The document provides information about family partnerships and the tax implications of establishing a family partnership. Some key points: 1) Family partnerships allow for income shifting from family members active in the business to inactive family members, which can reduce the family's overall tax liability. However, the IRS scrutinizes these arrangements to ensure a true transfer of capital interest rather than just an assignment of income. 2) To achieve tax advantages, the validity of the partnership must be established by proving intent to jointly operate a business and share profits/losses. Capital contributions, services provided, participation in management, and asset control are factors considered. 3) The document advises establishing a limited partnership with the father as general partner and daughter

1. Partnership Distributions,
Dispositions of
Partnership Interests, and
Partnership Terminations
Solutions to Tax Research Problems
TA X RE S E A R C H PR O B L E M S
10-54 Family partnerships are attractive for both tax and nontax reasons. The income-shifting potential of a
family partnership depends on the spread between the lowest and highest marginal tax rates of the partners.
The income-shifting potential is limited by the kiddie tax under which the unearned income of certain
dependents is taxed at the higher of their marginal tax rate or their parents’ marginal tax rate. The kiddie
tax applies to children who are 18 and under and children between 19 and 23 who are full-time students.
However, children between 18 and 23 are only included if their earned income does not exceed 50% of their
total support for the year.
5- The income from a partnership could constitute unearned income, particularly if the daughter is a limited
partner. The kiddie tax will continue to apply until she is at least 18, and perhaps longer depending on her
college plans. Family partnerships also provide an incentive for a family member to enter the family business.
5- Because family partnerships may transfer income from a member active in the business to an inactive
member, and thereby reduce the tax liability of the family unit, they are closely scrutinized to ensure that
the effect is not merely an assignment of income but rather a transfer of a capital interest.
5- In order to achieve the tax advantages inherent in family partnerships, the validity of the partnership
must be established. In assessing its validity, the IRS and the courts determine whether the parties actually
intend to join together to carry on a business and to share the profits and losses of this business [Comm. v.
Culbertson 49-1 USTC {9112, 10 AFTR2d 6068, 310 F2d 412 (CA-7, 1962)]. This decision is based on a
number of factors. Some of the more important ones are the capital contributions, rendition of vital
services, participation in management, and control of the assets necessary to the partnership business.
5- Difficulties often arise with family partnerships where one or more of the partners is a minor who
contributes no services and whose interest was acquired by gift. Such is the case with B and his daughter.
They, therefore, must prove that the daughter owns a capital interest in a partnership in which capital is a
material income-producing factor [§ 704(e)].
5- Capital (including goodwill) is a material income-producing factor if a substantial part of the gross
income of the business was earned by its use. [Bateman v. U.S. 74-1 USTC {9176, 33 AFTR2d 74-483, 490
F2d 549 (CA-9 1973)]. Because the business manufactures and sells utility tables, it requires a substantial
investment in plant, equipment, and inventory and should have amassed at least some unrecorded
goodwill. Furthermore, net ordinary income for the proprietorship is relatively small in relation to net
assets (27%) when you consider the fact that no proprietor’s salary is deductible in arriving at net income.
Thus, capital undoubtedly is a material income-producing factor.
5- Assuming the above is true, the daughter qualifies as a partner if she owns a capital interest in the
partnership, regardless of whether her interest was acquired through purchase or gift (Jeremiah J.
O’Connell, Jr. et al, 23 TCM 210, T.C. Memo 1964-38). If she actually owns a capital interest, the pro rata
share of partnership income, after allocation of a reasonable salary to her father, would be taxable to her.
10
10-1

2. Otherwise, all of the income is taxable to her father. A capital interest is more than merely sharing in the
profits and losses, however [Reg. § 1.704-1(e)]. It involves an interest in the net assets of the business that
would be distributable to the owners upon liquidation or withdrawal from the partnership.
5- Ownership of this interest is a sensitive issue. Because the daughter is a minor, it is even more difficult
to prove that she actually received a partnership interest that she owns and controls. Unless she is mature
enough to manage her interest and participate in the partnership activities, she will not be considered a
partner. Given her age of 13, it is most unlikely that she satisfies this requirement. To circumvent this
problem, a trust could be established with the daughter as its sole beneficiary [Theodore D. Stern 15 T.C.
521 (1950)]. The trustee would then control the partnership interest and ensure that her rights are upheld
[Reg. § 1.704-1(e)(2)(viii)].
5- Although it is possible for her father to serve as trustee, this could jeopardize the tax plan. He would be
serving as a partner in his individual capacity and also in the capacity of a trustee. This could make it difficult
for him to prove that he, as trustee, acted solely in the interest of the beneficiary. Although this is not
impossible if his rights as owner and as trustee are differentiated, he should be advised against this dual role.
5- Engaging someone else as trustee would alleviate some of the problems. The trustee’s control over the
interest for the sole benefit of the beneficiary must still be established. The trustee’s participation in the
management of the partnership must show that he is independent of the donor (the father) and does not
subordinate the interest of the beneficiary to those of the donor or of the partnership. The trustee also
should be given specific rights to act as a partner. He should have the power to retain the trust’s share of
earnings in the partnership or invest the distributed amounts elsewhere. He should have the right to
liquidate or sell the trust’s interest. Although such right may be limited by a requirement that the interest
be sold or offered to another family member, it must not prevent the donee from receiving the fair market
value of the interest, including any unrecorded goodwill.
5- Rather than structuring the business as a general partnership, however, it may be more beneficial to
establish a limited partnership, with the father as a general partner and the trustee as a limited partner.
While such an arrangement is still subject to the test of whether control, and therefore, ownership of the
interest has been transferred, control is defined differently. Limited partners may not participate in the
management of the business [Reg. § 1.704-1(e)(2)(ix)]. Instead, control is evidenced by the limited partner’s
right to invest distributions elsewhere and to liquidate or withdraw the interest. Furthermore, the general
partner may not exercise any control that restricts the rights of the limited partner beyond those that would
be experienced by any unrelated limited partner.
5- Advice to B: B should establish a limited partnership, with himself as a general partner and the
daughter as a limited partner. (Recall, however, that tax benefits for unearned income will not begin until
the kiddie tax no longer applies.) It does not matter how her capital contribution is achieved as long as it
actually occurs and is properly recorded. Her interest should be held in trust and administered by an
independent third party.
5- In establishing the partnership, the father must file a gift tax return and pay any gift tax liability. (Even
if no return is required, it is advisable to file a return, since it demonstrates the father’s intent to make the
gift.) He also must comply with all the formalities involved in creating a partnership, including filing the
appropriate papers to change the ownership of the business, creating a partnership bank account, holding
the trust out as a partner to creditors and customers, and filing partnership returns. Although these
formalities alone do not validate the partnership, noncompliance could be interpreted as evidence of a lack
of intent to carry on the business as a partnership.
5- As a general partner, B could manage the business. He must, however, distribute to the trust its pro
rata share (based on capital accounts) of net income after deducting a reasonable amount for salary to the
father (and to the daughter—although not required, it is advisable—if she performs any services). Cash
distributions are not required to the extent assets are used for reasonable business needs, including daily
working capital and the accumulation of capital for planned expansion. Cash distributed to the trust must
be for the daughter’s use. It cannot, however, be used to pay for her support [Pflugradt v. U.S., 63-1 USTC
{9112, 10 AFTR2d 6068, 310 F2d 412 (CA-7, 1962)].
5- There are numerous family partnership cases. One of these, Ginsberg v. Comm. [74-2 USTC {9660,
34 AFTR2d 74-5760, 502 F.2d 965 (CA-6, 1974)] is a detailed discussion of a family partnership that
violates many of the requirements.
10-2 Chapter 10 Partnership Distributions, Dispositions of Partnership Interests, and Partnership Terminations

3. 10-55 In Rev. Rul. 93-7, 1993-1 C.B. 125, the IRS held that if a partnership distributes the debt of a partner to
that partner in liquidation of the partner’s interest in the partnership, the partner must treat the distribution
as a taxable exchange rather than as a distribution of partnership property. The IRS’s rationale for this
conclusion is that the debt is extinguished upon its distribution to the debtor. Consequently, the partner
cannot take an adjusted basis in the distributed debt that would allow for the deferral of gain or loss
realized by the partner on the distribution. Based on this ruling, Corporation Z must recognize a capital
gain equal to the $34,000 excess of the $150,000 principal amount of the note over its $116,000 outside
basis in its partnership interest. Note that this is the same tax result as a $150,000 cash distribution to
Corporation Z by the partnership followed by Z’s use of the cash to repay its debt. The ruling also holds
that under § 731(b), the XYZ Partnership does not recognize gain or loss on the distribution of the debt of
a partner. If XYZ has a § 754 election in effect, it can adjust the basis of its remaining assets under § 734(b)
to reflect the $34,000 gain recognized by Corporation Z.
Solutions to Tax Research Problems 10-3

5. Partnership Distributions,
Dispositions of
Partnership Interests, and
Partnership Terminations
Test Bank
True or False
1. The entity theory of partnerships predominates in the Subchapter K Code sections dealing with the
tax consequences of cash and property distributions made by partnerships to partners.
2. A partner never recognizes loss upon the receipt of a current distribution from a partnership.
3. A partnership that distributes an asset the FMV of which exceeds its inside basis must recognize gain
equal to the excess.
4. Current cash distributions from partnerships are nontaxable unless they exceed the partner’s basis in
the partnership.
5. When a partner’s basis in his partnership interest is less than the partnership’s basis in a distributed
asset, the partner’s basis in his partnership interest is allocated among the assets according to their
relative fair market values.
6. Proportionate liquidating distributions of noncash partnership assets cannot result in recognized gain,
but may result in the recipient partner recognizing loss.
7. If a partner receives a property distribution consisting of partnership inventory, and in a subsequent
year sells the distributed property at a gain, such gain must always be recognized as ordinary income.
8. A retiring partner who receives a liquidating distribution of cash as payment for her share of
partnership substantially appreciated inventory must recognize ordinary income equal to the excess of
the FMV of her proportionate share of the inventory over her proportionate share of the inside basis
of the inventory.
9. If a liquidating distribution results in a capital gain or loss to the recipient partner, the partnership
must make a positive or negative adjustment to the basis of its remaining capital or § 1231 assets equal
to such gain or loss.
10
10-5

6. 10. Section 751 assets (“hot” assets) include (but are not limited to) amounts due from the performance of
services that have not previously been reported as income and recapture of depreciation.
11. The tax effects are identical whether a partner sells his or her interest to another partner, the
partnership, or a person who has not been a partner, assuming the amount of cash to be received is
the same.
12. When a general partner’s capital interest in a service partnership is retired, liquidating distributions
can include payment for goodwill and unrealized receivables if the partnership agreement so specifies.
13. The seller of a partnership interest may recognize ordinary gain on the sale, but will never recognize
ordinary loss.
14. The purchaser of a partnership interest takes an outside basis in the interest equal to his proportionate
share of the inside basis of partnership assets plus any amount of partnership debt apportionable to
the purchased interest.
15. The exchange of partnership interest can usually qualify for the like-kind exchange rules, provided all
requirements of the like-kind exchange provisions are met and proper elections are made at the
partnership level.
16. When an interest in a partnership with appreciated assets is sold and no § 754 election is made, the
new partner’s outside basis exceeds his inside basis due to the applicability of the entity concept.
17. The death of a partner closes the partnership taxable year with respect to that partner.
18. Whenever a partnership is dissolved under state law, it is terminated for federal tax purposes.
19. If a partnership satisfies a $50,000 guaranteed payment obligation by distributing property to the
partner with a fair market value of $50,000 and an adjusted basis of $40,000, the partner receiving the
payment must recognize $10,000 of gain.
Multiple Choice
20. Partner Z received a current distribution from the XYZ Partnership consisting of $3,000 cash and
partnership inventory (FMV $10,000 and basis $7,800). The distribution did not change Z’s profit and
loss sharing ratio. Immediately prior to the distribution, Z’s outside basis in his partnership interest
was $11,000. Because of the distribution Z must:
a. Recognize a $2,000 gain and reduce outside basis to zero
b. Recognize no gain or loss and reduce outside basis to $8,000
c. Recognize no gain or loss and reduce outside basis to zero
d. Recognize no gain or loss and reduce outside basis to $200
e. Recognize a $200 loss and reduce outside basis to zero
21. Partner R received a current distribution from the RST Partnership consisting of $20,000 cash, $6,000
of partnership zero basis accounts receivables, and a capital asset (FMV $7,000 and basis $1,500). The
distribution did not change R’s profit and loss sharing ratio. Immediately prior to the distribution, R’s
outside basis in his partnership interest was $25,000. After the distribution, what basis does R have in
the receivables, the capital asset, and his partnership interest?
a. Receivables $0, capital asset $1,500, and interest $3,500
b. Receivables $0, capital asset $5,000, and interest $0
c. Receivables $2,500, capital asset $2,500, and interest $0
d. Receivables $6,000, capital asset $7,000, and interest $12,000
e. Receivables $0, capital asset $1,500, and interest $23,500
10-6 Chapter 10 Partnership Distributions, Dispositions of Partnership Interests, and Partnership Terminations

7. 22. K owns 25 percent of a partnership. K’s basis in the partnership was $12,000 before she received a
current proportionate distribution of equipment with a basis of $14,000 and a liability against it of
$6,000. How much is K’s basis in the partnership after the distribution?
a. $1,500
b. $2,000
c. $2,500
d. $4,500
e. $0
23. K owns 25 percent of a partnership. K’s basis in the partnership was $12,000 before she received a
current proportionate distribution of equipment with a basis of $14,000 and a liability against it of
$6,000. By what total amount would the remaining partners need to reduce their bases?
a. $1,500
b. $2,500
c. $3,500
d. $4,500
e. $5,500
24. A partnership’s records show:
Inside
Basis FMV
Cash $ 4,000 $ 4,000
Inventory 16,000 30,000
Land 8,000 10,000
Equipment 72,000 60,000
Total assets $100,000 $104,000
D’s basis in her interest in this partnership is $18,000. She receives 20 percent of all partnership assets
as a current distribution. D’s basis for the equipment is
a. $12,000
b. $12,400
c. $13,500
d. $14,400
25. A partnership’s records show:
Inside
Basis FMV
Cash $ 4,000 $ 4,000
Inventory 16,000 30,000
Land 8,000 20,000
Equipment 72,000 60,000
Total assets $100,000 $114,000
D’s basis in her 25% interest in this partnership is $26,000. She receives 25 percent of all partnership
assets as a liquidating distribution. Compute D’s basis in each distributed asset.
Test Bank 10-7

8. a. Inventory $4,000, land $2,000, and equipment $18,000
b. Inventory $4,000, land $5,000, and equipment $16,000
c. Inventory $4,000, land $3,000, and equipment $18,000
d. Inventory $4,500, land $2,250, and equipment $19,250
e. None of the above
26. In 2012, Corporation C contributed land (FMV $100,000 and basis $60,000) to Beta Partnership in
exchange for a 25% interest in Beta. In 2012, Beta distributed the land to individual partner P, thereby
terminating P’s 30% interest in Beta. Immediately prior to distribution, the land was worth $110,000
and P’s outside basis in his interest was $200,000. Which of the following is the correct set of tax
consequences of the distribution?
a. There are no consequences to Corporation C. P takes a $200,000 basis in the land.
b. There are no consequences to Corporation C. P takes a $110,000 basis in the land.
c. There are no consequences to Corporation C. P takes a $100,000 basis in the land.
d. Corporation C must recognize a $50,000 gain and increase the basis in its partnership interest by
$50,000. P takes a $200,000 basis in the land.
e. Corporation C must recognize a $40,000 gain and increase the basis in its partnership interest by
$40,000. P takes a $200,000 basis in the land.
27. Partner L received a $55,000 cash distribution from the KLM Partnership in liquidation of his 25%
interest. Immediately prior to distribution, L’s outside basis was $48,000. KLM had the following
balance sheet:
Inside
Basis FMV
Cash $ 57,000 $ 57,000
Inventory 45,000 53,000
§ 1231 and capital assets 90,000 122,000
$192,000 $232,000
Debt $ 32,000 $ 32,000
Capital: Partner L 40,000 50,000
Others 120,000 150,000
$192,000 $232,000
Because of the distribution, L should recognize:
a. $15,000 capital gain
b. $10,000 capital gain and $5,000 ordinary income
c. $8,000 capital gain and $7,000 ordinary income
d. $10,000 capital gain
e. $8,000 capital gain and $2,000 ordinary income
10-8 Chapter 10 Partnership Distributions, Dispositions of Partnership Interests, and Partnership Terminations

9. 28. Partner E is retiring from the EFGH Partnership. The partnership agreement provides that E will be
paid $64,000 for his 15% net interest in partnership property (excluding goodwill) plus an additional
$36,000 retirement bonus. In addition, E will be immediately relieved of any personal liability for
partnership debts. The $100,000 cash will be paid to E in 10 annual $10,000 installments, beginning in
the current year. Immediately prior to his retirement, E’s outside basis in his partnership interest is
$28,000; this basis includes $20,000 of EFGH’s debt. In the current year, E will:
a. Recognize ordinary income of $9,000 and no capital gain.
b. Recognize ordinary income of $3,600 and no capital gain.
c. Recognize capital gain of $2,000.
d. Recognize ordinary income of $3,600 and capital gain of $6,400.
e. Recognize ordinary income of $9,000 and capital gain of $21,000.
29. Mega Partnership distributed inventory (FMV $50,000 and basis $19,000) to partner Q in complete
liquidation of her interest in Mega. Immediately prior to the distribution, Q’s outside basis in her
interest was $27,500. If Mega has a § 754 election in effect, which of the following statements is
accurate?
a. Mega must recognize a $31,000 ordinary gain on the distribution of its inventory.
b. Mega may increase the basis in its remaining inventory by $31,000.
c. Mega must decrease the basis in its capital and § 1231 assets by $8,500.
d. Mega must decrease the basis in its remaining inventory by $8,500.
e. The property distribution has no effect on the basis of Mega’s assets because the inventory retains
its $19,000 basis in Q’s hands.
30. Summa Partnership distributed $10,000 cash and a capital asset (FMV $5,000 and basis $3,400) to
partner D in complete liquidation of her interest in Summa. Immediately prior to the distribution, D’s
outside basis in her interest was $7,500. If Summa has a § 754 election in effect, which of the following
statements is accurate?
a. Summa may increase the basis in its capital and § 1231 assets by $2,500.
b. Summa may increase the basis in its capital and § 1231 assets by $5,000.
c. Summa may increase the basis in its capital and § 1231 assets by $3,400.
d. Summa may increase the basis in its capital and § 1231 assets by $5,900.
e. The property distribution has no effect on the basis of Summa’s assets.
31. Which of the following statements concerning a § 754 election is accurate?
a. The election can be made by any partner who purchases an interest or who inherits an interest
from a deceased partner.
b. The election is effective only for the partnership taxable year (or years) specifically stated in the
election.
c. The election has potential tax consequences only to a partner who purchases an interest or who
inherits an interest from a deceased partner.
d. The election can only result in an increase in the basis of partnership assets.
e. None of the above is accurate.
32. T receives a liquidating distribution of investment land with a partnership basis of $18,000 and a
FMV of $40,000 when her basis in the partnership is $15,000. If a § 754 election is in effect, the bases
of the partnership’s remaining assets will be increased by
a. $0
b. $15,000
c. $22,000
d. $3,000
e. None of the above
Test Bank 10-9

10. 33. A partnership is owned by a mother (60%) and her son (40%). Their capital accounts are maintained
in the same ratio. The son received his ownership interest as a gift from his mother several years ago.
Partnership income for the current year was $50,000. Although the mother performed services valued
at $10,000, there was no entry on the partnership books and she received no cash for her services. To
avoid a reallocation by the IRS, what amount of current year income should be allocated to the
mother?
a. $20,000
b. $30,000
c. $34,000
d. $40,000
e. $50,000
34. CDE Partnership has the following assets on its balance sheet.
Inside
Basis FMV
Cash $ 5,000 $ 5,000
Accounts receivables 20,000 20,000
Inventory 70,000 85,000
§ 1231 assets 90,000 50,000
Accumulated depreciation (40,000) —
Land 200,000 280,000
$345,000 $440,000
a. CDE has no § 751 hot assets.
b. CDE has $40,000 of unrealized receivables.
c. CDE has $20,000 of unrealized receivables.
d. CDE has substantially appreciated inventory items worth $85,000.
e. CDE has substantially appreciated inventory items worth $105,000.
35. Partnership records show:
Inside
Basis FMV
Inventory $12,000 $ 28,000
Land 48,000 70,000
Equipment 32,000 42,000
Capital accounts $92,000 $140,000
R is a 50 percent partner. The equipment has $10,000 of § 1245 recapture potential. R and her partner
each received a distribution from the partnership of a one-half interest in the land. If R’s
predistribution outside basis was $46,000, R’s recognized gain is:
a. $0
b. $5,000 ordinary gain
c. $5,000 capital gain
d. $20,000 ordinary gain
e. $20,000 capital gain
10-10 Chapter 10 Partnership Distributions, Dispositions of Partnership Interests, and Partnership Terminations

11. 36. Partnership records show:
Inside
Basis FMV
Inventory $12,000 $ 28,000
Land 48,000 70,000
Equipment 32,000 42,000
Capital accounts $92,000 $140,000
R is a 50 percent partner. The equipment has $10,000 of § 1245 recapture potential. R’s predistribution
outside basis is $46,000. The partnership liquidates by distributing the land to R and the inventory and
equipment to her partner. R’s recognized gain on the liquidation is
a. $0
b. $13,000 ordinary income
c. $24,000 capital gain
d. $11,000 capital gain
e. $13,000 ordinary income and $11,000 capital gain
37. Partnership records show:
Inside
Basis FMV
Inventory $12,000 $ 28,000
Land 48,000 70,000
Equipment 32,000 42,000
Capital accounts $92,000 $140,000
R is a 50 percent partner. The equipment has $10,000 of § 1245 recapture potential. R sells her entire
interest in the partnership for $70,000. Her basis in the partnership is $50,000. R’s $20,000 recognized
gain on the sale is
a. All ordinary income
b. All capital gain
c. $8,000 of ordinary income and $12,000 of capital gain
d. $13,000 of ordinary income and $7,000 of capital gain
e. $24,000 of ordinary income and $4,000 of capital loss
38. Which of the following statements concerning § 751(b) disproportionate distributions is accurate?
a. Both the distributing partnership and the recipient partner may recognize taxable gain because of
a disproportionate distribution.
b. A disproportionate distribution can trigger the recognition of either ordinary gain or loss to the
recipient partner.
c. A disproportionate distribution can only occur if the partnership has failed to make a valid § 754
election.
d. The disproportionate distribution rules of § 751(b) reflect the entity theory of partnerships.
e. None of the above is accurate.
Test Bank 10-11

12. 39. Corporation J sells its 10% limited interest in the Nelson Partnership for $100,000. J’s outside basis in
the interest is $85,000; no partnership debt is included in this basis. At date of sale, Nelson has
inventory worth $980,000 with an inside basis of $770,000. Based on these facts, Corporation J should
recognize:
a. A $15,000 ordinary gain
b. A $15,000 capital gain and a $21,000 ordinary gain
c. A $6,000 capital loss and a $21,000 ordinary gain
d. A $21,000 ordinary gain
e. A $15,000 ordinary gain
40. Generally, capital will be considered a material income-producing factor for the following types of
businesses except
a. An equipment manufacturer
b. A wholesale bakery
c. A retail drugstore
d. A household maid service
e. A commercial building contractor
41. Individual O owned a sole proprietorship with a net value of $400,000. At the beginning of the current
year, O created a partnership by giving a 20% interest in the business to his best friend M, and a 30%
interest in the business to his daughter D. During the current year, O performed services for the
partnership worth $20,000, although he chose not to bill the partnership for his work. The
partnership’s operating income for the year is $160,000. Based on these facts, the maximum amount of
this income allocable to M and D is:
a. Any amount as long as the allocation has substantial economic effect within the meaning of §
704(b).
b. The maximum allocations to M and D respectively are $28,000 and $42,000.
c. The maximum allocation to D is $42,000; any amount may be allocated to M as long as the
allocation has substantial economic effect.
d. The maximum allocation to D is $48,000; any amount may be allocated to M as long as the
allocation has substantial economic effect.
e. The maximum allocations to M and D respectively are $32,000 and $48,000.
42. Individuals T, U, and V formed the calendar year Trio Partnership in 1981 as equal partners. On June 2,
2012, T died and his interest was inherited by his grandson G, whom U and V welcomed as a new equal
partner in their business. On November 13, 2012, V sold his interest to individual B. On January 19,
2013, B sold this same interest to Corporation C. Which of the following statements is accurate?
a. The original Trio partnership is still in existence for federal tax purposes.
b. The original Trio partnership terminated for federal tax purposes on June 2, 2012 because T’s
death dissolved the partnership under state law.
c. The original Trio partnership terminated for federal tax purposes on November 13, 2012.
d. The original Trio partnership terminated for federal tax purposes on December 31, 2012.
e. The original Trio partnership terminated for federal tax purposes on January 19, 2013.
10-12 Chapter 10 Partnership Distributions, Dispositions of Partnership Interests, and Partnership Terminations

13. 43. Individuals W, X, Y, and Z are all calendar year taxpayers. W and X both own a 15% interest and Y
and Z both own a 35% interest in the Theta Partnership, which has a May 31 fiscal year end. On
November 30, 2012, the Theta Partnership was dissolved into two new partnerships: W and X
contributed their interests in Theta to become equal partners in WX Partnership, while Y and Z
contributed their interests in Theta to become equal partners in YZ Partnership. As a result of this
division:
a. All four Theta partners must include their shares of Theta’s income from June 1, 2011 through
November 30, 2012 in their 2012 taxable incomes.
b. All four Theta partners will include only their shares of Theta’s income from June 1, 2011
through May 31, 2012 in their 2012 taxable incomes.
c. W and X must include their shares of Theta’s income from June 1, 2011 through November 30,
2012 in their 2012 taxable incomes. Y and Z will include only their shares of Theta’s income from
June 1, 2011 through May 31, 2012 in their 2012 taxable incomes.
d. W and X must include their shares of Theta’s income from June 1, 2011 through November 30,
2012 in their 2012 taxable incomes. Y and Z will not include any Theta income in their 2012
taxable incomes.
e. Both the WX and the YZ Partnerships must adopt a taxable year, subject to the restrictions of
§ 706(b).
44. M and E are equal partners in the ME Partnership. E decides to leave the partnership and receives a
liquidating distribution of $15,000 cash and two items of inventory. Inventory R has a basis of $1,000
and a fair market value of $7,000 and inventory S has a basis of $2,000 and a fair market value of
$5,000. E’s adjusted basis for her partnership interest is $40,000. In addition to the cash and inventory,
E also receives two parcels of land that are investments assets. Parcel A has a basis to the partnership
of $12,000 and a fair market value of $16,000. Parcel B has a basis to the partnership of $20,000 and a
fair market value of $18,000. What is E’s basis in Parcel A and Parcel B? Assume that this distribution
is proportionate.
a. Parcel A’s basis is $8,800; Parcels B’s basis is $13,200.
b. Parcel A’s basis is $12,000; Parcels B’s basis is $20,000.
c. Parcel A’s basis is $12,000; Parcels B’s basis is $18,000.
d. Parcel A’s basis is $11,000; Parcels B’s basis is $11,000.
Test Bank 10-13

15. Partnership Distributions,
Dispositions of
Partnership Interests, and
Partnership Terminations
Solutions to Test Bank
True or False
1. False. The aggregate theory clearly underlies §§ 731 through 735, the Code sections pertaining to
partnership distributions. (See p. 10-2.)
2. True. Loss may be recognized on a liquidating distribution but not on a current distribution. [See pp. 10-2
and 10-8 and § 731(a)(2).]
3. False. A partnership never recognizes gain or loss upon the distribution of property to its partners. [See
pp. 10-3 and 10-8 and § 731(b).]
4. True. Cash distributions in excess of a partner’s basis are treated as gain recognized on the sale of the
partnership interest. [See p. 10-3 and § 731(a)(1).]
5. False. Per § 732(c), outside basis is first allocated to distributed unrealized receivables and inventory in an
amount not to exceed the partnership’s inside basis in such assets. An remaining outside basis is allocated
to any other distributed partnership assets. Within these two categories, basis is allocated to specific assets
under a basis decrease formula. (See Examples 4 through 6 and pp. 10-4 through 10-6.)
6. True. However, recognition of loss occurs only if the liquidating partner receives only unrealized
receivables or inventory and the partner’s basis in the partnership exceeds the partnership’s basis in the
distributed assets. [See Example 14, pp. 10-8 through 10-10, and § 731(a)(2).]
7. False. If the partner has held the distributed property for at least five years subsequent to its distribution
by the partnership, the character of gain recognized on sale will be determined by reference to the
partner’s use of the property. (See Example 26, p. 10-16, and § 735.)
8. True. The disproportionate distribution of cash is treated as payment in exchange for the recipient
partner’s undistributed share of the partnership’s substantially appreciated inventory. [See Example 37,
pp. 10-23 and 10-24, and § 751(b).]
9. False. A § 734(b) basis adjustment is required only if the partnership has a § 754 election in effect or if the
partner’s loss on the distribution and the basis increase to the distributed properties totals more than
$250,000. (See Examples 28 and 29 and pp. 10-17 and 10-18.)
10
10-15

16. 10. True. Section 751 assets are defined as unrealized receivables of the sort described, including recapture
of depreciation, as well as substantially appreciated inventory. [See pp. 10-20 and 10-21 and
§ 751(c).]
11. False. Although the amount of gain is the same, the character may differ if the partnership purchases the
capital interest. This occurs because partnership payments for goodwill may be characterized as ordinary
income payments (rather than property payments). If this occurs, the liquidating partner has more
ordinary income and the partnership has a deduction for the payment. Consequently, the remaining
partners report less net income from the partnership (or more net loss). [See Examples 22 and 23,
pp. 10-13 and 10-14, and §§ 736(a) and (b).]
12. False. The partnership agreement may specify that a partner is to receive a liquidating payment for his or
her share of partnership goodwill, but any payment for a partner’s share of unrealized receivables is
always considered a § 736(a) payment that the partner must recognize as ordinary income. (See Example
24, pp. 10-14 and 10-15, and § 736.)
13. True. The sale of an interest in a partnership with hot assets can trigger recognition of ordinary income
per § 751(a). If the partnership has no hot assets, the sale of a partnership interest results in either capital
gain or loss per § 741. (See Example 38 and pp. 10-25 through 10-26.)
14. False. The purchaser takes a cost basis in the partnership interest. This basis includes any amount of
partnership liabilities assumed by the new partner. (See Example 43, pp. 10-28 and 10-29, and § 742.)
15. False. Code § 1031 makes it clear that the exchange of partnership interest cannot qualify for like-kind
treatment. (See p. 10-32.)
16. True. Absent a § 754 election, the new partner’s outside cost basis exceeds the inside basis (basis in the
partnership’s assets). The purchasing partner’s outside basis is composed of the purchase price plus this
partner’s share of partnership liabilities. In contrast, the purchasing partner’s inside basis is composed of
the selling partner’s inside basis (i.e., his or her share of the basis in the partnership’s total assets). [See
Example 44, pp. 10-29 and 10-30, and § 743(a).]
17. True. [See Example 51, p. 10-35, and § 706(c)(2)(A)(ii).]
18. False. A partnership is terminated only under the specific statutory provisions of § 708. (See p. 10-37.)
19. False. The partner receiving the payment will recognize ordinary income of $50,000 for the guaranteed
payment. The partnership will recognize $10,000 of gain for using appreciated property to satisfy the
obligation.
Multiple Choice
20. d. Z must reduce his outside basis to $200 ($11,000 original basis $3,000 cash $7,800 inside basis of
distributed inventory). (See , p. 10-4, and § 733.)
21. a. R must reduce his outside basis in his partnership interest to $3,500 ($25,000 original basis — $20,000
cash — $1,500 inside basis of distributed capital asset). He takes a zero carryover basis in the accounts
receivables and a $1,500 carryover basis in the capital asset. [See Example 2, p. 10-4, and §§ 732(a)
and 733.]
22. c. K’s basis after the distribution is $2,500 ($12,000 $14,000 [(6,000 25% ¼ $1,500)] þ $6,000).
(See pp. 10-4 and 10-5 and § 752.)
23. d. K’s partners must reduce their bases by $4,500 [$6,000 (100% 25%)]. [See pp. 10-4 and 10-5 and
§ 752(b).]
10-16 Chapter 10 Partnership Distributions, Dispositions of Partnership Interests, and Partnership Terminations

17. 24. b. $12,400. D’s basis in the partnership ($18,000) is less than the sum of the partnership’s basis in the
assets distributed ($20,000). Because D’s basis is not less than the partnership’s basis in the first two
categories of assets ($800 cash and $3,200 inventory), the partnership’s basis is assigned to these
assets. D’s remaining basis of $14,000 ($18,000 $800 $3,200) is allocated between land and
equipment under a basis decrease formula. The amount of the basis decrease is $2,000 ($1,600
carryover basis in land þ $14,400 carryover basis in equipment ¼ $16,000 $14,000 remaining
outside basis). Because the equipment has $2,400 of unrealized depreciation in value ($14,400 basis
$12,000 fair market value), it will be allocated the entire $2,000 basis decrease. Thus D’s basis in the
equipment will be $12,400 ($14,400 carryover basis $2,000 basis decrease). Her basis in the land will
be its carryover basis of $1,600. [See Example 4, pp. 10-4 and 10-6; and §§ 732(a)(2), 732(c), and 733.]
25. c. This is a proportionate distribution so that § 751(b) is inapplicable. D’s $26,000 outside basis is
reduced by the $1,000 cash received and $4,000 of the basis is allocated to partnership inventory. The
remaining $21,000 of outside basis is allocated to the distributed land and equipment under a basis
increase formula. The amount of the basis increase is $1,000 ($26,000 outside basis $1,000 cash
$4,000 carryover basis in inventory $2,000 carryover basis in land $18,000 carryover basis in
equipment). Because the land is the only category 2 asset with unrealized appreciation in value, it is
allocated the entire $1,000 basis increase. Thus D’s basis in the land is $3,000 (its carryover basis of
$2,000 þ $1,000 basis increase) and her basis in the inventory and the equipment is the appropriate
carryover basis, $4,000 and $18,000 respectively. [See Example 19, pp. 10-10 through 10-12, and
§ 732(b) and (c).]
26. e. Per § 704(c)(1)(B), contributing partner Corporation C must recognize gain equal to the $40,000
precontribution appreciation in the land upon its distribution to P, and may increase the outside basis
in its interest by this amount. Under § 732(b), P will take a $200,000 substituted basis in the property.
(See Examples 7 and 8, and pp. 10-7 and 10-8.)
27. b. Because the partnership’s inventory is not substantially appreciated (the $53,000 FMV of the inventory
is only 118% of its basis), the partnership has no hot assets. The $63,000 liquidating distribution
($55,000 cash þ $8,000 relief of partnership liabilities) exceeds the $58,000 FMV of L’s 25% interest in
partnership property. The $5,000 excess payment is a § 736(a) payment that L must recognize as
ordinary income. The $10,000 excess of the $58,000 liquidating distribution over L’s $48,000 outside
basis is capital gain under § 731(a). (See Example 22, pp. 10-13 and 10-14, and § 736.)
28. a. E’s total distribution equals $120,000 ($100,000 cash þ $20,000 relief of debt). Only $84,000 of this
total is a liquidating distribution ($64,000 payment for net interest in partnership assets þ $20,000
relief of debt). The remaining $36,000 is a § 736(a) payment. Accordingly, 30% ($36,000/$120,000) of
each annual payment will be ordinary income to E and 70% ($84,000/$120,000) will be a liquidating
distribution. In the current year, E receives a $30,000 payment ($10,000 cash þ $20,000 debt relief)
and E must recognize $9,000 ordinary income (30% of $30,000). The $21,000 liquidating distribution
received in the current year reduces E’s $28,000 outside basis to $7,000 but does not trigger the
recognition of any capital gain. (See Example 25, p. 10-15, and § 736.)
29. c. Partner Q took a $19,000 basis in the distributed inventory and recognized his $8,500 unrecovered
basis in his partnership interest as a capital loss. Under § 734(b)(2), Mega must decrease the basis of
its capital and § 1231 assets by this capital loss. (See Example 29 and p. 10-17.)
30. d. Partner D recognized a $2,500 capital gain and took a zero basis in the distributed capital asset.
Under § 734(b)(1), Summa may increase the basis of its capital and § 1231 assets by the gain
recognized and the $3,400 “lost” basis in the capital asset. (See Example 28 and p. 10-17.)
Solutions to Test Bank 10-17

18. 31. e. See the discussion of the § 754 election and its consequences on pp. 10-17 through 10-20 and
pp. 10-25 through 10-28.
32. d. Partner T took a $15,000 substituted basis in the distributed land. Under § 734(b)(1), the partnership
may increase its basis in its remaining capital and § 1231 assets by the $3,000 “lost” basis in the
distributed land. (See Example 28 and p. 10-17.)
33. c. The first $10,000 should be allocated to the mother. Sixty percent of the remaining $40,000 should be
allocated to her, the rest to her son. Her total income allocation is $34,000 ($10,000 þ $24,000) and
his is $16,000. [See Examples 48 and 49, pp. 10-33 and 10-34 and § 704(e).]
34. a. CDE has no unrealized receivables because the accrual basis partnership’s accounts receivable have
already generated taxable income to the partnership, and the value of the § 1231 assets equals their
adjusted basis. The § 751 inventory items (inventory and accounts receivables) are not substantially
appreciated because their aggregate $105,000 value is only 117% of their aggregate $90,000 basis. (See
Example 34, pp. 10-21 and 10-22.)
35. a. This is a proportionate distribution and R recognizes no gain because she did not receive cash in
excess of outside basis. R simply takes a $24,000 carryover basis in the distributed land and reduces
her outside basis accordingly. (See Example 2, p. 10-4, and §§ 731 and 732.)
36. b. This is a disproportionate distribution. R is treated as though she received a proportionate distribution
of her 50% share in the partnership’s $38,000 of hot assets (FMV $19,000) and took a $6,000 basis
(50% of $12,000 inside basis of inventory) in these assets. She then constructively exchanged her
interest in hot assets for $19,000 of land. Consequently, she must recognize $13,000 of ordinary
income. The proportionate distribution of the remainder of the land is nontaxable. [See Example 37,
pp. 10-23 and 10-24, and § 751(b).]
37. d. The partnership has $38,000 of hot assets. If the inventory and equipment were sold, R would be
allocated $13,000 of ordinary income ($8,000 from the inventory and $5,000 of recapture from the
equipment). Therefore, R must recognize a $13,000 ordinary gain on the constructive sale of her share
of partnership hot assets. The remaining $7,000 of gain is capital gain. [See Example 39,
pp. 10-26 through 10-28, and § 751(a).]
38. a. Because a § 751(b) disproportionate distribution is treated as an exchange of properties between
partner and partnership, both parties to the exchange can recognize taxable gain or loss. [See
Example 37, pp. 10-23 and 10-24, and § 751(b).]
39. c. The partnership has $980,000 of hot assets. If the inventory were sold, J would recognize $21,000 of
ordinary income (10% ($98,000 $770,000). Therefore, J must recognize a $21,000 ordinary gain
on the constructive sale of its share of partnership hot assets. The $6,000 excess of J’s $8,000
remaining outside basis ($85,000 $77,000) over the remaining $2,000 amount realized is a capital
loss recognized on sale of the partnership interest. [See Example 38, pp. 10-25 and 10-26, and
§ 751(a).]
40. d. All of the businesses listed except the household maid service require substantial investment in plant,
equipment, and inventory. (See footnote 74 and p. 10-34.)
41. b. Because the partnership interests of both M and D were created by gift, the family partnership
limitation of § 704(e) applies. O must receive a $20,000 allocation of profits to compensate him for
services rendered to the partnership. The percentage allocations of the remaining $140,000 of
partnership income to the two donee partners cannot exceed their percentage interests in partnership
capital. Therefore, the maximum allocations to M and D are $28,000 (20% of $140,000) and $42,000
(30% of $140,000), respectively. [See Examples 49 and 50, pp. 10-34 and 10-35, and § 704(e).]
10-18 Chapter 10 Partnership Distributions, Dispositions of Partnership Interests, and Partnership Terminations

19. 42. a. During the 12 month period ending on January 19, 2011, only a single one-third interest (V’s original
interest) was sold. Therefore, no technical termination of the original TUV Partnership occurred. (See
Example 55, pp. 10-37 and 10-38, and § 708.)
43. c. Because Y and Z owned more than a 50% interest in the Theta Partnership, the YZ Partnership is a
continuation of Theta. Since W and X terminated their interest in Theta, the partnership’s taxable
year closes for them on November 30, 2012. Therefore, two partnership taxable years close in the 2012
calendar year for W and X. However, Theta’s year does not close prematurely for Y and Z, and only
Theta’s fiscal year ending May 31, 2012 closes in their 2012 taxable year. (See Example 57, pp. 10-38
and 10-39, and § 708.)
44. a. E’s outside basis is reduced by the basis of the property distributed, as follows:
E’s Basis
$ 40,000
Cash (15,000)
$ 25,000
Inventory R (1,000)
Inventory S (2,000)
$ 22,000
Capital Assets (22,000)
$ 0
E has a basis of $0 in his partnership interest. E has a basis of $1,000 and $2,000, respectively, in
inventory items R and S. The $22,000 basis for the investment assets must be pro-rated between the
assets as follows:
Inside
Basis
Excess of Basis
Over Value
Basis Reduced
by Excess
* Decrease
Formula R’s Basis
Capital Asset A $12,000 $ 0 $ 12,000 $3,200 $ 8,800
Capital Asset B 20,000 2,000 18,000 4,800 13,200
[See Examples 4 through 6, pp. 10-4 through 10-6.]
*Decrease Formula:
Capital Asset A {($12,000/$30,000) $8,000] ¼ $3,200
Capital Asset B {($18,000/$30,000) $8,000] ¼ $4,800
Solutions to Test Bank 10-19

21. Partnership Distributions,
Dispositions of
Partnership Interests, and
Partnership Terminations
Comprehensive Problems
FA C T S F O R CO M P R E H E N S I V E PR O B L E M S
X, a cash basis partnership, has the following balance sheet items before any of the following transactions are
entered into.
Assets
Basis FMV
Cash $ 200,000 $ 200,000
Inventory 100,000 100,000
Equipment 400,000 750,000
Accumulated depreciation (200,000) (200,000)
Total Assets $ 500,000 $ 850,000
Liabilities and Capital
Recourse debt $ 400,000 $ 400,000
Nonrecourse debt 20,000 20,000
Partner A, capital 8,000 43,000
Partner B, capital 8,000 43,000
Partner C, capital 16,000 86,000
Partner D, capital 48,000 258,000
Total $500,000 $ 850,000
Partners C and D are general partners, and partners A and B are limited partners. Profits and losses are allocated
10 percent each to A and B, 20 percent to C, and 60 percent to D. Partnership X has a § 754 election in effect.
Assume that inside and outside bases are equal for all partners.
10
10-21

22. CO M P R E H E N S I V E PR O B L E M S
1. Compute the following, showing your work.
a. Partner A’s basis
b. Partner B’s basis
c. Partner C’s basis
d. Partner D’s basis
2. Assume all the cash ($200,000) is distributed to the partners (10% to A, 10% to B, 20% to C, and 60% to D).
Compute the following amounts, showing your work.
a. Any gain or loss recognized by A on the distribution
b. Any gain or loss recognized by C on the distribution
c. Partner A’s basis in the partnership after the distribution
d. Partner C’s basis in the partnership after the distribution
3. Assume A sells his 10 percent partnership interest to E for $43,000. Compute the following, showing your
work.
a. Gain recognized by A
b. Character of the gain recognized by A
c. E’s basis in the partnership
d. The § 743(b) adjustment and how it will be allocated
4. Assume C liquidates her 20 percent partnership interest. She receives $40,000 cash and 20 percent of both
the inventory and the equipment.
a. Compute any gain or loss that C must recognize.
b. Compute C’s basis in the inventory and equipment she receives.
c. Compute any gain or loss recognized by the partnership.
10-22 Chapter 10 Partnership Distributions, Dispositions of Partnership Interests, and Partnership Terminations

23. Solutions to Comprehensive Problems
1. a. Capital $ 8,000
Nonrecourse debt (10%) 2,000
$10,000
b. Capital $ 8,000
Nonrecourse debt (10%) 2,000
$10,000
c. Capital $ 16,000
Nonrecourse debt (20%) 4,000
Recourse debt* 100,000
$120,000
*Recourse debt is allocated to partners C and D according to their economic risk of loss, computed as
follows under the constructive liquidation scenario. The constructive loss is equal to the value of the
partnership’s assets, which is $480,000 after the nonrecourse debt of $20,000 is deemed to be paid:
Partner A B C D
Capital Account $ 8,000 $ 8,000 $ 16,000 $ 48,000
Constructive Loss: $480,000 (8,000) (8,000) (116,000) (348,000)
Economic Risk of Loss $ 0 $ 0 $(100,000) $(300,000)
Note that partners A and B are each limited to an allocation of $8,000 because they cannot have a
negative capital account. The remaining loss ($464,000) is allocated 25% to C and 75% to D.
d. Capital $ 48,000
Nonrecourse debt (60%) 12,000
Recourse debt* 300,000
$360,000
2. a. Cash received ($200,000 10%) $ 20,000
Basis before distribution (10,000)
$ 10,000 Gain
b. Cash received ($200,000 20%) $ 40,000
Basis before distribution 120,000
$ 0 Gain
c. Basis before distribution $ 10,000
Gain recognized 10,000
Cash distribution (20,000)
Basis after distribution $ 0
d. Basis before distribution $120,000
Cash distribution (40,000)
Basis after distribution $ 80,000
Solutions to Comprehensive Problems 10-23

24. 3. a. Amount received:
Cash from E $ 43,000
Liability relief 2,000
$ 45,000
Basis (10,000)
Gain $ 35,000
b. Ordinary income:
$200,000 10% $ 20,000
The $200,000 is potential § 1245 depreciation
recapture which is a § 751 asset.
Capital gain:
Total gain $ 35,000
Ordinary income (20,000)
$ 15,000
c. E’s basis in the partnership will be her purchase price plus her share of partnership liabilities.
Purchase price $43,000
Nonrecourse debt (10%) 2,000
Total basis $45,000
d. Outside basis $45,000
Inside basis 10,000
§ 743(b) adjustment $35,000
This is an positive adjustment, and the full $35,000 will be allocated to the equipment since if this asset
was sold, $35,000 of gain would be allocated to E.
4. a. Cash received $ 40,000
Liabilities relief 104,000
Total received $ 144,000
Basis (120,000)
Gain recognized $ 24,000
b. C’s partnership basis $ 120,000
Gain recognized(from 4a above) 24,000
$ 144,000
Cash received (40,000)
Liabilities relieved (104,000)
Remaining basis $ 0
C’s basis in the inventory and equipment will be 0.
c. None. This was a proportionate distribution.
10-24 Chapter 10 Partnership Distributions, Dispositions of Partnership Interests, and Partnership Terminations