Corporate & Partner Tax Instructor: Dwight Drake Partner’s Interest Changing During Year Objective: Allocate to each partner share based on changing interests during year. 706(d). Two approaches: - “Interim Closing of Books” Approach: Treat as if books closed and specific income and loss items determined each time interests change during year. Then allocate items for each stub period based on interests held during the stub period. - “Proration” Approach: Assume items incurred evenly through-out year and allocate based on number of days each partner held the varying interests. Easier but more arbitrary.

Corporate & Partner Tax Instructor: Dwight Drake Anti-Abuse Provisions of 706(d) 1. Cash Basis Exceptions. If interests change during year, “allocable cash basis items” are assigned to period to which they are attributable. Essentially, converted to accrual deductions: Include - Interest - Taxes - Payment for services or use of property - Other items specified by IRS. 2.Different Year Exception: Cash basis item attributable to later year deemed paid on last day of year. Cash basis item attributable to earlier year deemed paid on 1 st day of year and allocated to partners in accordance with varying interests in the earlier year. If earlier year partner no longer partner on first day of year of payment, such partners share capitalized by partnership and added to basis. 3.Tiered Partnership Exception: Lower tier accrual periods flow to upper tier.

Corporate & Partner Tax Instructor: Dwight Drake Problem Basic Facts: A, B, & C equal partners through 10/31 of calendar year accrual partnership. C makes contribution, and C’s interest goes to 50% as of 11/1. (a)Partnership losses 24k and uses proration method. How losses allocated? A B C First 10 months [24k x 10/12 x.33%] 6,667 6,667 6,667. Last Two Months [24k x 2/12 x.25%] 1,000 1,000 [24k x 2/12 x.50%] 2,000 Total Loss 7,667 7,667 8,667

Corporate & Partner Tax Instructor: Dwight Drake Problem Basic Facts: A, B, & C equal partners through 10/31 of calendar year accrual partnership. C makes contribution, and C’s interest goes to 50% as of 11/1. (b)Same as (a) but all 24k loss incurred in first half of year. Loss allocated 1/3 to each partner under interim closing method – 8k to each partner. When expenses paid not factor. If C wanted bigger share of loss, should use proration method. (c) –(i) Loss of 24k due to 24k payment on 11/15 for rent for year. Partnership cash basis, use interim closing method, all other items uniform throughout year. Rent is allocable cash item, deemed uniform throughout year. Thus, answer same as (a) – 7667 to A & B and 8,667 to C.

Corporate & Partner Tax Instructor: Dwight Drake Problem Basic Facts: A, B, & C equal partners through 10/31 of calendar year accrual partnership. C makes contribution, and C’s interest goes to 50% as of 11/1. (c) –(ii) Loss of 24k due to 24k payment on lawsuit made 11/15, settled on 6/1. Use interim closing method, all other items uniform throughout year. Cash basis. Payment not allocable cash item, allocated when paid – 25% to A & B; 50% to C. (c) – (iii) Same assumptions, 24k loss from payment on March 1 for prior year rent. Loss allocated 1/3 top each partner to reflect interest in partnership during prior year (8k each partner).

Corporate & Partner Tax Instructor: Dwight Drake Problem Basic Facts: AB Partnership owns 75% of ABC Partnership, which has 16k loss. AB admits new 1/3 partner D on 12/1. All loss incurred ratably throughout year. AB share of ABC 16k loss is 12k (75%), allocated as follows under proration method A B D First 11 months [12k x 11/12 x.50] 5,500 5,500 Last Month [12k x 1/12 x.33%] Total Loss 5,833 5, Same allocation under interim closing method if loss incurred ratably through year at ABC level.

Corporate & Partner Tax Instructor: Dwight Drake Family Partnership Rules – 704(e) General Rule of (e)(1): Person recognized as partner for interest derived from purchase or gift if: - Person owns capital interest, and - Capital is material income producing item. Gift Interest Refinement of (e)(2): If interest created by gift, distributive share to donee OK if: - Donor reasonably compensated for services, and - Donee’s share is not greater than donors share, based on respective capital interests. Family Purchase: Purchase from family member deemed gift. Family includes ancestors, lineal descendants, spouse and any trusts for same.

Corporate & Partner Tax Instructor: Dwight Drake Problem Issue: Capital Material Income Producing Requirement of 704(e)(1). (a) Father lawyers makes son and daughter (both non-lawyers) partners in sole law firm. No hope. Services, not capital, are source of income. (b) Daughter (law school graduate) joins father’s law firm as partner. 704(e) no help, but may still have partnership under Culbertson test – Daughter is participant in practice and parties have joined together in good faith effort to carry on a business. (c) Father transfers building subject to lease to partnership with Son and Daughter. Test clearly satisfied for capital (here building) as material income producing item. (d) Father transfers just lease to partnership. Test not satisfied. Invalid assignment of income. Fruit taxed to owner of tree (Father). (e) Building transferred, but Father retains right to allocate income and to give building to Mother. Son and Daughter “own” nothing under Reg (e)(2). Father retained rights. Similar to grantor trust rules. Thus, all taxed to Father.

Corporate & Partner Tax Instructor: Dwight Drake Problem Facts: Father transfers commercial properties to partnership with Son and Daughter by gift, each 1/3 owner. Partnership has 90k income. (a)What impact if Father services worth 30k but 90 allocated and paid equally (30k) each to partners? Per 704(e)(2), 30k allocated to Father for services and remaining 60k allocated equally. Excess distributed to kids (10k each) is gift from father to each, income tax free under 102 but subject to gift tax consequences. (b)No services from Father, but special 40% allocation to each kid. 704(e) prevents allocation to donees in excess of pro rata capital. Here, 30k must be allocated to father. Extra 12k paid to kids (excess of 72k 0ver 60k) is gift from father (6k to each child). (c)Father renders 30k services and still have split in favor of kids. 704(e) requires Father to be allocated 30k for services. Other 60k allocated pro rata for capital. Hence, Father is allocated 50k total; Son 20k; Daughter 20k. Excess 32k paid to kids (50k less 18k) is gift from Father to Kids.

Corporate & Partner Tax Instructor: Dwight Drake Problem Facts: Father transfers commercial properties to partnership with Son and Daughter by gift, each 1/3 owner. Partnership has 30k income. (d)Son renders 30k services and still have split in favor of kids. 704(e) not deal with Donee’s services, but assignment of income doctrine requires Son to pick up 30k for services. Other 60k allocated pro rata for capital. Hence, Son is allocated 50k total; Father 20k; Daughter 20k. (e)What results if Son and Daughter purchased interests for FMV from Father? Same result; purchase from family member deemed gift for 704(e) rules.

Corporate & Partner Tax Instructor: Dwight Drake Problem Facts: A& B unrelated equal partners in cash basis partnership with 40k ordinary income and 20k LTCG. B paid 10% to compensate for his services to partnership. One 7/1, B transfers ½ his partnership interest to son S and provides: - B keeps as service 10%. - S gets all non-service income for entire year, - B gets all depreciation deductions allocable to the ½ interest for B and S. Are allocations valid? - Service 10% allocation good under 704(e)(2). Thus B pick up 4k of ordinary and 2k of LTCG from this allocation. - B attempted assignment of first have income to S invalid under 706(d). B must be taxed on ½ income all income items for first half. 706(d) overrides 704(b). First half income 18k ordinary and 9k LTCG after service allocation. Half of each allocated to B, not S.

Corporate & Partner Tax Instructor: Dwight Drake Problem Facts: A& B unrelated equal partners in cash basis partnership with 40k ordinary income and 20k LTCG. B paid 10% to compensate for his services to partnership. One 7/1, B transfers ½ his partnership interest to son S and provides: - B keeps as service 10%. - S gets all non-service income for entire year, - B gets all depreciation deductions allocable to the ½ interest for B and S. Are allocations valid? - Service 10% allocation good under 704(e)(2). Thus B pick up 4k of ordinary and 2k of LTCG from this allocation. - B attempted assignment of first have income to S invalid under 706(d). B must be taxed on ½ income all income items for first half. 706(d) overrides 704(b). First half income 18k ordinary and 9k LTCG after service allocation. Half of each allocated to B, not S.

Corporate & Partner Tax Instructor: Dwight Drake Problem For second half of year, S allocation of income can’t exceed pro rata share based on capital. So attempt to allocate all to S invalid under 704(e), which overrides 704(b). Hence, second half income items allocated equally to B and S. -Attempted special allocation of all depreciation deductions to B also bad under 704(e)(2) family rules. Has the bottom line effect of giving the donee S more, which is what the rule prohibits.