Liquidating Payments That Trigger Section...
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Liquidating Payments That Trigger Section 736(a) Sec. 736 Liquidating Payments Sec. 736 divides all such liquidating payments into two categories: 1) Payments in exchange for the FMV of php. property--Sec. 736(b). 2) Payments in excess of FMV of php. property--Sec. 736(a). • Distributive Share (736(a)(1)) • Guaranteed Payment (736(a)(2) 15-43
Transcript of Liquidating Payments That Trigger Section...
Liquidating Payments That Trigger Section
736(a)
Sec. 736 Liquidating Payments
Sec. 736 divides all such liquidating payments into two categories:
1) Payments in exchange for the FMV of php. property--Sec. 736(b).
2) Payments in excess of FMV of php. property--Sec. 736(a).• Distributive Share (736(a)(1))• Guaranteed Payment (736(a)(2)
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Special Rule for
Service Phps.
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Amounts paid for
Unstated Goodwill, and “Unrealized Receivables”
are treated as NOT made in exchange for an interest in partnership property
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Example 15-27Service Partnership
Partner'sBasis FMV Outside
Cash 26,000$ 26,000$ BasisAccounts Receivable -$ 26,000$
Total Assets 26,000$ 52,000$
Agnes (50%) 13,000$ 26,000$ 13,000$ Bob (25%) 6,500$ 13,000$ 6,500$ Cao (25%) 6,500$ 13,000$ 6,500$
Total Equity 26,000$ 52,000$
ABC Partnership January 1, 2005
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ABC Partnership
Distibute $26,000 cash to Agnes in liquidation
$26,000 Cash To Agnes:
$13,000 IRC sec. 736(b) Pyt. –tax free return of O.B.
$13,000 IRC sec. 736(a)(2) Pyt. –guaranteed payment
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If not a Service Partnership, then all $26,000 is IRC sec. 736(b) Pyt.
$13,000 O.I. per Sec. 751
$13,000 return of capital (IRC sec. 731)
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Partner'sBasis FMV Outside
Cash 26,000$ 26,000$ BasisAccounts Receivable -$ 26,000$
Total Assets 26,000$ 52,000$
Agnes (50%) 13,000$ 26,000$ 13,000$ Bob (25%) 6,500$ 13,000$ 6,500$ Cao (25%) 6,500$ 13,000$ 6,500$
Total Equity 26,000$ 52,000$
ABC Partnership January 1, 2005
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ABC Partnership
Example 15-28Service Partnership
Bob is liquidated for $20,000 cash.
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$20,000 To Bob:
$6,500 IRC sec. 736(b) Pyt. –tax free return of O.B.
$13,500 IRC sec. 736(a)(2) Pyt. –guaranteed payment ($6,500 for U/R and $6,000 premium)
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Tax Consequences to Bob:
$13,500 ordinary income per IRC sec. 736(a) (for the U/R)
Continuing Partners:
Deduction of $13,500 as a guaranteed payment
If not a Service Partnership, then:
$13,000 is IRC sec. 736(b) Pyt. –$6,500 of OI (IRC sec. 751) and $6,500 tax free (IRC sec. 731)
$7,000 is IRC sec. 736(a)(2) guaranteed payment (a premium)
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Perspective of Continuing Partners in a
Service Partnership.
Sec. 736(a) payments are desirable so unstated goodwill and unrealized receivables are desirable
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Perspective of Retired Partner (or Successor of
Deceased Partner)
Sec. 736(a) payments are undesirable so unstated goodwill and unrealized receivables are undesirable
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Example 15-29Service Partnership
Bob is liquidated for $20,000 cash
but Bob’s share of goodwill
is stated at $7,000.
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ABC Prof. Service Partnership Partner’s Outside Basis
Basis FMV
Cash $26,000 $26,000
Accounts Rec. $0 $26,000
Stated Goodwill $0 $28,000
Total Assets $26,000 $80,000
Agnes (50%) $13,000 $40,000 $13,000
Bob (25%) $ 6,500 $20,000 $ 6,500
Cao (25%) $ 6.500 $20,000 $ 6,500
Total Debt + Capital
$26,000 $80,000
$20,000 To Bob:
$13,500 IRC sec. 736(b) Pyt. –capital gain of $7,000 (IRC sec. 731)
$6,500 IRC sec. 736(a)(2) Pyt. –guaranteed payment for U/R
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Summary of Tax Consequences to Bob:
• $7,000 of capital gain per IRC secs. 736(b) and 731(a).
• $6,500 ordinary income per IRC sec. 736(a)(2) (for the U/R)
Compare $13,500 guaranteed payment if unstated goodwill
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Distribution versus
Saleand Buy/Sell
LanguageDistributee partner may
prefer sale 19
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Self-Employment Tax Exception for
Payments--for Life--to Retired Partners
(Reg. 1.1402(a)-17).
See PLR 20040305620
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IRC sec. 707(c) guaranteed
payments for services are NOT
NII (whether SE income or not)
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Reg. sec. 1.1402(a)-17 payments for services escape both:
SE Tax
and
Net Investment Income Tax(per 1411 prop. regs.)
Allocation of Installment Payments
Between Sec. 736(a) and (b).
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The Sec. 736 regulations were last updated in 1965 and thus do not include the 1993 Act changes which limit the applicability of Sec 736(b)(2) to service partnerships.
Example 15-31
• Partner A (service partner) retires.
• Partner A receives payments totaling $30,000:
$ 9,000 Year 1 (+ $1,000 of debt relief)$10,000 Year 2$10,000 Year 3
• No stated goodwill25
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Assets:
Tax Basis FMV Outside
BasisCash $13,000 $13,000Unrealized Rec. $0 $30,000Cap. & §1231 $20,000 $23,000
Total Assets $33,000 $66,000Liabilities: $3,000 $3,000Capital:
A $10,000 $21,000 $11,000B $10,000 $21,000 $11,000C $10,000 $21,000 $11,000
Debt + Equity $33,000 $66,000
Hypothetical
• If all $30,000 were paid in Year 1:
12,000 736(b) Pyt for Property (A’s Cap. Gain = $1,000)
18,000 736(a)(2) Guaranteed Pyt(ordinary income)
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(40%)
(60%)
Unless Agreed Otherwise
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Yr Pyt. Tax FreeO.B.
§731Gain
Guart.Pyt.
1 $10,000 4,000 0 6,000
§736(b) §736(a)(2)
Unless Agreed Otherwise
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Yr Pyt. Tax FreeO.B.
§731Gain
Guart.Pyt.
1 $10,000 4,000 0 6,0002 $10,000 4,000 0 6,000
§736(b) §736(a)(2)
Unless Agreed Otherwise
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Yr Pyt. Tax FreeO.B.
§731Gain
Guart.Pyt.
1 $10,000 4,000 0 6,0002 $10,000 4,000 0 6,0003 $10,000 3,000 1,000 6,000
§736(b) §736(a)(2)
How reported on Form 1065 K-1?
31How reported on Form 1065 K-1?
K-1 Reporting Each Year:
$6,000 Box 4 Guaranteed Pyt.
$4,000 Box 19 Distribution
Ptr A Option
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Yr Pyt. Tax FreeO.B.
§731Gain
Guart.Pyt.
1 $10,000 3,667 333 6,0002 $10,000 3,667 333 6,0003 $10,000 3,667 333 6,000
§736(b) §736(a)(2)
Example 15-32
Same as Example 15-31 except the agreement provides for payments equal to a percentage of annual income.
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Unless Agreed Otherwise
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Yr Pyt. Tax FreeO.B.
§731Gain
Dist.Share
1 $10,000 10,000 0 0
§736(b) §736(a)(1)
Unless Agreed Otherwise
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Yr Pyt. Tax FreeO.B.
§731Gain
Dist.Share
1 $10,000 10,000 0 02 $10,000 1,000 1,000 8,000
§736(b) §736(a)(1)
Unless Agreed Otherwise
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Yr Pyt. Tax FreeO.B.
§731Gain
Dist.Share
1 $10,000 10,000 0 02 $10,000 1,000 1,000 8,0003 $10,000 0 0 10,000
§736(b) §736(a)(1)
How reported on Form 1065 K-1?
37How reported on Form 1065 K-1?
K-1 Year 1:
10,000 Box 19 Distribution
K-1 Year 2:
2,000 Box 19 Distribution8,000 Box 1 Ordinary Income
K-1 Year 3:
10,000 Box 1 Ordinary Income
Example 15-33
Same as Example 15-31 except the partnership has stated goodwill of $9,000
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Assets:Tax Basis FMV Outside
Basis
Cash $13,000 $13,000Unrealized Rec. $0 $30,000Cap. & §1231 $20,000 $23,000St. Goodwill $0 $9,000
Total Assets $33,000 $75,000Liabilities: $3,000 $3,000Capital:
A $10,000 $24,000 $11,000B $10,000 $24,000 $11,000C $10,000 $24,000 $11,000
Debt + Equity $33,000 $75,000
• If all $30,000 were paid in Year 1:
15,000 736(b) Pyt for Property (A’s Gain = $4,000)
15,000 736(a)(2) Guaranteed Pyt(ordinary income)
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(50%)
(50%)
Unless Agreed Otherwise
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Yr Pyt. Tax FreeO.B.
§731Gain
Guart.Pyt.
1 $10,000 5,000 0 5,000
§736(b) §736(a)(2)
Unless Agreed Otherwise
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Yr Pyt. Tax FreeO.B.
§731Gain
Guart.Pyt.
1 $10,000 5,000 0 5,0002 $10,000 5,000 0 5,000
§736(b) §736(a)(2)
Unless Agreed Otherwise
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Yr Pyt. Tax FreeO.B.
§731Gain
Guart.Pyt.
1 $10,000 5,000 0 5,0002 $10,000 5,000 0 5,0003 $10,000 1,000 4,000 5,000
§736(b) §736(a)(2)
IRC sec. 736
and
Net Investment Income Tax
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Lengthy Discussion of IRC sec. 736 in Prop. Reg. Preamble
Zero discussion in text of prop. regs.
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IRC sec. 736(b)/731 Payments
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Distribution gains are generally treated as the sale or exchange of partnership property so generally Category Three NII.
Discussed in prop. reg. 1.1411-7 preamble but not in text of regs.
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Apply reg. sec. 1.1411-7 to reduce NII based upon IRC sec. 1411(c)(4) – so
no NII on nonpassiveactivity gain.
For a passive partner, the entire gain is NII
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For IRC sec. 736(b) purposes, payments spread over several years, NII exposure
is determined in the year of the liquidation
IRC sec. 736(a) Payments
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(a)(1) Distributive Share
(a)(2) Guaranteed Payment
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Payments under section 736(a)(1) (distributive share) are:
• In a manner consistent with the item's chapter 1 character and treatment. For example:
• Interest income on working capital is NII
• Nonpassive business income is not NII
See reg. sec. 1.469 (e)(2)(iii)(B)(1)
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Payments under section 736(a)(2) (guaranteed pyts.) are:
• For services (not NII)
• For the use of capital (NII unless SE tax), or
• Section 736(a) Property--U/R and Unstated Goodwill. (no NII if nonpassive -- determined in year of liquidation)
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IRC sec. 736(a)(1) and (2) payments are characterized annually, except for the portion relating to “Section 736(a) Property” (U/R and Goodwill) which are characterized at the time of the liquidation.
