Accounting 432/732

Handout H

  1. Partnership Agreement. Ms. Tower and Ms. Strong each contributed $50,000 cash to form Towstro Partnership. Because Ms. Tower has more business experience than Ms. Strong, the original partnership agreement provided that Ms. Tower would be allocated 65 percent and Ms. Strong would be allocated 35 percent of partnership income or loss. After two years of operations, Ms. Strong considered leaving the partnership. To induce her partner to stay, Ms. Tower consented to amend their agreement to provide that future income and loss would be allocated equally between the partners.

At the close of the partnership’s year, each capital account is credited with the partner’s share of annual income or charged with the partner’s share of annual loss. If the partnership distributes cash during the year, each capital account is charged with the partner’s share of the distribution.

Capital Account Allocations. Towstro Partnership generated a $12,000 operating loss in its first year, $27,400 income in its second year, and $59,300 income in its third year. Towstro made no cash distributions during its first two years. In its third year, the partnership distributed $10,000 cash each to Ms. Tower and Ms. Strong. Compute each partner’s capital account at the end of the third year.

  1. Refer back to the Towstro Partnership with its two partners, Ms. Tower and Ms. Strong. In its third year, Towstro generated $59,300 income that was allocated equally between the partners’ capital accounts. Suppose that the partners’ individual tax situations were such that Ms. Tower was in the 39.6 percent tax bracket, while Ms. Strong was in the 15 percent tax bracket. Could the partners take advantage of the difference in their marginal rates by agreeing that Ms. Tower’s distributive share of partnership income reported on her Schedule K-1 would be zero, while Ms. Strong’s distributive share reported on her Schedule K-1 would be $59,300?
  1. Micro Inc., Mr. Boise, and Dr. Lind each contributed $25,000 to form MBL General Partnership. The partnership agreement provides that each general partner is allocated an equal share of MBL’s income or loss. After three years, MBL has the following balance sheet.

Assets / $105,000
Unsecured liabilities / $150,000
Capital: / Micro Inc. / (15,000)
Mr. Boise / (15,000)
Dr. Lind / (15,000)
$105,000

The deficits in the partners’ capital accounts resulted from allocations of MBL’s operating losses. At this point, the partners have each lost their $25,000 initial investment. If the partnership is immediately liquidated, how much must each partner contribute?

  1. Assume that MBL is a limited partnership in which Micro Inc. is the general partner and Mr. Boise and Dr. Lind are limited partners. The partnership agreement provides that each partner is allocated an equal share of MBL’s income or loss, but loss allocations to the two limited partners cannot cause or increase a deficit balance in their capital accounts. After three years, MBL has the following balance sheet.

Assets / $105,000
Unsecured liabilities / $150,000
Capital: / Micro Inc. / (45,000)
Mr. Boise / -0-
Dr. Lind / -0-
$105,000

How are the additional losses allocated?

  1. Assume the same facts, as in Question 4 and the capital accounts of MBL of each member is ($15,000). If the LLC is liquidated, how much must each member contribute? How much of the $15,000 deficit could be deducted under the at risk rules?
  1. Two years ago, Rawling Inc. contributed undeveloped land to RT Limited Partnership in exchange for a 20 percent interest in partnership capital and profits. At date of contribution, the land was worth $800,000, so RT recorded an asset with an $800,000 book basis and credited Rawling’s capital account with $800,000. Rawling’s basis in the land was only $500,000, which carried over as RT’s inside tax basis. The $300,000 excess of contributed value over contributed basis was a built-in gain.

This year, RT sold the land for $1 million. How much should be allocated to Rawling, Inc. for book purposes and for tax purposes?

  1. Assume that RT sold the land contributed by Rawlings, Inc. for $750,000. Calculate RT’s initial book loss/gain and tax loss/gain. Determine the book and tax loss using the ceiling rule.
  1. Assume the same facts as in Question 7 except that RT elects to use the remedial method. Calculate Rawlings, Inc. book and tax loss/gain on the sale and the notional item on Form 1065, K-1.
  1. Traditional Method. On January 1, 2002, Ms. Toffee contributed equipment to Freeway Partnership, which uses the calendar year for tax purposes. The equipment’s adjusted basis was $20,000, and its fair market value was $25,000. Ms. Toffee has a 35 percent capital and profits interest. According to Ms. Toffee’s MACRS depreciation schedule, the equipment is five-year recovery property with three years left in its recovery period. The LLC will continue to depreciate the property according to Ms. Toffee’s schedule as follows:

Book / Tax
Depreciable basis / $25,000 / $20,000
2001 depreciation / (10,000) / (8,000)
2002 depreciation / (10,000) / (8,000)
2003 depreciation / (5,000) / (4,000)
Adjusted basis / -0- / -0-

The book/tax depreciation allocations to the partners are presented in the following table.

Ms. Toffee (35%) / Other Members (65%)
Book / Tax / Book / Tax
2001 depreciation / $(3,500) / $(1,500) / $(6,500) / $(6,500)
2002 depreciation / (3,500) / (1,500) / (6,500) / (6,500)
2003 depreciation / (1,750) / (750) / (3,250) / (3,250)
$(8,750) / $(3,750) / $(16,250) / $(16,250)

Over the remaining life of the equipment, the difference between Ms. Toffee’s book and tax depreciation is $5,000, which was her built-in gain on the date of contribution. At the end of the recovery period, the equipment’s book basis and tax basis are both zero, and the built-in gain has been eradicated.

  1. Ceiling Rule. Assume that the adjusted basis of Ms. Toffee’s contributed equipment was only $13,000, so that Freeway has the following depreciation schedule.

Book / Tax
Depreciable basis / 25,000 / 13,000
2001 depreciation / (10,000) / (5,200)
2002 depreciation / (10,000) / (5,200)
2003 depreciation / (5,000) / (2,600)
Adjusted basis / -0- / -0-

Because Ms. Toffee’s contributed basis is so much less than contributed value, Freeway does not have enough tax depreciation to allocate to the other members.

Ms. Toffee (35%) / Other Members (65%)
Book / Tax / Book / Tax
2001 depreciation / $(3,500) / -0- / $(6,500) / $(5,200)
2002 depreciation / (3,500) / -0- / (6,500) / (5,200)
2003 depreciation / (1,750) / -0- / (3,250) / (2,600)
$(8,750) / -0- / $(16,250) / $(13,000)

Over the remaining life of the equipment, the difference between Ms. Toffee’s book and tax depreciation is only $8,750, which is $3,250 less than her $12,000 built-in gain. The other members have been allocated only $13,000 tax depreciation, which is $3,250 less than their book depreciation.

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