Chapter 2 Partnership Formation and Computation of Partner Basis

Partnership Interest When property is transferred to a partnership in exchange for a partnership interest, generally no gain or loss is recognized. General rule: This is treated as a tax-free exchange – more appropriately tax-deferral v. tax free Contributions to an S corporation in exchange for stock are taxable unless shareholders owning 80 percent or more of the outstanding stock make contributions to the S corporation in the same transaction Key Related Tax Doctrines Ability to pay / Assignment of Income

Partner’s and Partnership’s Basis The partner has an “exchanged basis” in the partnership interest. Equal to the combined bases of the contributed properties. The partnership takes a “transferred basis” in the contributed property. Equal to the contributing partner’s basis. Tax Basis of Partnership Interest Partners Tax Capital (Carryover Basis of Assets contributed – NPV of liabilities assumed by partnership) Plus partner share of partnership liabilities (recourse, nonrecourse, qualified non-recourse)

Code Sec. 754 Election This election allows the partnership to adjust the basis of its assets to reflect the gain or loss recognized by the contributor-partner on the sale of his or her partnership interest. This avoids recognizing a gain or loss twice (once when the partner sells his or her interest in the partnership and another time when the partnership disposes of the contributed asset. Section 754 elections will be discussed at length in the last 2 weeks of the semester.

Code Sec. 705 Basis Adjustments The partner’s partnership interest basis is increased by the partner’s share of taxed income. So, when the partner sells his interest in the partnership, the previously taxed income isn’t taxed again. The partner’s partnership interest basis is also increased by his share of tax-exempt income. Nondeductible non-capitalized expenditures reduce the basis of partnership interest. Deductible losses or expenses reduce the basis of the partnership interest.

Partnership Basis At formation, the total of the partnership’s basis in its properties (“inside basis”) is equals the total of the partners’ bases in their partnership interest (“outside basis”). However, many events can cause inequality between the inside and outside bases. Inside basis: Allocation of the partnership tax basis of assets to the partners Outside Basis: Partners Tax Capital + Share of liabilities, adjusted for any gain recognition on formation or suspension of losses – Outside tax basis can never be negative

Sale of Partnership Interest When a partnership interest is sold (absent a Code Sec. 754 election), the partnership’s inside basis remains unchanged but the outside basis is changed. Usually the difference between the bases equals the seller’s gain or loss on the sale. If a Code Sec. 754 election is made, equality between the inside and outside basis usually continues. Sales of partnership interests will be discussed in depth in the last 3 weeks of the semester.

Holding Period A partner must add the holding period of contributed capital and Code Sec. 1231 assets to the holding period of his or her partnership interest (which was received for contributing the assets). The partnership interest received for contributions of other property starts the day after it’s received. Whenever there is carryover basis of an asset, the holding period for the asset contributed and the partnership interest is “tacked”.

Depreciation Methods When depreciable property is contributed in a tax-free exchange, the partnership must use the transferor’s depreciation method and remaining depreciable life. No basis increase is allowed if a partner recognizes gain on a contribution of encumbered property to the partnership.

Contributions of Encumbered Property Both the contributing partner and the other partners should treat the contribution of encumbered property as consisting of 2 steps: 1) The existence of the debt is ignored and the contributing partner increases his or her basis by the amount of the contributed property’s basis. 2)The debt is taken into account. Each partner has a deemed cash contribution or distribution. Partners with deemed cash contributions will increase their basis by that amount and partner’s with deemed cash distributions will decrease their basis by that amount. Use the accounting equation (A-L=E) for both FMV and tax computations . To determine economic interest, starting point is the FMV of assets contributed less liabilities assumed by partnership. For tax purposes, tax basis of the assets contributed is used in place of FMV

Contributions of Encumbered Property (Cont.) When encumbered property is contributed to a partnership and the partnership becomes primarily liable for paying the debt, the contributing partner’s non-partnership-related liabilities for which he or she is directly responsible decrease by the amount of such debt. This is treated as a cash distribution from the partnership. However, in taking over this liability, the partnership’s indebtedness increases by the same amount. This means that each partner is treated as having made a cash contribution to the partnership in the amount of his or her share in the new debt.

Contributing Property Creating a Gain To determine a partner’s net debt relief: An increase in the partner’s share of debt from the previous year-end to the current year-end is deemed a cash contribution. The cash contribution is offset against the partner’s debt taken over by the partnership and any net debt relief is deemed a cash distribution. If this cash distribution exceeds his basis in the partnership interest, the excess is gain.

Effect of Partnership Operations on Basis (Cont.) Income and Loss—Taxable and Tax-Exempt A basis increase is necessary when taxable income is earned, otherwise it could be taxed a second time as gain from the sale of the partnership interest when it’s eventually sold. A basis increase is necessary when tax-exempt income is earned to avoid having the tax-exempt income result in increased gain (or reduced loss) on the sale of the partnership interest.

Effect of Partnership Operations on Basis (Cont.) A partner’s basis must be reduced for his share of the partnership’s losses. Otherwise, the partner would be allowed a second loss (or reduced gain) on sale of the partnership. If increased loss or reduced gain was allowed on tax-exempt income, then the income would essentially no longer be tax-free. Under Code Sec. 705(a)(3), a partner’s basis in their partnership interest will also be increased for their share of the excess of depletion over the basis of the property subject to depletion. However, a partner’s basis will not be affected by the production activities deduction they are allowed to take as a result of partnership activities.

Effect of Partnership Operations on Basis (Cont.) Contributions and Distributions Contributions result in an increased basis. Distributions result in a decreased basis. Distributions may not make the basis go below zero. The adjustments to basis are intended to ensure that: 1) A partner’s share of taxable income and deductions is taken into account only once. 2) Nondeductible expenditures and tax-exempt income remain characterized as such. 3) Distributions of previous contributions and previously taxed income are not taxed.

Contributions Requiring Special Considerations Property Subject to Depreciation Recapture The depreciation recapture provisions generally require that when recapture property is transferred the potential recapture amount is taxed. Code Sec. 1245 Gain on Contribution: The amount realized (hypothetical distribution of cash) is divided between Code Sec. 1245 and non-Sec. 1245 property based on the fair market value of recapture property versus other property contributed.

Contributions Requiring Special Considerations (Cont.) Partnership Recognizes Code Sec. 1245 Gain: When the partnership eventually sells the contributed property, it may be required to recapture depreciation deductions previously claimed either before or after the contribution. To the extent the gain on a subsequent sale represents the difference between the fair market value of the Code Sec. 1245 property and the adjusted tax basis at the time of contribution, that gain including the recapture will be allocated to the contributing partner.

Contributions Requiring Special Considerations (Cont.) Accounts Receivable Considered property and may be transferred free of taxation pursuant to Code Sec. 721. The contributor’s basis in the accounts receivable will become the partnership’s transferred basis in the receivables. The partnership will report income if its collections of these receivables exceed their transferred basis. Accounting method of the contributor is crucial Cash method taxpayers have zero basis in A/R since the receivables have not yet been taken into taxable income Accrual method taxpayers have already been taxed on A/R so they will have basis in the A/R.

Contributions Requiring Special Considerations (Cont.) Partner’s Personal Obligations The obligation is treated as a promise to provide funds in the future. It does not constitute a current contribution of property or money within the meaning of Code Sec. 721.

Contributions Requiring Special Considerations (Cont.) Personal Use Property (A partner’s contribution of property which, before the contribution, was not considered investment or business property) Partnership’s Basis: Takes the lower of the FMV at the time of contribution or the contributing partner’s adjusted basis. Basis for Loss Computations: Lower of FMV or the partner’s basis at the time of contribution. Basis for Gain Computations: Partner’s basis plus or minus adjustments attributable to partnership’s ownership. If using the loss basis produces a gain, or using the gain basis produces a loss, then the partnership will not report a gain or a loss.

Contributions Requiring Special Considerations (Cont.) Partner’s Basis: The partner’s basis in his partnership interest shouldn’t include the amount by which the contributed property’s basis exceeded its value at the time of contribution. The exchanged basis should be limited to the FMV. When computing a gain, both the partner’s basis in his interest, and the partnership’s basis in its assets, include the contributor’s entire basis. When computing gain on the receipt of money in excess of the partner’s basis in the partnership interest, the exchanged basis should be the carryover basis without reference to the FMV of the contributed property.

Contributions Requiring Special Considerations (Cont.) Suspended Losses Any losses suspended by Code Secs. 465 or 469 prior to the contribution of the related activity remain with the contributing partner and are not transferred to the partnership. If the activity produces income in the partnership’s hands, it will be either passive income or “income from a former passive activity” which can be offset by any of the activity’s unused passive activity deductions from a prior year. All income generated by the activity on the partnership’s hands results in an additional at-risk amount.

Chapter 9: Partner’s Share of Partnership Debt

Partner’s Share of Debt: Adjustments The partnership must disclose on Schedule K-1 each partner’s share of: Nonrecourse debt other than that considered qualified nonrecourse debt under Code Sec. 465(b)(6). Qualified nonrecourse financing. Each partner’s share of the partnership’s recourse debt. A liability for which any partner or party related to a partner bears the economic risk of loss.

Partner’s Share of Debt: Adjustments (Cont.) Code Sec. 752 treats an increase or a decrease in a partner’s share of partnership liabilities as a deemed money contribution or distribution, respectively. Contributions increase a partner’s basis. Distributions decrease a partner’s basis (but not below zero). Distributions in excess of the basis trigger a gain.

Partner’s Share of Debt: Adjustments (Cont.) A deemed contribution or distribution will arise only if one or both of the following events occurs: The total partnership debt changes; and/or The method for sharing partnership debt changes. A partner’s share of debt is calculated as of the last day of the partnership year.

Partner’s Share of Debt: Contributions & Distributions Contribution of Encumbered Property The contribution of encumbered property to a partnership should be analyzed as two separate transactions: The contribution of property by the partner to the partnership, followed by A distribution of cash by the partnership to the partner. This is equal to the amount of the liability encumbering the property less the contributing partner’s share of the transferred debt.

Partner’s Share of Debt: Contributions & Distributions (Cont.) Distributions of Encumbered Property A partnership distribution of property encumbered by a liability should be analyzed as two transactions: The distribution of unencumbered property to the partner, accompanied by The contribution by the recipient-partner of money to the partnership. The assumption by the partner of partnership debt is treated as a cash contribution to the partnership. As such, it increases the partner’s basis in the partnership interest rather than his or her basis in the distributed property.

What is a “Liability”? - Additional Code Sec. 752 Requirements (Cont.) In preparing Form 1065, the partnership will in most instances ignore cash basis accounts payable in calculating partnership debt. Contingent liabilities do not affect basis until they create an asset or are the source of a deduction. A nonrecourse obligation is treated as a “liability” for Code Sec. 752 purposes to the same extent that it is treated as a liability for purposes of determining the basis of property or claiming a deduction.

Classification of Partnership Liabilities as Recourse vs. Nonrecourse A partnership liability is deemed a recourse liability to the extent that any partner bears the economic risk of loss for that liability. A nonrecourse loan, in contrast, is one where the lender has no right to demand payment from the borrower in the event of default. The nonrecourse lender’s only option is to take possession of the property securing the loan. If the value of the property is not sufficient to satisfy the outstanding debt, the lender has no recourse against the borrower or any other party.

Classification of Partnership Liabilities as Recourse vs Classification of Partnership Liabilities as Recourse vs. Nonrecourse (Cont.) Recourse liabilities are shared among the partners in accordance with the manner in which they share the economic risk of loss associated with partnership operations. Nonrecourse liabilities are generally shared in accordance with the way the partners will share in the gain from sale of the property securing the nonrecourse liabilities.

Partner’s Share of Recourse Debt A partner bears the economic risk of loss for a partnership liability only to the extent that the partner: Can be required to make a capital contribution to the partnership Restore a deficit in his or her capital account Pay a creditor directly, or Reimburse another partner for a payment made by such partner to a creditor of the partnership.

Partner’s Share of Recourse Debt: Constructive Liquidation of the Partnership The regulations require the partnership to analyze the consequences that would result from a hypothetical “constructive liquidation”. A constructive liquidation is a hypothetical situation in which all the partnership’s assets become completely worthless and the partnership is left with no funds available to pay its creditors. The partnership’s assets are deemed to have been exchanged for no consideration, and the resulting hypothetical losses are allocated among the partners in accordance with their loss-sharing ratios in the partnership agreement.

Partner’s Share of Recourse Debt: Constructive Liquidation of the Partnership (Cont.) When these hypothetical losses are posted to the partners’ capital accounts, the resulting balances reflect the partners’ potential risk of loss at that moment in time from partnership operations. Partners with deficit balances in their capital accounts following the hypothetical liquidation would be required to make payments to the partnership. Those payments serve as the measure of the partners’ individual risks of loss with respect to partnership liabilities.

Partner’s Share of Recourse Debt: Constructive Liquidation of the Partnership (Cont.) Distributions and special loss allocations have the effect of shifting debt, and therefore basis, to those partners receiving the distributions or special loss allocations (assuming such partners’ shares of subsequent partnership loss are not affected by the distribution or special allocation).

Partner’s Share of Recourse Debt: Nonrecourse Loans Recharacterized as Recourse Nonrecourse Loans From Partners Generally speaking, a nonrecourse loan from a partner to the partnership will be recharacterized as a recourse loan allocable entirely to the partner who made the loan. Reimbursement Rights A partner’s obligation to pay a partnership liability is reduced to the extent that the partner is entitled to reimbursement from another partner or a person who is related to another partner.

Partner’s Share of Recourse Debt: Nonrecourse Loans Recharacterized as Recourse (Cont.) Plan to Avoid An obligation will be disregarded if the facts and circumstances indicate a plan to circumvent or avoid such obligation. Tantamount to a Guarantee If one or more partners or related persons undertake contractual obligations that substantially eliminate a creditor’s risk on an otherwise nonrecourse loan, the arrangement may be considered tantamount to a guarantee and treated for all purposes under the regulations as a guarantee.

Partner’s Share of Recourse Debt: Nonrecourse Loans Recharacterized as Recourse (Cont.) Guarantees The partners who bear the economic risk of loss are deemed to bear the risk of loss constituting the obligation. The person with the primary liability will be considered the party with the risk of loss. The guarantor of a partnership recourse liability generally has a “reimbursement right” from the partnership’s general partners and is therefore not the person with the ultimate risk of loss. The guarantor of a nonrecourse liability does not have the right to reimbursement from the other partners and will be treated as bearing 100% of the risk for the guaranteed nonrecourse liability.

Partner’s Share of Partnership Nonrecourse Debt Nonrecourse liabilities are those liabilities for which no partner (or related person) bears personal risk of loss. If the loan is obtained from a partner then the lender, who is a partner in the partnership, bears personal risk of loss and the liability will be treated as a recourse loan for purposes of Code Sec. 752. The debt is included in the basis.

Partner’s Share of Nonrecourse Debt (Cont.) Partners’ interests in partnership nonrecourse debt are divided into three categories: “Book” (Code Sec. 704(b)) minimum gain The partner’s share of “Code Sec. 704(b )” minimum gain (nonrecourse debt minus book value); Code Sec. 704(c) minimum gain The partner’s share of taxable gain (not already allocated under (1) above) that would be allocated to the partner under Code Sec. 704(c) if the property was disposed of in full satisfaction of its nonrecourse debt. This equals the partner’s share of any excess of book value over tax basis for Code Sec. 704(c) assets, where the nonrecourse debt exceeds book value), and

Partner’s Share of Nonrecourse Debt (Cont.) Other profits The partner’s share of the excess nonrecourse liabilities of the partnership as determined in accordance with the partner’s share of partnership profits.

Partner’s Share of Nonrecourse Debt: Minimum Gain Partnership “minimum gain” is the amount of gain which would be recognized by the partnership if it surrendered the property to the nonrecourse lender in satisfaction of the outstanding balance of the debt. This is an amount equal to the excess of the outstanding balance of the loan over the book value (adjusted for book depreciation deductions) of the property. The partnership could realize more gain on disposition of the property but never less.

Partner’s Share of Nonrecourse Debt: Minimum Gain (Cont.) If there is minimum gain the partners’ capital accounts may fall below zero even in the absence of any requirement on their parts to make additional capital contributions to “restore” these deficit balances. As long as the deficits do not exceed the partners’ shares of minimum gain, any deficit in their capital accounts can theoretically be made up with an allocation of minimum gain when the asset is sold or foreclosed on. This later allocation of gain would offset the deductions allowed that created the deficit capital balances.

Partner’s Share of Nonrecourse Debt: Code Sec. 704(c) Code Sec. 704(c) minimum gain arises when a partnership owns property encumbered by nonrecourse debt which has a book value in excess of its tax basis. The total amount of “minimum gain” which would be recognized by the partnership in the event of default and foreclosure by the nonrecourse lender is in this case equal to the excess of the principal amount of the note over the tax basis of the property. The excess of principal amount over book value would already have been allocated as “Code Sec. 704(b)” minimum gain.

Partner’s Share of Nonrecourse Debt: Code Sec. 704(c) (Cont.) It is possible to have Code Sec. 704(c) minimum gain, but no “book” minimum gain. Similarly, it is possible to have “book minimum gain, but no Code Sec. 704(c) minimum gain. Partnership nonrecourse liabilities in excess of the partnership’s Code Sec. 704(b) and Code Sec. 704(c) minimum gains are allocated in accordance with the partners’ interests in general partnership profits.