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CCH Federal Taxation Comprehensive Topics Chapter 19 Partnerships— Formation and Operation ©2005, CCH INCORPORATED 4025 W. Peterson Ave. Chicago, IL 60646-6085.

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Presentation on theme: "CCH Federal Taxation Comprehensive Topics Chapter 19 Partnerships— Formation and Operation ©2005, CCH INCORPORATED 4025 W. Peterson Ave. Chicago, IL 60646-6085."— Presentation transcript:

1 CCH Federal Taxation Comprehensive Topics Chapter 19 Partnerships— Formation and Operation ©2005, CCH INCORPORATED 4025 W. Peterson Ave. Chicago, IL

2 CCH Federal Taxation Comprehensive Topics 2 of 67 Chapter 19 Exhibits Chapter 19, Exhibit Contents A 1. Partnerships—Overview 2. Partnerships—Types of Partnerships 3. Partnerships—Tax Years 4. Partnerships—Accounting Methods 5. Partnerships—Tax Formula 6. Code Section 702(a)(8) Income or Loss 7. Separately Stated Items 8. Formation of Partnerships—Partner Perspective 9. Formation of Partnerships—Overview of Code Section Contribution of Part Property/Part Services 11. Contribution of Part Property/Part Services—Example 12. Disguised Sales—General Rules 13. Disguised Sales—Example

3 CCH Federal Taxation Comprehensive Topics 3 of 67 Chapter 19 Exhibits Chapter 19, Exhibit Contents B 14. Contribution of Encumbered Property 15. Contribution of Encumbered Property—Example 16. Contribution of “Know-How” 17. Contribution of “Know-How”—Example 18. Inside Basis Computations 19. Outside Basis Computations 20. Outside Basis Computations—Example 21. Code Section 465 At-Risk Rules 22. Code Section 469 Passive Activity Loss (PAL) Rules 23. At-Risk and Passive Activity Loss Rules—Example 24. Partners Providing Infrequent, Nonessential Services to Partnerships for Compensation 25. Partners Providing Ongoing, Integral Services to Partnerships for Compensation

4 CCH Federal Taxation Comprehensive Topics 4 of 67 Chapter 19, Exhibit 1 Partnerships—Overview Definition Of Partnership. An unincorporated association with two or more persons who associate for a profit motive. For income tax purposes, partnerships are generally treated as pass- through entities, i.e., the partnership pays no taxes, and partnership income (loss) and separately stated items are allocated to each partner according to the partnership’s profit sharing agreement. The partners receive separate K-1 schedules from the partnership. Each K-1 reports each partner’s share of the partnership net profit and separately reported income and expense items. Partners report these items on their own 1040 tax returns, even if none of the items have been distributed to them.

5 CCH Federal Taxation Comprehensive Topics 5 of 67 Chapter 19, Exhibit 2a Partnerships—Types of Partnerships General Partnership [GP]. A GP has one or more general partners who is personally liable for partnership debts; a general partner can be bankrupted by a malpractice judgment brought against the partnership, even though the partner was not personally involved in the malpractice. Limited Liability Partnership [LLP]. An LLP is similar to a general partnership, except that an LLP partner is not liable for any malpractice committed by the other LLP partners. Limited Partnership [LP]. An LP is comprised of at least one general partner and often many limited partners. Limited partners may not participate in the management of the LP, and their risks of loss are restricted to their equity investments in the LP.

6 CCH Federal Taxation Comprehensive Topics 6 of 67 Chapter 19, Exhibit 2b Partnerships—Types of Partnerships Limited Liability Company [LLC]. An LLC is a state-registered association generally taxed as a partnership if it “checks the box.” LLC members, like corporate shareholders are not personally liable. Unlike limited partners, LLC members may participate in management without risking personal liability. However, guaranteed payments are subject to self-employment tax, along with the members’ share of ordinary income or loss from the LLC.

7 CCH Federal Taxation Comprehensive Topics 7 of 67 Partnerships—Tax Years The following rules govern tax years of partnerships: Majority Interest Taxable Year. Partnerships are generally required to elect the same taxable year as their partners who represent a majority interest on the first day of the partnership’s first tax year. Code Sec. 706(b). Five Percenters’ Common Tax Year. If there is no majority interest taxable year, the partnership must use the same year as that of the principal partners, i.e., those owning five percent or more interest in either profits or capital. Chapter 19, Exhibit 3a

8 CCH Federal Taxation Comprehensive Topics 8 of 67 Calendar Tax Year. If there is no majority interest tax year and the principal partners do not have the same taxable year, the partnership generally must use the calendar year. There are two exceptions, (1) minimum deferral rules and (2) business purpose rules. Details regarding these exceptions are covered in the text. Partnerships—Tax Years Chapter 19, Exhibit 3b

9 CCH Federal Taxation Comprehensive Topics 9 of 67 Cash method. The cash method is available to partnerships that do not have a C corporation partner. The cash method however, “MAY” be used by partnerships with C corporation partners if the partnership’s average annual gross receipts are $5 million or less in the 3 preceding years. The determination is made annually. Accrual Method. Once the three-year average annual gross receipts exceeds $5 million, a partnership with a C corporation partner must use the accrual basis thereafter. Partnerships—Accounting Methods Chapter 19, Exhibit 4

10 CCH Federal Taxation Comprehensive Topics 10 of 67 Tax Formula Separately Stated Items (These are items that may result in different tax treatment by different partners. Examples include capital gain or loss and charitable contributions.) + or - Code Sec. 702(a)(8) Ordinary Income– Operating Expenses- Gross Income from Business Operations= Exclusions and Cost of Goods Sold– Ordinary Income “From Whatever Source Derived” (including Code Sec recapture) [Taxation at Owner Level] Chapter 19, Exhibit 5

11 CCH Federal Taxation Comprehensive Topics 11 of 67 Code Section 702(a)(8) Income or Loss Definition. Earned income from operations generally follows the same rules as for individuals (i.e., all income from whatever source derived, unless specifically excluded). It is offset by cost of goods sold and operating expenses to produce a single reporting item, “Code Sec. 702(a)(8) income or loss.” The following items are included in the Code Sec. 702(a)(8) computation because they always get ordinary treatment:  Code Sec depreciation recapture  Cost of goods sold  Depreciation and other operating expenses  Amortization of organizational expenditures Chapter 19, Exhibit 6a

12 CCH Federal Taxation Comprehensive Topics 12 of 67 Code Section 702(a)(8) Income or Loss (1) Amortizable expenditures. Organizational expenses qualify for amortization (and reduce Code Sec. 702(a)(8) income) if: (a) = incurred incidental to formation of the partnership. (e.g., legal fees for drafting the partnership agreement, cost of state filings, cost of required notice publications and organizational meeting costs.) and (b) = incurred before the end of the tax year in which the partnership commences business. At the election of the partnership, a deduction is allowed for the taxable year in which the partnership begins business in an amount equal to the lesser of (a) actual organizational expenses, or (b) $5,000 (reduced dollar-for-dollar by the amount by which such organizational costs exceed $50,000). The remainder of such organizational costs are allowed as a deduction ratably over the 180-month period beginning with the month in which the partnership begins business. (2) Nonamortizable expenditures. Organizational expenses DO NOT qualify for amortization if related to issuing and marketing partnership interests. Examples are prospectus preparation costs and commissions on sales of limited partnership interests. They are written off when the partnership is terminated. Chapter 19, Exhibit 6b

13 CCH Federal Taxation Comprehensive Topics 13 of 67 Separately Stated Items Items other than partnership operating income and expenses must be separately stated. The reason for showing these items separately is that their ultimate tax treatment may vary from partner to partner. Separately stated items are first computed at the partnership level (same computation method as with individuals). Next, each partner’s distributive share of each separately stated item is reported on his Schedule K-1 of the partnership return. Finally, the K-1 is sent to each partner who transfers his distributive share of Code Sec. 702(a)(8) TI, and each separately stated item listed, from the K-1 to the appropriate section of his individual return. For example, a distributive share of charitable contributions reported on K-1 is transferred to Schedule A of Form There, it is subject to certain AGI limitations of the partner, which will differ from that of the other partners. Chapter 19, Exhibit 7a

14 CCH Federal Taxation Comprehensive Topics 14 of 67 Separately Stated Items Items that must be separately stated include the following:  Code Sec gain and loss  Code Sec depreciation recapture (Code Sec. 1250, unlike Code Sec. 1245, must be separately stated because corporate partners may be subject to an additional recapture adjustment under Code Sec. 291)  Capital gains and losses  Dividends eligible for a corporate dividend-received deduction  Tax-exempt income and related expense  Investment income and related expense  Passive income and losses from rental and other nonoperating activities  Recovery items (e.g., tax refunds, recovery of bad debts)  Distributions of unrealized receivables or inventory that have substantially appreciated  Tax credits  Charitable contributions  Foreign income taxes paid or accrued  Depletion on oil and gas wells  Alimony payments  Other nonbusiness expenses Chapter 19, Exhibit 7b

15 CCH Federal Taxation Comprehensive Topics 15 of 67 Operating Item Undistributed income:Current tax Current losses: General Current deduction LimitOutside basis at risk Character conduit:Yes Owner’s basis: General Adjusted annually Effect of entity debtOutside basis AND at-risk amount affected (Code Sec. 752) Separately Stated Items Chapter 19, Exhibit 7c

16 CCH Federal Taxation Comprehensive Topics 16 of 67 Formation of Partnerships—Partner Perspective Control requirement for tax- free treatment: No control requirement Tax treatment for services contributed in exchange for ownership. Always ordinary income. Chapter 19, Exhibit 8

17 CCH Federal Taxation Comprehensive Topics 17 of No gain or loss. Generally, Code Sec. 721 requires that no gain or loss is recognized if property is transferred to a partnership in exchange for a partnership interest. It does not matter whether the transfer is during partnership formation or after the partnership had already been formed. Similar nonrecognition rules govern corporate shareholders in a Code Sec. 351 contribution, except for the 80% control requirement. Mandatory nonrecognition. Notwithstanding the exceptions in the following slide, nonrecognition treatment for qualified transactions under Code Sec. 721 is mandatory, not elective for partners. Similarly, nonrecognition treatment under Code Sec. 351 is mandatory for corporate shareholders. Formation of Partnerships— Overview of Code Section 721 Chapter 19, Exhibit 9a

18 CCH Federal Taxation Comprehensive Topics 18 of 67 Three exceptions to nonrecognition. Gain is recognized in either event below:  Services. A partner’s contribution of services in exchange for a partnership (P/S) interest creates ordinary income (OI) to the partner (P).  Disguised sale. A partner’s contribution of property to a P/S followed by a P/S’s distribution of property (other than a partnership interest) to a partner within 2 years is presumed by IRS to be a disguised sale.  Excess (XS) of P’s debt relief over P’s basis. XS debt relief enjoyed by a partner over the basis of contributed property is treated as capital gain. Similar treatment holds for corporate shareholders. Recall that a shareholder relieved of debt by a corporation has taxable boot if the debt relief exceeds that shareholder’s basis in contributed property Formation of Partnerships— Overview of Code Section 721 Chapter 19, Exhibit 9b

19 CCH Federal Taxation Comprehensive Topics 19 of No 80% control requirement. The 80% control requirement for corporate shareholders is not required of partners contributing property to a P/S. 3. Partner’s outside basis increases with P/S debt assumption. A partner’s outside basis increases by his pro rata share of a P/S’s increase in both recourse and non-recourse debt. The debt may include debt transferred by a contributing partner. (In contrast, a corporate shareholder’s stock basis is not affected by corporate debt assumption.) 4. Partner’s outside basis decreases with debt relief. Debt transferred by a contributing partner to the P/S results in debt relief to the contributing partner. The partner must reduce his basis in the P/S by the amount of debt relief. (Similarly, shareholders must reduce their basis in stock for the amount of their debt assumed by the corporation.) Formation of Partnerships— Overview of Code Section 721 Chapter 19, Exhibit 9c

20 CCH Federal Taxation Comprehensive Topics 20 of 67 Formation of Partnerships— Overview of Code Section 721 What was Congress thinking when it enacted Code Sec. 721? Same reason as with Code Sec. 351 for corporate shareholders. First, as partners receive only a partnership (P/S) interest, they may not have the wherewithal to pay taxes. Second, the formation of a partnership is not an economic transaction rather, a change in legal form only. Does the partnership recognize gain or loss in a Code Sec. 721 exchange? No. Chapter 19, Exhibit 9d

21 CCH Federal Taxation Comprehensive Topics 21 of 67 What is “property”? “Property” includes just about everything except services (i.e., cash, inventory, receivables, land, other tangible assets, nonexclusive licenses and industry know-how.) [Note: Since neither Congress nor the Treasury Dept. have offered a definition of property, the courts have been guided by analogous interpretations under Code Sec Recall that Code Sec. 351 provides for non-recognition treatment on the transfer of “property” to an 80% controlled corporation in exchange for stock.] Chapter 19, Exhibit 9e Formation of Partnerships— Overview of Code Section 721

22 CCH Federal Taxation Comprehensive Topics 22 of 67 Why are “services” NOT “property’? Reg (b)(1) provides that services are NOT property to ensure that a person who provides services to a partnership will be taxed either: Immediately, on the FMV of the P/S capital interest received: With a contribution of services, the FMV of the P/S capital interest received is taxed to the partner as compensation (i.e., OI). [Recall that a shareholder’s contribution of services gets similar ordinary treatment.] Or, eventually, on the receipt of income from an income only P/S interest: If services are performed in exchange for an income interest, (not a capital interest), then income recognition is DEFERRED until income is received. The reason for deferring the recognition of income is because of the difficulty in determining a market value of the speculative future profits. Chapter 19, Exhibit 9f Formation of Partnerships— Overview of Code Section 721

23 CCH Federal Taxation Comprehensive Topics 23 of 67 Contribution of Part Property/Part Services How does Code Sec. 721 apply if a person contributes both property and services? The receipt of a partnership (P/S) interest attributable to services will generally be treated as a separate transaction outside the scope of Code Sec The transfer of property remains protected from income recognition within the scope of Code Sec Chapter 19, Exhibit 10

24 CCH Federal Taxation Comprehensive Topics 24 of 67 QUESTION:How much income is recognized on the transfer? FACTS: “A” transfers the following items to XYZ Partnership in exchange for a capital interest: $ 0$35,000Services $10,000$50,000Land BasisFMVAsset Contribution of Part Property/Part Services—Example Chapter 19, Exhibit 11a

25 CCH Federal Taxation Comprehensive Topics 25 of 67 SOLUTION: Services: $35,000 OI as compensation. Land: $0. The $40,000 [$50,000 – $10,000 = $40,000] realized gain on transfer of land is NOT recognized, consistent with Code Sec. 721; rather, it is a built-in gain. Contribution of Part Property/Part Services—Example Chapter 19, Exhibit 11b

26 CCH Federal Taxation Comprehensive Topics 26 of 67 Disguised Sales—General Rules What is a disguised sale? Code Sec. 707(a)(2)(B) and Reg provide that any exchange of property (other than a capital interest) between partner and partnership (P/S) within 2 years of each other is presumed to be a disguised sale. The burden is on the taxpayers to prove otherwise. Chapter 19, Exhibit 12a

27 CCH Federal Taxation Comprehensive Topics 27 of 67 If a contribution of property by a partner to a P/S followed by a distribution by the P/S to the partner is a disguised sale, then it is treated as if: (1) The partner sold the contributed property to an unrelated 3rd party; and (2) The P/S sold the distributed property to an unrelated 3rd party. Gains or losses are recognized by partners and partnerships on disguised sales, based on the difference between fair market value (FMV) and adjusted basis (AB). However, recognition of losses depends on the partner’s % ownership interest. If the partner has a “ > 50% capital interest,” NEITHER may recognized losses. Instead, the related party rules must be applied. Code Sec. 707(b)(1). [Compare these rules with the rules for corporations. C Corporations recognize gain but NEVER LOSS on transfers of nonstock property to any shareholder, regardless of ownership %.] Disguised Sales—General Rules Chapter 19, Exhibit 12b

28 CCH Federal Taxation Comprehensive Topics 28 of 67 If a disguised sale involves the transfer by a partnership of a capital interest, does part of the transaction qualify for Code Sec. 721 non-recognition treatment? If so, how much? Yes, % of total transfers that get Code Sec. 721 nonrecognition treatment, are: [(a) - (b)]  (a), where: (a) = FMV of property contributed by the partner to the P/S; and (b) = FMV of property other than a capital interest distributed by the P/S to the partner within two years of new partnership. Disguised Sales—General Rules Chapter 19, Exhibit 12c

29 CCH Federal Taxation Comprehensive Topics 29 of 67 Disguised Sales—Example QUESTIONS: A. What portion of the exchange represents a disguised sale? B. What portion of the exchange represents a Code Sec. 721 contribution? C. What is the tax treatment to Fred? D. What is the tax treatment to P/S? FACTS: Fred transfers land [$400 fair market value (FMV), $120 adjusted basis (AB), held long-term for investment purposes] to a partnership (P/S) in exchange for: 1. A capital interest worth $100; 2. $300 cash. Chapter 19, Exhibit 13a

30 CCH Federal Taxation Comprehensive Topics 30 of 67 SOLUTION The transfer is treated as a partial disguised sale and a partial partnership contribution TotalDisguised Sale (75%): Contribution (25%): FMV of cap. int Cash Amount realized Basis in land12090 [75%]30 [25%] Realized gain Recognized gain2100 Character of gainLTCGNot recognized Disguised Sales—Example Chapter 19, Exhibit 13b

31 CCH Federal Taxation Comprehensive Topics 31 of 67 SOLUTION The transfer is treated as a partial disguised sale and a partial partnership contribution: TotalDisguised Sale (75%):Contribution (25%): Computation100% - 25% = 75% ( )  400) = 25% Reason for tax treatment Reg (a) Recognition of realized gain from disguised sale. Code Sec. 721 Non-recognition on transfer of property for a P/S interest. Fred’s basis in the partnership interest: $30 [25% of the basis of land is attributable to a “contribution.” P/S’ basis in the land: $330 [Fred’s 30 basis of land “contributed” “sale” price.] Disguised Sales—Example Chapter 19, Exhibit 13c

32 CCH Federal Taxation Comprehensive Topics 32 of 67 COMMENTS Even if Fred had received the $300 cash 2 years after receipt of a P/S interest, IRS would still presume that Fred’s contribution was partially a disguised sale as per above. Fred would have to prove otherwise. Chapter 19, Exhibit 13d Disguised Sales—Example

33 CCH Federal Taxation Comprehensive Topics 33 of 67 Contribution of Encumbered Property What is the tax effect to partner (P) and partnership (P/S) from contributing encumbered property to a P/S? When a partnership assumes the debt of a contributing partner, the partner relieved of debt is treated as if having received a distribution of money from the partnership in the amount of the debt relief. Code Sec. 752(b). The P’s debt relief is the P/S’s debt burden. That burden is shared by ALL P’s, in accordance with their ownership %’s. The term “ALL P’s” includes the partner relieved of 100% of the debt. In essence, he is relieved of 100% of the debt, then assumes his pro rata share of that same debt assumed by the P/S. The amount of partnership debt assumed by a partner is treated as a cash contribution by the partner to the partnership. Chapter 19, Exhibit 14a

34 CCH Federal Taxation Comprehensive Topics 34 of 67 The P’s “net” debt relief (total debt relief minus pro rata debt burden) is non-taxable to the relieved P to the extent of his basis in the P/S. Any net debt relief in excess of basis is capital gain (i.e., same effect as if the amount of excess net debt relief were cash proceeds from the sale of a partnership interest.) The capital gain is short-term or long-term depending on the holding period of the partnership interest. Refer to the Examples for an illustration of the tax effect on P and P/S from encumbered property distributions. Contribution of Encumbered Property Chapter 19, Exhibit 14b

35 CCH Federal Taxation Comprehensive Topics 35 of 67 Bob’s land is subject to a $10,000 mortgage that the partnership assumes. The FMV of the P/S is $100,000 [$110,000 FMV assets – $10,000 debt assumed.] 100%$110,000Totals 10%11,00010,000EquipmentCal 60%20,00070,000LandBob 30%$0$30,000ServicesAnn P’s % int.. in P/SAB to PFMVContributionPartner FACTS: Ann, Bob and Cal decide to pool their efforts and form a partnership. They make the following contributions to the partnership: Contribution of Encumbered Property—Example Chapter 19, Exhibit 15a

36 CCH Federal Taxation Comprehensive Topics 36 of 67 QUESTIONS: (a) Does this transfer of assets qualify for Code Sec. 721 treatment? (b) What is each partner’s gain or loss on contributions to the partnership? (c) What is the resulting basis of each partner in the P/S (“outside basis”)? (d) What is the P/S’s basis in the assets received (“inside basis”)? Contribution of Encumbered Property—Example Chapter 19, Exhibit 15b

37 CCH Federal Taxation Comprehensive Topics 37 of 67 SOLUTION Ann’s transfer of services falls outside the scope of Code Sec However, Bob and Cal’s transfers still qualify for Code Sec. 721 treatment, since they represent property contributions. Note that Bob and Cal, get non-recognition treatment under Code Sec. 721, even though they do not have 80% control immediately after the exchange. As previously pointed out, the 80% control rule applies only to corporations. Contribution of Encumbered Property—Example Chapter 19, Exhibit 15c

38 CCH Federal Taxation Comprehensive Topics 38 of 67 Solution to Questions (A), (B), and (C): Partner (P): Realized G/L (FMV - AB) (A) Recog. Gain/Loss (B) Outside Basis of P (See computations in next table) (C) Inside Basis of P/S Ann (Service) 30,000 (30m - 0) 30,000 (since services income) 33,00030,000 Bob (Land) 50,000 (70m - 20m) 0 (since no XS debt relief) 16,00020,000 Cal (Equip.) (1,000) (10m - 11m) 0 (since Code Sec. 721 nonrecog applies.) 12,00011,000 Basis of the land to the P/S: $20,000. (Bob’s AB of $20m + $0 gain recognized by Bob) Contribution of Encumbered Property—Example Chapter 19, Exhibit 15d

39 CCH Federal Taxation Comprehensive Topics 39 of 67 COMMENTS: The results in this partnership problem differ from a similar corporate problem in two ways: 1.No 80% control requirement for non-recognition treatment under Code Sec. 721 (Not so for shareholders under Code Sec. 351.) 2.Debt assumption is added to a partner’s basis in the P/S. (Not so with a shareholder’s stock basis. However, note that debt relief does reduce the basis of both partner and shareholder.) Contribution of Encumbered Property—Example Chapter 19, Exhibit 15e

40 CCH Federal Taxation Comprehensive Topics 40 of 67 Contribution of Encumbered Property—Example Chapter 19, Exhibit 15f Code Sec. 721 (Nonrecog. rule) Code Sec. 721 (Nonrecog. rule) Code Sec. 83(a) (Services cont’d are OI to extent of FMV of P/S interest.) Reason for tax treatment $ 0 $30,000 Ordinary income recognized on service contribution (d) = (c) from services (1,000)50,00030,000 Realized gain (loss)(c) = (a) – (b) (11,000)(20,000)0 Basis in asset contributed (b) $ 10,000$ 70,000$30,000 FMV, P/S interest received (a) Cal (Equipment) Bob (Land) Ann (Services) Formula: COMPUTATIONS

41 CCH Federal Taxation Comprehensive Topics 41 of 67 Contribution of Encumbered Property—Example Chapter 19, Exhibit 15g Code Sec. 731(a)(1) (No XS debt relief, so no capital gain) Code Sec. 731(a)(1) (No XS debt relief, so no capital gain) Code Sec. 731(a)(1) (No XS debt relief, so no capital gain) Reason for tax treatment $ 0 Capital gain recognized on excess debt relief (j) = (i) N/A0 Excess debt relief(i) = (g) – (h) (11,000)(20,000)0 Basis in asset contributed(h) = (b) 04,0000 Net debt relief(g) = (e) – (f) 1,0006,0003,000 Less: Share of debt assumption (f) = P/S debt assumption x 1/3 $ 0$ 10,000$ 0 Gross debt relief(e) Cal (Equipment) Bob (Land) Ann (Services) Formula: COMPUTATIONS

42 CCH Federal Taxation Comprehensive Topics 42 of 67 Contribution of Encumbered Property—Example Chapter 19, Exhibit 15h Code Sec.732 P/S basis in assets is same as P’s before contribution Code Sec.732 P/S basis in assets is same as P’s before contribution Code Sec.732 P/S basis in assets is same as P’s before contribution + any Code Sec. 83(a) gain Reason for tax treatment: $11,000$20,000$30,000 P/S inside basis(m) = (k) + (l) 0030,000 Gain on service cont’n: (l) = (d) $11,000$20,000$ 0 Basis in asset contributed (k) = (b) Cal (Equipment) Bob (Land) Ann (Services) Formula: COMPUTATIONS

43 CCH Federal Taxation Comprehensive Topics 43 of 67 Contribution of Encumbered Property—Example Chapter 19, Exhibit 15i Code Sec. 752(a): Debts assumed by P/S are treated as contributions by P’s Code Sec. 752(b): A P’s debt relief is treated as a P/S distribution to that P Code Sec. 731(a) and 722: XS debt relief over basis of assets cont’d is gain and such gain increases a P’s basis in the P/S. Code Sec.752(a) Debts assumed by P/S are treated as contributions by P’s Code Sec.752(a) Debts assumed by P/S are treated as contribution s by P’s Reason for tax treatment $12,000$ 16,000$33,000 Partner’s outside basis (q) = (m) + (n) + (o) – (p) 0$(10,000)0 Debt relief(p) = (e) 1,0006,0003,000 Share of debt assumption (o) = (f) $ 0 Gain on XS debt relief (n) = (j) Cal (Equipment) Bob (Land) Ann (Services) Formula: COMPUTATIONS

44 CCH Federal Taxation Comprehensive Topics 44 of 67 Contribution of “Know-How” What is the tax effect on a partner who acquires a P/S interest without contributing property or services? A person may be valued by a partnership (P/S) for her client contacts, or unique ability to do certain things (“know-how”). If admitted into the P/S without contributing property or services, the P/S credits the partner’s capital account, based on her % share of the fair market value (FMV) of P/S assets, net of her % share of P/S debt. The offset is to goodwill, which is treated as property in a Code Sec. 721 exchange (i.e., non-recognition treatment when contributed to the P/S in exchange for an outside interest). Chapter 19, Exhibit 16

45 CCH Federal Taxation Comprehensive Topics 45 of 67 $15,000 (15 + 0) $15,000 (10 + 5) Capital balance of each partner $ 0$ 5,000P/S inside basis in the assets 15,00010,000Built-in gains $ 0$ 5,000P’s outside basis in P/S int. 0 (Code Sec. 721) 0 (Code Sec. 721) Recognized gain on contrib’n $15,000$10,000Realizable gain on contrib’n 05,000Basis $15,000 Agreed upon FMV GoodwillLandProperty Contributed JillJack FACTS: Jack and Jill form a P/S by contributing the property listed below. QUESTION: What are the tax consequences to Jack, Jill and the P/S? Contribution of “Know-How”—Example Chapter 19, Exhibit 17a

46 CCH Federal Taxation Comprehensive Topics 46 of 67 SOLUTION: If both Jack and Jill were to sell their partnership interests for $15,000 each, assuming no other transactions, the partnership would have no distributive gain, [since post- contribution-date values do not change] but Jack and Jill would recognize their respective built-in gains: Jack: $10,000 capital gain [$15,000 FMV at contribution – $5,000 basis at contribution] Jill: $15m capital gain [$15,00 FMV at contribution – $0 basis at contribution]. Contribution of “Know-How”—Example Chapter 19, Exhibit 17b

47 CCH Federal Taxation Comprehensive Topics 47 of 67 Inside Basis Computations How is a partnership’s inside basis in property contributed by partners determined? Code Sec. 763 provides that the basis of property received by a partnership will be Partner’s basis in contributed property; + Ordinary income recognized by a partner on contributions of services. =Partnership’s inside basis in property Note that gain recognized by a partner on excess debt relief (i.e., debt relief - debt assumption - basis in assets contributed) does not increase the partnership’s inside basis in the contributed assets, even though it DOES increases the outside basis of the contributing partner in her partnership interest. Chapter 19, Exhibit 18

48 CCH Federal Taxation Comprehensive Topics 48 of 67 Outside Basis Computations How is the partner’s outside basis in the partnership (P/S) determined? Code Sec. 722 and related regulations provide the following formula: + Basis in contributed property +/– Share of P/S’s taxable income or loss under Code Sec. 702(a)(8) (i.e., earned income/loss, both active and passive) +/– Share of “separately stated items” + Gain recognized by partner on services contributed + Gain recognized by partner on excess debt relief + Share of debt assumption (if recourse debt, % share is based on % share of P/S loss; if non-recourse debt, % share is based on % share of P/S profits. Both % are usually the same.) – Share of P/S losses – Debt relief – Basis of property distributions, including cash = Partner’s outside basis of partnership interest Chapter 19, Exhibit 19a

49 CCH Federal Taxation Comprehensive Topics 49 of 67 Special basis rules: 1. Losses may not reduce basis below zero. Instead, they remain suspended under the at-risk rules until sufficient basis arises to pass the at-risk hurdle. 2. At-risk basis is reduced by the amount of any released losses previously suspended under the at-risk rules. 3. No separate adjustment to basis is made for guaranteed payments received by a partner from his P/S. The reason: Guaranteed payments to partners are deductible by the P/S against Code Sec. 702(a)(8) operating income (since they are not contingent upon P/S profits). When Code Sec. 702(a)(8) income is later allocated to the partner, he automatically gets a basis reduction reflecting the guaranteed payment deduction taken by the P/S. Outside Basis Computations Chapter 19, Exhibit 19b

50 CCH Federal Taxation Comprehensive Topics 50 of 67 What is a partner’s holding period (HP) in the outside basis? The HP depends on the type of property contributed by the partner: Type of ContributionHP of Partnership Interest: Investment or business property:Tacks on to property contributed. Other property (e.g., receivables and inventory): Begins on day after contribution. ServicesBegins on day after contribution. [Note that an outside basis can have a split holding period if multiple assets are contributed.] Outside Basis Computations Chapter 19, Exhibit 19c

51 CCH Federal Taxation Comprehensive Topics 51 of 67 FACTS:  Mary and Joe are equal partners in the accrual basis MJ partnership.  At the beginning of the current year, Mary’s capital account has a balance of $10,000 and the partnership has debts of $30,000 payable to unrelated parties. The following information about MJ’s operations for the current year is obtained from the partnership’s records: Code Sec. 702(a)(8) income]$48,000 Tax-exempt interest income5,000 Code Sec gain (this is a smoke screen) 4,000 Code Sec gain6,200 Long-term capital gain500 Long-term capital loss100 Short-term capital loss250 Charitable contribution to Girl Scouts $ 800 Distribution of land to MaryBasis: $10,000; FMV: $15,000 Chapter 19, Exhibit 20a Outside Basis Computations—Example

52 CCH Federal Taxation Comprehensive Topics 52 of 67 ASSUMPTIONS:  None of the property was contributed by the partners (therefore no built-in gains)  Year-end partnership debt payable to unrelated parties is $24,000. QUESTIONS:  What is Mary’s outside basis at the beginning of the year?  What is Mary’s outside basis at the end of the year?  What is Mary’s capital account balance at the end of the year? Outside Basis Computations—Example Chapter 19, Exhibit 20b

53 CCH Federal Taxation Comprehensive Topics 53 of 67 Outside Basis Computations—Example Chapter 19, Exhibit 20c $29,275 =[$41,275 - (1/2 x $24,000 debt]Mary’s ending capital acct bal. (C) $41,275Mary’s ending basis (B) $(10,000) = [100% x $10,000]Basis of land distributions to Mary– $ (3,000) =[1/2 x ($30,000 - $24,000)]Share of debt relief– $5,275 =[1/2 x ( )]Share of “separately stated items”+ $24,000 =[1/2 x $48,000]Share of P/S’s TI under Code Sec. 702(a)(8) + $25,000Mary’s beginning basis (A)+ (C): $29,275 [see below] (B): $41,275 [see below] (A): $25,000 [$10,000 capital account + (1/2 x $30,000 P/S debt)] SOLUTION

54 CCH Federal Taxation Comprehensive Topics 54 of 67 Note: The Code Sec gain was a “smoke screen” because it is already included in Code Sec. 702(a)(8) TI. Recall that Code Sec gain gets ordinary treatment and is not part of the netting process. With its “automatic” ordinary treatment, there is no need for it to be “separately stated.” Doing so in this problem would have resulted in its being counted twice. Outside Basis Computations—Example Chapter 19, Exhibit 20d

55 CCH Federal Taxation Comprehensive Topics 55 of 67 Code Section 465 At-Risk Rules A partner’s distributive share of partnership losses and deductions from both business and investment activities are “at-risk.” Code Sec. 465(b)(1) and (2). Using classroom vernacular, such losses are allowed to “jump Hurdle 1” only to the extent of the partner’s at-risk amount at the end of the partnership’s tax year. (a) The at-risk amount is generally the partner’s outside basis defined at Code Sec. 704(d). (i) Nonrecourse loans from “non-qualified” lenders are generally excluded from the at-risk basis amount but included in the Code Sec. 704(d) outside basis. (b) If a partnership has more than one “activity,” then the at-risk rules must be applied to each activity separately (i.e., each activity must have its own “at-risk” basis). Code Sec. 465(c)(2)(A) and (3)( A). Chapter 19, Exhibit 21a

56 CCH Federal Taxation Comprehensive Topics 56 of 67 Code Section 465 At-Risk Rules (c) If only a portion of losses are allowed to “jump Hurdle 1,” how does a partner decide which losses jump H1? Prop. Reg answers this question by requiring the following order of deductions: (1) Capital losses must first jump H1; (2) Code Sec losses are applied next; (3) Deductions that do NOT reduce AMT tax preferences. (4) Deductions that DO reduce AMT tax preferences. (5) All other losses in whatever order the partner chooses. These are generally Code Sec. 702(a)(8) losses that get ordinary treatment. Chapter 19, Exhibit 21b

57 CCH Federal Taxation Comprehensive Topics 57 of 67 Code Section 465 At-Risk Rules (d) What about alimony paid, charitable contributions and other non- business/non-investment expenses? Prop. Reg addresses this question by providing that, “...allowable deductions allocable to an [passive] activity are those otherwise allowable deductions incurred in a trade or business or for the production of income from the activity.” (In other words, alimony and charitable contributions paid by a partnership are generally NOT subject to the at-risk rules since they do not ordinarily serve a business or investment purpose to the passive activity incurring these expenses. However, facts and circumstances govern “purpose”.) Chapter 19, Exhibit 21c

58 CCH Federal Taxation Comprehensive Topics 58 of 67 Code Section 469 Passive Activity Loss (PAL) Rules As with the at-risk rules, the PAL rules are applied on a partner-by-partner basis, not at the partnership level. However, unlike the at-risk rules, the PAL rules apply only to business income and losses [i.e., Code Sec. 702(a)(8) TI or Loss.] PALs are deductible (i.e., allowed to “jump Hurdle 2”) to the extent of Code Sec. 702(a)(8) income from all passive activities in the aggregate. “Portfolio income” (interest, dividends, annuities, royalties not derived from the ordinary course of business and gains or losses from assets that produce such income, less related expenses) shall not be considered as arising from a passive activity. Code Sec. 469(e)(1). Partnership ordinary loss is generally passive to a partner unless the partner materially participates in the partnership activity. Chapter 19, Exhibit 22

59 CCH Federal Taxation Comprehensive Topics 59 of 67 At-Risk and Passive Activity Loss Rules—Example FACTS: 1/1/x1: Rhonda’s outside basis in her 25% partnership interest is $24, x1: The partnership incurred a $100,000 Code Sec. 702(a)(8) operating loss. 20x2: The partnership earned $12,000 Code Sec. 702(a)(8) operating income. Rhonda does not materially participate. QUESTION: Determine the tax effect on Rhonda for 20x1 and 20x2. Chapter 19, Exhibit 23a

60 CCH Federal Taxation Comprehensive Topics 60 of 67 (21) 0 + (24) - (3) = (21) (3) Lesser of: [0 + (24) = (24)]; or neg. [ /- 0] = (2); Lesser = (2). 030x2 (1) (25) (24) = (1) (24) Lesser of: [(25) + 0 = (25)]; or neg. [ /- 0] = (24); Lesser = (24). 0(25)24x1 (f) = [(c) + (f) from prior period] - (e) (e) = Lesser of: [(c) + (f) from prior yr.] or [(a)+(b)+/-(d)], expressed as a negative number. (d)(c)(b)(a) = (i) from prior yr. Loss “Blocked” By H1 Amt. of Loss “Jumping” H1Contrib. (Distr.) Passive (Loss) Passive Income Beg. At- Risk Basis Yr At-Risk Hurdle (H1) SOLUTION At-Risk and Passive Activity Loss Rules—Example Chapter 19, Exhibit 23b

61 CCH Federal Taxation Comprehensive Topics 61 of 67 (3)30 [ (2) = 0] (24) [(3) + (24) - (3) = (24)] (3) [(3) + (24) = (27]; neg. 3 = (3); Lesser = (3) x2 0 (g) = 0(b) = 0 0 [ (24) = 0] (24) [(24) = (24)] 0x1 (k) = (g)(j) = (b) from all passive activities (i) = (a) + (b) +/- (d) + (e) (h) = [(e) + (h) from prior period] - (g) (g) = Lesser of: [(e) + (h) from prior yr.]; or [(b) from all passive activities, expressed as a neg. number. DeductIncomeEnding At-Risk Basis Loss “Blocked” By H2 Amt. of Loss “Jumping” H2 Yr Passive Hurdle (H2) At-Risk and Passive Activity Loss Rules—Example Chapter 19, Exhibit 23c

62 CCH Federal Taxation Comprehensive Topics 62 of 67 Partners Providing Infrequent, Nonessential Services to Partnerships for Compensation What rules govern transactions between partners and partnerships (P/Ss)? Infrequent, nonessential services. Code Sec. 707(a)(1) allows non- partner status when a partner acts in an independent capacity, rendering services that are neither ongoing nor integral to the operations of the partnership. [For example, a partner who is a licensed CPA prepares the partnership’s tax returns for his customary fee.] Code Sec. 707(a)(1) encompasses both “outbound” (partnership pays partner) and “inbound” (partner pays partnership) payments. The payments may be for services, interest on loans, leases or purchase of property. Chapter 19, Exhibit 24a

63 CCH Federal Taxation Comprehensive Topics 63 of 67 Tax Treatment Partner: Ordinary Income, No Adjustment to Outside Basis. Payments received by partner are treated as if the transaction took place between two unrelated parties. Partnership: Deductible. The value of the services is deductible by the P/S. (or capitalizable if appropriate—e.g., a partner’s fee for replacing the roof of the partnership’s office building is capitalized by the partnership under Code Sec. 263.) Partners Providing Infrequent, Nonessential Services to Partnerships for Compensation Chapter 19, Exhibit 24b

64 CCH Federal Taxation Comprehensive Topics 64 of 67 Partners Providing Ongoing, Integral Services to Partnerships for Compensation Ongoing, integral services that are guaranteed. Code Sec. 707(c) allows non-partner status with regard to ongoing, integral services performed by partners in exchange for guaranteed payment. Payments are guaranteed if they are determined without regard to partnership income. For example, a partner drives the delivery truck of a pizza delivery partnership in exchange for a guaranteed payment of $1,000 per month. The monthly payment resembles a salary and is treated as such. Chapter 19, Exhibit 25a

65 CCH Federal Taxation Comprehensive Topics 65 of 67 Tax Treatment Generally, the same as above, except: (i) Early recognition. Partner may have to report ordinary income whether or not received. This would occur if the P/S used the accrual method and took an accrual deduction one year and paid the partner in the next. (ii) Not-salary in QRP context. In the context of qualified retirement plans, guaranteed payments are not the same as salary. Therefore, a partnership-employer’s contributions into qualified self-employment retirement plan, such as a Keogh or SEP IRA, that match guaranteed payments, are not deductible by the partnership, nor tax deferred by the partner. Partners Providing Ongoing, Integral Services to Partnerships for Compensation Chapter 19, Exhibit 25b

66 CCH Federal Taxation Comprehensive Topics 66 of 67 Ongoing, integral services that are NOT guaranteed. The courts have required “partner status” when a partner performed services that were ongoing and integral to the business of the partnership and remuneration was NOT guaranteed. For example, driving the delivery truck of a pizza delivery partnership in exchange for 25% of the profits. Partners Providing Ongoing, Integral Services to Partnerships for Compensation Chapter 19, Exhibit 25c

67 CCH Federal Taxation Comprehensive Topics 67 of 67 Tax Treatment (worst case treatment) Partner: Ordinary Income, Adjustment to Outside Basis. An ongoing, integral, non-guaranteed payment received by a partner is treated as a distribution of profits rather than compensation. The partner’s outside basis must be reduced by the amount of the partnership’s inside basis in the property distributed. Partnership: Not deductible. The partnership’s payment for services is not deductible by the partnership. Partners Providing Ongoing, Integral Services to Partnerships for Compensation Chapter 19, Exhibit 25d


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