2013 cch basic principles ch16 pii


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2013 cch basic principles ch16 pii

  1. 1. Chapter 16 Partnerships, Corporations, and S Corporations Part II: Partnerships©2012 CCH. All Rights Reserved.4025 W. Peterson Ave.Chicago, IL 60646-60851 800 248 3248www.CCHGroup.com
  2. 2. Chapter 16 Exhibits 1. Definition of Partnership 2. Types of Partnerships 3. Tax Years 4. Accounting Methods 5. Tax Formula 6. Code Section 702(a)(8) Income or Loss 7. Separately Stated Items 8. Formation of Partnerships—Overview of Code Section 721 9. Contribution of Part Property/Part Services 10. Part Property/Part Services—Example 11. Disguised Sales—General Rules 12. Disguised Sales—Example 13. Contribution of Encumbered Property 14. Contribution of Encumbered Property—ExampleChapter 16, Exhibit Contents A CCH Federal Taxation Basic Principles2 of 69
  3. 3. Chapter 16 Exhibits 15. Contribution of “Know-How” 16. Goodwill Contributions in a Code Section 721 Exchange—Example 17. Inside Basis Computations 18. Outside Basis Computations 19. Special Basis Rules 20. What Is a Partner’s Holding Period (HP) in the Outside Basis? 21. Outside Basis Computations—Example 22. Code Section 465 At-Risk Rules 23. Code Section 469 Passive Activity Loss Rules 24. At-Risk and Passive Activity Loss Rules—Example 25. Partners Providing Infrequent, Nonessential Services to Partnerships for Compensation 26. Partners Providing Ongoing, Integral Services to Partnerships for CompensationChapter 16, Exhibit Contents B CCH Federal Taxation Basic Principles3 of 69
  4. 4. 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.Chapter 16, Exhibit 1 CCH Federal Taxation Basic Principles4 of 69
  5. 5. 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.Chapter 16, Exhibit 2a CCH Federal Taxation Basic Principles5 of 69
  6. 6. Types of Partnerships 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. 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.Chapter 16, Exhibit 2b CCH Federal Taxation Basic Principles6 of 69
  7. 7. Tax YearsMajority Interest Taxable Year. Partnerships are generally requiredto elect the same taxable year as their partners who represent amajority 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 interesttaxable year, the partnership must use the same year as that of theprincipal partners, i.e., those owning five percent or more interest ineither profits or capital.Calendar Tax Year. If there is no majority interest tax year and theprincipal partners do not have the same taxable year, the partnershipgenerally must use the calendar year. There are two exceptions, (1)minimum deferral rules and (2) business purpose rules. Detailsregarding these exceptions are covered in the text.Chapter 16, Exhibit 3 CCH Federal Taxation Basic Principles7 of 69
  8. 8. Accounting Methods 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 three preceding years. The determination is made annually. Accrual Method. Once the partnership’s three-year average exceeds $5 million, it must use the accrual basis thereafter.Chapter 16, Exhibit 4 CCH Federal Taxation Basic Principles8 of 69
  9. 9. Tax Formula [Taxation at Owner Level] Ordinary Income “From Whatever Source Derived” (including Code Sec. 1245 recapture) – Exclusions and Cost of Goods Sold = Gross Income from Business Operations - Operating Expenses – Code Sec. 702(a)(8) Ordinary Income + or - 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.)Chapter 16, Exhibit 5 CCH Federal Taxation Basic Principles9 of 69
  10. 10. 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.Chapter 16, Exhibit 6a CCH Federal Taxation Basic Principles10 of 69
  11. 11. Code Section 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. 1245 depreciation recapture  Cost of goods sold  Depreciation and other operating expenses  Organizational expenditures. (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. The amortization period must be over at least 60 months, starting with the month that the corporation commences business.Chapter 16, Exhibit 6b CCH Federal Taxation Basic Principles11 of 69
  12. 12. Code Section 702(a)(8) Income or Loss (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 16, Exhibit 6c CCH Federal Taxation Basic Principles12 of 69
  13. 13. 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.Chapter 16, Exhibit 7a CCH Federal Taxation Basic Principles13 of 69
  14. 14. Separately Stated Items  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) taxable income, 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 1040. There, it is subject to certain AGI limitations of the partner, which will differ from that of the other partners.Chapter 16, Exhibit 7b CCH Federal Taxation Basic Principles14 of 69
  15. 15. Separately Stated ItemsItems that must be separately stated include the following:  Code Sec. 1231 gain and loss  Code Sec. 1250 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 expensesChapter 16, Exhibit 7c CCH Federal Taxation Basic Principles15 of 69
  16. 16. Formation of Partnerships— Overview of Code Section 721 What is the general rule for transferring property to a partnership (P/S) in exchange for a P/S interest? The rules are similar to Code Sec. 351 for corporations, except (1) there is no 80% control requirement, and (2) debt assumption does increase partners’ bases, while it does not affect shareholders’ stock basis.Chapter 16, Exhibit 8a CCH Federal Taxation Basic Principles16 of 69
  17. 17. Formation of Partnerships— Overview of Code Section 721  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 non-recognition. 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.Chapter 16, Exhibit 8b CCH Federal Taxation Basic Principles17 of 69
  18. 18. Formation of Partnerships— Overview of Code Section 721Three exceptions to non-recognition. Gain is recognized in either event below:1. Services. A partner’s contribution of services in exchange for a P/S interest creates OI to the partner.2. 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.3. 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.Chapter 16, Exhibit 8c CCH Federal Taxation Basic Principles18 of 69
  19. 19. Formation of Partnerships— Overview of Code Section 721 No 80% control requirement. The 80% control requirement for corporate shareholders is not required of partners contributing property to a P/S.Chapter 16, Exhibit 8d CCH Federal Taxation Basic Principles19 of 69
  20. 20. Formation of Partnerships— Overview of Code Section 721 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 nonrecourse 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.)Chapter 16, Exhibit 8e CCH Federal Taxation Basic Principles20 of 69
  21. 21. Formation of Partnerships— Overview of Code Section 721 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.)Chapter 16, Exhibit 8f CCH Federal Taxation Basic Principles21 of 69
  22. 22. 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.Chapter 16, Exhibit 8g CCH Federal Taxation Basic Principles22 of 69
  23. 23. Formation of Partnerships— Overview of Code Section 721 Does the partnership recognize gain or loss in a Code Sec. 721 exchange? No.Chapter 16, Exhibit 8h CCH Federal Taxation Basic Principles23 of 69
  24. 24. Formation of Partnerships— Overview of Code Section 721 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. 351. Recall that Code Sec. 351 provides for nonrecognition treatment on the transfer of “property” to an 80% controlled corporation in exchange for stock.]Chapter 16, Exhibit 8i CCH Federal Taxation Basic Principles24 of 69
  25. 25. Formation of Partnerships— Overview of Code Section 721 Why are “services” NOT “property’? Reg. §1.721-1(b)(1) provides that services are NOT property to ensure that a person who provides services to a partnership will be taxed either: 1. 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.] 2. 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 16, Exhibit 8j CCH Federal Taxation Basic Principles25 of 69
  26. 26. 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. 721. The transfer of property remains protected from income recognition within the scope of Code Sec. 721.Chapter 16, Exhibit 9 CCH Federal Taxation Basic Principles26 of 69
  27. 27. Part Property/ Part Services—Example FACTS “A” transfers the following items to XYZ Partnership in exchange for a capital interest: Asset FMV Basis Land $50,000 $10,000 Services $35,000 $0 QUESTION: How much income is recognized on the transfer? 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.Chapter 16, Exhibit 10 CCH Federal Taxation Basic Principles27 of 69
  28. 28. Disguised Sales—General Rules What is a disguised sale? Code Sec. 707(a)(2)(B) and Reg. §1.707-3 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. 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: The partner sold the contributed property to an unrelated 3rd party; and . . .Chapter 16, Exhibit 11a CCH Federal Taxation Basic Principles28 of 69
  29. 29. Disguised Sales—General Rules 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 %.]Chapter 16, Exhibit 11b CCH Federal Taxation Basic Principles29 of 69
  30. 30. Disguised Sales—General Rules If a disguised sale involves the transfer by a partnership of a capital interest, does part of the transaction qualify for Code Sec. 721 nonrecognition 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.Chapter 16, Exhibit 11c CCH Federal Taxation Basic Principles30 of 69
  31. 31. Disguised Sales—Example 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. 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?Chapter 16, Exhibit 12a CCH Federal Taxation Basic Principles31 of 69
  32. 32. Disguised Sales—Example SOLUTION The transfer is treated as a partial disguised sale and a partial partnership contribution: Total Disguised Sale (75%): Contribution (25%): FMV of cap. int. 100 75 25 Cash 300 225 75 Amount realized 400 300 100 Basis in land 120 90 [75%] 30 [25%] Realized gain 280 210 70 Recognized gain 210 0 Character of gain LTCG Not recognized Computation 100% - 25% = 75% (400 - 300) ÷ 400) = 25% Reason for tax Reg. §1.707-3(a) Code Sec. 721 treatment: Recognition of realized gain Nonrecognition on transfer of from disguised sale. property for a P/S interest.Chapter 16, Exhibit 12b CCH Federal Taxation Basic Principles32 of 69
  33. 33. Disguised Sales—Example SOLUTION 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” + 300 “sale” price.] COMMENTS Even if Fred had received the $300 cash 2 years after receipt of a P/S interest, the IRS would still presume that Fred’s contribution was partially a disguised sale as per above. Fred would have to prove otherwise.Chapter 16, Exhibit 12c CCH Federal Taxation Basic Principles33 of 69
  34. 34. 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).Chapter 16, Exhibit 13a CCH Federal Taxation Basic Principles34 of 69
  35. 35. Contribution of Encumbered Property The P’s debt relief is the P/S’s debt burden. That burden is shared by ALL Ps, in accordance with their ownership percentages. The term “ALL Ps” 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 P’s “net” debt relief (total debt relief minus pro rata debt burden) is nontaxable to the relieved P to the extent of his basis in the P/S.Chapter 16, Exhibit 13b CCH Federal Taxation Basic Principles35 of 69
  36. 36. Contribution of Encumbered Property 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.Chapter 16, Exhibit 13c CCH Federal Taxation Basic Principles36 of 69
  37. 37. Contribution of Encumbered Property—Example FACTS: Ann, Bob and Cal decide to pool their efforts and form a partnership. They make the following contributions to the partnership: C Partner FMV AB to P P’s % int. in P/S: ontribution Ann Services $ 30,000 $ 0 30% Bob Land 70,000 20,000 60% Cal Equipment 10,000 11,000 10% TOTALS $110,000 100% 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.] Does this transfer of assets qualify for Code Sec. 721 treatment? What is each partner’s gain or loss on contributions to the partnership? What is the resulting basis of each partner in the P/S (“outside basis”)? What is the P/S’s basis in the assets received (“inside basis”)?Chapter 16, Exhibit 14a CCH Federal Taxation Basic Principles37 of 69
  38. 38. Contribution of Encumbered Property—Example SOLUTION Ann’s transfer of services falls outside the scope of Code Sec. 721. However, Bob and Cal’s transfers still qualify for Code Sec. 721 treatment, since they represent property contributions. Note that Bob and Cal, get nonrecognition 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.Chapter 16, Exhibit 14b CCH Federal Taxation Basic Principles38 of 69
  39. 39. Contribution of Encumbered Property—Example Solution to Questions (A), (B), and (C): Partner (P): Realized G/L (A) (B) (C) (FMV - AB) Recog. Outside Basis of P (See Inside Basis Gain/Loss computations in next of P/S table) Ann 30,000 30,000 (since 33,000 30,000 (Service) (30,000 - 0) services income) Bob 50,000 0 (since no XS 16,000 20,000 (Land) (70,000 - 20,000) debt relief) Cal (1,000) 0 (since Sec. 12,000 11,000 (Equip.) (10,000 - 11,000) 721 nonrecog. applies.) Basis of the land to the P/S: $20,000. (Ellworth’s AB of $20,000 + $0 gain recognized by Bob)Chapter 16, Exhibit 14c CCH Federal Taxation Basic Principles39 of 69
  40. 40. Contribution of Encumbered Property—Example COMMENTS The results in this partnership problem differ from a similar corporate problem in two ways: 1. No 80% control requirement for nonrecognition 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.)Chapter 16, Exhibit 14d CCH Federal Taxation Basic Principles40 of 69
  41. 41. Contribution of Encumbered Property—Example Formula Ann Bob Cal (Services) (Land) (Equipment) (a) FMV, P/S 30,000 60,000 10,000 interest rec’d: (b) Basis in asset 0 (20,000) (11,000) contributed: (c) = (a) – (b) Realized gain 30,000 40,000 (1,000) (loss): (d) = (c) from Ordinary 30,000 0 0 services income recognized on service contribution: Reason for tax treatment: Sec. 83(a) Sec. 721 Sec. 721 (Services cont’d are OI (Nonrecog. (Nonrecog. to extent of FMV of rule) rule) P/S interest.)Chapter 16, Exhibit 14e CCH Federal Taxation Basic Principles41 of 69
  42. 42. Contribution of Encumbered Property—Example Formula Ann Bob Cal (Services) (Land) (Equipment) (e) Gross debt relief: 0 10,000 0 (f) = P/S debt Less: Share of 3,000 6,000 1,000 assumption x debt assumption 1/3 (g) = (e) – (f) Net debt relief: 0 4,000 0 (h) = (b) Basis in asset 0 (20,000) (11,000) contributed: (i) = (g) – (h) XS debt relief: N/A 0 N/AChapter 16, Exhibit 14f CCH Federal Taxation Basic Principles42 of 69
  43. 43. Contribution of Encumbered Property—Example Formula Ann Bob Cal (Services) (Land) (Equipment) (j) = (i) Capital gain 0 0 0 recognized on excess debt relief Reason for tax treatment: Sec. 731(a)(1) Sec. 731(a)(1) Sec. 731(a)(1) (No XS debt relief, XS debt (No (No XS debt relief, so no so no capital gain) relief, so no cap. gain) capital gain)Chapter 16, Exhibit 14g CCH Federal Taxation Basic Principles43 of 69
  44. 44. Contribution of Encumbered Property—Example Formula Ann Bob Cal (Services) (Land) (Equipment) (k) = (b) Basis in asset 0 0 0 contributed: (l) = (d) Gain on service 30,000 0 0 cont’n: (m) = (k) + (l) P/S inside 30,000 20,000 11,000 basis Reason for tax treatment: Sec. 732 Sec. 732 Sec. 732 P/S basis in assets is P/S basis in P/S basis in same as P’s before assets is same assets is same contribution + any as P’s before as P’s before Sec. 83(a) gain contribution contributionChapter 16, Exhibit 14h CCH Federal Taxation Basic Principles44 of 69
  45. 45. Contribution of Encumbered Property—Example Formula Ann Bob Cal (Services) (Land) (Equipment) (n) = (j) Gain on XS 0 0 debt relief (o) = (f) Share of debt 3,000 6,000 1,000 assumption (p) = (e) Debt relief 0 (10,000) 0Chapter 16, Exhibit 14i CCH Federal Taxation Basic Principles45 of 69
  46. 46. Contribution of Encumbered Property—Example Formula Ann Bob Cal (Services) (Land) (Equipment) (q) = Partner’s 33,000 16,000 12,000 (m) + (n) + (o) – (p) outside basis Reason for tax treatment: Sec.752(a) Sec.752(a) Sec. 752(a): Debts assumed Debts assumed Debts assumed by P/S are treated as by P/S are by P/S are contributions by Ps. treated as treated as Sec. 752(b): A P’s debt relief contributions contributions is treated as a P/S distribution by Ps by Partner to that P. 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.Chapter 16, Exhibit 14j CCH Federal Taxation Basic Principles46 of 69
  47. 47. 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., nonrecognition treatment when contributed to the P/S in exchange for an outside interest).Chapter 16, Exhibit 15 CCH Federal Taxation Basic Principles47 of 69
  48. 48. Goodwill Contributions in a Code Section 721 Exchange—Example 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? Jack Jill Property Contributed: Land Goodwill Agreed upon FMV 15,000 15,000 Basis 5,000 0 Realizable gain on contribution: 10,000 15,000 Recognized gain on contribution: 0 0 (Code Sec. 721) (Code Sec. 721) P’s outside basis in P/S int. 5,000 0 Built-in gains 10,000 15,000 P/S inside basis in the assets 5,000 0 Capital balance of each partner 15,000 (10 + 5) 15,000 (15 + 0)Chapter 16, Exhibit 16a CCH Federal Taxation Basic Principles48 of 69
  49. 49. Goodwill Contributions in a Code Section 721 Exchange—Example 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: $15,000 capital gain [15,000 FMV at contribution - 0 basis at contribution].Chapter 16, Exhibit 16b CCH Federal Taxation Basic Principles49 of 69
  50. 50. 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 16, Exhibit 17 CCH Federal Taxation Basic Principles50 of 69
  51. 51. 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 nonrecourse 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 16, Exhibit 18 CCH Federal Taxation Basic Principles51 of 69
  52. 52. 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.Chapter 16, Exhibit 19 CCH Federal Taxation Basic Principles52 of 69
  53. 53. 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 Contribution HP of Partnership Interest Investment or business property Tacks on to property contributed. Other property (e.g., receivables and Begins on day after contribution. inventory) Services Begins on day after contribution. [Note that an outside basis can have a split holding period if multiple assets are contributed.]Chapter 16, Exhibit 20 CCH Federal Taxation Basic Principles53 of 69
  54. 54. Outside Basis Computations—Example 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 income 5,000 Code Sec. 1245 gain (this is a smoke screen) 4,000 Code Sec. 1231 gain 6,200 Long-term capital gain 500 Long-term capital loss 100 Short-term capital loss 250 Charitable contribution to Girl Scouts 800 Distribution of land to Mary Basis: 10,000; FMV: 15,000Chapter 16, Exhibit 21a CCH Federal Taxation Basic Principles54 of 69
  55. 55. Outside Basis Computations—Example 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?Chapter 16, Exhibit 21b CCH Federal Taxation Basic Principles55 of 69
  56. 56. Outside Basis Computations—Example (A): $25,000 [10,000 capital account + (1/2 x 30,000 P/S debt)] (B): $41,275 [see below] (C): $29,275 [see below] + MARY’S BEGINNING BASIS (A) + Share of P/S’s TI under Sec. 702(a)(8) 24,000 =[1/2 x 48,000] + Share of “separately stated items” 5,275 =[1/2 x (5 + 6.2 + .5 - .1 - .25 - .8)] – Share of debt relief (3,000) =[1/2 x (30,000 - 24,000)] – Basis of land distributions to Mary (10,000) = [100% x 10,000] MARY’S ENDING BASIS (B) 41,275 MARY’S ENDING CAPITAL ACCT 29,275 =[41,275 - (1/2 x 24,000 debt] BAL. (C) Note: The Code Sec. 1245 gain was a “smoke screen” because it is already included in Code Sec. 702(a)(8) taxable income. Recall that Code Sec. 1245 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.Chapter 16, Exhibit 21c CCH Federal Taxation Basic Principles56 of 69
  57. 57. 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 “nonqualified” 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 16, Exhibit 22a CCH Federal Taxation Basic Principles57 of 69
  58. 58. 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 Hurdle 1? Prop. Reg. §1.465-38 answers this question by requiring the following order of deductions: (1) Capital losses must first jump Hurdle 1; (2) Code Sec. 1231 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 16, Exhibit 22b CCH Federal Taxation Basic Principles58 of 69
  59. 59. Code Section 465 At-Risk Rules (d) What about alimony paid, charitable contributions and other nonbusiness/noninvestment expenses? Prop. Reg. §1.465-13 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 16, Exhibit 22c CCH Federal Taxation Basic Principles59 of 69
  60. 60. Code Section 469 Passive Activity Loss Rules As with the at-risk rules, the passive activity loss (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) taxable income 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 16, Exhibit 23 CCH Federal Taxation Basic Principles60 of 69
  61. 61. At-Risk and Passive Activity Loss Rules—Example FACTS:  1/1/x1: Rhonda’s outside basis in her 25% partnership interest is $24,000.  20x1: The partnership incurred a $100,000 Code Sec. 702(a)(8) operating loss.  20x2: The partnership earned $12,000 Sec. 702(a)(8) operating income.  Rhonda does not materially participate. QUESTION: Determine the tax effect on Rhonda for 20x1 and 20x2.Chapter 16, Exhibit 24a CCH Federal Taxation Basic Principles61 of 69
  62. 62. At-Risk and Passive Activity Loss Rules—Example At-Risk Hurdle (H1) Yr Beg. At- Passive Passive Contrib. Amt. of Loss “Jumping” H1 Loss “Blocked” By Risk Basis Income (Loss) (Distr.) H1 (a) = (i) (b) (c) (d) (e) = (f) = from prior Lesser of: [(c) + (f) from prior yr. period] - (e) [(c) + (f) from prior yr.] or [(a)+(b)+/-(d)], expressed as a negative number. x1 24 (25) 0 (24) (1) Lesser of: (25) + 0 - (24) = (1) [(25) + 0 = (25)]; or neg. [24 + 0 + /- 0] = (24); Lesser = (24). x2 0 3 0 (3) (21) Lesser of: 0 + (24) - (3) = (21) [0 + (24) = (24)]; or neg. [0 + 3 + /- 0] = (2); Lesser = (2).Chapter 16, Exhibit 24b CCH Federal Taxation Basic Principles62 of 69
  63. 63. At-Risk and Passive Activity Loss Rules—Example Passive Hurdle (H2) Yr Amt. of Loss Loss “Blocked” Ending At-Risk Income Deduct “Jumping” H2 By H2 Basis (g) = (h) = (i) = (j) = (k) = (g) Lesser of: [(e) + (h) from (a) + (b) +/- (d) + (b) from all [(e) + (h) from prior prior period] - (e) passive activities yr.]; or (g) [(b) from all passive activities, expressed as a neg. number. x1 0 (24) 0 0 [(24) + 0 - 0 = [24 + 0 + 0 + (24) (b) = 0 (g) = 0 (24)] = 0] x2 (3) (24) 0 3 (3) [(3) + (24) = (27]; [(3) + (24) - (3) [0 + 3 + 0 + (2) = neg. 3 = (3); = (24)] 0] Lesser = (3)Chapter 16, Exhibit 24c CCH Federal Taxation Basic Principles63 of 69
  64. 64. 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 nonpartner 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 16, Exhibit 25a CCH Federal Taxation Basic Principles64 of 69
  65. 65. Partners Providing Infrequent, Nonessential Services to Partnerships for Compensation 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 P/S’s office building is capitalized by the P/S under Code Sec. 263.)Chapter 16, Exhibit 25b CCH Federal Taxation Basic Principles65 of 69
  66. 66. Partners Providing Ongoing, Integral Services to Partnerships for Compensation Ongoing, integral services that are guaranteed. Code Sec. 707(c) allows nonpartner 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 16, Exhibit 26a CCH Federal Taxation Basic Principles66 of 69
  67. 67. Partners Providing Ongoing, Integral Services to Partnerships for Compensation Tax treatment: Generally, the same as before, except:  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.  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.Chapter 16, Exhibit 26b CCH Federal Taxation Basic Principles67 of 69
  68. 68. Partners Providing Ongoing, Integral Services to Partnerships for Compensation 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.Chapter 16, Exhibit 26c CCH Federal Taxation Basic Principles68 of 69
  69. 69. Partners Providing Ongoing, Integral Services to Partnerships for Compensation 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 P/S’s payment for services is not deductible by the P/S.Chapter 16, Exhibit 26d CCH Federal Taxation Basic Principles69 of 69