Chapter 11   Partnerships: Distributions,   Transfer of Interests,   and Terminations   Corporations, Partnerships,   Esta...
The Big Picture (slide 1 of 4)• In the previous chapter, Josh, Kyle, and Maria created  Beachside Properties, LLC, to own ...
The Big Picture (slide 2 of 4)• The area has grown substantially, and it appears to be  a good time to develop the remaini...
The Big Picture (slide 3 of 4)• The transfer of Kyle’s and Maria’s interests and the  admission of the new LLC members can...
The Big Picture (slide 4 of 4)• Although the two alternatives have identical  economic effects, the tax results could diff...
Distributions from a Partnership                           (slide 1 of 4)• A payment from a partnership to a partner is no...
Distributions from a Partnership                           (slide 2 of 4)• A liquidating distribution occurs when either: ...
Distributions from a Partnership                             (slide 3 of 4)• A nonliquidating distribution is any  distrib...
Distributions from a Partnership                      (slide 4 of 4)• Distributions from a partnership may be either:  – P...
The Big Picture – Example 1    Distributions From A Partnership• Return to the facts of The Big Picture on p. 11-2.• Assum...
Proportionate Nonliquidating          Distributions (slide 1 of 3)• In general, neither partner nor partnership  recognize...
Proportionate Nonliquidating        Distributions (slide 2 of 3)– Partner recognizes gain to extent cash received  exceeds...
Proportionate Nonliquidating          Distributions (slide 3 of 3)• Property distributions  – In general, no gain recogniz...
Ordering Rules• 1. Cash• 2. Unrealized receivables and inventory• 3. All other assets• Basis is allocated to assets within...
Proportionate Nonliquidating     Distribution Examples (slide 1 of 6)Bill’s basis in partnership interest: $30,000 Proport...
Proportionate Nonliquidating Distribution             Examples (slide 2 of 6)                           A           B     ...
Proportionate Nonliquidating Distribution            Examples (slide 3 of 6)                          A         B         ...
Proportionate Nonliquidating Distribution            Examples (slide 4 of 6)Bill’s basis in partnership interest:      $30...
Proportionate Nonliquidating Distribution            Examples (slide 5 of 6)                               D           E  ...
Proportionate Nonliquidating Distribution             Examples (slide 6 of 6)                              D          E   ...
Effect of Liquidating Distribution• In general:  – No gain or loss is recognized by partnership  – Partner reduces basis i...
Exceptions to Liquidating Distribution            Rules (slide 1 of 2)• Gain is recognized if:  – Cash distributed exceeds...
Exceptions to Liquidating Distribution            Rules (slide 2 of 2)• Loss is recognized only if:  – Assets received inc...
Proportionate Liquidating Distribution              Examples (slide 1 of 4)Bill’s basis in partnership interest: $30,000Pr...
Proportionate Liquidating Distribution            Examples (slide 2 of 4)                       G          H           I  ...
Proportionate Liquidating Distribution              Examples (slide 3 of 4)                             G          H      ...
Proportionate Liquidating Distribution            Examples (slide 4 of 4)Sale of non-cash assets at FMV:Example H:        ...
Property Distributions with Special        Tax Treatment (slide 1 of 4)• Disguised sales  – Contribution of appreciated pr...
Property Distributions with Special        Tax Treatment (slide 2 of 4)• Marketable securities  – FMV of marketable securi...
Property Distributions with Special        Tax Treatment (slide 3 of 4)• Precontribution gain property  – Contributing par...
Property Distributions with Special        Tax Treatment (slide 4 of 4)• Precontribution gain property  – Contributing par...
Disproportionate Distributions                    (slide 1 of 3)• Occurs when partnership distributes cash or  property to...
Disproportionate Distributions                       (slide 2 of 3)• If partner receives less than proportionate  share of...
Disproportionate Distributions                         (slide 3 of 3)• Hot assets include:  – Substantially appreciated in...
§736: Liquidating Distribution Where     P’ship Does Not Liquidate (slide 1 of 3)• §736(a) income payment:  – Treated as d...
§736: Liquidating Distribution Where    P’ship Does Not Liquidate (slide 2 of 3)• §736(a) income payment:  – Partner has: ...
§736: Liquidating Distribution Where    P’ship Does Not Liquidate (slide 3 of 3)• §736(b) property payment:  – Disproporti...
The Big Picture – Example 27   § 736(b) Property Payments (slide 1 of 4)• Return to the facts of The Big Picture on p. 11-...
The Big Picture – Example 27   § 736(b) Property Payments (slide 2 of 4)The current balance sheet for Beachside Properties...
The Big Picture – Example 27   § 736(b) Property Payments (slide 3 of 4)• Capital is a ‘‘material income-producing  factor...
The Big Picture – Example 27   § 736(b) Property Payments (slide 4 of 4)• Because Kyle and Maria receive cash in lieu of t...
Sale of Partnership Interest                       (slide 1 of 4)• Generally, results in gain or loss recognition  by sell...
Sale of Partnership Interest                        (slide 2 of 4)• Partnership tax year closes for selling partner  on sa...
Sale of Partnership Interest                           (slide 3 of 4)• Effect of hot assets  – Hot assets include:     • U...
Sale of Partnership Interest                       (slide 4 of 4)• Effect of hot assets (cont’d)  – Must allocate sales pr...
The Big Picture – Example 36          Effect Of Hot Assets (slide 1 of 2)• Return to the facts of The Big Picture on p. 11...
The Big Picture – Example 36         Effect Of Hot Assets (slide 2 of 2)• Refer back to the balance sheet in Example 27.  ...
Other Dispositions of Partnership           Interests (slide 1 of 8)• Transfer of a partnership interest to a  controlled ...
Other Dispositions of Partnership            Interests (slide 2 of 8)• Incorporating a partnership  – At least three metho...
Other Dispositions of Partnership            Interests (slide 3 of 8)• Incorporating a partnership (cont’d)     • 2. Trans...
Other Dispositions of Partnership            Interests (slide 4 of 8)• Incorporating a partnership (cont’d)     • 3. Partn...
Other Dispositions of Partnership            Interests (slide 5 of 8)• Incorporating a partnership (cont’d)  – All three m...
Other Dispositions of Partnership            Interests (slide 6 of 8)• Nontaxable like-kind exchange rules do not  apply t...
Other Dispositions of Partnership            Interests (slide 7 of 8)• Generally, the gift of a partnership interest is  t...
Other Dispositions of Partnership            Interests (slide 8 of 8)• Death of a partner  – Taxable year of partnership c...
§754 Election• Adjusts partnership’s basis in assets to reflect:   – The difference in the amount paid by the purchasing  ...
The Big Picture – Example 43                § 754 Election (slide 1 of 2)• Return to the facts of The Big Picture on p. 11...
The Big Picture – Example 43                § 754 Election (slide 2 of 2)• Step-up related to distribution in liquidation ...
Termination of Partnership                       (slide 1 of 3)• Partnership terminates when either of the  following even...
Termination of Partnership                      (slide 2 of 3)• Partnership terminates and its tax year closes  when:  – T...
Termination of Partnership                       (slide 3 of 3)• Partnership tax year usually does not close:  – Upon the ...
The Big Picture – Example 45  Termination Of A Partnership (slide 1 of 2)• Return to the facts of The Big Picture on p. 11...
The Big Picture – Example 45  Termination Of A Partnership (slide 2 of 2)• A technical termination would require  redeterm...
Family Partnerships                     (slide 1 of 3)• Owned and controlled primarily by members  of the same family  – O...
Family Partnerships                            (slide 2 of 3)• Family member will be recognized as a partner if:   – Capit...
Family Partnerships                          (slide 3 of 3)• Kiddy tax may apply to child partner under age 19 (or  a stud...
Limited Liability Companies• A LLC with 2 or more owners is taxed as a  partnership  – LLC members are not personally liab...
Limited Liability Partnerships• Partners are not personally liable for the  malpractice and torts of their partners• Taxab...
Refocus On The Big Picture (slide 1 of 3)• Two things are happening when the new developers  become members of Beachside P...
Refocus On The Big Picture (slide 2 of 3)What If?• Changing the facts, assume the developers  have only $2 million in cash...
Refocus On The Big Picture (slide 3 of 3)What If?• This loan, though, is not large enough to also completely buy  out Kyle...
If you have any comments or suggestions concerning this                   PowerPoint Presentation for South-Western Federa...
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Vol 02 chapter 11 2012

  1. 1. Chapter 11 Partnerships: Distributions, Transfer of Interests, and Terminations Corporations, Partnerships, Estates & Trusts© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1
  2. 2. The Big Picture (slide 1 of 4)• In the previous chapter, Josh, Kyle, and Maria created Beachside Properties, LLC, to own and operate the Beachsider Cafe´ and to own, manage, and lease the remaining properties in the Shorefront Center.• Several years have passed since the LLC was formed. – The LLC interests and the net underlying assets are currently valued at approximately $10 million (including $1 million of goodwill for the Beachsider Cafe´). – During this period, the LLC has made significant distributions of cash and property to its members.
  3. 3. The Big Picture (slide 2 of 4)• The area has grown substantially, and it appears to be a good time to develop the remaining 7 acres of property. – The cost of development is estimated at $10 million.• Josh wants to manage the expansion. – Kyle and Maria are nearing retirement age. – They would prefer to dispose of their interests (valued at $9.5 million, or 95% of the net LLC value).• Josh has been approached by a group of developers who are willing to invest the $19.5 million necessary to make the improvements and to purchase Kyle’s and Maria’s interests.
  4. 4. The Big Picture (slide 3 of 4)• The transfer of Kyle’s and Maria’s interests and the admission of the new LLC members can be accomplished in two ways. – First, the LLC could admit the new members for $19.5 million of cash • Use $9.5 million to redeem the interests of Kyle and Maria. – Second, Kyle and Maria could sell their LLC interests directly to the new members for $9.5 million. • The new members would also contribute $10 million of cash to the LLC for the expansion.
  5. 5. The Big Picture (slide 4 of 4)• Although the two alternatives have identical economic effects, the tax results could differ substantially. – How are the distributions of cash and property to the LLC members treated over the years? – What are the tax consequences of admitting the new members to the LLC and redeeming the interests of Kyle and Maria? – What are the results if the new members acquire the interests directly from Kyle and Maria and contribute the cash for expansion to the LLC?• Read the chapter and formulate your response.
  6. 6. Distributions from a Partnership (slide 1 of 4)• A payment from a partnership to a partner is not necessarily treated as a distribution – e.g., Partnership may pay interest or rent to a partner, make a guaranteed payment, or purchase property from a partner• If a payment is treated as a distribution, it will fall into one of two categories: – Liquidating distributions – Nonliquidating distributions• Depends on whether the partner remains a partner in the partnership after the distribution
  7. 7. Distributions from a Partnership (slide 2 of 4)• A liquidating distribution occurs when either: – Partnership itself liquidates and distributes all its property to the partners, or – Ongoing partnership redeems interest of one of its partners • e.g., Partner retires
  8. 8. Distributions from a Partnership (slide 3 of 4)• A nonliquidating distribution is any distribution from a continuing partnership to a continuing partner – Two types of nonliquidating distributions • Draw – Distribution of partner’s share of current or accumulated profits • Partial liquidation – Reduces partner’s interest in partnership capital but does not liquidate partner’s interest
  9. 9. Distributions from a Partnership (slide 4 of 4)• Distributions from a partnership may be either: – Proportionate—Partner receives his or her share of certain ordinary income-producing assets – Disproportionate—Partner’s share of certain ordinary income-producing assets increases or decreases
  10. 10. The Big Picture – Example 1 Distributions From A Partnership• Return to the facts of The Big Picture on p. 11-2.• Assume that Josh’s basis in his interest in Beachside Properties, LLC, is $300,000.• The LLC distributes $50,000 cash to Josh at the end of the year. – Josh does not recognize any gain on the distribution and reduces his basis by $50,000 (the amount of the distribution) to $250,000. – Josh’s basis in the cash he received is $50,000,and the LLC’s inside basis for his assets is reduced by the $50,000 cash distributed.
  11. 11. Proportionate Nonliquidating Distributions (slide 1 of 3)• In general, neither partner nor partnership recognizes gain or loss on proportionate nonliquidating distributions – Partner usually takes a carryover basis in assets distributed – Basis in partnership interest is reduced by amount of cash and basis of property distributed
  12. 12. Proportionate Nonliquidating Distributions (slide 2 of 3)– Partner recognizes gain to extent cash received exceeds partner’s adjusted basis (outside basis) in partnership interest • Reduction in partner’s share of partnership debt is treated as a distribution of cash – First reduces partner’s basis in partnership – Any reduction in excess of partner’s basis in partnership results in taxable gain to the partner– Partner cannot recognize loss on a proportionate nonliquidating distribution
  13. 13. Proportionate Nonliquidating Distributions (slide 3 of 3)• Property distributions – In general, no gain recognized on a property distribution • If inside basis of property distributed exceeds partner’s outside basis in partnership interest, distributed asset takes substituted basis • Assets are deemed distributed and basis applied in a certain order
  14. 14. Ordering Rules• 1. Cash• 2. Unrealized receivables and inventory• 3. All other assets• Basis is allocated to assets within a category based on adjusted basis to partnership
  15. 15. Proportionate Nonliquidating Distribution Examples (slide 1 of 6)Bill’s basis in partnership interest: $30,000 Proportionate nonliquidating distributions (independent fact situations): Assets Distributed A B C .Cash $15,000 $15,000 $ 5,000Land—basis N/A $ 6,000 N/A (Fair mkt value) N/A $10,000 N/AAccts rec—basis N/A N/A -0-(Fair mkt value) N/A N/A $16,000
  16. 16. Proportionate Nonliquidating Distribution Examples (slide 2 of 6) A B C .Basis in interest $30,000 $30,000 $30,000Cash distributed ( 15,000) (15,000) (5,000)Basis after cash 15,000 15,000 25,000Acct. rec. distrib. N/A N/A (-0-)Basis after A.R. 15,000 15,000 25,000Land Distrib. N/A ( 6,000) N/ABasis after all dist. $15,000 $ 9,000 $25,000
  17. 17. Proportionate Nonliquidating Distribution Examples (slide 3 of 6) A B C .Basis in p’ship int. $15,000 $9,000 $25,000Basis in cash 15,000 15,000 5,000Basis in land N/A 6,000 N/ABasis in A/R N/A N/A -0-Total basis $30,000 $30,000 $30,000Sale of non-cash assetsat FMV: Selling price N/A $10,000 $16,000Basis N/A (6,000) (-0-)Gain N/A $4,000 $16,000
  18. 18. Proportionate Nonliquidating Distribution Examples (slide 4 of 6)Bill’s basis in partnership interest: $30,000Proportionate nonliquidating distributions(independent fact situations):Assets Distributed D E F .Cash $40,000 N/A $20,000Relief of liabilities N/A 40,000 N/ALand-basis N/A N/A $30,000(Fair mkt value) N/A N/A $50,000
  19. 19. Proportionate Nonliquidating Distribution Examples (slide 5 of 6) D E F .Basis in interest $30,000 $30,000 $30,000Cash distributed (40,000) N/A (20,000)Relief of liabilities N/A (40,000) N/AGain recognized 10,000 10,000 N/A .Basis after cash (anddeemed cash) dist. -0- -0- 10,000Land distrib. N/A N/A (10,000)Basis after all distrib. -0- -0- -0-
  20. 20. Proportionate Nonliquidating Distribution Examples (slide 6 of 6) D E F .Basis in pship int. -0- -0- -0-Basis in cash 40,000 N/A 20,000Liabilities relieved N/A 40,000 N/ABasis in land N/A N/A 10,000Gain recognized (10,000) (10,000) N/A .Original basis 30,000 30,000 30,000Sale of non-cash assetsat FMV: Selling price N/A N/A $50,000Basis N/A N/A (10,000)Gain N/A N/A $40,000
  21. 21. Effect of Liquidating Distribution• In general: – No gain or loss is recognized by partnership – Partner reduces basis in partnership interest by basis in property received at each level using Ordering Rules – Partner’s entire basis in interest will be absorbed by distributed assets
  22. 22. Exceptions to Liquidating Distribution Rules (slide 1 of 2)• Gain is recognized if: – Cash distributed exceeds partner’s basis – Precontribution gain exceptions – Disproportionate distribution
  23. 23. Exceptions to Liquidating Distribution Rules (slide 2 of 2)• Loss is recognized only if: – Assets received include only cash, unrealized receivables and inventory, and – Outside basis exceeds partnership’s inside basis in distributed property
  24. 24. Proportionate Liquidating Distribution Examples (slide 1 of 4)Bill’s basis in partnership interest: $30,000Proportionate liquidating distributions (partnership also liquidates) (independent fact situations): G H I .Cash $50,000 $10,000 $10,000Unrealized rec. N/A -0- -0-(Fair mkt value) N/A $16,000 $16,000Filing cabinet (1231) N/A N/A 300(Fair mkt value) N/A N/A 300
  25. 25. Proportionate Liquidating Distribution Examples (slide 2 of 4) G H I .Basis in interest $30,000 $30,000 $30,000Cash distribution (50,000) (10,000) (10,000)Gain recognized 20,000 N/A N/ABasis after cash -0- 20,000 20,000A/R distrib. N/A -0- -0-Loss recognized N/A (20,000) N/ABasis after A/R -0- -0- 20,000Filing cabinet N/A N/A (20,000)Ending basis $ -0- $ -0- $ -0-
  26. 26. Proportionate Liquidating Distribution Examples (slide 3 of 4) G H I .Basis in p’ship int. $ -0- $ -0- $ -0-Basis in cash 50,000 10,000 10,000Basis in A/R N/A -0- -0-Basis in filing cabinet N/A N/A 20,000Capital (Gain)/loss (20,000) 20,000 N/A .Original basis $30,000 $30,000 $30,000
  27. 27. Proportionate Liquidating Distribution Examples (slide 4 of 4)Sale of non-cash assets at FMV:Example H: A/R Fil.Cab. Total . Selling price $16,000 N/A $16,000 Basis -0- N/A -0- . Gain/(loss) $16,000 N/A $16,000 (Ordinary)Example I: Selling price $16,000 $ 300 $16,300 Basis -0- 20,000 20,000 Gain/(loss) $16,000 ($19,700) ($3,700) (Ordinary) (May be ord)
  28. 28. Property Distributions with Special Tax Treatment (slide 1 of 4)• Disguised sales – Contribution of appreciated property to partnership followed by a cash distribution to the contributing party may be treated as a disguised sale – Treated as a sale of property resulting in gain recognition • Partnership’s basis in the asset is cost
  29. 29. Property Distributions with Special Tax Treatment (slide 2 of 4)• Marketable securities – FMV of marketable securities distributed to a partner is treated as a cash distribution • Some or all of excess of FMV of securities distributed over partner’s outside basis is taxable gain – Marketable securities include most actively traded debt or equity interests, options, futures, and derivatives – Exceptions apply
  30. 30. Property Distributions with Special Tax Treatment (slide 3 of 4)• Precontribution gain property – Contributing partner recognizes gain on distribution of precontribution gain property in two situations: • 1. If property is distributed to another partner within 7 years of contribution date, contributing partner recognizes remaining precontribution gain – Partner’s basis in partnership and basis of distributed property is increased by gain recognized
  31. 31. Property Distributions with Special Tax Treatment (slide 4 of 4)• Precontribution gain property – Contributing partner recognizes gain on distribution of precontribution gain property in two situations (cont’d): • 2. If partnership distributes any property other than cash to a partner within 7 years after that partner contributes appreciated property, the partner recognizes the lesser of: – Remaining net precontribution gain – Excess of FMV of distributed property over partner’s basis in partnership interest
  32. 32. Disproportionate Distributions (slide 1 of 3)• Occurs when partnership distributes cash or property to a partner which increases or decreases the partner’s share of ordinary income-producing assets (hot assets)
  33. 33. Disproportionate Distributions (slide 2 of 3)• If partner receives less than proportionate share of hot assets, then treated as if: – Partnership distributed some of the assets, and – Partner sold these hot assets back to partnership – Partner recognizes ordinary income on sale of the hot assets; Partnership’s basis in hot assets is cost
  34. 34. Disproportionate Distributions (slide 3 of 3)• Hot assets include: – Substantially appreciated inventory • Inventory includes all assets other than cash, capital and §1231 assets • Substantially appreciated means FMV > 120% of partnership’s adjusted basis in inventory – Unrealized receivables • Rights to receive future amounts that will result in ordinary income recognition
  35. 35. §736: Liquidating Distribution Where P’ship Does Not Liquidate (slide 1 of 3)• §736(a) income payment: – Treated as distributive share of partnership income or guaranteed payment to partner – Certain items if partnership is service-provider and retiring partner is a general partner: • Unrealized receivables (except depreciation recapture) • Goodwill (unless provided for in partnership agreement)• §736(b) property payment: – Payments made for liquidated partner’s share of partnership’s assets
  36. 36. §736: Liquidating Distribution Where P’ship Does Not Liquidate (slide 2 of 3)• §736(a) income payment: – Partner has: • Ordinary income (guaranteed payment), or • Distributive share of income – Partnership has: • Guaranteed payment (deductible) if determined without regard to partnership profits • Distributive share if based on profits
  37. 37. §736: Liquidating Distribution Where P’ship Does Not Liquidate (slide 3 of 3)• §736(b) property payment: – Disproportionate distribution to extent of partner’s share of hot assets – Return of basis (and capital gain (loss) for remainder)
  38. 38. The Big Picture – Example 27 § 736(b) Property Payments (slide 1 of 4)• Return to the facts of The Big Picture on p. 11-2.• Recall that the members of Beachside Properties, LLC, are considering two alternatives for its future expansion.• Assume that they decide to admit new partners for $19.5 million and use $9.5 million of the cash to redeem the interests of Kyle and Maria.• Because the LLC itself is not liquidating, the distribution to Kyle and Maria is classified under § 736.
  39. 39. The Big Picture – Example 27 § 736(b) Property Payments (slide 2 of 4)The current balance sheet for Beachside Properties, LLC, is as follows:
  40. 40. The Big Picture – Example 27 § 736(b) Property Payments (slide 3 of 4)• Capital is a ‘‘material income-producing factor’’ for Beachside Properties, LLC. – The entire $9.5 million distribution from the LLC to Kyle and Maria is a § 736(b) payment for their interests in the partnership’s property. – Kyle and Maria will recognize gain to the extent that this cash distribution (including forgiveness of their shares of the LLC’s debt) exceeds their bases in the LLC interests.
  41. 41. The Big Picture – Example 27 § 736(b) Property Payments (slide 4 of 4)• Because Kyle and Maria receive cash in lieu of their shares of the LLC’s unrealized receivables and inventory, this is a disproportionate distribution. – They will recognize ordinary income to the extent that their gain relates to these receivables and inventory.• The remaining gain will be a capital gain.• As there are no § 736(a) payments, the LLC cannot claim any deductions. – Absent a § 754 election (discussed later), the basis of the LLC’s property will not be affected
  42. 42. Sale of Partnership Interest (slide 1 of 4)• Generally, results in gain or loss recognition by selling partner – Gain (loss) = amount realized less partner’s basis in partnership interest – Partnership liabilities assumed by purchasing partner are treated as part of consideration paid for the partnership interest
  43. 43. Sale of Partnership Interest (slide 2 of 4)• Partnership tax year closes for selling partner on sale date – Partner’s share of income through sale date is calculated • Can prorate annual income or use interim closing of the books – Taxed to selling partner and increases basis in partnership interest
  44. 44. Sale of Partnership Interest (slide 3 of 4)• Effect of hot assets – Hot assets include: • Unrealized receivables (same as for disproportionate distributions) • Inventory – Includes all partnership property except money, capital assets, and §1231 assets
  45. 45. Sale of Partnership Interest (slide 4 of 4)• Effect of hot assets (cont’d) – Must allocate sales price of partnership interest between “hot” (ordinary income) assets and “nonhot” (capital gain) components – Selling partner’s gain is classified as a capital gain or loss portion and an ordinary income or loss amount related to the hot assets
  46. 46. The Big Picture – Example 36 Effect Of Hot Assets (slide 1 of 2)• Return to the facts of The Big Picture on p. 11-2• Recall that the second restructuring option for Beachside Properties, LLC, is for Kyle and Maria to sell their interests directly to the new members of the LLC. – The new members will contribute $10 million of cash to Beachside Properties and pay $4.75 million each to Kyle and Maria in exchange for their interests in the LLC.
  47. 47. The Big Picture – Example 36 Effect Of Hot Assets (slide 2 of 2)• Refer back to the balance sheet in Example 27. – Kyle and Maria will receive cash of $9.5 million (total) plus relief of their shares of the LLC’s debt. – Their bases in the LLC interests equal their capital account balances plus their shares of the LLC’s liabilities.• The difference must be recognized as a gain. – The gain is ordinary income to the extent that it relates to Kyle’s and Maria’s shares of the LLC’s accounts receivable, inventory, and depreciation recapture. – The remaining gain is a capital gain.• Absent a § 754 election (discussed later), the basis of the LLC’s property will not be affected.
  48. 48. Other Dispositions of Partnership Interests (slide 1 of 8)• Transfer of a partnership interest to a controlled corporation – Tax free if §351 requirements are met – If 50% or more of the total interest in capital and profits of the partnership are transferred, the partnership terminates
  49. 49. Other Dispositions of Partnership Interests (slide 2 of 8)• Incorporating a partnership – At least three methods available: • 1. Transfer each partner’s interest to the corp in exchange for stock – Partnership terminates – Corp becomes owner of all partnership assets – Corp has substituted basis in assets; Old partners have substituted basis in stock
  50. 50. Other Dispositions of Partnership Interests (slide 3 of 8)• Incorporating a partnership (cont’d) • 2. Transfer partnership assets to corp in exchange for stock and assumption of partnership liabilities – Partnership distributes stock to partners in liquidating distribution – Corp has carryover basis in assets; Old partners have substituted basis in stock
  51. 51. Other Dispositions of Partnership Interests (slide 4 of 8)• Incorporating a partnership (cont’d) • 3. Partnership distributes all assets and liabilities pro rata to partners in complete liquidation of partnership – Partners transfer assets and liabilities to corp in exchange for stock under §351 – Corp has substituted basis for assets; Partners have substituted basis for stock
  52. 52. Other Dispositions of Partnership Interests (slide 5 of 8)• Incorporating a partnership (cont’d) – All three methods of incorporating a partnership are tax-free • Exception: if liabilities of partnership exceed basis of transferred assets
  53. 53. Other Dispositions of Partnership Interests (slide 6 of 8)• Nontaxable like-kind exchange rules do not apply to the exchange of interests in different partnerships
  54. 54. Other Dispositions of Partnership Interests (slide 7 of 8)• Generally, the gift of a partnership interest is tax-free – Partnership income, loss, etc. is prorated between donor and donee
  55. 55. Other Dispositions of Partnership Interests (slide 8 of 8)• Death of a partner – Taxable year of partnership closes with respect to that partner on date of death – Compute deceased partner’s share of partnership income or loss to that date and report on partner’s final Form 1040
  56. 56. §754 Election• Adjusts partnership’s basis in assets to reflect: – The difference in the amount paid by the purchasing partner and his share of the inside basis of partnership assets • The adjustment can be positive or negative • The adjustment affects the basis of partnership property with respect to the transferee partner only – Gain or loss recognized by partner receiving distribution from partnership• Once made, election remains in effect for all future years unless election revoked with IRS consent
  57. 57. The Big Picture – Example 43 § 754 Election (slide 1 of 2)• Return to the facts of The Big Picture on p. 11-2.• For either restructuring option, Beachside Properties could make a § 754 election and reflect an adjustment to the basis of the LLC’s property.• Step-up related to sale of interests – On a sale of the interests to the new LLC members, the step-up would equal the difference between the $9.5 million paid and Kyle’s and Maria’s share of the inside basis of the LLC’s property. – This step-up of approximately $7.6 million [$9.5 million - (95% X $2 million net assets)] would be allocated to the various partnership properties under the rules of § 755 (not discussed in this chapter). – Deductions related to the stepup, such as depreciation, would be allocated to the new developer group.
  58. 58. The Big Picture – Example 43 § 754 Election (slide 2 of 2)• Step-up related to distribution in liquidation of the partners’ interests. – If the LLC redeems the interests of Kyle and Maria, the LLC can step up the bases of its remaining assets by the amount of gain recognized by Kyle and Maria. – This step-up is approximately $7.8 million [$9.5million distribution - $1.7 million total basis in partnership interests (Kyle’s basis of $400,000 + Maria’s basis of $1.3 million)], and benefits all the remaining partners in the partnership.• Note that the step-up differs depending on whether there is a sale or redemption, because Kyle’s and Maria’s share of the basis of the assets differs from their basis in the LLC interests
  59. 59. Termination of Partnership (slide 1 of 3)• Partnership terminates when either of the following events occur: – No part of the business continues to be carried on by any partners – Within a 12-month period, 50% or more of the partnership’s capital and profits interests are sold or exchanged
  60. 60. Termination of Partnership (slide 2 of 3)• Partnership terminates and its tax year closes when: – The partnership incorporates – One partner in a two-party partnership buys out the other partner• A termination also occurs when the partnership ceases operations and liquidates
  61. 61. Termination of Partnership (slide 3 of 3)• Partnership tax year usually does not close: – Upon the death of a partner – Entry of a new partner – Liquidation of a partner’s interest in other than a two-party partnership – Sale or exchange of a less than 50% partnership interest
  62. 62. The Big Picture – Example 45 Termination Of A Partnership (slide 1 of 2)• Return to the facts of The Big Picture on p. 11-2.• Before the sale or redemption, Kyle’s and Maria’s combined interests equal – 95% of the LLC’s capital, and – 80% of the LLC’s profits interests.• If they both sell their interests within a 12-month period, they will cause a technical termination of the existing LLC, and a new LLC will be deemed to be formed.
  63. 63. The Big Picture – Example 45 Termination Of A Partnership (slide 2 of 2)• A technical termination would require redetermination of the LLC’s basis in its assets and reestablishing the (new) LLC as an entity. – Note: The partners could structure the sale so that the termination did not occur. – For example, have Kyle and Maria sell less than a 50% interest in the LLC in one year and the remaining interest more than 12 months later.• If the LLC redeems the interests, there is no sale or exchange transaction, and no technical termination of the LLC.
  64. 64. Family Partnerships (slide 1 of 3)• Owned and controlled primarily by members of the same family – Often formed to save taxes by funneling some of parent’s income to the children• Often difficult to establish for tax purposes
  65. 65. Family Partnerships (slide 2 of 3)• Family member will be recognized as a partner if: – Capital is a material income-producing factor and partnership interest is acquired in a bona fide transaction where ownership and control are received • Can be acquired by gift or purchase from another family member – Capital is not a material income-producing factor, but family member contributes substantial or vital services
  66. 66. Family Partnerships (slide 3 of 3)• Kiddy tax may apply to child partner under age 19 (or a student under age 24) and claimed as a dependent by parent-partner• Family member whose interest is acquired by gift from another family member may only have a portion of partnership income allocated to them – Donor partner must be allocated income representing reasonable compensation for services rendered to the partnership
  67. 67. Limited Liability Companies• A LLC with 2 or more owners is taxed as a partnership – LLC members are not personally liable for debts of the entity • Effectively treated as a limited partnership with no general partners – LLCs are relatively new so there is no established body of case law available • Makes planning difficult
  68. 68. Limited Liability Partnerships• Partners are not personally liable for the malpractice and torts of their partners• Taxable as a partnership• Conversion of a general partnership into a LLP is not taxable if all of the general partners become LLP partners and hold the same proportionate interest
  69. 69. Refocus On The Big Picture (slide 1 of 3)• Two things are happening when the new developers become members of Beachside Properties, LLC. – The developers are buying out the interests of two existing LLC members, and – They are providing cash with which to expand the LLC’s operations.• The expansion itself raises no specific tax problems. – An LLC can admit new members with no immediate tax consequences.• In addition to the issues addressed earlier in the chapter, the LLC’s operating agreement should be modified to ensure that there is no shift in ownership rights between Josh and the new LLC members.
  70. 70. Refocus On The Big Picture (slide 2 of 3)What If?• Changing the facts, assume the developers have only $2 million in cash, with good prospects for receiving an additional $2 million over the next two years, and $1 million more in the third year. – The LLC has found a bridge loan and temporary financing to cover costs during this interim period.
  71. 71. Refocus On The Big Picture (slide 3 of 3)What If?• This loan, though, is not large enough to also completely buy out Kyle’s and Maria’s interests. – Thus, they have agreed to accept installment payments for the sale or redemption of their interests.• Now the buyout of Kyle and Maria can be treated either as an installment sale or as a redemption under § 736 requiring a series of payments.• While the specific results of these arrangements are beyond the scope of this chapter, different tax consequences might arise as to the timing and character of Kyle’s and Maria’s gain recognition.
  72. 72. If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 72
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