2013 cch basic principles ch16 pii

Chapter 16
Partnerships, Corporations,
and S Corporations
Part II: Partnerships
©2012 CCH. All Rights Reserved.
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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—Example

Chapter 16, Exhibit Contents A CCH Federal Taxation Basic Principles2 of 69

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
Compensation

Chapter 16, Exhibit Contents B CCH Federal Taxation Basic Principles3 of 69

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

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

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

Tax Years
Majority Interest Taxable Year. Partnerships are generally required
to elect the same taxable year as their partners who represent a
majority interest on the first day of the partnership’s first tax year.
Code Sec. 706(b).

Five Percenters’ Common Tax Year. If there is no majority interest
taxable year, the partnership must use the same year as that of the
principal partners, i.e., those owning five percent or more interest in
either profits or capital.

Calendar Tax Year. If there is no majority interest tax year and the
principal partners do not have the same taxable year, the partnership
generally must use the calendar year. There are two exceptions, (1)
minimum deferral rules and (2) business purpose rules. Details
regarding these exceptions are covered in the text.


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.


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.)


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.


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.



(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

Separately Stated Items

Items other than partnership operating income and expenses must
be separately stated. The reason for showing these items
separately is that their ultimate tax treatment may vary from
partner to partner.


 Separately stated items are first computed at the partnership level
(same computation method as with individuals).

 Next, each partner’s distributive share of each separately stated
item is reported on his Schedule K-1 of the partnership return.

 Finally, the K-1 is sent to each partner who transfers his
distributive share of Code Sec. 702(a)(8) 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.


Items 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 expenses


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.


 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.


Three 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.



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


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


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


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


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

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

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

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.


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.


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 . . .



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
%.]


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.


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?


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.



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.


Contribution of Encumbered Property

What is the tax effect to partner (P) and partnership
(P/S) from contributing encumbered property to a
P/S?

When a partnership assumes the debt of a
contributing partner, the partner relieved of debt is
treated as if having received a distribution of money
from the partnership in the amount of the debt relief.
Code Sec. 752(b).



The P’s debt relief is the P/S’s debt burden. That
burden is shared by ALL 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.



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.


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”)?



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.


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)



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.)


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


Formula Ann Bob Cal

(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/A

Chapter 16, Exhibit 14f CCH Federal Taxation Basic Principles42 of 69


Formula Ann Bob Cal
(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


Formula Ann Bob Cal

(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 contribution

Chapter 16, Exhibit 14h CCH Federal Taxation Basic Principles44 of 69


Formula Ann Bob Cal

(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) 0

Chapter 16, Exhibit 14i CCH Federal Taxation Basic Principles45 of 69

Formula Ann Bob Cal

(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

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).

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)


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].


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.


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.

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.


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.]


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: 15,000


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?


(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.


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).


(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.


(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”.)


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.

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.


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).


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)


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.


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.)


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.


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.


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.


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.


2013 cch basic principles ch16 pii

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