Tax Chapter 20 No Homework-Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20Forming and Operating Partnerships

SOLUTIONS MANUAL

Discussion Questions

1. [LO 1] What is a flow-through entity, and what effect does this designation have on

how business entities and their owners are taxed?

Flow-through entities are entities that are not taxed on the entity level; rather, these entities are taxed on the owner’s level. These types of entities conduct a regular business; however, the income earned and deductions allowed are passed to the owners of these flow-through en-tities, and the owners are taxed on the amount allocated to them. Thus, flow-through entities provide a way for income and deductions to be taxed only once instead of twice.

2. [LO 1] What types of business entities are taxed as flow-through entities?

The two main business entities that are taxed as flow-through entities are partnerships and S corporations. Partnerships are taxed under Subchapter K and consist of general partnerships, limited partnerships, and limited liability companies (LLC). S corporations are taxed under Subchapter S. Both these types of business entities are treated as flow-through entities and are taxed accordingly.

3. [LO 1] Compare and contrast the aggregate and entity concepts for taxing partnerships

and their partners.

The aggregate concept treats partnerships more align with an individ-ual. Each partnership is viewed as an aggregation of each partner’s separate interest in the assets and liabilities of the partnership. For example, each partner is proportioned and taxed on a certain amount of income the partnership creates. The partnership, as a whole, is never taxed.

The entity concept treats partnerships more align with a corporation. Each partnership is an entity separate from its partners. For example, the partnership decides on which tax method to use and which tax elections to make, not the partners individually.

4. [LO 2] What is a partnership interest, and what specific economic rights or entitlements

are included with it?

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A partnership interest is an equity interest in a partnership. This inter-est is created through a transfer or sale of cash, property, or services in exchange for an equity interest in the partnership. A partnership in-terest gives each partner certain rights or entitlements. The two main economic rights are a capital interest and profit interest in the partner-ship. A capital interest is the right for a partner to receive a share of the partnership assets during liquidation. A profit interest is the right or obligation for a partner to receive a share of the future income or losses of the partnership.

5. [LO 2] What is the rationale for requiring partners to defer most gains and all losses

when they contribute property to a partnership?

The rationale for requiring partners to defer most gains and losses when contributing property to a partnership is twofold. First, the IRS desires that entrepreneurs have a way to start their own business with-out having to pay any taxes upfront. Second, the partners are consid-ered still owning the property they have contributed to the partnership. While they don’t own the property outright, each partner has a small percentage of the property contributed in her/his partnership interest she/he exchanged for. This second reasoning helps further support the idea that partnerships follow the aggregate concept.

6. [LO 2] Under what circumstances is it possible for partners to recognize gain when con-

tributing property to partnerships?

Partners have the potential of recognizing gain on the contribution of property when the property contributed is secured by debt. In deter-mining whether gain must be recognized, the partner must assess the cash deemed to have received from the partnership distribution com-pared with the tax basis of the partner’s partnership interest prior to the deemed distribution. If the cash deemed to have received exceeds the tax basis, then a gain must be recognized. This circumstance oc-curs due to the negative basis created for the partner, which is not al-lowed under partnership tax law.

7. [LO 2] What are inside basis and outside basis, and why are they relevant for tax-

ing partnerships and partners?

An inside basis, in relation to partnerships, is the basis the partnership takes in the assets that the partnership holds. An outside basis, in re-lation to partnerships, is the tax basis each partner has in the partner-ship. The inside basis is necessary to compute the gain/loss recog-nized on all property sold by the partnership. The outside basis is nec-essary to compute the gain/loss recognized on the partnership interest when sold. For tax purposes, the inside basis is similar to the basis the

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partner had in the property prior to contribution. On the other hand, the outside basis corresponds not only to the contributed property, but also to the debt and income/losses of the partnership.

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8. [LO 2] What is recourse and nonrecourse debt, and how is each generally allocated to

partners?

Recourse debt is debt for which partners are considered to have an economic risk of loss. This type of debt partners are legally liable for and must satisfy personally if the partnership cannot. An example of recourse debt is accounts payable. Nonrecourse debt is debt for which no partners are considered to have an economic risk of loss in. This is a debt for which partners are not legally liable for. An example of non-recourse debt is a mortgage.

In regards to a partnership’s debt, recourse debt is allocated to those partners that have the ultimate responsibility of paying the debt. The debt is allocated to the partners that have an economic risk of loss. On the other hand, nonrecourse debt is allocated to all the partners ac-cording to the profit sharing ratios. Despite the partners not being legally liable for this debt, the debt is allocated proportionately to ad-just the outside basis of each partner.

9. [LO 2] How does the amount of debt allocated to a partner affect the amount of gain a

partner recognizes when contributing property secured by debt?

A partner that contributes property secured by debt is not only con-tributing the property to the partnership but also the debt. In calculat-ing the outside basis of the partner, the partner must take her/his tax basis in the property and decrease her/his basis by the amount of the property’s debt. Next, the property’s debt is allocated to each partner according to who is ultimately responsible for it or by each partner’s profit-sharing ratio. If the partner is not allocated enough debt, the partner’s outside basis will become negative and a gain must be recog-nized. Thus, a partner can only avoid gain by obtaining enough of the partnership debt to keep her/his basis at least above zero.

10. [LO 2] What is a tax-basis capital account, and what type of tax-related information does

it provide?

A tax-basis capital account is an equity account that is created for each partner of the partnership. This account is measured using the tax ac-counting rules. The account reflects tax basis of any capital contribu-tions (i.e., property and cash), capital distributions, and future earnings and losses allocated to that partner. Additionally, a tax-basis capital account can provide more tax-related information for each partner. For instance, each partner’s share of inside basis of the partnership’s assets can be calculated by adding the partner’s share of debt to her/his capital account. Furthermore, if a partner acquires her/his interests

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by contributing property tax-free, then the partner’s outside basis will be equal to that partner’s share of partnership inside basis.

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11. [LO 2] Distinguish between a capital interest and a profits interest, and explain how part-

ners and partnerships treat when exchanging them for services provided.

A partnership interest can be broken down into two distinct rights: (1) capital interest and (2) profits interest. To become a partner in a part-nership, you will receive at least one of these rights. A capital interest is the right to receive a share of the partnership assets at liquidation. A profits interest is the right to share in the future earnings and losses of the partnership. While these rights are given to most partners that contribute cash or property, special rules exist when these rights are given to partners in exchange for services.

When a partner receives a capital interest in exchange for services rendered to the partnership, the partner must treat the liquidation value of the capital interest as ordinary income. Further, the tax basis for the partner will be equivalent to the amount of ordinary income rec-ognized. The holding period for this tax basis will begin on the date the capital interest is received. From the partnership’s perspective, the partnership can deduct or capitalize the value of the capital inter-est depending upon the type of services rendered. This is determined on a fact and circumstance basis. Additionally, the amount deducted by the partnership is allocated to the non-service partners as consider-ation for effectively transferring a portion of their capital interest to the service partner.

When a partner receives a profit interest in exchange for services ren-dered to the partnership, the partner has no immediate tax impact be-cause they have no liquidation value at the time they are received. Thus, the non-service partners will not receive any deductions for the additional partner to the partnership. As the partnership makes future profits and losses, the service partner will be allocated her/his portion of these losses according to the profit sharing ratios. The debt allo-cated to non-service partners must also be redistributed with the addi-tional service partner receiving her/his portion of debt. Therefore, the tax basis of a service partner with only a profit interest will either be zero or the portion of debt the partner is allocated.

12. [LO 2] How do partners who purchase a partnership interest determine the tax basis and

holding period of their partnership interests?

When a partner purchases a partnership interest, the initial tax basis for the partner is a determined by taking the cost basis of the interest the partner purchased and adding to this basis any debt allocated to the partner’s interest. The holding period for this purchased interest will begin on the date that the partner purchased the partnership inter-est.

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13. [LO 3] Why do you think partnerships, rather than the individual partners, are responsible

for making most of the tax elections related to the operation of the partnership?

The responsibility for the partnership, not the partners, to make the majority of tax elections regarding the operation of the partnership is twofold. First, partnerships can consist of many different partners ranging from two to hundreds. The hassle to obtain every partner’s approval on what elections to make would be very time consuming. The costs would more than likely outweigh the benefits in performing this function. Second, in many partnerships only a few partners are ac-tively involved in the management of the partnership. The limited partners have ownership to obtain a tax advantage on their own per-sonal returns. Thus, the entity concept would appear more reasonable when dealing with the actual operations of the partnership.

14. [LO 3] If a partner with a taxable year-end of December 31 is in a partnership with a

March 31 taxable year-end, how many months of deferral will the partner receive? Why?

A partner with a calendar year end will receive nine months of deferral in her/his partnership interest that has a March 31 year end. A partner must report the income or loss of the partnership not at the partner’s year end but at the partnership’s year end. Thus, the first year of the partnership will be reported by the partner on her/his second return which includes the partnership’s year end.

15. [LO 3] In what situation will there be a common year-end for the principal partners when

there is no majority interest taxable year?

The principal partner test states that the required tax year is the tax-able year all the principal partners have in common. A principal part-ner is a partner that owns at least 5 percent interest in the partnership profits and capital. For the principal partner test to pass and not the majority interest test, the partnership must consists of numerous part-ners that (1) own less than 5 percent profit and capital interest and (2) have a variety of fiscal year ends. For example, if four partners with a calendar year end owned 10 percent and 20 additional partners with differing fiscal year ends owned less than 5 percent, then the majority test would not pass, but the principal partners test would.

16. [LO 3] Explain the least aggregate deferral test for determining a partnership’s year end

and discuss when it applies.

The least aggregate deferral test is the last resort test that a partner-ship must follow when figuring out the partnership year end. The first test is the majority interest test. The second test is the principal part-ners test. If these two tests don’t apply, along with the exception to

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elect an alternative year end, then the least aggregate deferral test goes into effect.

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The least aggregate deferral test selects the tax year which provides the partner group as a whole the smallest amount of aggregate tax de-ferral. This is calculated by taking each partner’s months of deferral under the potential tax year and weighting it with the partner’s profit interest percentage. Then, each partner’s weighted totals are summed up to come up with an aggregate deferral number. The potential tax year that produces the smallest aggregate deferral must be the one chosen by the partnership.

17. [LO 3] When are partnerships eligible to use the cash method of accounting?

A partnership is eligible to use the cash method of accounting unless the partnership has average gross receipts over the past three taxable years greater than $5 million and has a corporate partner. Under the tax accounting laws, a partnership must use the accrual method of ac-counting with a corporate partner, unless the above exception applies.

18. [LO 4] What is a partnership’s ordinary business income (loss) and how is it calculated?

Through the course of business, partnerships create income or losses. Some of these items are considered to affect a specific partner or groups of partners differently. Thus, these separately-stated items must be reported on a partner-by-partner basis. Then, after adjusting the partnership’s business income (loss) for these separately-stated items, the partnership reports the remaining amount of business in-come (loss) to ordinary business income (loss). The total amount will be allocated to each partner according to the special allocation rules agreed upon or else based upon the profit sharing ratios of the partner-ship.

19. [LO 4] What are some common separately stated items, and why must they be separately

stated to the partners?

Separately-stated items must be taken out of ordinary income (loss) because these items either (1) relate only to a specific partner in the partnership or (2) the item is taxed differently for each partner de-pending upon the entity of the partner and the partner’s current tax situation. The following is a list of items that are considered to be sep-arately stated on a partnership return.

1. Short-term capital gains (losses)2. Long-term capital gains (losses)3. Section 1231 gains (losses)4. Charitable contributions5. Dividends6. Interest income7. Guaranteed payments

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8. Net earnings (losses) from self-employment9. Tax-exempt income10. Net rental real estate income (loss)11. Investment interest expense12. Section 179 deductions

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20. [LO 4] Is the character of partnership income/gains and expenses/losses determined at the

partnership or partner level? Why?

In keeping with the entity concept, the character of all income/gains and expenses/losses is determined at the partnership level. Despite the chance that specific items would change character depending upon the partner who holds them, the IRS has decided to unify the character of all items by looking at the character from the partnership’s perspec-tive. Thus, partnerships are required to file a 1065 return along with all partners’ K-1s to help audit the amounts and character that show up on the individual partner’s return.

21. [LO 4] What are guaranteed payments and how do partnerships and partners treat them

for income and self-employment tax purposes?

Guaranteed payments are similar to cash salary payments for services provided. The idea behind a guaranteed payment is for a partner to receive a fixed amount of income no matter the profit (loss) for the partnership’s taxable year. Thus, on the partnership level, they are treated like a salary payment to an unrelated party. The partnership deducts the guaranteed payment in computing the partnership’s ordi-nary business income (loss).

On the partner level, the partner that receives a guaranteed payment must account for the guaranteed payment as a separately-stated item that is taxed as ordinary income. Further, the partner must include the amount of the guaranteed payment in computing self-employment in-come for tax purposes. This amount is included no matter if the part-ner is a general partner, limited partner, or LLC member.

22. [LO 4] How do general and limited partners treat their share of ordinary business income

for self-employment tax purposes?

In determining how different partners treat their share of ordinary busi-ness income, the IRS assesses the involvement the partner has in the partnership. General partners are considered to be actively involved in the management of the partnership. Thus, the general partner’s share of ordinary business income is treated as trade or business income and is subject to self-employment tax. Conversely, limited partners are generally not actively involved with managing the partnership. The limited partner’s share of ordinary business income is treated as in-vestment income and not subject to self-employment tax. Both types of partners must treat guaranteed payments as income relating to self-employment; however, the ordinary business income depends on the type of partner.

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23. [LO 4] What challenges do LLCs face when deciding whether to treat their members’

shares of ordinary business income as self-employment income?

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Due to the lack of authoritative ruling that exists for LLCs, members must decide on their own whether to include ordinary business income as self-employment income or not. A proposed regulation gave us clarity on this matter; however, the regulation was withdrawn. Mem-bers of an LLC should still review this proposed regulation to under-stand the stance the IRS is trying to take and whether they will take an aggressive or conservative stance for their specific situation.

The proposed regulation helped clarify that if an LLC member is in-volved in the operations of the LLC, the member should treat the ordi-nary business income as self-employment income. The regulation listed the following three criteria that would demonstrate active in-volvement in the LLC: (1) personally liable for the debt of the LLC as an LLC member, (2) authority to contract on behalf of the LLC, or (3) par-ticipate in more than 500 hours in the LLC’s trade or business during the taxable year. If any one of these requirements is met, then the LLC member would be more associated as a general partner and should more than likely account for the ordinary business income as self-employment income.

24. [LO 4] How much flexibility do partnerships have in allocating partnership items to part-

ners?

Partnerships have a great deal of flexibility in determining how to allo-cate partnership items to partners, both separately-stated and non-separately stated items. The determining factors must be (1) the part-ners agree upon the allocations and (2) the allocations have substan-tial economic effect. The second factor is put into place to make sure the allocations are being accomplished for a business objective and not just to reduce or avoid taxes. While both of these items need to be met for a special allocation of a partnership item, certain items have mandatory allocations to specific partners. For example, contributed property built-in gain (loss) must be allocated to the partner who con-tributed the property when the property is sold. Any additional gain (loss) will be allocated according to the partnership agreement. Over-all, if the partnership has no mandatory allocations or does not specify and meet the requirements for special allocations, the partnership will allocate according to the capital or profit interest.

25. [LO4] What are the basic tax-filing requirements imposed on partnerships?

While a partnership does not pay taxes, the IRS still requires all part-nerships to file an information return to the IRS – Form 1065 (U.S. Re-turn of Partnership Income). This form must be filed by the 15th day of the 4th month of the partnership’s year end. For calendar year end partnerships, the form must be filed by April 15th. An extension is

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available to file by the due date of the original return and provides the partnership an additional five months to file Form 1065. The extension must be filed on Form 7004.

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The tax return that must be filed by all partnerships consists of a de-tailed calculation of the partnerships ordinary business income (loss) on page 1 of Form 1065. On page 3 of Form 1065, Schedule K must be filled out which lists the ordinary business income (loss) along with any separately-stated items. This schedule is an aggregate of each part-ner’s share of items both separately-stated and non-separately stated. In addition, each partner’s proportion of the above items is reported on a Schedule K-1. A Schedule K-1 for every partner must be filed with Form 1065, and each individual partner will receive her/his own Sched-ule K-1 from the partnership.

26. [LO 5] In what situations do partners need to know the tax basis in their partnership inter-

ests?

Partners should always keep track of the tax basis in their partnership interest; however, certain situations require partners to actually know their tax basis. These situations include when a partner sells her/his partnership interest or when a partner receives a distribution from the partnership. The main reasoning is to help the partner figure out the amount of gain which s/he most report on her/his current tax return.

27. [LO 5] Why does a partner’s tax basis in her partnership need to be adjusted annually?

A partner’s tax basis needs to be adjusted annually for the following three reasons. First, a partner does not want to double count any in-come/gain from the partnership when she/he sells her/his partnership interest or receive a distribution from the partnership. Second, the IRS does not want partners to double count any expenses/losses from the partnership in a similar situation from above. Last, partners want to make sure they adjust for tax-exempt income and non-deductible ex-penses, so these items will not ultimately be taxed or deducted at the time of selling a partnership interest or receiving a distribution from the partnership.

28. [LO 5] What items will increase a partner’s basis in her partnership interest?

The following items will increase a partner’s basis and must be ad-justed for on an annual basis in the order given.

1. Actual and deemed cash contributions to the partnership2. Partner’s share of ordinary business income 3. Partner’s share of separately-stated income/gain items and4. Partner’s share of tax-exempt income

29. [LO 5] What items will decrease a partner’s basis in her partnership interest?

The following items will decrease a partner’s basis and must be ad-justed for on an annual basis in the order given. These items will be

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adjusted after all the increases to a partner’s basis have been taken into effect.

1. Actual and deemed cash distributions from the partnership2. Partner’s share of non-deductible expenses (fines, penalties,

etc.)3. Partner’s share of ordinary business losses and4. Partner’s share of separately-stated expenses/loss items

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30. [LO 6] What hurdles (or limitations) must partners overcome before they can ultimately

deduct partnership losses on their tax returns?

While a partnership can create an ordinary business loss, the individual partners potentially will not be able to deduct the entire amount in the year of the loss. The partner must overcome three loss limitation rules before the deduction is available. If the loss does not pass any of the limitations, then the loss is suspended indefinitely under that specific hurdle. The three loss limitations are (1) assessing the tax basis of the partner, (2) evaluating the at-risk loss limitation, and (3) the passive activity loss limitation.

First, a partner is not able to take any losses that exceed the tax basis of the partner, the partner’s outside basis. This limitation prevents partners from taking losses beyond their investment or basis in their partnership interests. Second, a partner cannot take any losses that exceed the at-risk limit for the partner. The at-risk limit is generally the same as the partner’s tax basis, except for the share of nonre-course debt attributable to the partner. This limit still includes re-course debt and qualified nonrecourse debt. Finally, losses cannot be taken if the loss exceeds the amount of passive income reported by the partner. Passive losses, losses from rental activities or limited partnerships, can only be offset with passive gains.

31. [LO 6] What happens to partnership losses allocated to partners in excess of the tax basis

in their partnership interests?

Losses that are allocated to partners that exceed the partner’s tax ba-sis cannot be used during the current taxable year. The excess loss will be suspended and carried forward indefinitely until the partner has sufficient basis to utilize the losses. A partner would be able to in-crease her/his tax basis by (1) making a capital contribution, (2) guar-anteeing more partnership debt, or (3) helping the partnership become more profitable. Once the partner’s tax basis is positive, the losses previously suspended can be used.

32. [LO 6] In what sense is the at-risk loss limitation rule more restrictive than the tax basis

loss limitation rule?

While the at-risk loss limitation and tax basis loss limitation are basi-cally the same, one difference exists between the two different hurdles a partner must overcome when faced with losses. The at-risk loss limi-tation only accounts for those items that the partner is at risk for. The major item that is not included under the at-risk calculation but is in-cluded in the tax basis is nonrecourse debt. As a note, qualified nonre-

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course debt is still considered to be part of the partner’s at-risk calcula-tion.

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33. [LO 6] How do partners measure the amount they have at risk in the partnership?

A partner will measure her/his partnership at-risk amount by looking at what items affect the partner’s economic risk of loss. In most cases, items included in the at-risk amount would include cash contributed, tax basis of property contributed, recourse debt, qualified nonrecourse debt, and any other adjustments to the partner’s tax basis excluding nonrecourse debt. Nonrecourse debt is considered a part of the tax basis but not a part of the at-risk basis since the partner does not have an economic risk of loss for this type of debt.

34. [LO 6] In what order are the loss limitation rules applied to limit partner’s losses from

partnerships?

The order of the hurdles a partner must pass for the loss limitation rules are (1) tax basis loss limitation, (2) at-risk loss limitation, and (3) passive activity loss limitation. As the losses exceed the limitation in each hurdle, the suspended losses will be carried forward indefinitely within each group until enough basis or income is generated to cover these losses. Once the loss has passed all three limitations, the part-ner can use the loss as a deduction on her/his own personal return.

35. [LO 6] How do partners determine whether they are passive participants in partnerships

when applying the passive activity loss limitation rules?

According to the Code, a partner is considered to be a passive partici-pant if the activity conducted is a trade or business and the partner does not materially participate in the activity. The IRS has made it clear that those participants in rental activities and limited partners within a partnership are automatically considered to be passive partici-pants.

Further, regulations help clarify whether a partner would be considered a material participant. If the partner meets any of the conditions be-low, then the partner would be a material participant and the activity would not be considered a passive activity to the partner.

1. The individual participates in the activity more than 500 hours dur-

ing the year.

2. The individual’s activity constitutes substantially all of the partici-

pation in such activity by individuals.

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3. The individual participates more than 100 hours during the year

and the individual’s participation is not less than any other individ-

ual’s participation in the activity.

4. The activity qualifies as a “significant participation activity” (indi-

vidual participates for more than 100 hours during the year) and the

aggregate of all other “significant participation activities” is greater

than 500 hours for the year.

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5. The individual materially participated in the activity for any 5 of

the preceding 10 taxable years.

6. The activity involves personal services in health, law, accounting,

architecture, and so on, and the individual materially participated for

any three preceding years.

7. Taking into account all the facts and circumstances, the individual

participates on a regular, continuous, and substantial basis during

the year.

36. [LO 6] Under what circumstances can partners with passive losses from partnerships

deduct their passive losses?

A partner may deduct the passive losses she/he has generated from a partnership under three circumstances. First, a passive loss is not de-ductible until the taxpayer generates current year passive income in the activity producing the loss. Second, a passive loss is not de-ductible until the taxpayer generates current year passive income from another passive activity the taxpayer is involved with. Last, a passive loss will not be deductible unless the taxpayer sells the activity that has produced the passive loss. In this case, the taxpayer will report a gain or loss on the sale and can use the passive loss to offset this or any other source of income ( i.e., active income, portfolio income, or other passive income).

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Problems

37. [LO 2] Joseph contributed $22,000 in cash and equipment with a tax basis of $5,000 and

a fair market value of $11,000 to Berry Hill Partnership in exchange for a partnership in-

terest.

a. What is Joseph’s tax basis in his partnership interest?

b. What is Berry Hill’s basis in the equipment?

a. $27,000.Joseph’s tax basis is considered to be his outside basis in the part-nership. The tax basis includes the $22,000 in cash and his original basis in the equipment, $5,000. Joseph’s holding period for his out-side basis would depend upon the holding period of the assets con-tributed. All capital or Section 1231 assets tacks onto the partner-ship interest. All other property has a holding period from the date the partnership interest is acquired.

b. $5,000.Berry Hill Partnership’s basis in the equipment is a carryover basis from the partner who contributed the equipment. The basis in the equipment plus the basis in the cash will give us Berry Hill Partner-ship’s inside basis. The holding period for the equipment carries over to the Berry Hill Partnership from Joseph.

38. [ LO 2] Lance contributed investment property worth $500,000, purchased three years ago for $200,000 cash, to Cloud Peak LLC in exchange for an 85 percent profits and cap-ital interest in the LLC. Cloud Peak owes $300,000 to its suppliers but has no other debts.

a. What is Lance’s tax basis in his LLC interest?

b. What is Lance’s holding period in his interest?

c. What is Cloud Peak’s basis in the contributed property?

d. What is Cloud Peak’s holding period in the contributed property?

a. $455,000. Lance’s basis in his LLC interest is made up of the $200,000 basis of

the investment property he transferred to the LLC and his $255,000 share of the LLC debt (85% x $300,000). Because LLC general debt

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obligations are treated as nonrecourse debt, Lance’s profit sharing ratio is used to allocate a portion of the LLC debt to him.

b. Three years.

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Because Lance contributed a capital asset, the holding period of the contributed assets “tacks onto” his partnership interest.

c. $200,000.The LLC takes a carryover basis in the contributed property.

d. Three years.The LLC inherits Lance’s holding period in the contributed property.

39. [ LO 2] Laurel contributed equipment worth $200,000, purchased 10 months ago (ac-quired on January 31st) for $250,000 cash and used in her sole proprietorship, to Sand Creek LLC in exchange for a 15 percent profits and capital interest in the LLC. Laurel agreed to guarantee all $15,000 of Sand Creek’s accounts payable but she did not guaran-tee any portion of the $100,000 nonrecourse mortgage securing Sand Creek’s office building. Other than the accounts payable and mortgage, Sand Creek does not owe any debts to other creditors.

a. What is Laurel’s initial tax basis in her LLC interest?

b. What is Laurel’s holding period in her interest?

c. What is Sand Creek’s initial basis in the contributed property?

d. What is Sand Creek’s holding period in the contributed property?

40. [LO 2] {Planning}Harry and Sally formed the Evergreen partnership by contributing the

following assets in exchange for a 50 percent capital and profits interest in the partner-ship:

Harry: Basis Fair Market ValueCash $ 30,000 $ 30,000Land 100,000 120,000 Totals $ 130,000 $ 150,000

Sally:Equipment used in a business 200,000 150,000 Totals $ 200,000 $ 150,000

a. How much gain or loss will Harry recognize on the contribution?

b. How much gain or loss will Sally recognize on the contribution?

c. How could the transaction be structured a different way to get a better result for Sally?

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d. What is Harry’s tax basis in his partnership interest?

e. What is Sally’s tax basis in her partnership interest?

f. What is Evergreen’s tax basis in its assets?

g. Prepare a tax basis balance sheet for the Evergreen partnership showing the tax capital accounts for the partners.

a. $0.Generally, partners recognize gain on property contributed to a partnership only when the cash they are deemed to receive from debt relief exceeds their basis in the partnership prior to the deemed distribution. Harry did not have any debt relief.

b. $0.Partners may never recognize loss when property is contributed to a partnership even when they are relieved of debt.

c. Sally should consider selling the property to the partnership rather than contributing it. By selling the property, she could recognize the $50,000 built-in loss on the equipment.

d. $130,000.Harry’s basis in his partnership interest is simply the combined tax basis in the cash and land he contributed to the partnership.

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e. $200,000.Sally’s basis in her partnership interest equals $200,000 basis in the equipment she contributed.

f. $330,000.The partnership’s basis in its assets equals the sum of the partners’ bases in the cash ($30,000), in the land ($100,000), and in the equipment ($200,000).

g. The partnership’s tax basis balance sheet would appear as follows:

Evergreen Partnership

Tax Basis Balance Sheet

Tax Basis

Assets:

Cash $30,000

Equipment 200,000

Land 100,000

Totals $330,000

Capital:

Capital-Harry 130,000

Capital-Sally 200,000

Totals $330,000

41. [LO 2] Cosmo contributed land with a fair market value of $400,000 and a tax basis of $90,000 to the Y Mountain partnership in exchange for a 25 percent profits and capital interest in the partnership. The land is secured by $120,000 of nonrecourse debt. Other than this nonrecourse debt, Y Mountain partnership does not have any debt.

a. How much gain will Cosmo recognize from the contribution?

b. What is Cosmo’s tax basis in his partnership interest?

a. $0.As reflected in the table below, Cosmo does not recognize any gain because the $120,000 of cash he is deemed to receive from debt

20-27


relief does not exceed his basis in Y Mountain prior to this deemed distribution.

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Description Cosmo Explanation

(1) Basis in contributed

Land

$90,000

(2) Nonrecourse mort-

gage in excess of basis in

contributed land

$30,000Nonrecourse

debt > basis

is allocated

only to Cosmo

(3) Remaining nonre-

course mortgage

$22,50025% x

[120,000 -

(2)]

(4) Relief from mortgage

debt

($120,000)

Cosmo’s initial tax basis

in Y Mountain

$22,500(1) + (2) + (3)

+ (4)

b. $22,500 as indicated in the table above.

42. [LO2] Maude, James, Harold and Jenny formed the High Horizon LLC by contributing the following assets in exchange for 25 percent capital and profits interests in the LLC:

Maude: Basis Fair Market ValueCash $ 20,000 $ 20,000Land* 100,000 200,000 Totals $ 120,000 $ 220,000

*Nonrecourse debt secured by the land equals $160,000

James, Harold and Jenny each contributed $220,000 in cash.

a. How much gain or loss will Maude and the other members recognize?

b. What is Maude’s tax basis in her LLC interest?

c. What tax basis do James, Harold, and Jenny have in their LLC interests?

d. What is High Horizon’s tax basis in its assets?

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e. Prepare a tax basis balance sheet for the High Horizon LLC showing the tax capital accounts for the members.

a.$0.None of the partners recognize gain because their debt relief was not in excess of their bases in their partnership interest prior to any debt relief. See table below:

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Description Maude Other Mem-

bers

Explanation


Land

$100,000

(2) Cash contributed $20,000 $220,000



contributed land

$60,000 Nonrecourse

debt > basis

is allocated

only to Maude


course mortgage

$25,000 $25,000 25% x

[160,000 -

(3)]


debt

($160,000)

Each member’s initial tax

basis in the LLC

$45,000 $245,000 (1) + (2) + (3)

+ (4) + (5)

b.$45,000.See table in part a. above.

c. $245,000 each.See table in part a. above.

d. $780,000.High Horizon takes a $120,000 carryover basis in the assets Maude contributes and a $660,000 in the total cash the other three mem-bers contributed.

e. High Horizon’s tax basis balance sheet would appear as follows:

High Horizons, LLC


Tax Basis

Assets:

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Cash $680,000

Land 100,000

Totals 780,000

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Liabilities and Capital:

Mortgage debt 160,000

Capital-Maude (40,000)

Capital-James 220,000

Capital-Harold 220,000

Capital-Jenny 220,000

Totals 780,000

Note that the members’ tax capital accounts are equal to their bases in the LLC interests less their individual shares of LLC debt.

43. [LO2] Kevan, Jerry, and Dave formed Albee LLC. Jerry and Dave each contributed $245,000 in cash. Kevan contributed the following assets:

Kevan:Basis Fair Market ValueCash $ 15,000 $ 15,000Land* 120,000 230,000 Totals $ 135,000 $ 245,000

*Nonrecourse debt secured by the land equals $210,000

Each member received a one-third capital and profits interest in the LLC.

a. How much gain or loss will Jerry, Dave and Kevan recognize on the contribu-tions?

b. What is Kevan’s tax basis in his LLC interest?

c. What tax basis do Jerry and Dave have in their LLC interests?

d. What is Albee LLC’s tax basis in its assets?

e. Prepare a tax basis balance sheet for the Albee LLC showing the tax capital ac-counts for the members. What is Kevan’s share of the LLC’s inside basis?

f. If the lender holding the nonrecourse debt secured by Kevan’s land required Kevan to guarantee 33.33 percent of the debt and Jerry to guarantee the remaining 66.67 percent of the debt when Albee LLC was formed, how much gain or loss will Kevan recognize?

g. If the lender holding the nonrecourse debt secured by Kevan’s land required Kevan to guarantee 33.33 percent of the debt and Jerry to guarantee the remaining 66.67 percent of

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the debt when Albee LLC was formed, what are the members’ tax bases in their LLC in-terests?

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a. $0.None of the partners recognize gain because their debt relief was not in excess of their bases in their partnership interest prior to any debt relief. See table below:

Description Kevan Other Mem-

bers

Explanation


Land

$120,000




contributed land

$90,000 Nonrecourse

debt > basis

is allocated

only to Kevan


course mortgage

$40,000 $40,000 33.3% x

[$210,000 -

(3)]


debt

($210,000)

Each member’s initial tax

basis in the LLC

$55,000 $285,000 (1) + (2) + (3)

+ (4)+ (5)

b.$55,000.See table in part a. above.

c. $285,000 each.See table in part a. above.

d. $625,000.Albee, LLC takes a $135,000 carryover basis in the assets Kevan contributes and a $490,000 in the total cash the other two members contributed.

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e. Albee, LLC’s tax basis balance sheet would appear as follows:

Albee , LLC


Tax Basis

Assets:

Cash $505,000

Land 120,000

Totals 625,000

Liabilities and Capital:

Mortgage debt 210,000

Capital-Kevan (75,000)

Capital-Jerry 245,000

Capital-Dave 245,000

Totals 625,000

Note that the members’ tax capital accounts are equal to their bases in the LLC interests less their individual shares of LLC debt.

f. $5,000. See table below:

Description Kevan Jerry Dave Explanation

(1) Basis in contrib-

uted Land

$120,000

(2) Cash contributed $15,000 $245,000 $245,000

(3) Mortgage Guar-

antee

$70,000 $140,000 $033.33% x

$210,000

for Kevan

and 66.67%

x $210,000

for Jerry

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(4) Relief from mort-

gage debt

($210,000)

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(5) Gain Recognized $5,000 $0 $0[(1)+ (2)+

(3) + (4)]

Each member’s ini-

tial tax basis in the

LLC

$0 $385,000 $245,000(1) + (2) +

(3)+ (4) +

(5)

g. Kevan’s basis is $0, Jerry’s basis is $385,000, and Dave’s basis is $245,000. See the table in part f. above.

44. [LO2] {Research} Jim has decided to contribute some equipment he previously used in his sole proprietorship in exchange for a 10 percent profits and capital interest in Fast Choppers LLC. Jim originally paid $200,000 cash for the equipment. Since then, the tax basis in the equipment has been reduced to $100,000 because of tax depreciation, and the fair market value of the equipment is now $150,000.

a. Must Jim recognize any of the potential § 1245 recapture when he contributes the ma-chinery to Fast Choppers? {Hint: See § 1245(b)(3).}

b. What cost recovery method will Fast Choppers use to depreciate the machinery? {Hint: See § 168(i)(7).}

c. If Fast Choppers were to immediately sell the equipment Jim contributed for $150,000, how much gain would Jim recognize and what is its character? {Hint: See § 1245 and 704(c).}

a. According to Section 1245(b)(3), recapture potential on property contributed to a partnership is only recognized to the extent any gain is recognized from the contribution of property. Because Jim was not relieved of any debt in the transaction, he will not recognize gain from the contribution under Section 721. Therefore, Jim does not recognize any of the Section 1245 recapture potential on the equipment at the time of contribution.

b. According to Section 168(i)(7), a transferee partnership will step into the shoes of the transferor partner for purposes of depreciating contributed equipment. In this situation, Fast Choppers will con-tinue to depreciate the equipment using the same method insti-tuted by Jim over the remaining useful life of the equipment. In other words, the annual depreciation calculation will proceed as if the property were still held by Jim.

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c. Under Section 704(c), all $50,000 of gain recognized from the sale of the equipment would be allocated to Jim because this gain was built-in at the time the equipment was contributed. Moreover, the Section 1245 recapture potential remains with the equipment after the contribution; as a result, all $50,000 of gain recognized (the lesser of the $50,000 gain recognized or the $100,000 depreciation taken) must be characterized as Section 1245 recapture income.

45. [LO2] {Research} Ansel purchased raw land three years ago for $200,000 to hold as an investment. After watching the value of the land drop to $150,000, he decided to contrib-ute it to Mountainside Developers LLC in exchange for a 5 percent capital and profits in-terest. Mountainside plans to develop the property and will treat it as inventory, like all of the other real estate it holds.

a. If Mountainside sells the property for $150,000 after holding it for one year, how much gain or loss does it recognize and what is the character of its gain or loss? {Hint: See §724.}

b. If Mountainside sells the property for $125,000 after holding it for two years, how much gain or loss does it recognize and what is the character of the gain or loss?

c. If Mountainside sells the property for $150,000 after holding it six years, how much gain or loss is recognized and what is the character of the gain or loss?

a. According to Section 724(c), recognized losses on assets that were capital assets in the hands of contributing partners are treated as capital losses up to the amount of loss built into the assets at the time they were contributed if they are sold within a five year period beginning on the date of contribution. Thus, Mountainside Develop-ers will recognize a $50,000 loss characterized as a capital rather than an ordinary loss.

b. In this instance, Mountainside Developers will recognize a $75,000 loss from the sale of the land. The built-in loss at the time the land was contributed or $50,000 will be characterized as a capital loss, and the remaining $25,000 loss will be characterized as an ordinary loss per Section 724(c).

c. Because Mountainside Developers held the land as inventory for more than five years, it will recognize a $50,000 ordinary loss per Section 724(c).

46. [LO2] {Research} Claude purchased raw land three years ago for $1,500,000 to develop into lots and sell to individuals planning to build their dream homes. Claude intended to treat this property as inventory, like his other development properties. Before completing the development of the property, however, he decided to contribute it to South Peak In-

20-39


vestors LLC when it was worth $2,500,000, in exchange for a 10 percent capital and profits interest. South Peak’s strategy is to hold land for investment purposes only and then sell it later at a gain.

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a. If South Peak sells the property for $3,000,000 four years after Claude’s contribution, how much gain or loss is recognized and what is its character? {Hint: See § 724.}

b. If South Peak sells the property for $3,000,000 five and one-half years after Claude’s contribution, how much gain or loss is recognized and what is its character?

a. Under Section 724(b), any gain or loss on contributed property that was treated as inventory by the contributing partner and sold by the partnership during the five year period beginning on the date of contribution is treated as ordinary gain or loss. Thus, the entire $1,500,000 gain from the sale of the land will be treated as ordinary gain.

b. Section 724(b) only applies if contributed property is sold during the five year period beginning on the date of contribution. Because South Peak sold the land after the expiration of this time period and held the land as investment property, it should recognize $1,500,000 of capital gain.

47. [LO2] {Research} Reggie contributed $10,000 in cash and a capital asset he had held for three years with a fair market value of $20,000 and tax basis of $10,000 for a 5 percent capital and profits interest in Green Valley LLC.

a. If Reggie sells his LLC interest thirteen months later for $30,000 when the tax basis in his partnership interest is still $20,000, how much gain does he report and what is its character?

b. If Reggie sells his LLC interest two months later for $30,000 when the tax basis in his partnership interest is still $20,000, how much gain does he report and what is its charac-ter? {Hint: See Reg. §1.1223-3}

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48. [LO2] Connie recently provided legal services to the Winterhaven LLC and received a 5 percent interest in the LLC as compensation. Winterhaven currently has $50,000 of ac-counts payable and no other debt. The current fair market value of Winterhaven’s capital is $200,000.

a. If Connie receives a 5 percent capital interest only, how much income must she report and what is her tax basis in the LLC interest?

b. If Connie receives a 5 percent profits interest only, how much income must she report and what is her tax basis in the LLC interest?

c. If Connie receives a 5 percent capital and profits interest, how much income must she report and what is her tax basis in the LLC interest?

a. Connie reports $10,000 of ordinary income or 5 percent of the LLC’s capital of $200,000. Her basis in the LLC interest is also $10,000.

b. Connie will not report any income but will have a basis in the LLC in-terest equal to her share of the LLC’s debt. Because the LLC’s debt is a nonrecourse debt, it must be allocated to her using Connie’s profits interest. Thus, her basis in the LLC equals $2,500 or 5 per-cent of the LLC’s $50,000 accounts payable.

c. Connie reports $10,000 of ordinary income or 5 percent of the LLC’s capital of $200,000. Her basis in the LLC is $12,500 consisting of the $10,000 of income she recognizes for the receipt of her capital interest and her $2,500 share of the LLC’s nonrecourse accounts payable.

49. [LO2] Mary and Scott formed a partnership that maintains its records on a calendar-year basis. The balance sheet of the MS Partnership at year-end is as follows:

Basis Fair Market ValueCash $ 60 $ 60Land 60 180Inventory 72 60

$192 $300

Mary $ 96 $150Scott 96 150

$192 $300

At the end of the current year, Kari will receive a one-third capital interest only in ex-change for services rendered. Kari’s interest will not be subject to a substantial risk of forfeiture and the costs for the type of services she provided are typically not capitalized by the partnership. For the current year, the income and expenses from operations are

20-42


equal. Consequently, the only tax consequences for the year are those relating to the ad-mission of Kari to the partnership.

20-43


a. Compute and characterize any gain or loss Kari may have to recognize as a result of her admission to the partnership.

b. Compute Kari’s basis in her partnership interest.

c. Prepare a balance sheet of the partnership immediately after Kari’s admission showing the partners’ tax capital accounts and capital accounts stated at fair market value.

d. Calculate how much gain or loss Kari would have to recognize if, instead of a capital interest, she only received a profits interest.

a. Kari will recognize one-third of the fair market value of the partner-ship’s capital or $100 as ordinary income.

b. Kari’s basis in her partnership interest will be equal to the amount of income she reports or $100.

c. Immediately after Kari’s admission into the partnership the partner-ship’s balance sheet will appear as follows:

MS Partnership

Balance Sheet

Tax Basis 704(b)/FMV

Assets:

Cash $60 60

Land 60 180

Inventory 72 60

Totals $192 300

Capital:

Capital-Mary 46 100

Capital-Scott 46 100

Capital-Kari 100 100

Totals $192 $300

Essentially, the tax capital and 704(b) capital accounts for both Scott and Mary are reduced by their $50 share of the $100 compen-sation expense the partnership will deduct for the capital interest Kari receives.

20-44


20-45


d. If Kari only receives a profits interest, she will not recognize any in-come until she receives a profits allocation from the partnership.

50. [LO2] Dave LaCroix recently received a 10 percent capital and profits interest in Cirque Capital LLC in exchange for consulting services he provided. If Cirque Capital had paid an outsider to provide the advice, it would have deducted the payment as compensation expense. Cirque Capital’s balance sheet on the day Dave received his capital interest ap-pears below:

Assets: Basis Fair Market ValueCash $ 150,000 $ 150,000Investments 200,000 700,000

Land 150,000 250,000 Totals $ 500,000 $1,100,000

Liabilities and capital:Nonrecourse Debt 100,000 100,000

Lance* 200,000 500,000Robert* 200,000 500,000

Totals $ 500,000 $ 1,100,000

*Assume that Lance’s basis and Robert’s basis in their LLC interests equal their tax basis capital accounts.

a. Compute and characterize any gain or loss Dave may have to recognize as a result of his admission to Cirque Capital.

b. Compute each member’s tax basis in his LLC interest immediately after Dave’s receipt of his interest.

c. Prepare a balance sheet for Cirque Capital immediately after Dave’s admission show-ing the members’ tax capital accounts and their capital accounts stated at fair market value.

d. Compute and characterize any gain or loss Dave may have to recognize as a result of his admission to Cirque Capital if he receives only a profits interest.

e. Compute each member’s tax basis in his LLC interest immediately after Dave’s receipt of his interest if Dave only receives a profits interest.

a. The tax consequences of giving Dave both a 10 percent capital and profits interest are summarized in the following table:

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Description Dave Lance Robert Explanation

(1) Beginning

Basis in LLC

$0 $250,000 $250,000$200,000 tax basis capital

account + [.5 x $100,000

nonrecourse debt]

(2) Ordinary

Income

$100,000 Liquidation Value of Capital

Interest (.1 x $1,000,000

fair market value of LLC

capital)

(3) Ordinary

Deduction

($50,000) ($50,000)Capital Shift from Non-Ser-

vice Partners.

(2) x .5

(4) Increase in

Debt Allocation

$10,000 [$100,000 nonrecourse

debt x 10% profit sharing

ratio]

(5) Decrease

in Debt Alloca-

tion

(5,000) (5,000) (4) x .5

(6) Ending Ba-

sis in LLC

$110,000 $195,000 $195,000 (1) + (2) + (3) + (4) + (5)

As indicated in line (2) of the table above, Dave recognizes $100,000 of ordinary income.

b. As indicated in line (6) of the table above, the member’s tax bases in the LLC interests immediately after Dave is admitted are as fol-lows: $110,000 for Dave and $195,000 for Lance and Robert.

c. Immediately after Dave’s admission into the LLC, the LLC’s balance sheet will appear as follows:

Cirque, LLC

Balance Sheet

Tax Basis 704(b/)FMV

Assets:

Cash $150,000 $150,000

20-47


Land 200,000 700,000

Inventory 150,000 250,000

Totals $500,000 $1,100,000

20-48


Capital:

Nonrecourse Debt $100,000 100,000

Capital-Lance 150,000 450,000

Capital-Robert 150,000 450,000

Capital-Dave 100,000 100,000

Totals $500,000 $1,100,000

d. The tax consequences of giving Dave only a 10 percent profits inter-est are summarized in the following table:

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Description Dave Lance Robert Explanation

(1) Begin-

ning Basis in

LLC

$0 $250,000 $250,000$200,000 tax basis capi-

tal account + [.5 x

$100,000 nonrecourse

debt]

(2) Ordinary

Income

$0 Dave does not recognize

any income because he

only receives a profits in-

terest.

(3) Increase

in Debt Allo-

cation

$10,000 [$100,000 nonrecourse

debt x 10% profit sharing

ratio]

(4) De-

crease in

Debt Alloca-

tion

(5,000) (5,000) (3) x .5

(5) Ending

Basis in LLC

$10,000 $245,000 $245,000 (1) + (2) + (3) + (4)

Dave does not recognize any income because he only received a profits interest.

e. As reflected in line (5) of the table above, Dave’s basis is $10,000, Lance’s basis is $245,000, and Robert’s basis is $245,000.

51. [LO 2] Last December 31, Ramon sold the 10 percent interest in the Del Sol Partnership that he had held for two years to Garrett for $400,000. Prior to selling his interest, Ra-mon’s basis in Del Sol was $200,000 which included a $100,000 share of nonrecourse debt allocated to him.

a. What is Garrett’s tax basis in his partnership interest?

b. If Garrett sells his partnership interests three months after receiving it and recognizes a gain, what is the character of his gain?

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a. Garrett’s basis in his partnership interest is equal to the $400,000 amount he paid for it plus his $100,000 share of partnership debt or $500,000.

b. Because Garrett purchased his partnership interest, his holding pe-riod for the interest begins on the date the interest was purchased. As a result, he only has a three month holding period before the partnership interest is sold. This means his capital gain from the sale of his partnership interest will be short-term capital gain.

52. [LO 3] Broken Rock LLC was recently formed with the following members:

Name Tax Year End Capital/Profits %

George Allen December 31 33.3%

Elanax Corp. June 30 33.3%

Ray Kirk December 31 33.3%

What is the required taxable year-end for Broken Rock LLC?

George Allen and Ray Kirk together own more than 50 percent of the profits and capital of Broken Rock. Because both George and Ray have a December 31 year end, December 31 is majority interest taxable year and is also the required year end for Broken Rock.

53. [LO 3] Granite Slab LLC was recently formed with the following members:


Nelson Black December 31 22.0%

Brittany Jones December 31 24.0%

Lone Pine, LLC June 30 4.5%

Red Spot, Inc. October 31 4.5%

Pale Rock, Inc. September 30 4.5%

Thunder Ridge, LLC July 31 4.5%

Alpensee, LLC March 31 4.5%

Lakewood, Inc. June 30 4.5%

Streamside, LLC October 31 4.5%

Burnt Fork, Inc. October 31 4.5%

Snowy Ridge, LP June 30 4.5%

Whitewater, LP October 31 4.5%

Straw Hat, LLC January 31 4.5%

Wildfire, Inc. September 30 4.5%

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What is the required taxable year-end for Granite Slab LLC?

Because none of the partners with the same year end together own more than 50 percent of the capital and profits of Granite Slab, there is no majority interest taxable year. However, Nelson Black and Brittany Jones are principal partners because they individually own more than 5 percent of the profits and capital of Granite Slab. Moreover, they both have a December 31 year end. Therefore, the required year end of the partnership is year end of the principal partners or December 31.

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54. [LO 3] Tall Tree LLC was recently formed with the following members:


Eddie Robinson December 31 40%

Pitcher Lenders, LLC June 30 25%

Perry Homes, Inc. October 31 35%

What is the required taxable year-end for Tall Tree LLC?

55. [LO 3] Rock Creek LLC was recently formed with the following members:


Mark Banks December 31 35%

Highball Properties, LLC

March 31 25%

Chavez Builders, Inc. November 30 40%

What is the required taxable year-end for Rock Creek LLC?

Rock Creek does not have a majority interest taxable year because no partner or group of partners with the same year end owns more than 50 percent of the profits and capital interests in Rock Creek. Also, be-cause all three principal partners in Rock Creek have different year ends, the principal partner test is not met. As a result, Rock Creek must decide which of three potential year ends, December 31, March 31, or November 30, will provide its members the least aggregate de-ferral. The table below illustrates the required computations:

Possible Year Ends 12/31 Year End 3/31 Year End 11/30 Year End

Members % Tax

Year

Months

Deferral*

(MD)

% x MD Months

Deferral*

(MD)

% x MD Months

Deferral*

(MD)

% x

MD

Mark Banks 35% 12/31 0 0 9 3.15 1 .35

Highball Prop-

erties, LLC

25% 3/31 3 .75 0 0 4 1

Chavez

Builders,Inc.

40% 11/30 11 4.4 8 3.2 0 0

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Total Aggre-

gate Deferral

5.15 6.35 1.35

*Months deferral equals number of members between proposed year end and part-

ner’s year end.

As the table above indicates, Rock Creek must use November 30 as its year end because it provides the least amount of aggregate deferral to the members.

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56. [LO 3]{Research} Ryan, Dahir, and Bill have operated Broken Feather LLC for the last four years using a calendar year-end. Each has a one-third interest. Since they began op-erating, their busy season has run from June through August, with 35 percent of their gross receipts coming in July and August. The members would like to change their tax year-end and have asked you to address the following questions:

a. Can they change to an August 31 year-end and, if so, how do they make the change? {Hint: See Rev. Proc. 2002-38.}b. Can they change to a September 30 year-end and, if so, how do they make the change? {Hint: See § 444.}

a. If Broken Feather can establish that 25 percent of its gross receipts for the current twelve month period ending on August 31 fell within the months of July and August, and it can establish the same thing for the two preceding years ending on August 31, then Broken Feather can change its year end to August 31 under Rev. Proc. 2002-38.

b. Under Section 444, Broken Feather can elect to have its year end fall up to three months ahead of its normal required calendar year end. Thus, it may elect to have a September 30, October 31, or No-vember 30 year end under Section 444. However, if it makes the Section 444 election, it must calculate and deposit a Section 7519 payment with the IRS to offset the deferral benefit the partners re-ceive by having the year end fall before December 31.

57. [LO 3] {Research}Ashlee, Hiroki, Kate, and Albee LLC each own a 25 percent interest in Tally Industries LLC, which generates annual gross receipts of over $10 million. Ash-lee, Hiroki, and Kate manage the business, but Albee LLC is a nonmanaging member. Although Tally Industries has historically been profitable, for the last three years losses have been allocated to the members. Given these facts, the members want to know whether Tally Industries can use the cash method of accounting. Why or why not? {Hint: See § 448(b)(3)}

Generally, partnerships without corporate partners may use the cash method of accounting. However, partnerships that are tax shelters may not use the cash method of accounting. According to Section 448(b)(3), partnerships defined as “tax shelters” are ineligible to use the cash method. Section 461(i)(3)(B) includes “syndicates” among the other categories of “tax shelters”. Section 1256(e)(3)(B) defines a syndicate as any partnership that allocates more than 35 percent of its losses to either limited partners or “limited entrepreneurs”. In addition to limited partnerships, this provision likely also applies to LLCs be-cause Section 464(e)(2) defines a limited entrepreneur as any person, including LLC members, other than a limited partner, who does not ac-tively participate in the management of the enterprise. In summary, if

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more than 35 percent of losses in a given year are allocated to either limited partners or to LLC members not actively participating in the management of an LLC, the limited partnership or LLC will be not be permitted to use the cash method. Because of these restrictions, a significant number of limited partnerships and LLCs that would other-wise qualify are denied the use of the cash method.

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Because only 25 percent of Tally Industries’ loss for the year is allo-cated to a member that does not actively participate in management and it does not have a corporate member, Tally will be able to use the cash method.

58. [LO 4] Turtle Creek Partnership had the following revenues, expenses, gains, losses, and distributions:

Sales revenue $40,000Long-term capital gains $2,000Cost of goods sold ($13,000)Depreciation - MACRS ($3,000)Amortization of organization costs ($1,000)Guaranteed payments to partners for general management ($10,000)Cash distributions to partners ($2,000)

Given these items, what is Turtle Creek’s ordinary business income (loss) for the year?

Turtle Creek’s ordinary business income is calculated in the table be-low:

Note that guaranteed payments must be separately disclosed to the partners that receive them, and cash distributions must be separately disclosed so that partners can reduce the tax basis of their partnership interests by the amount of the distributions.

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Description Amount

Sales revenue $40,000

Less:

Cost of good sold (13,000)

Depreciation - MACRS (3,000)

Amortization of organization costs (1,000)

Guaranteed payments (10,000)

Ordinary Business Income $13,000

Separately Stated Items on Schedule K-

1:

Long-term capital gains $2,000

Guaranteed payments $10,000

Cash distributions $2,000


59. [LO 4] Georgio owns a 20 percent profits and capital interest in Rain Tree LLC. For the current year, Rain Tree had the following revenues, expenses, gains, and losses:

Sales revenue $70,000Gain on sale of land (§1231) $11,000Cost of goods sold ($26,000)Depreciation - MACRS ($3,000)Section 179 deduction* ($10,000)Employee wages ($11,000)Fines and penalties ($3,000)Municipal bond interest $6,000Short-term capital gains $4,000Guaranteed payment to Sandra ($3,000)

*Assume the §179 property placed in service limitation does not apply.

a. How much ordinary business income (loss) is allocated to Georgio for the year?

b. What are Georgio’s separately stated items for the year?

a. Georgio’s allocation of ordinary business income is reflected in the table below:

b. Georgio’s separately stated items are calculated in the table below:

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Description Total

Amount

20% Allo-

cated to

Georgio


Less:



Employee wages (11,000)


Ordinary Business Income $27,000 $5,400


Description Total

Amount

20% Allo-

cated to

Georgio

Separately Stated Items on Schedule K-

1:

Section 1231 gains $11,000 $2,200

Section 179 deduction (10,000) (2,000)

Short-term capital gains 4,000 800

Municipal bond interest* 6,000 1,200

Fines and penalties* (3,000) (600)

*Although these amounts are not included in Georgio’s taxable income computation, they must be separately disclosed because they affect Georgio’s tax basis in his LLC interest.

60. [LO 4] The partnership agreement of the G&P general partnership states that Gary will receive a guaranteed payment of $13,000, and that Gary and Prudence will share the re-maining profits or losses in a 45/55 ratio. For year 1, the G&P partnership reports the following results:

Sales revenue $70,000Gain on sale of land (§ 1231) $8,000Cost of goods sold ($38,000)Depreciation - MACRS ($9,000)Employee wages ($14,000)Cash charitable contributions ($3,000)Municipal bond interest $2,000Other expenses ($2,000)

a. Compute Gary’s share of ordinary income (loss) and separately stated items to be re-ported on his year 1 Schedule K-1, including his self-employment income (loss).

b. Compute Gary’s share of self-employment income (loss) to be reported on his year 1 Schedule K-1, assuming G&P is a limited partnership and Gary is a limited partner.

c. What do you believe Gary’s share of self-employment income (loss) to be reported on his year 1 Schedule K-1 should be, assuming G&P is an LLC and Gary spends 2,000 hours per year working there full time?

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Gary’s ordinary business income, separately stated items, and self-em-

ployment income are calculated in the table below:

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Description Total

Amount

Allocated to Gary Explanation


Less:




Other expenses (2,000)


Ordinary Business Loss ($6,000) ($2,700) 45% allocation to

Gary

Separately Stated

Items on Schedule K-1:

Section 1231 gains $8,000 $3,600 45% allocation to Gary

Cash charitable contri-

butions

($3,000) ($1,350) 45% allocation to Gary

Guaranteed payment $13,000 $13,000 Gary’s guaranteed

payment

Municipal bond interest $2,000 $900 45% allocation to

Gary

Self-employment in-

come

$7,000

[$13,000

guaranteed

payment -

$6,000 ordi-

nary loss]

$10,300 ($2,700) ordinary

business loss allo-

cated to Gary +

$13,000 guaranteed

payment


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a. If Gary is a limited partner, then his self-employment income would equal the $13,000 guaranteed payment he received.

b. Under Proposed Reg. §1.1402(a)-2, Gary’s $2,700 share of ordinary business loss will reduce his $13,000 guaranteed payment leaving him with $10,300 of self-employment income (because he spent more than 500 hours working in the trade or business of the LLC). In this instance, the proposed regulations provide Gary with a favor-able interpretation of the law.

61. [LO 4] {Research} Hoki Poki, a cash-method general partnership, recorded the following items for its current tax year:

Rental real estate income $2,000Sales revenue $70,000Section 1245 recapture income $8,000Interest income $2,000Cost of goods sold ($38,000)Depreciation - MACRS ($9,000)Supplies expense ($1,000)Employee wages ($14,000)Investment interest expense ($1,000)Partner’s medical insurance premiums paid by Hoki Poki ($3,000)

As part of preparing Hoki Poki’s current year return, identify the items that should be in-cluded in computing its ordinary business income (loss) and those that should be sepa-rately stated. {Hint: See Schedule K-1 and related preparer’s instructions at www.irs.gov.}

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http://www.irs.gov/


62. [LO 4] {Research} On the last day of its current tax year, Buy Rite LLC received $300,000 when it sold a machine it had purchased for $200,000 three years ago to use in its business. At the time of the sale, the basis in the equipment had been reduced to $100,000 due to tax depreciation taken. How much did Buy Rite’s self-employment earnings increase when the equipment was sold? {Hint: See §1402(a)(3).}

Buy Rite’s self-employment income does not increase due to the sale of the equipment. According to §1402(a)(3)(C), gains from the sale of equipment are not included in Buy Rite’s self-employment income. Thus, Buy Rite must insure that the $100,000 of ordinary Section 1245 recapture is subtracted from its ordinary business income or loss when calculating its self-employment income. Because the remaining $100,000 of Section 1231 gain is separately stated, it is not included in ordinary business income or loss and therefore will not be included in self-employment income.

63. [LO 4] Jhumpa, Stewart, and Kelly are all one-third partners in the capital and profits of Firewalker general partnership. In addition to their normal share of the partnership’s an-nual income, Jhumpa and Stewart receive an annual guaranteed payment of $10,000 to compensate them for additional services they provide. Firewalker’s income statement for the current year reflects the following revenues and expenses:

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Sales revenue $340,000Interest income 3,300Long-term capital gains 1,200Cost of good sold (120,000)Employee wages (75,000)Depreciation expense (28,000)Guaranteed payments (20,000)Miscellaneous expenses (4,500)Overall net income $97,000

a. Given Firewalker’s operating results, how much ordinary business income (loss) and what separately stated items [including the partners’ self-employment earnings (loss)] will it report on its return for the year?

b. How will it allocate these amounts to its partners?

c. How much self-employment tax will each partner pay assuming none have any other source of income or loss?

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The table below illustrates Firewalker’s ordinary business income and separately stated items. Note that the total self employment income for all partners consists of Firewalker’s $92,500 ordinary business in-come (because ordinary business income from a general partnership is always treated as self-employment income by the partners) plus the

$20,000 in guaranteed payments made to Dave and Stewart.

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Description Total Jhumpa Stewart Kelly


Less:



Depreciation expense (28,000)

Misc. expenses (4,500)


Ordinary Business In-

come

$92,500 $30,833 $30,833 $30,833

Separately Stated Items

on Schedule K-1:

Interest income $3,300 $1,100 $1,100 $1,100

Long-term capital gains $1,200 $400 $400 $400

Self-employment income $112,500 $40,833 $40,833 $30,833


a. The table above reflects the partner’s shares of ordinary business income and her/his separately stated items. Note that each part-ner’s self employment income consists of her/his individual shares of ordinary business income plus the guaranteed payment she/he received, if any.

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b. The table below reflects the partner’s self-employment tax liability:

Description Stewart Jhumpa Kelly Explanation

(1)Self-employment

income

$40,833 $40,833 $30,833

(2) Percentage of self

employment income

subject to self-employ-

ment tax

92.35% 92.35% 92.35%

(3) Earnings from self-

employment

$37,709 $37,709 $28,474 (1) x (2)

(4) Self employment

tax rate

15.3% 15.3% 15.3%

(7) Self-employment

tax liability

$5,769 $5,769 $4,357 (3) x (4)

64. [LO 4] {Research} Lane and Cal each own 50 percent of the profits and capital of High-Yield LLC. HighYield owns a portfolio of taxable and municipal bonds, and each year the portfolio generates approximately $10,000 of taxable interest and $10,000 of tax- ex-empt interest. Lane’s marginal tax rate is 35 percent while Cal’s marginal tax rate is 15 percent. To take advantage of the difference in their marginal tax rates, Lane and Cal want to modify their operating agreement to specially allocate all of the taxable interest to Cal and all of the tax-exempt interest to Lane. Until now, Lane and Cal had been allo-cated 50 percent of each type of interest income.

a. Is HighYield’s proposed special allocation acceptable under current tax rules? Why or why not? {Hint: See Reg. §1.704-1(b)(2)(iii)(b) and §1.704-1(b)(5) Example (5).}

b. If the IRS ultimately disagrees with HighYield’s special allocation, how will it likely reallocate the taxable and tax-exempt interest among the members? {Hint: See Reg. §1.704-1(b)(5) Example (5)(ii).}

a. According to IRC §704 partnership allocations will be respected by the IRS unless they do not have “substantial economic effect.” The facts provided are almost identical to the general scenario de-scribed in Reg. §1.704-1(b)(2)(iii)(b) and to the detailed facts de-scribed in §1.704-1(b)(5) Example (5) given that the special alloca-tion to Lane and Cal simply changes the character of the income al-located to Lane and Cal but not the amount. Thus, this allocation is not appropriate because it is not substantial.

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b. As described in Reg. §1.704-1(b)(5) Example (5)(ii), the IRS will likely assert that 50 percent of both the taxable and tax-exempt bond interest should be allocated to Lane and Cal.

65. [LO 5] Larry’s tax basis in his partnership interest at the beginning of the year was $10,000. If his share of the partnership debt increased by $10,000 during the year and his share of partnership income for the year is $3,000, what is his tax basis in his partnership interest at the end of the year?

$23,000 as computed in the table below:

Description Total Amount

Beginning Tax Basis $10,000

Increase in Partner’s Share of Debt

10,000

Partner’s Share of In-come

3,000

Ending Tax Basis $23,000

66. [LO 5] Carmine was allocated the following items from the Piccolo LLC for last year:

Ordinary business lossNondeductible penaltiesTax-exempt interest incomeShort-term capital gainCash distributions

Rank these items in terms of the order they should be applied to adjust Carmine’s tax ba-sis in Piccolo for the year.

Items that increase basis are applied first, then distributions, and then items that reduce basis. Thus, the items above should be applied in the following order to adjust Carmine’s tax basis:

Tax Exempt Income and Short Term Capital Gain (basis increasing items come first)Cash Distribution (distributions come after basis increasing items)Ordinary Business Loss and Non-Deductible Penalties (basis reducing items come last)

67. [LO 5] Oscar, Felix, and Marv are all one-third partners in the capital and profits of East-side general partnership. In addition to their normal share of the partnership’s annual in-come, Oscar and Felix receive annual guaranteed payments of $7,000 to compensate them for additional services they provide. Eastside’s income statement for the current year reflects the following revenues and expenses:

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Sales revenue $ 420,000Dividend income 5,700Short-term capital gains 2,800Cost of good sold (210,000)Employee wages (115,000)Depreciation expense (28,000)Guaranteed payments (14,000)Miscellaneous expenses (9,500)Overall net income $ 52,000

In addition, Eastside owed creditors $120,000 at the beginning of the year but managed to pay down its debts to $90,000 by the end of the year. All partnership debt is allocated equally among the partners. Finally, Oscar, Felix and Marv had a tax basis of $80,000 in their interests at the beginning of the year.

a. What tax basis do the partners have in their partnership interests at the end of the year?

b. Assume the partners began the year with a tax basis of $10,000 and all the debt was paid off on the last day of the year. How much gain will the partners recognize when the debt is paid off? What tax basis do the partners have in their partnership interests at the end of the year?

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a. All of the partners have an ending tax basis of $87,333 as calcu-lated in the table below:

Description Oscar Felix Marv Explanation

(1)Beginning tax basis (including partners’ share of debt)

$80,000 $80,000 $80,000

(2)Dividend income $1,900 $1,900 $1,900 $5,700 x 33.33%

(3)Short-term capi-tal gains

$933 $933 $933 $2,800 x 33.33%

(4)Partner’s share of ordinary busi-ness income

$14,500 $14,500 $14,500 [$52,000 overall net income -

($5,700 Dividend Income + $2,800

Short-Term Capital Gains)] x 33.3%

(5)Deemed distri-bution from debt repayment

($10,000) ($10,000) ($10,000) [$120,000 - $90,000] x 33.33%

(6)Guaranteed pay-ments received

0 0 Partners don’t in-crease the basis of their partnership in-

terests by the amount of guaran-teed payments re-

ceived(7)Ending tax basis $87,333 $87,333 $87,333(1)+(2)+(3)+(4)+(5

)

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b. Each partner recognizes gain of $12,667 and has an ending basis of zero as calculated in the table below:

Description Oscar Felix Marv Explanation

(1)Beginning tax Basis (including partners’ share of debt)

$10,000 $10,000 $10,000

(2)Dividend in-come

$1,900 $1,900 $1,900 $5,700 x 33.33%

(3)Short-term capi-tal gains

$933 $933 $933 $2,800 x 33.33%

(4)Partner’s share of ordinary busi-ness income

$14,500 $14,500 $14,500 [$52,000 overall net income - ($5,700

Dividend Income + $2,800 Short-Term Capital Gains)] x

33.3%(5)Deemed distri-bution from debt repayment

($40,000) ($40,000) ($40,000) [$120,000 - $0] x 33.33%

(6)Guaranteed payments received

0 0 Partners don’t in-crease the basis of their partnership in-

terests by the amount of guaran-teed payments re-

ceived(7)Gain recognized by partners

$12,667 $12,667 $12,667 -[(5)+(1)+(2)+(3)+(4

)](8)Ending tax basis 0 0 0 Generally

(1)+(2)+(3)+(4)+(5) but may not go lower than zero

68. [LO 5] Pam, Sergei, and Mercedes are all one-third partners in the capital and profits of Oak Grove General Partnership. Partnership debt is allocated among the partners in ac-cordance with their capital and profits interests. In addition to their normal share of the partnership’s annual income, Pam and Sergei receive annual guaranteed payments of $20,000 to compensate them for additional services they provide. Oak Grove’s income statement for the current year reflects the following revenues and expenses:

Sales revenue $476,700Dividend income 6,600Section 1231 losses (3,800)Cost of good sold (245,000)

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Employee wages (92,000)Depreciation expense (31,000)Guaranteed payments (40,000)Miscellaneous expenses (11,500)Overall net income $ 60,000

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In addition, Oak Grove owed creditors $90,000 at the beginning and $150,000 at the end of the year, and Pam, Sergei and Mercedes had a tax basis of $50,000 in their interests at the beginning of the year. Also, Sergei and Mercedes agreed to increase Pam’s capital and profits interest from 33.3 percent to 40 percent at the end of the tax year in exchange for additional services she provided to the partnership. The liquidation value of the addi-tional capital interest Pam received at the end of the tax year is $40,000.

a. What tax basis do the partners have in their partnership interests at the end of the year?

b. If, in addition to the expenses listed above, the partnership donated $12,000 to a politi-cal campaign, what tax basis do the partners have in their partnership interests at the end of the year assuming the liquidation value of the additional capital interest Pam receives at the end of the year remains at $40,000?

a. Pam’s basis is $140,000, Sergei’s basis is $65,000, and Mercedes’s basis is $65,000 as computed in the table below:

Description Pam Sergei Mercedes Explanation

(1)Beginning tax basis (in-

cluding partners’ share of

debt)

$50,000 $50,000 $50,000 Given

(2) Dividends income $2,200 $2,200 $2,200 $6,600 x 33.33% (Pam’s profits in-terest doesn’t in-crease until the end of the year)

(3)Partner’s share of ordi-

nary business income

$19,067 $19,067 $19,067 [$60,000 overall net income -

($6,600 Dividend Income - ($3,800)

Section 1231 Losses)] x 33.3%

(4) Debt increase (deemed

cash contribution)

$30,000 $15,000 $15,000Pam :[( $150,000 x

40%) – ($90,000 x

33.33%)]

Other Partners:

[($150,000 x 30%)

– ($90,000 x

33.33%)]

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(5) Pam’s new 6.67% capital

interest

$40,000 ($20,000) ($20,000) Additional 6.67%

capital interest to

Pam is a guaran-

teed payment to

Pam and a deduc-

tion allocated

equally to other

partners

(6) Cash guaranteed pay-ments received

0 0 Partners don’t in-crease the basis of their partnership interests by the amount of cash guaranteed pay-ments received

(7) Section 1231 losses ($1,267)($1,267) ($1,267) ($3,800) x 33.33%

(8)Ending tax basis $140,000 $65,000 $65,000Sum of (1) through

(7)

b. Pam’s basis is $136,000, Sergei’s basis is $61,000, and Mercedes’ basis is $61,000 as computed in the table below:

Description Pam Sergei Mercedes Explanation

Ending tax basis given facts

in part a.

$140,000 $65,000 $65,000See solution to

part a. above

Campaign contribution ($4,000) ($4,000) ($4,000)($12,000) x

33.33% Non-de-

ductible expenses

must reduce a

partner’s tax basis

New ending basis given facts

in part b.

$136,000 $61,000 $61,000

69. [LO 6] Alfonso began the year with a tax basis in his partnership interest of $30,000. His share of partnership debt at the beginning and end of the year consists of $5,000 of re-

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course debt and $5,000 of nonrecourse debt. During the year, he was allocated $40,000 of partnership ordinary business loss. Alfonso does not materially participate in this part-nership and he has $1,000 of passive income from other sources.

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a. How much of Alfonso’s loss is limited by his tax basis?

b. How much of Alfonso’s loss is limited by his at-risk amount?

c. How much of Alfonso’s loss is limited by the passive activity loss rules?

a. Because Alfonso’s basis before the loss allocation is $30,000, $10,000 of his $40,000 loss allocation is limited by his tax basis and will carryover to the following year.

b. Of the $30,000 loss not already limited by Alfonso’s tax basis, $5,000 is limited because Alfonso’s at-risk amount is only $25,000 ($30,000 regular tax basis less the $5,000 nonrecourse debt not al-lowed in calculating the at-risk amount). Thus, $25,000 of loss re-mains after the tax basis and at-risk limitations and Alfonso has a $5,000 at-risk carryover.

c. Because Alfonso doesn’t materially participate in the partnership, he may only deduct the $25,000 loss remaining after the tax basis and at-risk limitations to the extent he has passive income from other sources. Thus, he may deduct $1,000 of the $25,000 loss cur-rently and will have a $24,000 passive activity loss carryover.

70. [LO 5, 6] {Research} Juan Diego began the year with a tax basis in his partnership inter-est of $50,000. During the year, he was allocated $20,000 of partnership ordinary busi-ness income, $70,000 of §1231 losses, $30,000 of short-term capital losses, and received a cash distribution of $50,000.

a. What items related to these allocations does Juan Diego actually report on his tax re-turn for the year? {Hint: See Reg. §1.704-1(d)(2) and Rev. Rul. 66-94.}

b. If any deductions or losses are limited, what are the carryover amounts and what is their character? {Hint: See Reg. §1.704-1(d).}

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a. According to Rev. Rul. 66-94, Juan Diego should increase his basis first by his $20,000 share of ordinary business income and then re-duce it by his $50,000 cash distribution. At this point, his remaining basis of $20,000 will be reduced to zero by the $70,000 Section 1231 losses and $30,000 short-term capital losses allocated to him. Reg. §1.704-1(d)(2) describes how Juan Diego’s $20,000 tax basis before considering the loss allocations should be allocated to the two types of losses. The table below illustrates the required calcula-tions:

(1) Original Loss

(2) Amount Deducted Currently

(1) – (2) Loss Carryover

Section 1231 losses

$70,000 $14,000($20,000 x

$70,000/$100,000)

$56,000

Short-term capital losses

$30,000 $6,000($20,000 x

$30,000/$100,000)

$24,000

b. As indicated in the table above, Juan Diego’s $80,000 loss carryover (due to his $20,000 tax basis limitation) will be characterized as a $56,000 Section 1231 loss and a $24,000 short-term capital loss.

71. [LO 6] Farell is a member of Sierra Vista LLC. Although Sierra Vista is involved in a number of different business ventures, it is not currently involved in real estate either as an investor or as a developer. On January 1, year 1, Farell has a $100,000 tax basis in his LLC interest that includes his $90,000 share of Sierra Vista’s general debt obligations. By the end of the year, Sierra Vista’s general debt obligations have increased to $100,000. Because of the time he spends in other endeavors, Farell does not materially participate in Sierra Vista. His share of the Sierra Vista losses for year 1 is $120,000 and, as a partner in the Riverwoods Partnership, he has year 1 Schedule K-1 passive income of $5,000.

a. Determine how much of the Sierra Vista loss Farell will currently be able to deduct on his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations.

b. Assuming Farrell’s Riverwoods K-1 indicates passive income of $30,000, determine how much of the Sierra Vista loss he will ultimately be able to deduct on his tax return for year 1 and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations.

c. Assuming Farrell is deemed to be an active participant in Sierra Vista, determine how much of the Sierra Vista loss he will ultimately be able to deduct on his tax return for

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year 1 and list the losses suspended due to tax basis, at-risk, and passive activity loss lim-itations.

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a.

72. [LO 6] {Research} Jenkins has a one-third capital and profits interest in the Maverick General Partnership. On January 1, year 1, Maverick has $120,000 of general debt obli-gations and Jenkins has a $50,000 tax basis in his partnership interest. During the year, Maverick incurred a $30,000 in nonrecourse debt that is not secured by real estate. Be-cause Maverick is a rental real estate partnership, Jenkins is deemed to be a passive par-ticipant in Maverick. His share of the Maverick losses for year 1 is $105,000. Jenkins is not involved in any other passive activities and this is the first year he has been allocated losses from Maverick.

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a. Determine how much of the Maverick loss Jenkins will currently be able to deduct on his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations.

b. If Jenkins sells his interest on January 1, year 2, what happens to his suspended losses from year 1? {Hint: See Sennett v. Commissioner 80 TC 825 (1983) and Prop. Reg. §1.465-66(a).}

a. Jenkins may not deduct any losses currently, and he will have a $25,000 loss suspended by the tax basis limitation, a $30,000 loss suspended by the at-risk limitation, and a $50,000 loss suspended by the passive activity loss limitation as illustrated in the table be-low:

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Description Tax Basis Limitation

At-risk Limi-tation

Passive Activ-ity Limitation

Explanation

(1) Beginning Tax basis and At-risk amount

$50,000 $50,000 General debt obliga-tions of general part-nerships are treated

as recourse debt. Thus, Jenkins’ begin-ning at-risk amount is the same as his

beginning tax basis.(2) Increase in nonrecourse debt

$30,000 $0 Nonrecourse debt generally not in-cluded in at-risk amount.

(3) Tax basis and At-risk amount before ordinary busi-ness loss

$80,000 $50,000 (1) + (2)

(4) Ordinary business loss

($105,000)

(5) Loss clearing the Tax basis hurdle

($80,000) Loss limited to $80,000 tax basis

(6)Loss sus-pended by Tax basis hurdle

($25,000) (4) - (5)

(7) Loss clearing Tax basis hurdle

($80,000) (5)

(8) Loss clearing At-risk hurdle

($50,000) Loss limited to $50,000 at-risk

amount(9) Loss sus-pended by At-risk hurdle

($30,000) (7) - (8)

(10) Passive ac-tivity loss

($50,000) (8)Jenkins is not a material participant

(11) Passive in-come

$0 Given

(12) Loss used to offset Passive income

$0 Loss only used to the extent of passive in-

come(13) Passive ac-tivity loss carry-over

($50,000) (10) – (12)


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b. According to Sennett v. Commissioner 80 TC 825 (1983), a partner with losses suspended by the tax basis limitation disappear when the partnership interest is sold. Thus, Jenkins will lose the $25,000 loss suspended by the tax basis limitation. In addition, Prop. Reg. §1.465-66(a) provides that Jenkins may utilize the $30,000 loss sus-pended by the at-risk limitation to offset any gain he would other-wise report from the disposition of his partnership interest. Finally, Jenkins may deduct the $50,000 passive activity loss carryover in the year of disposition.

73. [LO 6] {Planning} Suki and Steve own 50 percent capital and profits interests in Lorinda LLC. Lorinda operates the local minor league baseball team and owns the stadium where the team plays. Although the debt incurred to build the stadium was paid off several years ago, Lorinda owes its general creditors $300,000 (at the beginning and end of the year) that is not secured by firm property or guaranteed by any of the members. At the beginning of the current year Suki and Steve had a tax basis of $170,000 in their LLC in-terests including their share of debt owed to the general creditors. Shortly before the end of the year they each received a $10,000 cash distribution, even though Lorinda’s ordi-nary business loss for the year was $400,000. Because of the time commitment to oper-ate a baseball team, both Suki and Steve spent more than 1,500 hours during the year op-erating Lorinda.

a. Determine how much of the Lorinda loss Suki and Steve will each be able to deduct on their current tax returns, and list their losses suspended by the tax basis, at-risk, and pas-sive activity loss limitations.

b. Assume that sometime before receiving the $10,000 cash distribution, Steve is advised by his tax advisor that his marginal tax rate will be abnormally high during the current year because of an unexpected windfall. To help Steve utilize more of the losses allo-cated from Lorinda in the current year, his advisor recommends refusing the cash distri-bution and personally guaranteeing $100,000 of Lorinda’s debt, without the right to be reimbursed by Suki. If Steve follows his advisor’s recommendations, how much addi-tional Lorinda loss can he deduct on his current tax return? How does Steve’s decision affect the amount of loss Suki can deduct on her current return and the amount and type of her suspended losses?

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a. The members (either Steve or Suki) may deduct $10,000 in losses currently, and they will have a $40,000 loss suspended by the tax basis limitation, and a $150,000 loss suspended by the at-risk limi-

tation as illustrated in the table below:

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At-risk Limi-tation

Explanation


$170,000 $20,000 General debt obligations of LLCs are treated as nonrecourse

debt. Thus, Suki or Steve’s be-ginning at-risk amount is

$150,000 less than their begin-ning tax basis.

(2) Distribution ($10,000) ($10,000)


$160,000 $10,000 (1) + (2)


($200,000) $400,000 x50%


($160,000) Loss limited to $160,000 tax ba-sis


($40,000) (4) - (5)


($160,000) (5)

(8) Loss clearing At-risk hurdle and currently deductible

($10,000) Loss limited to $10,000 at-risk amount on line (3). This amount is currently deductible because Steve is an active participant in

the activity.(9) Loss sus-pended by At-risk hurdle

($150,000) (7) - (8)


Under these facts, Steve may deduct $120,000 in losses currently (a $110,000 increase over the loss he could deduct in part a.), and will

have a

$80,000 loss suspended by the at-risk limitation as illustrated in the ta-ble below:

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At-risk Limi-tation

Explanation


$170,000 $20,000 General debt obligations of LLCs are treated as

nonrecourse debt. Thus, Steve’s beginning at-risk amount is $150,000 less than his beginning tax

basis.(2) Increase in debt allocation

$50,000 $100,000 [(100,000 + 50% x $200,000) - $150,000] for tax basis and [100,000 – 0] for at-risk amount be-cause guaranteeing the debt makes it recourse

debt(3) Tax basis and At-risk amount before ordinary busi-ness loss

$220,000 $120,000 (1) + (2)


($200,000)


($200,000) Loss is less than tax basis limitation


$0 (4) - (5)


($200,000) (5)


($120,000) Loss is limited to at-risk amount on line (3). This amount is currently de-

ductible because Steve is an active participant in


($80,000) (7) - (8)


Suki may deduct $10,000 in losses currently (the same amount of loss as in part a.), and she will have a $90,000 loss suspended by the tax basis limitation and a $100,000 loss suspended by the at-risk lim-itation as illustrated in the table below:

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74. [LO 6]{Re-

search} Ray and Chuck own 50 percent capital and profits interests in Alpine Properties LLC. Alpine builds and manages rental real estate, and Ray and Chuck each work full time (over 1000 hours per year) managing Alpine. Alpine’s debt (both at the beginning and end of the year) consists of $1,500,000 in nonrecourse mortgages obtained from an unrelated bank and secured by various rental properties. At the beginning of the current year, Ray and Chuck each had a tax basis of $250,000 in his LLC interest including his share of the nonrecourse mortgage debt. Alpine’s ordinary business losses for the current year totaled $600,000 and neither member is involved in other activities that generate passive income.

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At-risk Limi-tation

Explanation


$170,000 $20,000 General debt obligations of LLCs are treated as

nonrecourse debt. Thus, Suki’s beginning at-risk amount is $150,000 less than her beginning tax

basis.(2) Distribution ($10,000) ($10,000)

(3) Decrease in debt allocation

($50,000) $0 [($200,000 x 50% ) –($300,000 x 50%)]


$110,000 $10,000 (1) + (2)+ (3)


($200,000)


($110,000) Loss is limited to the tax basis


($90,000) (5) - (6)


($110,000) (6)


($10,000) Loss is limited to at-risk amount on line (4). This amount is currently de-ductible because Suki is an active participant in


($100,000) (7) - (8)


a. How much of each member’s loss is suspended because of the tax basis limitation?

b. How much of each member’s loss is suspended because of the at-risk limitation?

c. How much of each member’s loss is suspended because of the passive activity loss limitation? {Hint: See §469(b)(7).}

a. Each member will have $50,000 of loss suspended because of the tax basis limitation as reflected in the table below:

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At-risk Limi-tation

Passive Activ-ity Limitation

Explanation


$250,000 $250,000 Because the LLC’s mortgage debt is

qualified nonrecourse financing, it is in-cluded in both the

tax basis and at-risk amount


($300,000) 50% x $600,000


($250,000) Loss limited to $250,000 tax basis

(4) Loss sus-pended by Tax basis hurdle

($50,000) (2) - (3)


($250,000) (3)

(6) Loss clearing At-risk hurdle

($250,000) Loss limited to $250,000 at-risk

amount(7) Loss sus-pended by At-risk hurdle

$0 (7) - (8)


b. As indicated in the table above, none of the members’ loss alloca-tion will be suspended because of the at-risk limitation.

c. Each member’s $250,000 loss remaining after the tax basis and at-risk limitations (see table in part a.) is deductible currently. Al-though rental real estate ventures are generally treated as passive activities under §469(c)(2), §469(b)(7) provides an exception for tax-payers that work more than half of the time in real property trades or businesses and work more than 750 hours in real property trades or businesses in a given year. Given the facts in this problem, both members will be treated as active participants and will therefore be able to immediately deduct $250,000.

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Comprehensive Problems

75. [LO 2, 4, 5] Aaron, Deanne, and Keon formed the Blue Bell General Partnership at the beginning of the current year. Aaron and Deanne each contributed $110,000 and Keon transferred an acre of undeveloped land to the partnership. The land had a tax basis of $70,000 and was appraised at $180,000. The land was also encumbered with a $70,000 nonrecourse mortgage for which no one was personally liable. All three partners agreed to split profits and losses equally. At the end of the first year Blue Bell made a $7,000 principal payment on the mortgage. For the first year of operations, the partnership records disclosed the following information:

Sales revenue $470,000Cost of goods sold $410,000Operating expenses $70,000Long-term capital gains $2,400Section 1231 gains $900Charitable contributions $300Municipal bond interest $300Salary paid as a guaranteed payment to Deanne (not included in expenses) $3,000

a. Compute the adjusted basis of each partner’s interest in the partnership immediately af-ter the formation of the partnership.

b. List the separate items of partnership income, gains, losses, and deductions that the partners must show on their individual income tax returns that include the results of the partnership’s first year of operations.

c. (Optional) Using the information generated in answering parts a. and b., prepare Blue Bells’ page 1 and Schedule K to be included with its Form 1065 for its first year of opera-tions along with Schedule K-1 for Deanne.

d. What are the partners’ adjusted bases in their partnership interests at the end of the first year of operations?

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a. This initial adjusted basis for Keon is $23,333, for Aaron is $133,333, and for Deanne is $133,333 as shown in the calculations with table below:

Description Keon Aaron Deanne Explanation


uted land

$70,000


(3) Debt allocated to

partners

$23,333 $23,333 $23,333

(4) Relief from nonre-

course mortgage

($70,000)

(5) Gain recognized $0 $0 $0(4 )- [(1)+

(2)+ (3)] if

positive, oth-

erwise 0

(6) Partners’ initial tax

basis

$23,333 $133,333 $133,333(1) + (2) +

(3)+ (4) +

(5)

b. The partners’ shares of ordinary business loss and separately stated items are reflected in the table below:

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Description Total Keon Aaron Deanne Explanation

(1) Partners’ initial

Tax basis

$23,333 $133,333 $133,333See prob-

lem a. above

(2) Sales revenue $470,000

Less:

(3) Cost of goods

sold

(410,000)

(4) Operating ex-

penses

(70,000)

(5) Guaranteed

payments

(3,000)

(6) Ordinary Busi-

ness Loss

($13,000) ($4,333) ($4,333) ($4,333)[Sum of (2) through (5)] x 33.33%

Separately Stated

Items on Schedule

K-1:

(7) Long-term capi-

tal gains

$2,400 $800 $800 $800$2,400 x 33.33%

(8) Section 1231

gains

$900 $300 $300 $300$900 x 33.33%

(9) Municipal bond

interest

$300 $100 $100 $100$300 x 33.33%

(10) Charitable

contributions

($300) ($100) ($100) ($100)($300) x 33.33%

(11) Mortgage re-

duction (deemed

cash distribution)

($7,000) ($2,333) ($2,333) ($2,333)($7,000) x 33.33%

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(12) Self-employ-

ment Loss

($10,000) ($4,333) ($4,334) ($1,333)Line 6 +

$3,000 guar-

anteed pay-

ment to

Deanne

Partners’ ending

tax basis

$17,767 127,767 127,767(1) + (6)+

(7) through

(11)

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c. Blue Bell Partnership’s page 1 and Schedule K to be included with Form 1065 and Deanne’s Schedule K-1 are shown below:

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d. Keon has an ending basis of $17,767, Aaron has an ending basis of $127,767 and Deanne has an ending basis of $127,767. These amounts are calculated in the table included with the solution to part b. above.

76. [LO 4, 5, 6] The TimpRiders Limited Partnership has operated a motorcycle dealership for a number of years. Lance is the limited partner, Francesca is the general partner, and they share capital and profits equally. Francesca works full-time managing the partner-ship. Both the partnership and the partners report on a calendar-year basis. At the start of the current year, Lance and Francesca had bases of $10,000 and $3,000 respectively, and the partnership did not carry any debt. During the current year, the partnership re-ported the following results from operations:

Net sales $650,000Cost of goods sold $500,000Operating expenses $160,000Short-term capital loss $2,000Tax-exempt interest $2,000Section 1231 gain $6,000

On the last day of the year, the partnership distributed $3000 each to Lance and Francesca.

a. What outside basis do Lance and Francesca have in their partnership interests at the end of the year?

b. To what extent does the tax basis limitation apply in restricting the partners’ deductible losses for the year?

c. To what extent does the passive activity loss limitation apply in restricting their de-ductible losses for the year?

Lance has an ending basis of $5,000 and Francesca has an ending basis of $0 as illustrated in the table below:

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Description Total Lance

(Limited)

Francesca

(General)

Explanation

(1) Partners’ initial

Tax basis

$10,000 $3,000Given

Basis Increasing

Items:

(2) Section 1231

gain

$6,000 $3,000 $3,000$6,000 x 50%


a. As indicated in the table in part a., Lance’s loss allocations are not limited by his tax basis; however, Francesca’s total losses are lim-ited to $4,000—his tax basis prior to his loss allocations.

b. Although Lance’s loss allocations are not limited because of his tax basis, his share of the ordinary business loss is classified as a pas-sive activity loss because he is a limited partner. Thus, he must carryover his $5,000 ordinary business loss as a passive activity loss until he either receives passive income or he sells his partner-

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(3) Tax-exempt in-

terest

$2,000 $1,000 $1,000$2,000 x 50%

(4) Basis Before

Distributions

$14,000 $7,000Sum of lines (1) through (3)

(5) Cash distribu-

tions

($3,000) ($3,000)Given

(6) Basis Before

Loss Allocations

$11,000 $4,000(4) + (5)


Less:

(8) Cost of good

sold

(500,000)

(9) Operating ex-

penses

(160,000)

(10) Ordinary busi-

ness loss

($10,000) ($5,000) ($5,000)[Sum of (7) through (9)] x 50%

(11) Short-term

capital loss

($2,000) ($1,000) ($1,000)($2,000) x 50%

Partners’ ending

tax basis

$5,000 $0(6) + (10) + (11)

or limited to a ba-

sis of zero. Thus,

the tax basis limi-

tation applies to

Francesca.


ship income. His $1,000 short-term capital loss is not limited be-cause it is a portfolio rather than a passive loss. The passive activ-ity loss rules don’t apply to Francesca because he works full time managing the partnership and would be classified as a material par-ticipant.

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77. [LO 2, 4, 5] LeBron, Dennis, and Susan formed the Bar T LLC at the beginning of the current year. LeBron and Dennis each contributed $200,000 and Susan transferred sev-eral acres of agricultural land she had purchased two years earlier to the LLC. The land had a tax basis of $50,000 and was appraised at $300,000. The land was also encum-bered with a $100,000 nonrecourse mortgage (i.e., qualified nonrecourse financing) for which no one was personally liable. The members plan to use the land and cash to begin a cattle-feeding operation. Susan will work full-time operating the business, but LeBron and Dennis will devote less than two days per year to the operation. All three members agree to split profits and losses equally. At the end of the first year, Bar T had accumu-lated $40,000 of accounts payable jointly guaranteed by LeBron and Dennis and had made a $9,000 principal payment on the mortgage. None of the members have passive income from other sources.

For the first year of operations, the partnership records disclosed the following informa-tion:

Sales revenue $620,000Cost of goods sold $380,000Operating expenses $670,000Dividends $1,200Municipal bond interest $300Salary paid as a guaranteed payment to Susan (not included in expenses) $10,000Cash distributions split equally among the members at year-end $3,000

a. Compute the adjusted basis of each member’s interest immediately after the formation of the LLC.

b. When does each member’s holding period for his or her LLC interests begin?

c. What is Bar T’s tax basis and holding period in its land?

d. What is Bar T’s required tax year-end?

e. What overall methods of accounting are available to Bar T?

f. List the separate items of partnership income, gains, losses, deductions and other items that will be included in each member’s Schedule K-1 for the first year of operations. Use the proposed self-employment tax regulations to determine each member’s self-employ-ment income or loss.

g. What are the members’ adjusted bases in their LLC interests at the end of the first year of operations?

h. What are the members’ at-risk amounts in their LLC interests at the end of the first year of operations?

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i. How much loss from Bar T, if any, will the members be able to deduct on their individ-ual returns from the first year of operations?

a. LeBron’s adjusted basis is $216,667, Dennis’ adjusted basis is

$216,667, and Susan’s adjusted basis is $16,667 as calculated in

the table below:

Description LeBron Dennis Susan Explanation


uted land

$50,000



susan only

$50,000Nonrecourse

debt > Su-

san’s tax ba-

sis in con-

tributed

property


partners

$16,667 $16,667 $16,667[$100,000 -

$50,000] x

33.33%

(5) Relief from nonre-

course mortgage

($100,000)

(6) Gain recognized $0 $0 $0(5 )- [(1)+

(2)+ (3)+

(4)] if posi-

tive, other-

wise 0

(7) Partners’ initial tax

basis

$216,667 $216,667 $16,667(1) + (2) +

(3) + (4)

+(5)

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b. The holding period for LeBron and Dennis begins when they receive

their LLC interests because they only contribute cash. In contrast,

Susan’s holding period includes the holding period for the land he

contributed since Susan held the land as either a capital or Section

1231 asset.

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c. Bar T receives a $50,000 tax basis in the land and will include Su-

san’s holding period as part of its holding period.

d. Bar T must adopt a calendar year end because all of its members

have calendar year ends.

Description Total LeBron Dennis Susan Explanation

(1) Members’ Initial

Tax Basis

$216,667 $216,667 $16,667See part a. above

(2) Dividends $1,200 $400 $400 $400$1,200 x 33.33%

(3) Municipal bond in-

terest

$300 $100 $100 $100$300 x 33.33%

(4) Deemed cash con-

tribution from ac-

counts payable

$40,000 $20,000 $20,000 Accounts payable are only allocated to LeBron and Dennis because they guaranteed them

(5) Cash distributions ($3,000) ($1,000) ($1,000) ($1,000)

e. Bar T may adopt either the cash or accrual method of accounting. It

may generally use the cash method because it does not have a cor-

porate member. However, it must use the accrual method in ac-

counting for its inventory related transactions (i.e., the hybrid

method).

The member’s separately stated items are listed on lines (2), (3), (11), and (13) in the table below. Note that LeBron and Dennis have self-employment income under the proposed regulations because they are responsible for some of Bar T’s debt. Susan clearly has self-employment income under the proposed regulations because he works full time in the enterprise.

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(6) Deemed cash dis-

tribution to Susan for

mortgage repayment

($9,000)Because Susan was originally allo-cated the first $50,000 of the nonrecourse mort-gage, the repay-ment goes to re-duce her share of the debt.

(7) Member’s Tax Basis

Before Loss Allocation

$236,167 $236,167 $7,167Sum of (1) through (6)


Less:

(9) Cost of good sold (380,000)

(10) Operating ex-

penses

(670,000)

(11) Guaranteed pay-

ments

(10,000)

(12) Ordinary Business

Loss

($440,000) ($146,667

)

($146,667

)

($146,667

)

[Sum of (8) through (11)] x 33.33%

(13) Self-employment

loss

($430,000) ($146,667

)

($146,667)($136,667

)

Line (12) +

$10,000 guaran-

teed payment to

Susan

Members’ ending Tax

basis

$89,500 $89,500 $0(7)+ (12) but not

less than zero. Su-

san must carry

over $7,167 +

($146.667) or

($139,500) of ordi-

nary loss.

f. As indicated in the table in part f. above, the ending basis for Le-

Bron is $89,500, the ending basis for Dennis is $89,500, and the

ending basis for Susan is $0.

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g. Generally, the members’ at-risk amounts will be less than the

amount of their tax bases to the extent they are allocated nonre-

course debt that is not qualified nonrecourse financing. In this case,

the members’ at-risk amounts are the same as their tax bases in

part g. because the nonrecourse mortgage is qualified nonrecourse

financing and the accounts payable are treated as recourse debt

(i.e., they are guaranteed by LeBron and Dennis).

h. As indicated in the table in part f. above, the $146,667 loss allo-

cated to LeBron and Dennis is not limited by their tax bases. How-

ever, given the facts provided, they cannot deduct their losses cur-

rently and each has a $146,667 passive activity loss carryforward

because they are not material participants in the enterprise. As for

Susan, her $146,667 loss is initially limited to her $7,167 tax basis

leaving her with a $139,500 loss carryforward. However, because

she is a material participant in Bar T, she may deduct the $7,167

currently.

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Tax Chapter 20 No Homework-Forming and Operating Partnerships

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