 3,000)Basis to allocate $17,000Less: Allocation to inventory ( 7,000)Allocation to land $10,000

cPredistribution basis $26,000Less: Cash distribution ( 35,000)Basis to allocate (but not less than zero)

$ -0-

dBasis of property to partners:Land-1 Land-2 Land-3

Basis to Allocate

Predistribution basis $28,000First allocate to property basis $4,000 $ 6,000 $ 4,000 ( 14,000)Balance $14,000Then allocate to property appreciation 2,000 4,000 6,000 ( 12,000)Finally allocate based on relative FMV

462 769 769 $ 2,000

Total $6,462 $10,769 $10,769

C10-16

pp. C10-12 through C10-16.C10-35 Even though Marinda does not receive her proportionate share of each partnership asset in the liquidating distribution, the transaction has no Sec. 751 implications because the partnership has no Sec. 751 assets. Marinda is deemed to have received $110,000 in cash or deemed cash ($100,000 cash + $10,000 release from liability). Accordingly, she must recognize capital gain of $30,000 ($110,000 received - $80,000 basis). The partnership recognizes no gain. pp. C10-12 through C10-16.

C10-36

Alison BobBasis before liability reduction $110,000 $180,000

Minus: Liability reduction (deemed distribution) ( 50,000) ( 50,000)

Basis before distributions $ 60,000 $130,000

Minus: Cash distributions ( 20,000) ( 20,000)

Basis to be allocated $ 40,000 $110,000

Minus: Basis allocable to inventory ( 32,195)a ( 33,000)

Basis allocable to receivables ( 7,805)a ( 10,000)

Amount allocable to other property $ -0- $ 67,000

Minus: Basis allocable to land ( -0-) ( 15,000)b

Basis allocable to building ( -0-) ( 52,000)b

Ending basis in partnership interest $ -0- $ -0-

C10-17

aAllison’s allocation:

Inventory Receivables Total

FMV of assetMinus: Partnership’s basis for the assetDifference

Step 1: Give each asset the partnership’s basis for the assetMinus: Allison’s basis to be allocatedDecrease to allocate

Step 2: Asset basis after Step 1Allocate the decrease first to assets that have declined in valueAdjusted basis at this point in the calculation

Step 3: Allocate $1,000 remaining decrease based on relative adjusted basis at this point in the calculationAllison’s basis in the assets

$ 35,000 ( 33,000)$ 2,000

$ 33,000

$ 33,000

-0 -

$ 33,000

( 805)*$ 32,195

$ 8,000 ( 10,000) ( $2,000)

$10,000

$10,000

( 2,000)

$ 8,000

( 195) $ 7,805

$43,000 (43,000) $ -0 -

$43,000 ( 40,000) $ 3,000 $43,000

( 2,000)

$41,000

( 1,000) $40,000

*$33,000/($33,000 + $8,000) x $1,000 remaining decrease to be allocated.

bBob’s allocation:

Land Building Total

FMV of assetMinus: Partnership’s basis for the assetDifference

Step 1: Give each asset the partnership’s basis for the assetMinus: Bob’s basis to be allocatedIncrease to allocate

Step 2: Allocate the $12,000 increase first to assets that have appreciated in valueBob’s basis in the asset

$10,000 ( 15,000) ($ 5,000)

$15,000

-0- $15,000

$60,000 ( 40,000) $20,000

$40,000

12,000 $52,000

$70,000 ( 55,000) $15,000

$55,000 ( 67,000) $12,000

12,000 $67,000

The basis in each asset received is the number used to reduce the partner’s basis in the partnership interest. Note that Alison's basis in the inventory and receivables is smaller than a carryover basis from the partnership while Bob's basis in the building is larger than a carryover basis. Neither the partners nor the partnership recognize any gain or loss. pp. C10-12 through C10-14.

C10-18

C10-37 a, b, and c. Larry’s basis in his partnership interest:

Part a Part b Part c

Basis before distribution $40,000 $46,500 $46,500 Minus: Cash distribution ( 2,500) ( 2,500) ( 2,500) Basis to be allocated $37,500 $44,000 $44,000 Minus: Basis allocable to inventorya ( 8,000) ( 8,000) ( 8,000) Basis to be allocated to capital assetsb $29,500 $36,000 $36,000

aInventory is not substantially appreciated. Therefore, Sec. 751 does not apply. bSee Parts a – c below for remaining allocations. Also see summary of bases after Part c.

a.

Capital Asset 1 Capital Asset 2 Total

FMV of asset $15,000 $17,500 $32,500Minus: Partnership’s basis for the asset ( 10,000) ( 15,000) ( 25,000

)Difference $ 5,000 $ 2,500 $ 7,500

Step 1: Give each asset the partnership’s basis for the asset $10,000 $15,000 $25,000

Minus: Larry’s basis to be allocated ( 29,500)

Increase to allocate $ 4,500Step 2: Basis after Step 1 $10,000 $15,000 $25,000

Allocate the $4,500 increase to assets that have increased in value* 3,000 1,500 4,500

Larry’s basis in the capital assets $13,000 $16,500 $29,500

*Based on relative unrealized appreciation: Capital Asset 1, $5,000/$7,500 x $4,500; Capital Asset 2, $2,500/$7,500 x $4,500

C10-19

b.



)Difference $ 5,000 $ 2,500 $ 7,500



Increase to allocate $11,000Step 2: Basis after Step 1 $10,000 $15,000 $25,000

Allocate the increase to assets that have increased in valuea 5,000 2,500 7,500

Basis after Step 2 $15,000 $17,500 $32,500Step 3: Allocate the remaining $3,500

increaseb 1,615 1,885 3,500Larry’s basis in the capital assets $16,615 $19,385 $36,000

aBut not more than the unrealized appreciation.bBased on relative FMV: Capital Asset 1, $15,000/$32,500 x $3,500; Capital Asset 2, $17,500/$32,500 x $3,500

c.



)Difference $ 5,000 ($ 2,500) $ 2,500



Increase to allocate $ 6,000Step 2: Basis after Step 1 $10,000 $20,000 $30,000

Allocate the increase to assets that have increased in valuea 5,000 -0- 5,000

Basis after Step 2 $15,000 $20,000 $35,000Step 3: Allocate the remaining $1,000

increaseb 462 538 1,000Larry’s basis in the capital assets $15,462 $20,538 $36,000

C10-20

aBut not more than the unrealized appreciation.bBased on relative FMV: Capital Asset 1, $15,000/$32,500 x $1,000; Capital Asset 2, $17,500/$32,500 x $1,000

C10-21

Summary of asset bases: Part a Part b Part c

Cash $ 2,500 $ 2,500 $ 2,500 Inventory 8,000 8,000 8,000 Capital Asset 1 13,000 16,615 15,462 Capital Asset 2 16,500 19,385 20,538 Total $40,000 $46,500 $46,500


C10-38 a. Kelly's January 1 basis $35,000 Plus: Share of January income [($15,000 + $6,000) x ⅓] 7,000 Kelly's February 1 basis $42,000

b. The partnership has inventory and Sec. 1250 property. Accordingly, the sales transaction must be analyzed as follows:

Application of step 1 yields the following gain on Kelly’s sale of her partnership interest:

Amount realized on sale ($45,000 cash + $20,000 liabilities) $65,000Minus: Adjusted basis of partnership interest (42,000)Total gain realized $23,000


Deemed Sale of Assets Partnership Gain Kelly’s Share (1/3)

Inventory $60,000 $20,000Building 4,000 (all Sec. 1250 gain) 1,333 Land 5,000 1,667

Thus, on the sale of her partnership interest, Kelly recognizes ordinary income of $20,000 and a Sec. 1250 gain of $1,333.

Application of Step 3 yields the following residual allocation to capital gain:

Total gain realized $23,000Minus: Allocation to ordinary income and Sec. 1250 gain ( 21,333)Capital gain recognized $ 1,667

In summary, on the sale of her partnership interest, Kelly recognizes $20,000 of ordinary income, $1,333 of Sec. 1250 gain, and a $1,667 capital gain.

c. $65,000 = $45,000 cash paid + $20,000 share of partnership liabilities.C10-22

d. Unchanged from the basic facts.


C10-39 a. The results of the sale are determined as follows:

Application of step 1 yields the following gain on Clay’s sale of his partnership interest:

Amount realized on sale ($75,000 cash + $15,000 liabilities) $90,000Minus: Adjusted basis of partnership interest ($168,000 x 0.50) ( 84,000)Total gain realized $ 6,000


Deemed Sale of AssetsPartnershipGain (Loss) Clay’s Share (60% x 0.50)

Inventory $ 30,000 $ 9,000Land ( 10,000) ( 3,000)

Thus, on the sale of his partnership interest, Clay recognizes ordinary income of $9,000.

Application of step 3 yields the following residual allocation to capital loss:

Total gain realized $ 6,000Minus: Allocation to ordinary income ( 9,000) Capital loss recognized ($ 3,000)

In summary, on the sale of his partnership interest, Clay recognizes $9,000 of ordinary income and a $3,000 capital loss.

b. Steve's basis is $90,000, his purchase price of $75,000 cash paid plus $15,000 in liabilities assumed.

c. The partnership's basis will not be affected. d. If Clay sold his entire interest to Steve, the partnership would terminate on the

date of the sale. Clay's gain is twice the amounts shown in Part a ($18,000 ordinary income and $6,000 capital loss). Steve's basis in the partnership interest is $180,000 ($150,000 cash paid + $30,000 in liabilities assumed).

Under Reg. Sec. 1-708-(b)(iv), the old CAP Partnership is deemed to contribute all its assets and liabilities to a new partnership (NewCAP) in exchange for an interest in NewCAP. Under Sec. 723, NewCap takes a carryover basis (and holding period) in each of the assets contributed to it. Old CAP then distributes interests in NewCAP to Steve and the remaining partners. Each

C10-23

partners’ basis in the NewCap interest is the same as his or her basis in the old CAP Partnership interest.


C10-40 a. The result of the sale is determined as follows:

Application of step 1 yields the following gain on Alice’s sale of her partnership interest:

Amount realized on sale ($125,000 cash + $35,000 liabilities) $160,000Minus: Adjusted basis of partnership interest ( 110,000)Total gain realized $ 50,000

Application of step 2 yields the following allocation of Sec. 751 property:

Deemed Sale of AssetsPartnershipGain (Loss)

Alice’s Share (⅓)

Receivable $21,000 $ 7,000 Inventory 15,000 5,000Machinery 42,000a 14,000a

Building 45,000b 15,000b

Land ( 6,000) ( 2,000)Investments 33,000 11,000

aPartnership depreciation is $36,000, and Alice’s share is $12,000.bPartnership Sec. 1250 gain is $30,000, and Alice’s share is $10,000.

Thus, on the sale of her partnership interest, Alice recognizes ordinary income of $24,000 ($7,000 + $5,000 + $12,000 recapture). In addition, Alice’s Sec. 1250 gain is $10,000.


Total gain realized $50,000Minus: Allocation to ordinary income and Sec. 1250 gain (34,000)Capital gain recognized $16,000

In summary, on the sale of her partnership interest, Alice recognizes $24,000 of ordinary income, $10,000 of Sec. 1250 gain, and a $16,000 capital gain.

b. Darla’s basis in her partnership interest is $160,000 ($125,000 cash paid + $35,000 share of liabilities assumed). pp. C10-16 through C10-19.

C10-24

C10-41 a. Suzanne's share of partnership assets is $135,000 (1/3 x $405,000). Therefore, $135,000 of the $150,000 she receives ($130,000 cash + $20,000 release from liabilities) is a Sec. 736(b) payment. The Sec. 736(b) payment is treated as a distribution, so Suzanne must recognize a $30,000 gain (cash distribution of $135,000 exceeding $105,000 basis). The gain is capital gain if Suzanne held the partnership interest as a capital asset. The remaining $15,000 payment does not represent a payment for property. Because the payment is not determined based on partnership income, it is a guaranteed payment. Thus, the $15,000 payment is ordinary income to Suzanne.

b. Suzanne's capital account will be removed because she is no longer a partner. The partnership gets no deduction for the payments taxed as Sec. 736(b) payments, but the partnership can deduct the guaranteed payment of $15,000. The remaining partners' bases in the partnership must be increased to reflect the additional amount of liability each is allocated when Suzanne is no longer a partner. pp. C10-19 and C10-20.

C10-42 a. Brian's interest in Sec. 736(b) property is $49,600 (0.40 x $124,000 assets).Amount realized ($41,600 cash + $8,000 liability) $49,600 Minus: Sec. 736(b) payment (49,600) Sec. 736(a) payment $ -0 -

Sec. 736(b) payment $ 49,600 Minus: Basis in partnership ( 40,000) Capital gain $ 9,600

b. Brian's interest in the Sec. 736(b) property is $49,600 (0.40 x $124,000).

Amount realized ($50,000 cash + $8,000 liability) $58,000 Minus: Sec. 736(b) payment ( 49,600) Sec. 736(a) payment $ 8,400

Sec. 736(b) payment $49,600 Minus: Basis in partnership ( 40,000) Capital gain $ 9,600

Brian is taxed on the Sec. 736(a) payment as a guaranteed payment, and the partnership deducts the payment. pp. C10-19 and C10-20.

C10-25

C10-43 a. Amount realized ($65,000 cash + $25,000 liabilities) $90,000Minus: Sec. 736(b) payment (FMV of property interest) ( 90,000)Sec. 736(a) payment $ -0-

Sec. 736(b) payments $90,000 Minus: Basis in partnership ( 75,000) Recognized gain $15,000

The character of the gain is capital because the partnership has no unrealized receivables or substantially appreciated inventory.

b. Amount realized ($75,000 cash + $25,000 liabilities) $100,000Minus: Sec. 736(b) payment (FMV of property interest) ( 90,000)Sec. 736(a) payment $ 10,000

Sec. 736(b) payments $ 90,000 Minus: Basis in partnership ( 75,000) Recognized gain $ 15,000

The character of the gain is capital gain because the partnership has no Sec. 751 assets. The Sec. 736(a) payment is treated as a guaranteed payment because it is determined without reference to partnership income. It is ordinary income to Kim and deductible by the partnership. pp. C10-19 and C10-20.

C10-44 a. The FMV of Jerry's partnership interest is $160,000 (0.40 x $400,000) at the date of his death. His estate will receive payments totaling $250,000 ($220,000 cash + $30,000 release from liabilities) during the two-year period following death. Up to the FMV of his share of the assets ($160,000), the payments are Sec. 736(b) payments. The basis of his partnership interest to his successor-in-interest is its FMV on the date of Jerry's death ($160,000). Accordingly, the first $160,000 of payments is treated as liquidating distributions and will generate no gain. The remaining payments ($90,000) are Sec. 736(a) payments, which are not tied to partnership income and therefore are taxed as guaranteed payments to the successor-in-interest. These payments will be taxed as ordinary income to the successor-in-interest.

b. The partnership gets no deduction for the Sec. 736(b) payments, but it can deduct the Sec. 736(a) payments. Because this was a two-person partnership, the partnership will continue only until the partnership makes the last payment to Jerry's successor-in-interest. At the time the partnership makes the last payment, the partnership will terminate unless a new partner(s) is admitted. pp. C10-19 and C10-20.

C10-45 a. Amount realized ($130,000 cash + $20,000 liabilities) $150,000Minus: Adjusted basis (FMV at date of death) (150,000)

Realized gain $ -0-

C10-26

b. 10% of partnership income is treated as Bruce's successor-in-interest's distributive share in each of the next three years. It is not deductible by the partnership.

c. When the partnership makes the final payment.


C10-46 a. Because the accounts receivable have a basis equal to their FMV and because the building has no depreciation recapture potential, the partnership holds no unrealized receivables. However, the building does have Sec. 1250 gain potential.

John's sales: Each of the two sales (one to Stephen and one to Andrew) is as follows:

TotalAmount realized $222,000a Minus: Adjusted basis ( 166,800)b

Recognized gain $ 55,200a$186,000 + $36,000 release from liabilities b($261,600 x 0.50) + $36,000 share of liabilities

John's total gain from the two sales is $110,400, of which $60,000 is a Sec. 1250 gain subject to the 25% capital gains tax rate, and $50,400 is a capital gain.

The sale of a 60% interest terminates the JAS Partnership. If Andrew and Stephen continue to operate as a partnership, the old partnership makes a deemed contribution of assets to a new partnership and liquidating distribution of interests in the new partnership (NewJAS) to Andrew and Stephen. The NewJAS Partnership must make all necessary elections, such as taxable year and accounting methods. The termination has the following results:

Tax result for Andrew or Stephen continuing:Beginning basis in existing partnership interest ($87,200 + $24,000 liabilities) $111,200 Basis in partnership interest purchased from John ($186,000 + $36,000 liabilities) 222,000 Basis before deemed distribution of NewJAS Partnership interest $333,200

C10-27

Basis in NewJAS Partnership interest after deemed distribution $333,200

When the new partnership is formed, the assets will have carryover bases from the old partnership as follows (the holding periods also carryover).

Cash $160,000 Receivables 100,000 Building 200,000 Land 96,000

b. John's distributions are Sec. 736(b) distributions. For distribution purposes, the partnership holds no Sec. 751 assets. Thus, no Sec. 751 exchange occurs, and John will recognize no gain or loss on the distribution. His basis in each asset is determined as follows:

Beginning basis in partnership interest ($261,600 + $72,000 share of liabilities) $333,600 Minus: Actual cash ( 24,000)

Deemed cash (liability relief) ( 72,000) Receivables ( 60,000)

Basis allocable to land and building $177,600 Minus: Building (120,000)

Land ( 57,600) Ending basis in partnership interest $ -0 -

John holds the following assets after the distribution:

Adjusted Basis FMV

Cash $ 24,000 $ 24,000Receivables 60,000 60,000Building 120,000 180,000Land 57,600 108,000 Total $261,600 $372,000

Notice that the built-in gain on these assets is $110,400 ($372,000 - $261,600). Thus, John’s total gain is the same as in Part a except here the gain is deferred rather than recognized immediately.

The partnership does not terminate and has the following postdistribution balance sheet:

Partnership’s Basis FMVAssets:

Cash $136,000 $136,000Receivables 40,000 40,000Building 80,000 120,000Land 38,400 72,400 Total $294,400 $368,000

C10-28

Liabilities and Capital:Liabilities $120,000 $120,000Capital - Andrew 87,200 124,000 - Stephen 87,200 124,000 Total $294,400 $368,000

Andrew and Stephen each will have an outside basis of $147,200 ($87,200 + $60,000 share of liabilities).pp. C10-12 and C10-18 and C10-22 through C10-24.C10-47 a. Sec. 736(b) property: Cash $ 60,000 Receivables 20,000

Land 100,000 $180,000

The amount realized equals $160,000 cash + $20,000 release from liabilities, which is allocated all to the Sec. 736(b) property.

Amount realized ($160,000 cash + $20,000 liabilities) $180,000 Minus: Adjusted basis of partnership interest ( 120,000)

Recognized gain or loss $ 60,000

The character of the gain is capital gain because the partnership has no Sec. 751 assets or Sec. 1250 property.

b. Amount realized ($160,000 cash and $20,000 liabilities) $180,000

Minus: Adjusted basis of partnership interest ( 120,000) Recognized gain or loss $ 60,000

The character of the gain is capital because the partnership has no Sec. 751 assets or Sec. 1250 property. Thus, in total, the results are the same as in Part a.


C10-48 a. A taxable transaction occurs. The recognized gains for Josh and Diana are determined as follows:

Josh: Amount realized $60,000 Minus: Adjusted basis (40,000) Recognized gain $20,000

Diana: Amount realized $60,000 Minus: Adjusted basis (20,000)

C10-29

Recognized gain $40,000

All or part of the gains might be Sec. 1250 gain if the underlying real property was subject to depreciation.

b. An exchange of a partner's general partnership interest for a limited partnership interest in the same partnership is treated much like a corporate recapitalization and is likely to be nontaxable. pp. C10-20 and C10-21.

C10-30

C10-49 a. No. Only 40% is treated as having changed hands.b. No. Liquidating distributions do not terminate a partnership.c. Yes. Only one member of the partnership continues as owner.d. Yes. The partnership terminates on June 1 of the current year.e. The ABC Partnership terminates on December 30 of the current year. The WXY

Partnership is treated as having continued.f. The WXY Partnership terminates on January 1 of the current year.


C10-50 a. The KL Partnership continues while the MN Partnership terminates.b. The ABC Partnership continues while the CD Partnership terminates.c. The YZ and WX Partnerships both terminate.d. The DE Partnership is a continuation of the DEFG Partnership. The FG

Partnership is a new partnership.e. The HIJK Partnership terminates.

pp. C10-25 and C10-26.

C10-51 Amount realized $100,005a Minus: Adjusted basis ( -0-) Recognized gain $100,005

a$5 cash + release from $100,000 liability.


C10-52 a. The total optional basis adjustment is $20,000 computed as follows:

Cash purchase price $100,000

Minus: Patty’s share of partnership’s basis in asset’s (1/3 x $240,000) ( 80,000)

Optional basis adjustment $ 20,000

b. The partnership recognizes a $60,000 ($220,000 - $160,000) gain.

c. Patty’s share of the gain is $20,000. However, she recognizes none of this gain because of her $20,000 basis adjustment. pp. C10-26 through C10-29.

C10-31

C10-53 a. The ABC Company (an LLC) will be treated as a partnership. Alex will report his one-third share of each income item reported by the LLC.

Ordinary income $10,000 Short-term capital gain 4,000 Long-term capital loss ( 2,000)

The distribution is not taxable because it does not exceed Alex's basis in his ABC Company interest.

b. Beginning basis $40,000 Plus: Share of ordinary income 14,000Minus: Capital loss ( 2,000) Distribution (12,000) Ending basis $40,000

p. C10-30.

C10-54 a. Ordinary income:

Ordinary income before adjustments $ 5,200,000 Minus: Charitable contributions ( 164,000) Plus: Net short-term capital gain 390,300a Ordinary income $5,426,300

a $827,400 STCG - $437,100 LTCL

b. Separately stated items:

Rental loss (passive) $2,000,000


C10-55 a. Ordinary income:

Ordinary income before adjustments $ 700,000 Minus: Net Sec. 1231 loss ( 107,800)a Net loss $ 592,200

aSec. 1231 gains $ 27,000 Minus: Sec. 1231 losses ( 134,800) Net Sec. 1231 loss ($107,800)

C10-32

b. Separately stated items:Passive income $3,000,000 Long-term capital gains 437,600 General business tax credits 43,000


Comprehensive Problems

C10-56 a. Formation of Lifecycle Partnership:

Able, Baker, and Lifecycle Partnership recognize no gain or loss on the transfer of land to the partnership. Lifecycle Partnership takes the following tax basis and book values in the land:

Tax Basis Book Value

Land A $16,000 $30,000Land B 22,000 20,000

The partnership’s tax holding period for the land includes Able’s and Baker’s holding periods prior to the transfers. Able’s beginning basis in his partnership interest is $16,000, and Baker’s beginning basis is $22,000.

b. (1) Partnership ordinary and separately stated items:

2005 2006 2007

Sales $964,000 $990,000 $500,000Minus: Cost of goods sold (450,000) (500,000) (280,000)Gross profit $514,000 $490,000 $220,000Minus: Depreciation ( 94,000) (150,000) (115,000) Interest expense (140,000) (130,000) (125,000) Salary expense (guaranteed payment) -0- ( 12,000) -0- Operating expenses ( 30,000) ( 40,000) ( 60,000)Partnership ordinary income (loss) $250,000 $158,000 ($

80,000 )

Separately stated items: Dividend income $ -0- $ 2,000 $ -0- STCG; LTCG -0- 1,000 3,000 Tax-exempt interest -0- 1,500 -0- Charitable contribution -0- ( 500) -0-

Qualified production activities income $250,000 $158,000 None

C10-33

reported to partners

(2) Book capital accounts: Able Baker

Contribution of land (FMV) $ 30,000 $ 20,000Plus: Partnership ordinary income 150,000 100,000 Balance 12/31/05 $180,000 $120,000Plus: Partnership ordinary income 94,800 63,200 Short-term capital gain 600 400 Dividend income 1,200 800 Tax-exempt interest 900 600Minus: Charitable contribution ( 300) ( 200) Distributions to partners ( 42,000) ( 28,000)Balance 12/31/06 $235,200 $156,800Plus: Long-term capital gain 1,800 1,200Minus: Partnership ordinary loss ( 48,000) ( 32,000)Balance 12/31/07 $189,000 $126,000

(3) Basis in partnership interests:

Able Baker

Contribution of land (tax basis) $ 16,000 $ 22,000Plus: Increase in partnership liabilities 1,200,000 800,000 Partnership ordinary income 150,000 100,000 Balance 12/31/05 $1,366,000 $922,000Plus: Partnership ordinary income 94,800 63,200 Short-term capital gain 600 400 Dividend income 1,200 800 Tax-exempt interest 900 600Minus: Charitable contribution ( 300) ( 200) Distributions to partners ( 42,000) ( 28,000) Decrease in partnership liabilities ( 60,000) ( 40,000)Balance 12/31/06 $1,361,200 $918,800Plus: Long-term capital gain 1,800 1,200Minus: Partnership loss ( 48,000) ( 32,000) Decrease in partnership liabilities ( 18,000) ( 12,000)Balance 12/31/07 $1,297,000 $876,000

C10-34

c. (1) Results of asset sales:

Sale of assets for books:Total Able Baker

Selling price $1,366,000Minus: Total book value (1,191,000)Book gain $ 175,000 $ 105,000 $70,000

Sale of assets for tax:Total Able Baker

Selling price $1,366,000Minus: Total adjusted basis (1,179,000)Tax gain $ 187,000

Precontribution gain (loss) $ 12,000 $ 14,000 ($ 2,000)Postcontribution gain 175,000 105,000 70,000 Total $ 187,000 $ 119,000 $68,000

(2) Book capital accounts:Able Baker

Balance 12/31/07 $ 189,000 $126,000Plus: Book gain on asset sales 105,000 70,000 Balance before liquidating distributions $ 294,000 $196,000

(3) Basis in partnership interests:Able Baker

Basis 12/31/07 $1,297,000 $876,000Plus: Tax gain (loss) on asset sales: Precontribution 14,000 ( 2,000) Postcontribution 105,000 70,000Minus: Decrease in partnership liabilities (1,122,000) (748,000)Basis before liquidating distributions $ 294,000 $196,000

(4) Upon liquidation, Able receives $294,000, and Baker receives $196,000, which are the amounts of their book capital accounts. Able, Baker, and Lifecycle Partnership recognize no gain or loss on the liquidating distributions. The partners have no basis in the partnership because it has terminated.

C10-35

C10-57 WARNING. Be aware that this problem is very complex because it combines a number of concepts from within this chapter. Students are likely to need assistance in completing it.

a. Anne’s tax results:Cash payment $220,000Liability relief 31,200

Total payment $251,200

Sec. 736(b) payment (52% of asset FMV) $222,560 Sec. 736(a) payment [Total - 736(b)] $ 28,640

This Sec. 736(a) payment of $28,640 is a guaranteed payment (ordinary income) to Anne.

Analysis of Sec. 736(b) payment ($222,560):First separate out the Sec. 751 portion of the Sec. 736(b) payment. Assume the partnership first distributed her share of these assets to Anne and then purchased her share of these assets for their FMV.

Deemed distribution of Sec. 751 assets to Anne: Anne’s basis before the Sec. 751 transaction $120,000 Basis of Sec. 751 assets deemed distributed 12,480 Anne’s basis after the Sec. 751 transaction $107,520

Deemed sale to the partnership at FMV: FMV of 52% of Sec. 751 assets [0.52 x ($64,000 + $24,000)] $ 45,760 Adjusted basis of 52% of Sec. 751 assets 12,480 Ordinary income Anne must recognize $ 33,280Analysis of remaining Sec. 736(b) payment ($222,560 - $45,760): Anne’s basis after Sec. 751 transaction $107,520 Cash distribution ($222,560 - $45,760) 176,800 Cash distribution in excess of basis (capital gain) $ 69,280

Summary: Anne must recognize a guaranteed payment of $28,640, other ordinary income of $33,280, and capital gain of $69,280.

Partnership tax results:

Deduct the guaranteed payment of $28,640 paid to Anne. (In addition, the partnership would increase its basis in its accounts receivable to reflect the fact that some receivables were deemed purchased from Anne for $33,280.)

C10-36

b. Anne’s tax results: Application of step 1 yields the following gain on Anne’s sale of her partnership

interest:Amount realized on sale ($220,000 cash + $31,200 liabilities) $251,200

Minus: Adjusted basis of partnership interest ( 120,000) Total gain realized $131,200

Application of step 2 yields the following allocation to Sec. 751 property: Partnership gain on receivable = $64,000; Anne’s share = $64,000 x 0.52 = $33,280.

Thus, on the sale of her partnership interest, Anne recognizes ordinary income of $9,000.


Total gain realized $131,200Minus: Allocation to ordinary income ( 33,280)Capital gain recognized $ 97,920

In summary, on the sale of her partnership interest, Anne recognizes $33,280 of ordinary income and a $97,200 capital gain.

Partnership tax results:

ABC Partnership terminates because more than 50% of the capital and profits interest of the partnership has been sold. The new partnership will elect a tax year and make all necessary accounting elections. The assets of old ABC will be assumed contributed to new ABC. Accordingly, the basis and holding period of the assets will be unchanged by the termination and formation of a new partnership.


C10-37

Tax Strategy Problem

C10-58 a. The three options are analyzed below.

Option 1 (disproportionate distribution of cash)

(1) (2) (3) (4) (5)Daniel’s Daniel’s

Beginning Interest Interest FictionalPartnership Before After Proportionate

Amount Distribution Distribution Distribution Actual Difference(1/3) (-0-) (3)=(1)-(2) Distribution (5)=(4)-(3)

Sec. 751 Assets:

Receivables $ 60,000 $20,000 $ -0 - $20,000 $ -0 - ($20,000)

Other Assets:

Cash $ 60,000 $20,000 $ -0- $20,000 $60,000 $40,000Land 60,000 20,000 -0 - 20,000 -0 - (20,000)Total $120,000 $40,000 $ -0 - $40,000 $60,000 $20,000

Deemed distribution of receivables (adjusted basis) $ -0-

Daniel’s deemed sale of receivables for cash: Amount realized $20,000 Minus: Adjusted basis of receivables ( -0 - ) Daniel’s recognized gain (ordinary income) $20,000

Daniel’s basis in partnership interest: Beginning basis $30,000 Minus: Deemed distribution of receivables ( -0-) Distribution of remaining cash ($60,000 - $20,000) (40,000) Ending basis (but not less than zero) $ -0-

Because the $40,000 remaining cash distribution exceeds Daniel’s partnership basis ($30,000), he recognizes a $10,000 capital gain.

Summary of results:

Current ordinary income $20,000 Current capital gain 10,000

Option 2 (proportionate distribution of assets )

C10-38

Daniel receives the following assets: Basis FMV

Cash $20,000 $20,000 Receivables -0- 20,000 Land A 10,000 20,000 Total $30,000 $60,000

Because Daniel’s partnership basis exceeds the amount of cash distributed, he recognizes no gain on the distribution. His partnership basis is $10,000 after reduction for the cash distribution. He takes a zero basis in the receivables and a $10,000 basis in Land A. Daniel recognizes gain or income when he sells the assets.

Summary of results:

Deferred ordinary income $20,000 Deferred capital gain 10,000

Option 3 (sale of partnership interest )

The results of the sale are determined as follows:

Application of step 1 yields the following gain on Daniel’s sale of his partnership interest:

Amount realized on sale $60,000 Minus: Adjusted basis of partnership interest ( 30,000) Total gain realized $30,000

Application of step 2 yields the following allocation of Sec. 751 property:

PartnershipDeemed Sale of Assets Gain (Loss) Daniel’s Share

(1/3)

Receivables $60,000 $20,000Land A 10,000 3,333Land B 10,000 3,333Land C 10,000 3,333

Thus, on the sale of his partnership interest, Daniel recognizes ordinary income of $20,000.


C10-39

Total gain realized $30,000Minus: Allocation to ordinary income ( 20,000)Capital gain recognized $10,000

Summary of results:

Current ordinary of income $20,000 Current capital gain 10,000

b. Options 1 and 3 yield the same results: current gain recognition, a disadvantage, and current receipt of cash, an advantage. Conversely, Option 2 defers gain recognition and cash collection until Daniel collects on the receivables and sells the land. Thus, if Daniel has immediate need for cash, he should select Option 1 or Option 3. If he does not have immediate cash needs, he should consider Option 2.

Case Study Problems

C10-59 The points presented below are the major ones that should be covered in the memorandum to the two brothers. This information should be incorporated by the student into a properly structured memorandum using good form with proper grammar and punctuation.

Option 1: Michael’s purchase of interest.Amount realized = ($120,000 cash + $330,000 installment note + $200,000 liabilities) $650,000 Minus: Adjusted basis ( 300,000) Realized gain (LTCG) $350,000

Because the sale is an installment sale, Mark would recognize his gain on an installment basis. In the first year, he would recognize gain of $93,333, calculated as follows:

Gain realized Contract price

x Installment =$350,000 $450,000

x $120,000 = $93,333

C10-40

At a 15% maximum rate, the gain would result in taxes of $14,000, leaving Mark $106,000 ($120,000 - $14,000) of after-tax proceeds for the first year. In each of the following three years, he would recognize gain of $85,556, calculated as follows:

Gain realized x Installment = $350,000 $450,000

x $110,000 = $85,556Contract price

At a 15% maximum rate each year, the gain would result in taxes of $12,833, leaving Mark $97,167 ($110,000 - $12,833) of after-tax proceeds each year. Total proceeds for Mark for the four years are $450,000, and total taxes are $52,500 ($350,000 x 0.15). Thus, Mark’s total after-tax proceeds are $397,500 ($450,000 - $52,500).

Note that Michael is using after-tax dollars to pay Mark each year. Because this transaction is an installment sale between related parties, Mark would have to recognize any unrecognized gain if Michael later resold this partnership interest to another partner.

If no other partner is admitted to the partnership, the partnership will terminate when Michael buys Mark's interest. Michael would receive all the partnership assets in a liquidating distribution. The basis of the partnership assets would be changed as follows:

Michael's partnership interest basis $ 300,000 Basis of partnership interest purchased from Mark ($450,000

installment sale + $200,000 share of liabilities) 650,000

Deemed cash contributed by Michael because he assumes the partnership's liability 400,000

Balance before distributions $1,350,000 Minus: Cash and deemed cash distributed ( 600,000) Accounts receivable ( 90,000) Remaining basis allocable to land $ 660,000

Notice that this basis adjustment has greatly decreased the potential capital gain that Michael will recognize on the subsequent sale of the land investment.

Option 2A: Retirement from the partnership for $150,000 plus 50% of partnership profits for the next three years.

Assuming the brothers correctly project income to be approximately $200,000 for each of the next three years, Mark will receive a total of $450,000 over the four years. His gain will be $350,000, calculated as follows:

Amount realized $650,000 Minus: Adjusted basis (300,000) Realized gain $350,000

In the initial year, Mark will receive $150,000 cash that he will treat as a normal partnership distribution that reduces his basis. In future years, he will be allocated a 50% share

C10-41

of the partnership earnings (with the character they have at the partnership level), which will increase his basis. He also will receive a distribution from the partnership equal to the amount of income he recognizes, and this distribution will reduce his basis by the same amount the income recognition increases it. Accordingly, he will not be taxed on the distribution. After the final payment, Mark no longer will be a partner, so his final payment will include the deemed cash from the release of his liability share. Mark will report approximately $300,000 of income under this method, and the character of the income is determined at the partnership level. Because the main source of partnership income is the sale of investment land, most of the gain Mark will recognize also will be capital gain.

Assuming all partnership income is capital gain for the three years, each year Mark will be allocated $100,000 in capital gains and will pay taxes of $15,000 so that he has after-tax income of $85,000. The first year's payment is tax-free so he has after-tax receipts of $150,000 for the first year. Cash received over the four years is $450,000, and he will pay taxes of $45,000, leaving after-tax receipts of $405,000 ($450,000 - $45,000).

Michael's share of income for the three years is reduced by the income allocated to Mark. The partnership will continue in operation under this option until Mark receives his final payment from the partnership.

Option 2B: Retirement from the partnership for $150,000 cash plus $100,000 guaranteed payment for three years.

In this option, as in the preceding one, Mark's first year payment is simply a distribution from the partnership, which reduces his basis in the partnership interest. Likewise, in the final year Mark will be deemed to receive cash equal to the share of liabilities that he no longer will be liable for. Assuming the liabilities do not change, these two distributions will have the following results:

Beginning basis $300,000 Minus: Year one cash (150,000)

Basis after cash distribution 150,000

Minus: Year four liability release (200,000) Basis (but not less than zero) $ -0 -

Mark will recognize a $50,000 long-term capital gain in year four. At a 15% maximum tax rate, he will owe taxes of $7,500. Because this gain is caused by the deemed cash distribution from the liability release, Mark is not receiving any cash to pay these taxes. The $100,000 guaranteed payment will be taxed as ordinary income in each of the next three years. Assuming Mark’s ordinary tax rate is 35% each year, he will pay $35,000 in taxes for an after-tax amount of $65,000. Over the four years, Mark will receive cash of $450,000 and will pay taxes of $112,500 [($35,000 x 3) + $7,500] for after-tax receipts of $337,500 ($450,000 - $112,500).Option 3: Outside purchase of interest.

C10-42

Under this option, Mark will report a $350,000 long-term capital gain determined as follows:

Amount realized ($450,000 cash + $200,000 liabilities) $650,000 Minus: Adjusted basis (300,000) Realized gain (LTCG) $350,000

At a 15% maximum tax rate, the gain would result in taxes of $52,500, leaving Mark $397,500 ($450,000 cash - $52,500 taxes) of after-tax proceeds. (Mark receives the same after-tax benefits that he receives if Michael is the purchaser.)

Although this option technically terminates the partnership because of the 50% sale, the partnership nevertheless continues as a new partnership. This results contrasts with Option 1, where the partnership goes out of existence. If Michael wants to continue the partnership form of conducting the investment, he should consider this option. Also, unless the partnership has made a Sec. 754 election, no increased basis for the investment land occurs under this option.

Summary: Mark's after-tax receipts are highest for Option 2A -- the retirement from the partnership for $150,000 cash plus a 50% distributive share for the next three years. The memorandum should emphasize to Mark that this option is the only sales arrangement under which uncertainty exists about what he will receive. If land sales are unusually slow for the three-year payout period, Mark may receive little more than the $150,000 first year payment.

Accordingly, students may want to recommend the sale to John or the sale to Michael depending on whether or not Michael wants to continue as a sole proprietor or as John Watson's partner.

C10-60 Relevant facts:

Miguel wrote an opinion letter used in the prospectus of a tax shelter and prepared the first year tax-return. The tax shelter has grossly overvalued assets, and other revenues and expenses were falsified. The investors and the IRS do not know about the overvalued assets nor about the falsified revenues and expenses.

The AICPA bylaws designate the Accounting and Review Services Committee as the senior technical committee authorized to issue pronouncements in connection with the unaudited financial statements or other unaudited financial information of a nonpublic entity. The Committee promulgates Statements on Standards for Accounting and Review Services (SSARSs) and is authorized to promulgate attestation standards in its area of responsibility. Miguel must follow these standards in conducting the review for Mr. Azul. The information contained in the financial statements must conform with Generally Accepted Accounting Principles (GAAP) or, if applicable, with another comprehensive basis of accounting. The standard review report contains three paragraphs. The report does not have a title and is usually addressed to the owner or party who engaged the accountant.

C10-43

The first paragraph of the review report states which financial statements have been reviewed and that the review was conducted in accordance with SSARSs issued by the AICPA. It also states that all information contained in the review report is the representation of management or the owners of the company. The second paragraph of the review report describes what occurs during a review. A review consists principally of inquiries of company personnel and analytical procedures applied to financial data. It also states that a review is substantially less in scope than an examination in accordance with Generally Accepted Auditing Standards (GAAS). No opinion regarding the financial statements taken as a whole is expressed in a review report. The last paragraph of the review report states that the accountant is not aware of any material modifications that should be made to the accompanying financial statements for them to conform with GAAP. If GAAP is not followed, the departure from GAAP, including its effects, should be disclosed in a separate paragraph of the review report. The conclusion paragraphs of the review report should use the phrase "with the exception of" or "except for." The accountant is not required to determine the effects of the departure. If management or the owners have not determined the effects of the departure, the accountant should state that a determination has not been made.

Miguel apparently should have learned more about the cattle feeding operation before taking on the client. His work with local ranchers obviously was not enough experience to serve Mr. Azul's business properly. He should have immediately questioned the size of the tax advantages in the prospectus and not taken Mr. Azul's word that they were fairly usual for the industry. Miguel should have looked into why the asset values seemed high during the audit. Miguel also should have brought in a specialist to evaluate the fairness of the asset values. Lastly, Miguel did take the correct action by investigating why the numbers looked so good from Mr. Azul while the local gossip around town was that the cattle feeding operations were about to fold. Miguel could have avoided the problems he encountered by learning more about the industry and using better client acceptance techniques. Miguel violated the AICPA's Code of Professional Conduct because he failed to exercise due care while conducting the audit. He should have brought in a specialist with expertise concerning cattle feeding operations.

The following additional items should be addressed regarding the valuation and other issues:

Ethical issues:

1. Should Miguel inform the limited partners about the problems?2. Should Miguel inform the IRS about the problems?3. Is Miguel at fault for not investigating the partnership, or does all the fault lie with Mr.

Azul?

C10-44

Possible alternatives:

1. Prepare the return and say nothing.2. Refuse to prepare the return and say nothing.3. Refuse to prepare the return and tell only the investors.4. Refuse to prepare the return and tell only the IRS.5. Refuse to prepare the return and tell both the investors and the IRS.

Questions about the ethics of the alternatives:

1. What are the possible consequences to Miguel, to the investors, to the tax authorities, and to Mr. Azul of each alternative?

2. Which alternative would provide the greatest benefit to the largest number of people?3. Which alternative would be most fair to the investors? To the tax authorities? To

Miguel?4. Does Miguel have the right to report the tax shelter to the IRS?5. Did Miguel meet his obligations under the AICPA's Statements on Standards for Tax

Services, No. 1 and No. 3?6. Does Miguel have a potential problem with the IRS under the tax return preparer rules

(see Chapter C15).7. Does Miguel have a potential problem with Treasury Department Circular 230 (see

Chapter C15).8. Should the federal government be able to require tax preparers to investigate what their

clients tell them?

Tax Research Problems

C10-61Tax Results:

Revenue Ruling 84-111, 1984-2 C.B. 88, requires that the tax results for incorporating a partnership must follow the results generated by the form of the transaction. Accordingly, the formation of the corporation is tax free under Sec. 351 and is tax free to both the transferee corporation and the transferor partnership. The liquidation of the partnership is a liquidating distribution and is subject to the rules of Sec. 731, and the ex-partner’s basis in the new corporation’s stock is governed by Sec. 732.

Asset and Liability Transfer:

Each asset will take a carryover basis from the partnership transferor, so the total basis of corporate assets will be $460,000. The partnership, as the sole shareholder, has a basis in its corporate stock equal to the carryover basis of its assets ($460,000) reduced by the partnership's liability assumed by the corporation ($100,000), or $360,000.

C10-45

Partnership Liquidation:

Partner Arnie Becky Clay Total

Basis before transferMinus: liab. reductionBasis before distributionBasis in stock

$80,000 (33,333) $46,667 $46,667

$120,000 ( 33,333)

$ 86,667 $ 86,667

$160,000 ( 33,334)

$126,666 $126,666

$360,000 (100,000) $260,000

Neither the partner nor the partnership recognizes gain or loss on the asset and liability transfer.

Financial Accounting Results:

First, the partnership’s assets would be appraised and written up to reflect the current FMV of each asset. All gains and losses would be recognized for financial accounting purposes and allocated among the three partners according to their interest in gains and losses (equally). Each partner’s capital account would be increased by his or her share of the $110,000 gain that would result. See Reg. Sec. 1.704-1(b)(2)(iv)(f).

The entries on the partnership’s financial accounting books to record the gains would be as follows:

Inventory 50,000 Land 60,000

Arnie’s capital 36,667

Becky’s capital 36,667 Clay’s capital 36,666

Recording the transfer of assets and liabilities to the new corporation in exchange for the stock of the new corporation would require the following entries on the partnership’s books (assuming the corporation opens a new set of books instead of continuing to use the partnership books):

Investment in ABC Corp. stock 500,000 Liabilities 100,000

Cash 50,000Accounts receivable 55,000Inventory 200,000Land 295,000

To distribute the stock and close the partnership’s books would require the final entry:

Arnie’s capital 166,667 Becky’s capital 166,667 Clay’s capital 166,666

Investment in ABC Corp. stock 500,000

C10-46

To establish the new ABC Corporation, the corporation would record the following entry:

Cash 50,000 Accounts receivable 55,000 Inventory 200,000 Land 295,000

Liabilities 100,000 Common stock 500,000

Assets would be recorded on the corporation’s books at their FMV, so the total basis of the assets for financial accounting purposes would be $600,000 (APB 29).

C10-62 Della's share of property:

Sec. 736(b) property - Cash $16,667 Receivables 10,000

Equipment 16,667 Building 33,333 Land 13,333 Goodwill 7,000 Total $97,000

All payments based on partnership income also will be Sec. 736(a) payments taxed as distributive shares.

Total fixed payments = $20,000 x 5 = $100,000Sec. 736(b) payments as portion of fixed payments: $97,000/$100,000 = 97%

Allocation of payments for years 1-5:

$20,000 payment: Sec. 736(b) (97%) $19,400a

Sec. 736(a) (3%) 600 guaranteed payment that is taxed as ordinary income

5% of partnership income: Sec. 736(a) 5,000 distributive share Total $25,000

a Sec. 736(b) payment $19,400 Minus: One-fifth basis in partnership interest (14,000) Capital gain $ 5,400

C10-47

Taxation of the partnership is not affected by the payments made for Della's interest in property. It takes no deduction and does not reduce the continuing partners' distributive share of the payments made for the interest in property. The small guaranteed payment each year is deductible by the partnership. The $5,000 distributive share results in a smaller distributive share for each of the remaining partners.

C10-63 Transfer of an interest in a partnership by gift does not terminate the partnership tax year for the donor. (Little authority exists to suggest how a part-sale, part-gift will be treated, but most practitioners agree that it will be treated the same as a gift transfer for this purpose.) However, the donor must recognize income from the partnership up to the date of the gift. Because the partnership tax year does not close on the date of the gift, the income is included in the partner's tax year that includes the normal partnership year-end (Reg. Sec. 1.706-1(c)(5)). On his tax return for the tax year ending June 30 of the current year, Pedro will report partnership income from the tax year that ended on December 31 of last year. He will report partnership income earned between January 1 of the current year and his June 15 gift on his tax return for the tax year that ends on the next June 30th. Juan and the American Red Cross must report all partnership income earned after June 14 of the current year.

Transfer of a majority interest by gift does not constitute a sale or exchange that can terminate a partnership (Reg. Sec. 1.708-1(b)(1)(ii)). Although part-sale, part-gift transactions like this one are not clearly covered by the Treasury Regulation, the sale portion of the transaction does not appear to be a majority interest.

The transfer to Juan is a part-sale and part-gift. See Victor P. Diedrich v. CIR, 47 AFTR 2d 81-977, 81-1 USTC ¶9249 (8th Cir., 1981). The 30% interest transferred to Juan is considered sold to him because the liability is one-half of the FMV ($50,000 liability $100,000 FMV of partnership interest transferred). Pedro must recognize gain on the sale of a 15% interest of $30,000 ($50,000 liabilities transferred - $20,000 basis). The remaining 15% interest is a gift to Juan. Pedro must report the gift portion for gift tax purposes at its FMV of $50,000.

The transfer to the American Red Cross also is a part-sale and part-gift but the allocation of basis to the sale and gift differ from the allocation above (Rev. Rul. 75-194, 1975-1 C.B. 80). Only a pro rata portion of the basis is allocated to the sale transaction, so basis of $10,000 ([$50,000 liability $100,000 FMV] x $20,000 basis) is allocated to the sale, and the remaining $10,000 of basis is allocated to the gift portion of the transaction. On the sale transaction, Pedro must recognize gain of $40,000 ($50,000 liability transferred - $10,000 basis allocated to sale transaction). Pedro makes a charitable contribution of the remaining partnership interest, which has a basis of $10,000 and FMV of $50,000. The contribution is eligible for a charitable contribution deduction.

C10-45

“What Would You Do In This Situation?” Solution

Ch. C10, p. C10-4. A New Kind of Tax-Free Exchange?

You probably should tell Betty and Thelma that the transaction will not be tax-free. First, Sec. 704 requires that the contributing partner must recognize any remaining precontribution gain (up to the amount of precontribution gain that would be recognized if the property were sold on the distribution date) when contributed property is distributed to another partner within five years of the contribution. Therefore, both Betty and Thelma would recognize gain when the properties were distributed unless the partnership held the property for more than five years.

Second, Treasury Regulations might prevent tax-free treatment even if the partnership held the property for more than five years. During 1995, the Treasury Department issued regulations to stop the abusive use of the partnership form to get tax treatment that is not available otherwise. These regulations require that all transactions be entered into for a substantial business purpose, and Thelma and Betty have no apparent business purpose for contributing these properties to the partnership or for distributing the properties from the partnership. Further, the regulations provide that if the partnership is used to frustrate any IRC provision, the IRS can treat the partnership as an aggregate of the partners. Because the exchange contemplated by Thelma and Betty clearly does not qualify as a tax-free like-kind exchange if the exchange were made directly between the two women, it is unlikely that they can make it tax-free by routing the exchange through their partnership.

C10-46

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