Partnerships: Formation, Operation, and Basis10-1
CHAPTER 10
PARTNERSHIPS: FORMATION, OPERATION, AND BASIS
SOLUTIONS TO PROBLEM MATERIALS
DISCUSSION QUESTIONS
1.As a general rule, both §§721 and 351 provide that no gain or loss is recognized if property is transferred to a partnership or corporation. However, §351 applies only if those persons transferring property to a corporation solely in exchange for stock are in control of the corporation immediately after the exchange. Section 721 does not include a control requirement and applies both to initial transfers and to all subsequent contributions.
Similarities exist between §§721 and 351 in that these nonrecognition provisions do not apply to all transfers. To be tax free under §721, the contributor must receive an interest in the partnership, while under §351, the transferor must receive stock in the corporation. Under both §§721 and 351 if the transfer of property results in the receipt of money or other consideration, the transaction may be deemed a taxable sale or exchange.
pp. 10-9 to 10-11, Concept Summary 10-1, and Chapter 3
2.The partnership assigns a carryover basis to assets that are contributed by its partners, increased by any §721(b) investment company gain that the partner recognized on the transaction.
Bases of such assets are not stepped up (or down) to fair market value as a result of the contribution.
p. 10-12, Example 14, and § 723
3The chapter outlines four situations which may result in a taxable gain to one or more of the partners.
- If property is contributed to an investment partnership, as determined under § 721(b), all built-in gains on transfers to the partnership are recognized by the transferors.
- If property is contributed to a partnership by two or more parties and that property is later distributed to the other parties in a transaction which appears to be an “exchange” rather than a contribution or distribution, the contribution and distribution are recast as a sale of the properties between the parties.
- If appreciated property is contributed by a partner to a partnership and that partner later receives a distribution from the partnership, the contribution and distribution may be recharacterized as a sale of the asset from the partner to the partnership.
- If a partner receives a partnership interest in exchange for services, the value of the partnership interest is treated as compensation paid to the partner and is reported as ordinary income by that partner.
pp. 10-10 to 10-12
4.When Justin contributes the land to the partnership, he recognizes no gain or loss. Instead, he takes a substituted basis of $85,000 in his partnership interest ($20,000 cash, plus $65,000 basis in land). The partnership takes a $65,000 carryover basis in the contributed land. The “built-in gain” on the contribution must be tracked and allocated to Justin if the property is ever sold at a gain [§ 704(c)].
Tiffany can either contribute the assets to the partnership or sell them to a third party. If she contributes the assets, she will have a $125,000 basis in a partnership interest worth $100,000. Similarly, the partnership will have a $125,000 basis in equipment worth $100,000.
Section 721 prevents Tiffany from recognizing the $25,000 loss on contribution to the partnership. The partnership will step into Tiffany’s shoes in determining depreciation deductions. Since this is “built-in loss” property, § 704(c) applies, and the depreciation must be allocated in accordance with Reg. § 1.704-3 (not discussed in detail in this text). Basically, a large portion of the depreciation deductions would be allocated to Tiffany to reduce the difference between her basis and the fair market value of her partnership interest as quickly as possible. (If the property basis was less than its fair market value, depreciation would first be allocated to the other partner.)
If Tiffany sells the assets to a third party and contributes the $100,000 of cash, she can claim a loss of $25,000 under § 1231. The partnership would use $10,000 of the cash contributed by Justin, plus all of Tiffany’s cash, to acquire similar new assets. Tiffany would take a $100,000 basis in her partnership interest, and the partnership would have a $110,000 cost basis in depreciable equipment. The partnership would depreciate the equipment according to its depreciable life, and the depreciation would be allocated between the partners equally or in whatever manner was prescribed by the partnership agreement.
pp. 10-9, 10-10, 10-12, 1013, 10-25, and Example 9
5.The SB Limited Liability Company must address the following issues in preparing its initial tax return:
- What year-end must the LLC use? Unless an election is made under §444, the LLC must use the year-end determined under the least aggregate deferral method. There is no majority member, and the principal members do not have the same year-end. Under the least aggregate deferral method, the LLC would use a July year-end since this would result in only a 5-month deferral of income to Block. pp. 10-18 to 10-20
- What method of accounting will the LLC use? Even though both members are Subchapter C corporations, the LLC may elect the cash method of accounting if average annual gross receipts are less than $5 million for the year. The LLC, then, could select either the cash, accrual, or a hybrid method of accounting. p. 10-18
- What elections must the LLC make in its initial tax return? Should the first $5,000 of organizational expenditures be immediately expensed and the balance amortized over a period of 180 months or more? Should the same election be made regarding start-up expenditures under § 195? Example 18
- The members’ initial bases in their LLC interests must be determined. The bases will be the substituted basis of the assets contributed to the LLC ($650,000 for Block, and $550,000 for Strauss). p. 10-12 and Example 14
- The LLC’s basis in the property received from the members must be determined, and any cost recovery related to contributed property calculated. The LLC takes a basis of $650,000 in the equipment and steps into Block’s shoes in determining cost recovery allowances. Since the licenses and drawings are contributed rather than sold, the LLC takes a $0 basis in these assets, with no cost recovery possible. The LLC takes a $50,000 carryover basis in the land and a $500,000 basis in the cash. p. 10-12
- The LLC must determine whether any portion of either of the LLC interests is issued in exchange for services. The equipment, cash, and land are considered “property” for purposes of §721. The building permits and architectural designs also are considered property under §721, even though they are intangible assets. Therefore, none of the LLC interests is issued in exchange for services. p. 10-12 and Example 13
- Treatment of expenses incurred during the initial period of operations must be considered. The legal fees are organization costs and their tax treatment was previously noted. The construction costs must be capitalized until such time as the building is placed in service. The office expense may have to be capitalized under either (1) §195, if it is determined that the business is still in the start-up stage, or (2) §263A if it is determined the costs relate to “production” of the rental property. If neither of these provisions applies, the office expense is currently deductible. pp.1016 and 10-17
If the land is later sold, a portion of the gain must be allocated to Strauss, since it was built-in at the time the property was contributed. Note that if the equipment had been appreciated, depreciation allocations would have to take the precontribution gain into account. Allocation of precontribution deductions related to depreciable property are not covered in this text. p. 10-25
13.a.False. The entity is required to file an information return, generally by the fifteenth day of the fourth month after the end of the partnership’s tax year. The return includes data concerning the partners’ allocable shares of the financial activities of the partnership. In addition, property, sales, and employment tax returns are likely to be required of the entity. pp.1020 and 10-21
b.False. The partnership chooses tax accounting periods and methods that are applied to all of the partners. pp. 10-15 and 10-18
c.False. Generally no gain or loss is recognized, but there are exceptions to §721, including those pertaining to the receipt of boot, the contribution of property with liabilities in excess of basis, and the receipt of a partnership interest in exchange for services provided to the partnership. pp. 10-10 and 10-11
d.True. p.10-32
e.False. The partner recognizes ordinary income, to the extent of the fair market value of the partnership interest that is received in this manner. p.1012
f.False. Such losses can be deducted by partners who hold a 50% or less ownership interest in the entity. p.10-39
g.False. An alternative tax year will never be required by the IRS; instead, the partnership must request permission from the IRS and illustrate to the IRS that it has a business purpose for using an alternative tax year. pp.10-19 and 10-20
h.True. pp. 10-28 and 10-29
i.True. Built-in losses, as well as gains, must be allocated to the contributing partner when recognized by the partnership. p. 10-25
j.False. If property which was inventory in the hands of the transferor partner is sold by the partnership within five years of the date it was contributed, any gain will be treated as ordinary income, regardless of the manner in which the property was held by the partnership. p. 10-13
Problems
14.a.Under § 721, neither the partnership nor the partners recognizes any gain on formation of the entity. pp. 10-9 and 10-10
b.Larry will take a cash basis of $50,000 in his partnership interest. Example 14
c.Ken will take a substituted basis of $30,000 in his partnership interest ($30,000 basis in the property contributed to the entity). p. 10-12 and Example 14
d.The partnership will take a carryover basis in the assets it receives ($50,000 basis in cash, and $30,000 basis in property). p. 10-12 and Example 14
15.a.Sally has a realized loss of $20,000. However, §721 contains the general rule that no gain or loss is recognized to a partnership or any of its partners upon the contribution of money or other property in exchange for a capital interest. Since Sally is subject to this rule, she does not recognize the loss. pp.10-9 and 10-10
b.$100,000. Section 722 provides that the basis of a partner’s interest acquired by a contribution of property, including money, is the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution. p. 10-12
c.$120,000, the adjusted basis of the contributed property (§ 722). p. 10-12
d.$120,000. Under §723, the basis of property to the entity is the adjusted basis of such property to the contributing partner at the time of the contribution, increased by any §721(b) gain recognized by such partner. Since no such gain (and no loss) was recognized by Sally on the contribution, the partnership takes a carryover basis in the property. Example14
e.A more efficient tax result may arise if Sally sells the property to an unrelated party for $100,000, recognizes the $20,000 loss on the property, and contributes $100,000 cash to the partnership. The partnership could then use the $100,000 to acquire similar property, in which it would take an $100,000 basis. Example9
Concept Summary 10-1
28.a.The partnership’s ordinary taxable income is determined as follows:
Sales revenue$130,000
Cost of sales(45,000)
Guaranteed payment to Rob(24,000)
Depreciation expense(12,500)
Utilities(15,000)
Rent (16,000)
Total ordinary income$ 17,500
Separately stated items:
Interest income$3,000
Tax-exempt interest income4,500
The payment to Mount Vernon Hospital for Bob’s medical expenses is treated as a distribution to Bob in the amount of $10,000. Bob may be able to claim a deduction for medical expenses on his personal tax return.
b.Bob’s basis in his partnership interest at the end of the tax year is determined as follows, using the ordering rules in Figure 10-3:
Beginning basis$14,000
Share of partnership income8,750*
Share of separately stated income items:
Interest income1,500*
Tax-exempt interest income2,250*
Distribution (payment for medical expenses)(10,000)
Ending basis in interest$16,500
*These items are reported on Bob’s personal income tax return for the year. (The tax-exempt interest is only an information item on the personal return.)
- Rob’s basis in his partnership interest at the end of the tax year is determined as follows:
Beginning basis$9,000
Share of partnership income8,750 *
Share of separately stated income items:
Interest income1,500 *
Tax-exempt interest income 2,250 *
Ending basis in interest$21,500
*These items are reported on Rob’s personal income tax return for the year. (The tax-exempt interest is only an information item on the personal return). In addition, Rob will report ordinary income from the guaranteed payment in the amount of $24,000. Reporting the guaranteed payment as income does not increase Rob’s basis in his partnership interest.
Note that the partnership deducts the guaranteed payment, and it affects both partners’ capital accounts equally.
pp. 10-21 to 10-23 and Examples 21 and 42
29.a.The partnership’s ordinary taxable income is determined as follows:
Sales revenue$90,000
Cost of sales(45,000)
Guaranteed payment to Rob(24,000)
Depreciation expense(12,500)
Utilities(15,000)
Rent(16,000)
Total ordinary loss($22,500)
Each partner’s share of the loss is $11,250.
Separately stated items remain as reported in Problem 28, with allocations to each partner as follows:
Total Amount for
AmountEach Partner
Interest income$3,000$1,500
Tax-exempt interest income4,5002,250
The payment to Mount Vernon Hospital for Bob’s medical expenses is treated as a distribution to Bob in the amount of $10,000. Bob should determine whether he can claim a deduction for medical expenses on his personal tax return. Both partners must also consider whether the distributions they received are taxable.
- Bob’s basis in his partnership interest at the end of the tax year is determined as follows, using the ordering rules in Figure 10-3:
Beginning basis$14,000
Share of separately stated income items:
Interest income1,500 *
Tax-exempt interest income 2,250 *
Basis before loss allocation and distribution$17,750
Less: Distribution(10,000)
Basis before loss allocation$ 7,750
Less: Ordinary loss allowed under § 704(d) (7,750) *
Ending basis in interest$ -0-
*As in Problem 28, Bob reports the interest income and tax-exempt income. The distribution from the partnership is not taxable since it is less than his basis after current income items. His ordinary loss from the partnership is limited under §704(d). Of the $11,250 total loss, only $7,750 is deductible currently. The remaining $3,500 ordinary loss is carried forward until such time as Bob has sufficient basis in his partnership interest to utilize the loss.
Example 35 and Figure 10-3
c.Rob’s basis in his partnership interest at the end of the tax year is determined as follows:
Beginning basis$ 9,000
Share of separately stated income items:
Interest income1,500*
Tax-exempt interest income 2,250*
Basis before loss allocation$12,750
Ordinary loss allowed under § 704(d) (11,250)*
Ending basis in interest$ 1,500
*Rob reports the interest income and reflects this amount and the tax-exempt income in his basis for his partnership interest before considering the loss from the partnership. Since he has adequate basis, the allocated loss is fully deductible.
Rob additionally will report as ordinary income the $24,000 guaranteed payment. (His partnership interest basis is not increased by the guaranteed payment.) Note that the partnership deducts the guaranteed payment, and it affects both partners’ capital accounts equally.
pp. 10-33 to 10-35, Figure 10-3, and Examples35 and 42