pship tax master outline

PARTNERSHIP AND SUBCHAPTER S TAX OUTLINESPRING 2009

VICE PRESIDENT, ASSOCIATE DEAN, AND PROFESSOR BRUCE A. MCGOVERNSTEPHEN A. LIND ET AL, FUNDAMENTALS OF PARTNERSHIP TAXATION: CASES AND MATERIALS (8th ed. 2008)

SELECTED FEDERAL TAXATION STATUTES AND REGULATIONS (Daniel J. Lathrope ed., 2009 ed. 2008)LAURA E. CUNNINGHAM & NOËL B. CUNNINGHAM, THE LOGIC OF SUBCHAPTER K: A CONCEPTUAL GUIDE TO THE TAXATION OF

PARTNERSHIPS (3d ed. 2006)

PART 1: AN OVERVIEW OF THE TAXATION OF PARTNERSHIPS AND PARTNERS..........................................................3I. Introduction to Subchapter K..........................................................................................................................3II. Tax Classification of Business Enterprises.......................................................................................................3

a. In General...................................................................................................................................................3b. Corporations and Partnerships...................................................................................................................3

i. “Check-the-Box” Regulations.................................................................................................................3ii. Existence of a Separate Entity for Federal Tax Purposes........................................................................4iii. Publicly Traded Partnerships..................................................................................................................6

c. Trusts..........................................................................................................................................................6d. Tax Policy Considerations...........................................................................................................................6

III. Introduction to Choice of Business Entity...................................................................................................7

PART 2: FORMATION OF A PARTNERSHIP...................................................................................................................8I. Contributions of Property...............................................................................................................................8

a. General Rules..............................................................................................................................................8b. Introduction to Partnership Accounting...................................................................................................11

II. Treatment of Liabilities: The Basics..............................................................................................................15a. Impact of Liabilities on Partner’s Outside Basis........................................................................................15b. Contributions of Encumbered Property....................................................................................................16

III. Contributions of Services..........................................................................................................................23a. Introduction..............................................................................................................................................23b. Receipt of Capital Interest for Services.....................................................................................................24c. Receipt of a Profits Interest for Services...................................................................................................30

i. Current Law..........................................................................................................................................30ii. Proposed Regulations...........................................................................................................................31

IV. Organization and Syndication Expenses...................................................................................................32

PART 3: OPERATIONS OF A PARTNERSHIP: GENERAL RULES....................................................................................34I. Tax Consequences to the Partnership: Aggregate and Entity Principles......................................................34

a. The Partnership as an Entity.....................................................................................................................34b. The Taxable Year.......................................................................................................................................34

II. Tax Consequences to the Partners................................................................................................................37a. General Rules............................................................................................................................................37b. Electing Large Partnerships.......................................................................................................................41

III. Limitations on Partnership Losses............................................................................................................41a. Basis Limitations.......................................................................................................................................41b. At-Risk Limitations....................................................................................................................................42c. Passive Loss Limitations............................................................................................................................45

PART 4: PARTNERSHIP ALLOCATIONS.......................................................................................................................52I. Introduction..................................................................................................................................................52II. Special Allocations Under Section 704(b)......................................................................................................52

a. Background: The Substantial Economic Effect Concept...........................................................................52b. The Section 704(b) Regulations: Basic Rules............................................................................................52

i. Economic Effect....................................................................................................................................52

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1. General Rules.......................................................................................................................522. Reallocations When an Allocation Lacks Economic Effect Because of the Absence of a Deficit

Restoration Obligation..........................................................................................................57ii. Substantiality........................................................................................................................................59

c. Allocations Attributable to Nonrecourse Debt..........................................................................................61III. Allocations With Respect to Contributed Property...................................................................................65

a. Introduction..............................................................................................................................................65b. Sales and Exchange of Contributed Property............................................................................................66

IV. Allocations of Partnership Liabilities.........................................................................................................70a. Introduction..............................................................................................................................................70b. Recourse Liabilities...................................................................................................................................71c. Nonrecourse Liabilities.............................................................................................................................78

V. Allocations Where Partners’ Interests Vary During the Year.........................................................................82

PART 5: TRANSACTIONS BETWEEN PARTNERS AND PARTNERSHIPS.........................................................................85I. Payments for Services and the Use of Property............................................................................................85

a. Introduction..............................................................................................................................................85b. Partner Acting in Nonpartner Capacity.....................................................................................................85c. Disguised Payments..................................................................................................................................86d. Guaranteed Payments..............................................................................................................................89

PART 6: SALES AND EXCHANGES OF PARTNERSHIP INTERESTS.................................................................................91I. Consequences to the Selling Partner............................................................................................................91II. Consequences to the Buying Partner............................................................................................................94

PART 7: OPERATING DISTRIBUTIONS........................................................................................................................99I. Introduction..................................................................................................................................................99II. Consequences to the Distributee Partner.....................................................................................................99

a. Nonrecognition Rules on the Distribution................................................................................................99b. Consequences on Subsequent Sales of Distributed Property.................................................................102

III. Consequences to the Distributing Partnership.......................................................................................102IV. Mixing Bowl Transactions.......................................................................................................................106

PART 8: LIQUIDATING DISTRIBUTIONS AND TERMINATIONS..................................................................................112I. Introduction................................................................................................................................................112II. Liquidation of a Partner’s Interest..............................................................................................................112

PART 9: S CORPORATIONS AND THEIR SHAREHOLDERS..........................................................................................117I. Introduction................................................................................................................................................117II. Eligibility for S Corporation Status...............................................................................................................117III. Election, Revocation and Termination....................................................................................................120IV. Treatment of the Shareholders...............................................................................................................123V. Distributions to Shareholders.....................................................................................................................126VI. Taxation of the S Corporation.................................................................................................................130

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PART 1: AN OVERVIEW OF THE TAXATION OF PARTNERSHIPS AND PARTNERS

I. Introduction to Subchapter Ka. Congress’s goals in enacting subchapter K were to provide simplicity, flexibility and equity as

btwn partners.b. Aggregate vs. Entity approaches

i. Entity: p’ship viewed as separate legal entityii. Aggregate: p’ship is merely the relationship btwn individuals (no separate identity)

(think “family” to describe a group of people)iii. Subchapter K takes a hybrid approach (i.e., it employs both); takes an aggregate

approach, unless doing so would be too complicated1. E.g., aggregate – p’ship not treated as a separately taxable entity2. E.g., entity – p’ship must have its own taxable year and method of accounting

II. Tax Classification of Business Enterprisesa. In General

i. Corporation vs. Partnership Taxing Regimes1. Corporations

a. Subchapter Ci. Separately taxable entity (entity approach), double taxation

ii. Example: GI = $100 (w/ no deductions)1. Corporation: $100 TI * 35% = $35 tax2. SH: $65 dividend * 15% = $10 tax

b. Subchapter Si. Subchapter K-like

ii. Restrictions on sub-S election (e.g., c/n have more than 100 SHs, no non-resident alien SHs). See § 1361(b).

2. Partnerships (Subchapter K)a. Pass-through scheme (aggregate approach)b. Partners include share of p’ship income in individual income (whether

distributed or not)c. $100 GI * 35% = $35 tax

ii. Classification of Corporations vs. Partnerships1. Statutory Guidance. The definition of “partnership” is so broad it includes

organizations that aren’t regarded as p’ships under state law. See § 7701(a)(2). The definition of “corporation” as an association isn’t helpful. See § 7701(a)(3).

2. Pre-1997: Kintner Regs. If an entity had 2 or fewer default corporate characteristics, it was a p’ship; if it had more than 2 it was classified as a corporation. Default corporate characteristics are continuity of life, centralized management, transferrable interests, and limited liability

3. Today. Check-the-box regs. See Reg. § 301.7701.b. Corporations and Partnerships

i. “Check-the-Box” Regulations1. STEP 1: Separate Entity. Is the activity/entity an entity separate from its

owners? See I.b.ii. Existence of a Separate Entity for Federal Tax Purposes, infra.

a. If no, not subject to classification regulationsb. If yes, move on to the next question

2. STEP 2: Business Entity. Is the entity regarded as a business entity? See Reg. § 301.7701-2(a) (not a trust or subject to special treatment).

a. If no, the entity is classified as:i. A trust under Reg. § 301.7701-4 or

ii. Subject to special tax treatment (e.g., a qualified settlement fund under § 468B)

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b. If yes, move on to the next question3. STEP 3: Eligible Entity. Is the entity an eligible entity under Reg. § 301.7701-

3(a)? That is, is the entity classified as a corporation under Reg. § 301.7701-2(b)(1), (3)-(8)?

a. If yes, the entity is a corporation for federal tax purposes (a “per se corporation”), taxed under Subchapter C or S

b. If no, move on to the next question4. STEP 4: ≥2 Members. Are there 2 or more members?

a. If yes, the entity can elect to be a partnership OR a corporationb. If no, the entity can elect to be a corporation or disregarded for

federal tax purposesc. Default Rules. Reg. § 301.7701-3(b)(1).

i. 2 or more members: treated as a p’shipii. 1 member: disregarded as an entity

5. Note: an eligible entity that chooses to be an S corporation automatically is treated as making the election to be a corporation

6. Rev. Rul. 2004-77. Second Owner Can’t be a Disregarded Entity. Suppose an eligible entity has 2 owners and 1 of the owners is a disregarded entity (e.g., a single-owned LLC). Since the 2d owner is a disregarded entity, there’s really only 1 owner.

a. Same result if the disregarded entity is a limited partner in a general partnership.

b. There would be 2 owners if the 2d entity is recognized for federal tax purposes.

ii. Existence of a Separate Entity for Federal Tax Purposes1. Matter of Federal Tax Law. Whether an activity/entity exists as a separate

entity is a matter of federal tax law and does not depend on the organization’s status under state law. Reg. § 301.7701-1(a)(1).

2. Undertakings Giving Rise to Entities. A joint venture or other contractual arrangement may create a separate entity if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. Reg. § 301.7701-1(a)(2).

a. Joint Profit Motive. Separate entity may exist if co-owners of an apartment building lease space and provide services to occupants. Id.

b. Not Expense Sharing. An undertaking to share expenses doesn’t create a separate entity for federal tax purposes. Id.

c. Not Mere Co-ownership. Mere co-ownership of property that is maintained, rented or leased is not a separate entity for federal tax purposes. Id.

3. Podell v. Commissioner. Podell (P) and Young (Y) agreed that P would provide capital to Y to purchase and renovate property, and they would split the profits. HELD: the agreement gave rise to a joint venture. The key factors considered was the agreement to share profits and a shared right to control. Although P didn’t exercise as much managerial control as Y, he retained the power to approve Y’s actions through his control over continued contributions.

4. Allison v. Commissioner. Acceptance (A) and Investment (I) agreed that A would arrange financing and I would acquire and subdivide property. A received 75 lots. HELD: no joint venture. There was no joint profit motive to sell the 75 lots. A’s receipt of the lots was compensation for its financing obligations.

5. Problem 1 (p. 16). Which of the following relationships are likely to constitute a separate entity for federal tax purposes?

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a. (a) A, B and C purchase a single parcel of land as tenants-in-common and hold the land as an investment.

i. No separate entityii. Reg. § 301.7701-1(a)(2)

1. Mere co-ownership of property isn’t regarded as a separate entity for federal tax purposes.

2. Last sentence: tenants in common leasing farm property is not a separate entity for federal tax purposes.

b. (b) Same as (a), above, except the land is subdivided and A, B and C sell the lots.

i. Separate entity b/c they have a joint profit motiveii. Joint venture or other contractual arrangement. See Reg. §

301.7701-1(a)(2).iii. Similar to Podell b/c of the profit-sharing and shared right to

control.c. (c) Litigator and Negotiator are attorneys who share an office and a

secretary. Each attorney services and bills his own individual clients.i. No separate entity

ii. Expense sharing arrangements not recognized as separate from owners. Reg. § 301.7701-1(a)(2).

d. (d) Doctor will locate and purchase a suitable four unit building. Architect will remodel it. When the work is done, the renovated building will be sold by the Doctor-Architect real estate company and Architect will receive 25% of the net profits.

i. Separate entityii. Similar to Podell b/c of the profit-sharing and shared right to

control.iii. Allison is distinguishable b/c here there is profit sharing.

e. (e) Would the result in (d), above, be different if Doctor and Architect agreed that Doctor will retain three of the units as rental property and Architect will receive one unit to hold as rental property?

i. Separate entity status not clear.ii. One unit to Architect may look like compensation. See

Allison.iii. This isn’t really co-ownership of property. See Reg. §

301.7701-1(a)(2).iv. But, is this really different from Problem 1(d)? Getting to

same result (25% of profits).v. Could go either way.

1. If partners want to be partners, should act as partners (write up p’ship agreement, file p’ship tax return, etc.).

2. If partners d/n want to be partners:a. May make 761(a) election.b. But, investment or active trade or business?

vi. Madison Gas & Electric Co. v. Commissioner. Three utility companies jointly constructed a nuclear power plant. Each was entitled to share of electricity, and sold to their own customers at their own rates. HELD: partnership for federal tax purposes. The partners were sharing profits, just as if they sold electricity at the entity level and split the profits.

vii. Difficult to reconcile Allison and Madison Gas.

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f. (f) Fisher will purchase and operate a fishing boat. Lender will provide 10-year nonrecourse financing to Fisher. The arrangement will be evidenced by a note, secured by the boat, which will require repayment of the principal sum ratably over the 10-year period. In addition, Lender will receive 15% of Fisher’s net profits from the fishing operation each year of the arrangement.

i. No separate entity.ii. Like Allison, the lender’s being compensated (for the use of

money).iii. Looks like lender-borrower relationship.iv. But, some lending relationships are classified as p’ships (e.g.,

if lender puts restrictions on business such that there’s control and profit sharing).

6. Problem 2 (pp. 16-17). Did the Treasury have the authority to issue the check-the-box regulations?

a. Categories of Regulationsi. Legislative Regs. Congress delegates legislative power to the

Secretary of the Treasury. Courts defer more to these regs.ii. Interpretive Regs. Regs where Congress hasn’t delegated

authority; the Treasury uses its inherent authority under §7805(a).

b. Arg Against Check-the-Box Regsi. Regs should be consistent w/ statutory provision. The

definitions of p’ship and corporation don’t give an election.c. Arg For Check-the-Box Regs

i. Well-advised clients could elect under the Kintner rules before anyway.

d. Littriello v. United States. T formed a single-member LLC (disregarded entity) that ran a nursing home. LLC failed to pay federal withholding and FICA taxes and gov’t went after T. Gov’t arg: the LLC is disregarded for federal tax purposes. T arg: check-the-box regs are invalid. HELD: uphold the regs.

iii. Publicly Traded Partnerships1. Publicly Traded Partnership. A PTP is a p’ship where interests are traded on an

established securities market or readily tradable on a secondary market. § 7704(b).

2. Treated as a Corporation. A publicly traded partnership shall be treated as a corporation. § 7704(a).

a. Exception for P’ships with Passive Income. If ≥ 90% of the p’ship’s income is certain passive income, it is treated as a p’ship. § 7704(c).

c. Trustsi. Trusts. A trust is an arrangement where a trustee takes title to property for the purpose

of protecting or conserving it for the beneficiaries. Reg. § 301.7701-4(a).1. Subchapter J. Trusts are subject to subchapter J. Under this subchapter, trust

income currently distributed to the recipient beneficiaries is taxed to the beneficiaries. If trust income is accumulated, it is taxed to the trust when earned but not taxed again when distributed.

ii. Business Trusts. Business trusts are created to carry on a profit-making business. A business trust is not classified as a trust, but a business entity under the check-the-box regs. As an unincorporated entity, it will be classified as a partnership if it has ≥ 2 members and does not elect to be a corporation. See Reg. § 301.7701-4(b).

d. Tax Policy Considerationsi. Impact of the Check-the-Box Regulations

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1. Taxpayers may now choose with greater simplicity and lower compliance costs whether they will pay tax under the corporate tax rules or partnership tax rules.

2. The choice between tax regimes is more broadly available for all businesses.3. The check-the-box regulations may be more limiting than prior entity

classifications for certain foreign entities that are per se corporations under Reg. § 301.7701-2(b)(8).

ii. Issues1. Is the policy of many existing tax rules that depend on an entity’s status

violated by making that status elective?2. Should the tax law continue to provide parallel, but differing, pass-through

treatment for business entities that are partnerships and other entities, such as S corporations?

III. Introduction to Choice of Business Entitya. Considerations on Choice of Entity. What best meets the client’s goals?

i. State Law. Attributes of particular business organization.ii. Federal Income Tax Treatment

1. Corp – Subchapter C or S2. LP, LLC – Subchapter K is possible

iii. Federal Employment Taxes1. Partners – all income subject to self-employment tax2. LLC classified as p’ship, are all earnings subject to self-employment tax? Not

clear.iv. State Taxes. How do states tax entities (e.g., Texas Margin Tax)?

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PART 2: FORMATION OF A PARTNERSHIP

I. Contributions of Propertya. General Rules

i. Nonrecognition of Gain or Loss on Contribution. Gains/losses are not recognized to a partnership or a partner for a contribution of property to the partnership in exchange for an interest in the partnership. § 721(a).

1. Rationale. The transfer of property to a p’ship is considered to be a mere change in the form of the partner’s investment.

2. Property. “Property” is broadly defined to embrace money, goodwill, and even intangible service-flavored assets such as A/R, patents, unpatented technical know-how and favorable loan or lease commitments embodied in a letter of intent secured through the efforts of the contributing partner. “Property” does not include services rendered to the p’ship.

3. § 1245 Property. Generally, gains on the disposition of § 1245 property must be recognized. § 1245(a). But, if a partner exchanges § 1245 property for a p’ship interest under § 721, no gain is recognized. See § 1245(b)(3).

4. Installment Obligations. Generally, gain/loss results from the sale of installment obligations. § 453B(a). But, if a partner contributes property to a p’ship under § 721, no gain or loss will result. Reg. 1.453-9(c)(2).

5. Exception: Investment Company. Subsection (a) does not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (an entity w/ > 80% readily marketable securities) if incorporated. § 721(b).

ii. Partner’s “Outside Basis” in a Partnership Interest. A partner’s outside basis in a p’ship interest is the amount of money and AB of property contributed, increased by any gain recognized under § 721(b). § 722.

iii. Partner’s Holding Period in a Partnership Interest. Generally, the holding period begins the day after the partner contributes property to the p’ship. The period a partner held contributed property is tacked to the holding period of a p’ship interest if (1) the p’ship interest has the same basis as the property contributed and (2) the property exchanged was a capital asset or § 1231 property. § 1223(1).

1. Capital Asset. “Capital asset” means property, but does not include: stock in trade or inventory; depreciable or real property used in trade/business; A/R for services or from sale of inventory; and supplies used in trade/business. § 1221(a).

2. § 1231 Property. § 1231 property means depreciable and real property used in a trade/business held more than 1 year. § 1231(b)(1).

3. Divided Holding Period. The holding period is divided if the partner acquired portions of the p’ship interest in exchange for property resulting in different holding periods. Reg. § 1.1223-3(a)(2). A holding period relates to the fraction: [FMV of portion of p’ship interest received] / [FMV of whole p’ship interest]. Reg. § 1.1223-3(b)(1). See I.a.vi. Problem (pp. 36–37), infra.

iv. Partnership’s “Inside Basis” in Contributed Property. A partnership’s inside basis in contributed property is the AB of such property to the contributing partner at contribution, increased by any gain recognized under § 721(b). § 723.

v. Partnership’s Holding Period in Contributed Property. The period contributed property was held by the partner tacks on to the p’ship’s holding period if such property has the same basis in the p’ship’s hands as it would have in the partner’s. § 1223(2).

vi. Problem (pp. 36–37). A, B, C and D (all individuals) form a general partnership in which they each have an equal interest in capital and profits. All the partners and the partnership are cash method taxpayers. In exchange for their respective partnership

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interests, each partner transfers the following assets, all of which have been held more than two years:

Partner Asset Adjusted Basis Fair Mkt. ValueA Land

Goodwill$30,000

0$70,00030,000

B Equipment (all § 1245 gain)Installment note from the sale of landInventory

25,000

20,0005,000

45,000

25,00030,000

C BuildingLandReceivables for services rendered to E

25,00025,000

0

60,00010,000

30,000D Cash 100,000 100,000

1. (a) What are the tax consequences (consider only gain or loss realized and recognized, basis and holding period) to each of the partners?

a. Gain/Loss Realizedi. § 1001: RG/RL = AR – AB

ii. Partner A1. $100k AR (p’ship interest) – $30k AB (aggregate) =

$70k RGiii. Partner B

1. $100k AR (p’ship interest) – $50k AB (aggregate) = $50k RG

iv. Partner C1. $90k AR (9/10 p’ship interest) – $25k AB (basis of

building and receivables) = $65k RG2. $10k AR (1/10 p’ship interest) – $25k AB (basis in

land) = $15k RLv. Partner D

1. $100k AR (p’ship interest) – $100k AB (face value basis in cash) = $0

b. Gain/Loss Recognizedi. § 1001(c): all gains recognized unless otherwise provided in

the Codeii. § 721(a): partner recognizes no gain/loss where she

contributes property to p’ship in exchange for p’ship interestiii. § 1245(b)(3): no gain recognized on § 1245 property if

transferee’s basis = transferor’s basis b/c of §721iv. Reg. § 1.453-9(c)(2): no gain/loss results for disposition of

installment obligation if § 721 appliesv. All partners recognize no gain/loss

c. “Outside Basis” in Partnership Interesti. § 722: basis in p’ship interest = cash + AB of property

contributed, increased by § 721(b) gainii. Here, p’ship is not treated as an investment company

iii. Partner A’s basis = $30k + 0 = $30kiv. Partner B’s basis = $25k + $20k + $5k = $50kv. Partner C’s basis = $25k + $25k + 0 = $50k

vi. Partner D’s basis = $100kd. Holding Period in Partnership Interest

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i. § 1223(1): tack period partner held property exchanged if p’ship interest received has same basis as property exchanged and property exchanged is a capital asset (§ 1221) or § 1231 property

ii. Reg. § 1.1223-3(a)(2): p’ship interest shall not have a divided holding period unless portions of p’ship interest exchanged for property resulting in different holding periods

iii. Reg. § 1.1223(b)(1): holding period relates to: FMV of portion of p’ship interest / FMV of whole p’ship interest

iv. Partner A1. Assuming Partner A is not a dealer in land (in which

case the land would be inventory), the land is either a capital asset (held for investment) or § 1231 property (if used in a trade or business).

2. Goodwill is a capital asset (doesn’t fall under an exception to “property” in § 1221).

3. Holding period in p’ship interest is more than two years.

v. Partner B1. § 1231(b)(1): equipment is probably § 1231

property2. § 1221: installment note is a capital asset, assuming

Partner B is not a dealer in land (§ 1221(a)(4))3. Inventory is not a capital asset or § 1231 property4. $70k (FMV portion of p’ship interest exchanged for

equip + installment note) / $100k (FMV whole p’ship interest) = 70%

a. 70% of p’ship interest has holding period of more than 2 years

5. $30k (FMV portion of p’ship interest exchanged for inventory) / $100k (FMV whole p’ship interest) = 30%

a. 30% of p’ship interest has holding period beginning day after contribution

vi. Partner C1. § 1231(b)(1): building and land are probably § 1231

property (assuming Partner C’s not a dealer in land)2. Receivables for services isn’t a capital asset (§

1221(a)(4)) or § 1231 property3. $70k (FMV portion of p’ship interest exchanged for

building + land) / $100k (FMV whole p’ship interest) = 70%

a. 70% of p’ship interest has holding period of more than 2 years

4. $30k (FMV portion of p’ship interest exchanged for receivables) / $100k (FMV whole p’ship interest) = 30%

a. 30% of p’ship interest has holding period beginning day after contribution

vii. Partner D1. Holding period begins on day after cash contribution

2. (b) What are the tax consequences (consider only gain recognized, basis and holding period) to the partnership?

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a. Gain Recognized to Partnershipi. § 721(a): no gain/loss recognized to p’ship for contribution of

property in exchange for p’ship interestb. “Inside Basis” in Partnership Property

i. § 723: basis of contributed property = AB to partner at contribution, increased by § 721(b) gain

ii. Here, p’ship is not treated as an investment companyc. Holding Period in Partnership Property

i. § 1223(2): tack holding period of transferor if transferee’s basis = transferor’s

ii. § 723: “inside basis” = partners’ basis at contributioniii. P’ship tacks the period held by partner

3. (c) Although each of the partners contributes property of equal value, D transfers only cash while the other partners transfer property. Section 704(c)(1)(A) requires the partnership to allocate the precontribution gain or loss solely to the contributing partner when the partnership subsequently disposes of the property. What is the objective of that section? See also § 724.

a. The objective of § 704(c)(1)(A) is to disallow partners from assigning income to other partners and impose gains on the partner who held the asset when the gain accrued.

vii. Proposed Regs on Noncompensatory Options to Acquire Partnership Interests. Under the proposed regs, § 721 does not apply to the transfer of property to a partnership in exchange for a noncompensatory option, but it does apply to the exercise of the option. Prop. Reg. § 1.721-2(a) & (b).

1. Example. An individual transfers property w/ a basis of $600 and a FMV of $1k to a p’ship in exchange for an option to buy a 1/3 p’ship interest for $5k at any time during the next three years. On the transfer for the option, the individual recognizes $400 of gain. If the individual later exercises the option by transferring property w/ a basis of $3k and a $5k FMV to the p’ship for a p’ship interest, that transfer is protected by §721.

b. Introduction to Partnership Accountingi. Historical Cost Convention. On the balance sheet, partnership assets are recorded at

their “book value.” Book value will not change until some event occurs that warrants a revaluation of the partnership’s assets.

ii. Capital Account. Each partner’s interest in p’ship assets is reflected on the balance sheet by the partner’s capital account. The capital account represents a partner’s equity in the firm. It generally identifies what each partner would be entitled to receive upon liquidation of his or her interest in the p’ship. It is a mechanism for determining contributions and distributions, and how much gain/loss is allocated to each partner.

iii. Maintaining Capital Accounts. A partner’s capital account is increased by her share of money and property (FMV) contributed to the p’ship, and also allocations to her of p’ship income and gain. It is decreased by, inter alia, the amount of money and property (FMV) distributed to her. Reg. §§ 1.704-1(b)(2)(iv)(b), -1(b)(2)(iv)(d)(1).

1. Determining FMV. FMV of property will be regarded as correct if (1) such value is reasonably agreed to among the partners in arm’s length negotiations, and (2) the partners have sufficiently adverse interests. Reg. § 1.704-1(b)(2)(iv)(h).

iv. Tax Capital Accounts. Tax capital accounts provide information regarding the partners’ shares of the partnership’s inside basis. We maintain tax capital accounts b/c tax/book disparities highlight and help keep track of § 704(c) (gains on contributed property allocated to contributing partner) and “reverse § 704(c)” (revaluation) allocation problems.

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v. Restating Partnership Assets. Partners may wish to readjust their capital accounts to reflect the current economic condition of the p’ship. The p’ship assets are reflected on the p’ship’s books at their current FMV and each partner’s capital account should be increased by her share of the unrealized postcontribution appreciation/depreciation. Reg. § 1.704-1(b)(2)(iv)(f).

1. Non-Tax Business Purpose. The adjustment must be made principally for a substantial non-tax business purpose, like in connection with a contribution of money/property by a new partner as consideration for an interest in the p’ship. Reg. § 1.704-1(b)(2)(iv)(f)(5).

2. Gains/Losses Attributable to Partners When Accrued. The p’ship agreement must require that partners’ shares of gain/loss take into account the variation btwn AB and book value in the same manner as § 704(c). Reg. § 1.704-1(b)(2)(iv)(f)(4).

vi. Problem (pp. 43-44). A, B and C are equal general partners in the ABC Partnership. On formation of the partnership, A contributes $50,000 cash, B contributes land (Parcel #1) with a basis of $40,000 and a fair market value of $50,000, and C contributes securities with a basis and fair market value of $50,000. Prepare the partnership’s opening balance sheet and then reconstruct the balance sheet to account for each of the following (cumulative) subsequent events:

Assets Liabilities and Partner’s CapitalAdjusted

BasisBook Value Tax Capital Book Value

Cash $50k $50k Liabilities: None

Parcel #1 $40k $50k Capital:Securities $50k $50k A $50k $50k

B $40k $50kC $50k $50k

$140k $150k $140k $150k1. (a) The partnership leases Parcel #1 for $15,000 and sells the securities for

$50,000.a. Lease Land

i. Reg. § 1.704-1(b)(2)(iv)(b): increase book capital account by allocations of p’ship income

ii. Distribute $5k ($15k/3) to each partner.iii. Tax capital accounts also increased (by analogy to Regs on

book capital accounts)b. Sell Securities

i. Convert $50k securities to $50k cash.


BasisBook Value

Tax Capital

Book Value

Cash $115k $115k Liabilities: None

Parcel #1 $40k $50k Capital:A $55k $55kB $45k $55kC $55k $55k

$155k $165k $155k $165k

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2. (b) The partnership borrows $300,000 and then buys more land (Parcel #2) for $330,000.

a. Borrow $300ki. Increase liabilities by $300k (book and tax)

ii. Increase cash by $300kb. Buy Parcel #2 for $330k

i. Decrease cash by $330kii. Increase land (Parcel #2) by $330k. See Crane v.

Commissioner (when T acquires land subject to debt, include the unpaid principal balance in AB).


BasisBook Value

Tax Capital

Book Value

Cash $85k $85k Liabilities: $300k $300kParcel #1 $40k $50k Capital:Parcel #2 $330k $330k A $55k $55k

B $45k $55kC $55k $55k

$455k $465k $155k $165k3. (c) The partnership distributes $20,000 each to A, B and C.

a. Decrease cash by $60kb. Reg. § 1.704-1(b)(2)(iv)(b): decrease capital account by amount of

money distributed to partner by p’shipi. Decrease capital accounts by $20k


BasisBook Value

Tax Capital

Book Value

Cash $25k $25k Liabilities: $300k $300kParcel #1 $40k $50k Capital:Parcel #2 $330k $330k A $35k $35k

B $25k $35kC $35k $35k

$395k $405k $395k $405k4. (d) The partnership sells Parcel #1 for $65,000.

a. Book Gaini. $65k AR – $50k AB = $15k RG

ii. Reg. § 1.704(b)(2)(iv)(b): increase capital account by allocations to him of p’ship income and gain

iii. $15k gain distributed to partners ($5k each)b. Tax Gain

i. $65k AR – $40k AB = $25k RGii. § 704(c)(1)(A): precontribution gain must be allocated to the

contributing partner when p’ship sells the parcel1. The first $10k of the RG is allocated to B’s tax capital

account (b/c he contributed it)iii. Remaining $15k is distributed equally ($5k each)

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BasisBook Value

Tax Capital

Book Value

Cash $90k $90k Liabilities: $300k $300kParcel #2 $330k $330k Capital:

A $40k $40kB $40k $40kC $40k $40k

$420k $420k $420k $420k5. (e) When Parcel #2 has a value of $420,000, the assets and capital accounts are

restated to current value, and new partner D contributes $70,000 cash to the partnership in exchange for a 25% general partnership interest.

a. Restate P’ship Assetsi. Reg. § 1.704-1(b)(2)(iv)(f)(5)(i): revaluation must be made for

a substantial non-tax business purpose, which may be in connection of money/property to the p’ship by a new/existing partner as consideration for an interest in the p’ship

ii. Reg. § 1.704-1(b)(2)(iv)(f): capital accounts increased by their share of unrealized post-contribution appreciation

iii. $420k – $330k = $90k / 3 = $30k eachb. New Partner D Contributes $70k for a 25% P’ship Interest

i. Increase cash by $70kii. Reg. § 1.704(b)(2)(iv)(b): increase tax capital account by

amount of cash/property contributediii. Tax capital account = $70k


BasisBook Value

Tax Capital

Book Value

Cash $160k $160k Liabilities: $300k $300kParcel #2 $330k $420k Capital:

A $40k $70kB $40k $70kC $40k $70kD $70k $70k

$490k $580k $490k $580k6. Suppose the p’ship sells Parcel #2 for $420k and pays off the loan.

a. Book gain = 0 ($420k – $420k)b. Tax gain = $420k AR – $330k AB = $90k RG

i. Reg. § 1.704-1(b)(2)(iv)(f)(4): gain/loss must take into account the variation btwn AB and book value in the same manner as § 704(c).

ii. Allocate the $90k RG to A, B and C b/c they were partners when the gain accrued.

c. Pay Off the Loan: decrease cash, get rid of the liability

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BasisBook Value

Tax Capital

Book Value

Cash $280k $280k Liabilities:Capital:

A $70k $70kB $70k $70kC $70k $70kD $70k $70k

$280k $280k $280k $280kII. Treatment of Liabilities: The Basics

a. Impact of Liabilities on Partner’s Outside Basisi. Outside Basis Formula. Partner’s tax basis in p’ship interest = [initial basis in p’ship

interest] + [increase (decrease) in liabilities].ii. Increased Share of P’ship Liability: Treated as Contribution. Any increase in a partner’s

share of p’ship liabilities, or any increase in a partner’s individual liabilities b/c she assumed p’ship liabilities will be treated as a contribution of money by such partner to the p’ship. § 752(a).

1. Contributions Increase Capital Account. A partner’s outside basis shall be the amount of money and AB of property contributed. See § 722.

iii. Recourse vs. Nonrecourse Liability1. Recourse Liability Defined. A p’ship liability is a recourse liability to the extent

that any partner bears the economic risk of loss for that liability. See Reg. § 1.752-1(a)(1).

2. Nonrecourse Liability Defined. A p’ship liability is a nonrecourse liability to the extent that no partner bears the economic risk of loss for that liability. See Reg. § 1.752-1(a)(2).

iv. Partner’s Share of Nonrecourse Liability. A partner’s share of a p’ship’s nonrecourse liability is determined in accordance w/ the partner’s share of p’ship profits. Reg. § 1.752-3(a).

v. Partner’s Share of Recourse Liability. A partner’s share of recourse liability equals the portion of that liability, if any, for which the partner bears the economic risk of loss. Reg. § 1.752-2(a).

vi. Problem (p. 46). A, B, C, and D each contribute $25,000 to the ABCD partnership, which then acquires a $1,000,000 building, paying $100,000 cash and borrowing $900,000 on a nonrecourse basis.


BasisBook Value Tax Capital Book Value

Cash $0 $0 Liabilities: $900k $900kBuilding $1M $1M Capital:

A $25k $25kB $25k $25kC $25k $25kD $25k $25k

$1M $1M $1M $1M1. (a) If the parties are equal general partners, what is each partner’s outside

basis?a. §§ 752, 722: any increase in partner’s share of liability increases

outside basis

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b. Reg. § 1.752-1(a)(2): liability is nonrecourse if no partner bears economic risk of loss

i. Assume “nonrecourse” in problem means that lender restricted recovery to p’ship assets

c. Reg. § 1.752-3(a): partner’s share of p’ship’s nonrecourse liability is based on the partner’s share of p’ship profits

d. Since the partners share profits equally, each partner’s outside basis = $250k ($25k + $900k/4)

2. (b) What result if the partnership is a limited partnership, A is the sole general partner and all the partners share profits and losses equally?

a. Result is the same as part (a) b/c (despite the different structure), profits are still shared equally.

3. (c) What result in (b), above, if the partnership were personally liable for the debt?

a. Reg. § 1.752-1(a)(1): liability is recourse if any partner bears economic risk of loss

i. This debt is “recourse” b/c the general partner would bear the economic risk of loss of the liability

b. Reg. § 1.752-2(a): partner’s share of recourse liability equals the portion of that liability for which the partner bears the economic risk of loss.

i. Here, A, as a general partner, bears all the economic risk of loss according to state law. B, C and D, as limited partners, aren’t affected.

c. A’s outside basis = $925k ($25k initial outside basis + $900k increase in liability)

b. Contributions of Encumbered Propertyi. Contributing Partner

1. Original Outside Basis. Outside basis = cash + AB of property contributed. § 722.

2. Debt Relief Decreases Basisa. P’ship Assumes Debt. If contributed property is subject to debt, the

partnership is treated as having assumed the debt to the extent the debt ≤ property’s FMV. Reg. § 1.752-1(e).

b. Decrease in Liability Treated as Distribution. A decrease in a partner’s individual liability is treated as a cash distribution from the p’ship to the partner. § 752(b).

c. Distributions Decrease Basis. Outside basis is decreased (but not below zero) by cash/property distributions by the p’ship. §§ 705(a)(2), 733.

3. Increased Share of P’ship Liability Increases Basisa. Increased Share of P’ship Liability Treated as Contribution. An

increase in a partner’s share of p’ship liability is treated as a cash contribution by the partner to the p’ship. § 752(a).

i. Share of Recourse Liability. A partner’s share of recourse p’ship liability is the portion that partner bears the economic risk of loss. Reg. § 1.752-2(a)

ii. Nonrecourse. A partner’s share of NR liability is determined by the partner’s share of p’ship profits. Reg. § 1.752-3(a)(3).

b. Contributions Increase Basis. Outside basis is the amount of money and AB of property contributed. § 722.

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4. Netting Increases/Decreases. If partner incurs both an increase and decrease in liabilities, only the net increase (decrease) is treated as a contribution (distribution). Reg. § 1.752-1(f).

5. Recourse Liability in Excess of Basis. When a partner contributes property subject to recourse liability in excess of his outside basis, the net decrease in liabilities (treated as distribution) will exceed his outside basis. Since distributions decrease basis, this would result in a negative basis. Section 731 recognizes the excess distribution as gain.

a. Distributions in Excess of Basis are Recognized as Gain. Distributions are not recognized as gains, except to the extent that money distributed exceeds outside basis. § 731(a).

b. Capital Gain. Any gain recognized under § 731(a) is considered a gain from the sale/exchange of the partner’s p’ship interest. § 731(a) (flush language). P’ship interest is probably capital asset under § 741.

c. Avoid Result by Remaining Personally Liable. Suppose partner contributes property subject to recourse debt and remains personally liable to the creditor. Under § 1.752-1(e), the p’ship is treated as assuming the liability, resulting in a decrease of individual liabilities. But, the partner’s share of p’ship liability increases by the same amount b/c only that partner bears the economic risk of loss. The net result is that the partner’s outside basis is the AB of the contributed property.

6. Nonrecourse Liability in Excess of Basis. When a partner contributes property subject to nonrecourse liability in excess of his outside basis, the p’ship will take the property at the partner’s basis. § 723. When the p’ship sells the property, the AR will be at least the amount of the debt. See Commissioner v. Tufts. This gain should be allocated to the contributing partner. § 704(c)(1)(A). Liability is allocated accordingly.

a. Liability Allocated to Contributing Partner. A partner’s share of p’ship liability includes gain that would be allocated under § 704(c) if the p’ship disposed of all p’ship property subject to NR p’ship liability in full satisfaction of the liability and for no other consideration. Reg. § 1.752-3(a)(2).

b. Remaining Liability Allocated by Share of Profits. After the allocation above, the partner’s share of p’ship liabilities is determined by the partner’s share of p’ship profits. Reg. § 1.752-3(a)(3).

ii. Other Partners1. Original Outside Basis. Outside basis = cash + AB of property contributed. §

722.2. Increased Share of P’ship Liability Increases Basis

a. Increased Share of P’ship Liability Treated as Contribution. An increase in a partner’s share of p’ship liability is treated as a cash contribution by the partner to the p’ship. § 752(a).

i. Share of Recourse Liability. A partner’s share of recourse p’ship liability is the portion that partner bears the economic risk of loss. Reg. § 1.752-2(a)

ii. Nonrecourse. After allocation (if any) for contributed property subject to NR debt in excess of the contributing partner’s outside basis, a partner’s share of NR liability is determined by the partner’s share of p’ship profits. Reg. § 1.752-2(a)(3). See Reg. § 1.752-2(a)(2).

b. Contributions Increase Basis. Outside basis is the amount of money and AB of property contributed. § 722.

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iii. Accounts Payable1. Not “Liability.” Accounts payable are not considered p’ship liabilities for

purposes of § 752. Rev. Rul. 88-77. That is, they do not count for increases (decreases) in individual or a partner’s share of p’ship liability and will not be treated as contributions (distributions).

2. Allocate Deductions. When the accounts payable are paid, allocate the deduction to the contributor/assignor. See § 704(c)(1), (3).

iv. Accounts Receivable: Allocate Income. When accounts receivable are contributed, income inherent in the A/R must be taxed to the contributing partner. See § 704(c)(1), (3).

v. Problem 1 (pp. 50-51). A and B each contribute $30,000 cash to the ABC partnership and C contributes land held for more than one year, worth $60,000 and subject to a recourse debt of $30,000. A, B and C are all general partners with a one-third interest in the profits and losses of ABC.

1. Reviewa. Gain Realized

i. A and B: no gain realized1. $30k AR (p’ship interest)2. $30k AB (AB of cash is face value)

ii. C: $20k gain realized1. $60k AR = $30k p’ship interest + $30k debt relief2. $40k AB in land

b. Gain Recognized by Partners and P’ship: none (§ 721)c. Holding Period

i. A and B: begins on day after contributionii. C: tack on period land was held (§ 1223(1): land is either

capital asset or § 1231 property)iii. P’ship holding period for the land includes period C held it (§

1223(2))2. (a) What are the tax consequences to A, B, C and ABC if the land has a

basis to C of $40,000 and the partnership assumes the debt?Assets Liabilities and Partner’s Capital

Adjusted Basis

Book Value

Tax Capital

Book Value

Cash $60k $60k Liabilities: $30k $30kBuilding $40k $60k Capital:

A $30k $30kB $30k $30kC $10k* $30k**

$100k $120k $100k $120k*$40k AB – $30k liability**$60k FMV – $30k liability

a. Assume the terms “recourse” and “nonrecourse” in the problem mean “recourse” and “nonrecourse” according to the definitions in the Regs.

b. A and Bi. Outside Basis = original outside basis + increase (decrease) in

liabilitiesii. Original Basis = $30k

1. § 722: outside basis = cash + AB of property contributed

2. Contributed $30k cashiii. Increase in Liabilities = $10

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1. § 752(a): increase in partner’s share of liabilities treated as cash contribution

2. § 722: outside basis = money + AB of property contributed

3. Reg. § 1.752-2(a): partner’s share of liability is portion that partner bears the economic risk of loss

4. $30k debt/3 partners = $10kiv. Outside Basis = $40

c. Ci. Original Basis = $40k


2. Contributed property w/ AB of $40kii. Debt relief: $30k

1. Reg. § 1.752-1(e): when property subject to debt is contributed, p’ship is treated as having assumed the debt (if ≤ FMV)

2. § 752(b): decrease in partner’s liability treated as cash distribution to partner

3. §§ 705(a), 733: outside basis reduced by distributions

4. Decrease outside basis by $30kiii. Increase in Liabilities = $10

1. Same analysis as A and Biv. Net Decrease = $20k

1. Reg. § 1.752-1(f): net the increases and decreases in liabilities resulting from the same transaction



v. Outside basis = $40k – $20k = $20k3. (b) Same as (a), above, except that the land has a basis to C of $10,000. What

could C do to avoid this result?a. C realizes $50k RG ($60k AR – $10k AB), but not recognizedb. § 723: p’ship inside basis in land: $10k (same as contributing

partner’s)Assets Liabilities and Partner’s Capital

Adjusted Basis

Book Value

Tax Capital

Book Value


A $30k $30kB $30k $30kC ($20k) $30k

$70k $120k $70k $120kc. A and B

i. Same analysis as part (a)d. C

i. Original Basis = $10k1. § 722: outside basis = cash + AB of property

contributed

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2. Contributed property w/ AB of $10kii. Debt relief: $30k

1. Reg. § 1.752-1(e): when property subject to debt is contributed, p’ship is treated as having assumed the debt (if ≤ FMV)






v. $10k original basis – $20k = –$10k!!!vi. Outside basis = 0

1. §§ 705(a), 733: distributions decrease outside basis (but not below zero)

vii. C realizes $10k gain1. § 731(a): gain/loss recognized to the extent

distributions exceed outside basis2. $20k distributions exceed $10 outside basis by $10k

viii. $10k gain is likely a capital gain1. § 731(a) (flush language): any gain/loss under this

subsection is treated as gain/loss from sale/exchange of p’ship interest

2. P’ship interest probably capital asset under § 741e. How to avoid this result?

i. Don’t let p’ship expressly assume the debt. See Reg. § 1.752-1(g), Ex. 1.

ii. Contribute another $10k cashiii. Pay capital expenditures to increase property’s ABiv. If Partner C contributed a $10k promissory note, it would

have no effect on outside basis b/c the partner has a zero basis in the note

f. Difference Between Outside and Inside Basis Leads to Double Taxationi. Aggregate Outside Basis = $80k

1. A and B = $40k each; C = 0ii. Aggregate Inside Basis = $70k (see table)

iii. If p’ship sold the land: $60k AR – $10k AB = $50k RGiv. § 704(c)(1)(A): $50k precontribution gain allocated to Cv. But, C already paid tax on $10k gain

vi. Note: p’ship can adjust basis of land if it makes a § 754 election

4. (c) Same as (a), above, except that the debt is nonrecourse, and the partners agree that for purposes of allocating nonrecourse liabilities they each have a one-third interest in profits.

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BasisBook Value

Tax Capital

Book Value


A $30k $30kB $30k $30kC $10k $30k

$100k $120k $100k $120ka. A and B

i. Outside Basis = original outside basis + increase (decrease) in liabilities

ii. Original Basis = $30k1. § 722: outside basis = cash + AB of property

contributed2. Contributed $30k cash

iii. Increase in Liabilities = $101. § 752(a): increase in partner’s share of liabilities

treated as cash contribution2. § 722: outside basis = money + AB of property

contributed3. Reg. § 1.752-2(a)(3): partner’s share of NR liability is

determined by partner’s share of p’ship profits4. $30k debt/3 partners (equal profits) = $10k

iv. Outside Basis = $40b. C


contributed2. Contributed property w/ AB of $40k

ii. Debt relief: $30k1. Reg. § 1.752-1(e): when property subject to debt is

contributed, p’ship is treated as having assumed the debt (if ≤ FMV)








v. Outside basis = $20k = $40k – $20k

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5. (d) Same as (b), above, except that the debt is nonrecourse and the partners agree that for purposes of allocating nonrecourse liabilities they each have a one-third interest in profits.


BasisBook Value

Tax Capital

Book Value


A $30k $30kB $30k $30kC –$20k $30k

$70k $120k $70k $120ka. C


contributed2. Contributed property w/ AB of $10k

ii. Debt relief: $30k1. Reg. § 1.752-1(e): when property subject to debt is

contributed, p’ship is treated as havng assumed the debt (if ≤ FMV)



4. Decrease outside basis by $30kiii. Liability Allocated to C: $20k

1. Reg. § 1.752-3(a)(2): partner who contributes property encumbered by NR debt is first allocated that portion of the liability equaling the gain that would be allocated to that partner under § 704(c) if the property were sold at the time of the contribution for an amount equal to the liability

2. $30k AR (Tufts) – $10k AB = $20k RG3. $20k liability allocated to C4. § 752(a): increase in partner’s share of liabilities

treated as cash contribution5. § 722: outside basis = money + AB of property

contributed6. Increase outside basis by $20k

iv. Increased liability: $3,3331. Reg. § 1.752-3(a)(3): liability remaining after

reallocation under -3(a)(2) allocated according to partners’ share of p’ship profits



4. $30k liability – $20k allocation = $10k remaining5. $10k liability /3 = $3,3336. Increase outside basis by $3,333

v. Net Decrease = $6,667

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4. –$30k + $20k + $3,333 = –$6,667vi. Outside basis = $10k – $6,667 = $3,333

b. A and Bi. Original Basis = $30k


2. Contributed $30k cashii. Increased liability: $3,333

1. Reg. § 1.752-3(a)(3): liability remaining after reallocation under -3(a)(2) allocated according to partners’ share of p’ship profits



4. $30k liability – $20k allocation = $10k remaining5. $10k liability /3 = $3,3336. Increase outside basis by $3,333

iii. Outside basis = $33,333vi. Problem 2 (p. 51). Attorney, a cash method unincorporated sole practitioner, joins a

cash method partnership of three other attorneys all of whom own an equal one-quarter interest in the partnership after Attorney joins the firm. Attorney transfers some accounts receivable for services with a zero basis and a $20,000 face value to the partnership as part of her contribution in exchange for her partnership interest. The partnership also assumes $6,000 of Attorney’s accounts payable. What are the tax consequences of the transaction to attorney? See § 704(c)(3).

1. Gain/loss realized: $20k AR – $0 = $20k2. § 721: no gain/loss recognized3. § 722: initial outside basis = $0 (AB of property contributed)4. Rev. Rul. 88-77: accounts payable of a cash method p’ship are not treated as a

liability for purposes of § 7525. When p’ship gets $20k income, the gain will be allocated to Attorney (§ 704)6. When the p’ship pays the accounts payable, deductions will be allocated to

AttorneyIII. Contributions of Services

a. Introductioni. Capital Interest and Profit Interest. A partner providing services might receive either a

capital interest or a profits interest.1. Capital Interest. A “capital interest” is an interest that would give the holder a

share of the proceeds if the p’ship assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the p’ship. Rev. Proc. 93-27, § 2.01.

2. Profits Interest. A “profits interest” is a partnership interest other than a capital interest.” Rev. Proc. 93-27, § 2.01.

ii. Example. A contributes $1k for a ½ p’ship interest and B rendered past services to A in exchange for a ½ p’ship interest. If B has a claim on part of that $1k, he has a capital (rather than profits) interest.

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b. Receipt of Capital Interest for Servicesi. Formation of a New Partnership

1. A Contributes Cash and B Contributes Past Services. Suppose A and B want to form a p’ship, where A contributes $1k and B contributed past services to A.

Assets Liab. and Partner’s CapitalAdjusted

BasisBook Value

Tax Capital

Book Value

Cash $1k $1k Liab. 0 0Capital:

A $500 $500B $500 $500

$1k $1k $1k $1k

2. Step One. A is treated as transferring cash to B (Service Provider).a. B (Service Provider): GI. Partner B has GI (compensation). See § 61.b. A: Potential Deduction. Partner A takes a deduction if the services B

provided were part of his trade or business or a profit-making activity of A. § 212. A takes no deduction if B’s activities were personal.

3. Step Two. A and B are treated as contributing $500 to the p’ship.a. Nonrecognition. Neither the partners nor the p’ship recognize gain. §

721(a).b. Outside Basis. The partners have a $500 basis in their p’ship interests.

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ii. A Contributes Land and B Contributes Past Services. Suppose A contributes land with a FMV of $1k and an AB of $600, and B contributes past services to A in the formation of a p’ship.

Assets Liab. and Partner’s CapitalAdjusted

BasisBook Value

Tax Capital

Book Value

Cash $800 $1k Liab. 0 0Capital:

A $300 $500B $500 $500

$800 $1k $800 $1k1. Step One. A is treated as transferring a ½ interest in the land to B in

compensation for B’s services.a. B: GI

i. Amount of Income. Service Provider has GI in the amount of FMV of property less any amount paid. See § 83(a).

ii. Timing of Income. Service Provider has income in the taxable year where her rights are transferable or not subject to a substantial risk of forfeiture. See § 83(a).

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iii. Basis in Land. Service Provider takes a “tax cost basis” in the land equal to its FMV. See Reg. § 1.61-2(d).

b. A: Deduction, GIi. Potential Deduction. Partner A takes a deduction (if the

expense is deductible under §§ 162 or 212) in the year where Service Provider has GI. See § 83(h), Reg. § 1.83-6(a).

ii. Realization Event. A recognizes gain to the extent Partner A receives an amount that exceeds the Partner A’s basis in the property. See Reg. § 1.83-6(b).

2. Step Two. A and B are treated as contributing a ½ interest in land for a ½ p’ship interest.

a. Nonrecognition. Neither partners nor p’ship recognize gain/loss. § 721(a).

b. Outside Basis. Partners’ outside basis is the AB of property contributed. See § 722.

c. Inside Basis. P’ship takes the basis of the contributing partners. See § 723.

iii. Adding Partners to Existing Partnership1. Analogy to Formation of New Partnership

a. Step One. P’ship treated as transferring a portion of p’ship property to New Partner.

i. New Partner: GI. New Partner has GI in the amount of FMV of property. § 83(a). New Partner’s “tax cost basis” in the property is the amount included in GI.

ii. Partnership1. Realization Event. P’ship has realized gain in the

amount the presumed value of services exceeds the AB in property transferred.

2. Possible Deduction. P’ship takes deduction equal to New Partner’s GI (if deductible it’s a deductible expense).

b. Step Two. New Partner treated as transferring the portion of p’ship property to p’ship.

i. Outside Basis. New Partner’s basis in p’ship is equal to AB property contributed. See § 722.

ii. Inside Basis. P’ship’s takes New Partner’s basis in p’ship property contributed. See § 723.

2. Proposed Regulationsa. Partnership Interest = Property. A partnership interest is “property”

within the meaning of § 83. Prop. Reg. § 1.83-3(e).b. Applicability of § 83. The transfer of a partnership interest to a

person in connection with the performance of services constitutes a transfer of property to which section 83 and the regulations thereunder apply. Prop. Reg. § 1.721-1(b)(1).

c. Service Provider’s GI. The service provider must include in GI the FMV of the property (p’ship interest) transferred, less whatever the service provider paid for it. § 83(a).

i. Value of P’ship Interest: Safe Harbor. The p’ship can elect a safe harbor under which the FMV of the p’ship interest transferred is treated as equal to the liquidation value of that interest. Prop. Reg. § 1.83-3(l)(1).

1. Liquidation Value. Liquidation value is “the amount of cash that the holder of that interest would receive

26

with respect to the interest if, immediately after the transfer of the interest, the partnership sold all of its assets [including goodwill and other intangibles] for cash equal to the fair market value of those assets, and then liquidated.” Preamble to Prop. Regs.

d. Partnership’s Nonrecognition. Generally, “no gain or loss shall be recognized by a partnership upon (i) [t]he transfer or substantial vesting of a compensatory partnership interest; or (ii) [t]he forfeiture of a compensatory partnership interest.” Prop. Reg. § 1.721-1(b)(2).

i. Compensatory Partnership Interest. A compensatory partnership interest is an interest in the transferring partnership that is transferred in connection with the performance of services for that partnership, including an interest that is transferred on the exercise of a compensatory partnership option. Prop. Reg. § 1.721-1(b)(3).

e. Partnership’s Deduction. The transfer is treated as a guaranteed payment for services. Prop. Reg. § 1.721-1(b)(4)(i). Therefore, the p’ship can deduct the pmt under § 707(c) if it is a deductible pmt (e.g., under § 162).

i. Timing. The timing of the p’ship’s deduction (and the service partner’s GI) is determined under the rules of §83, including § 83(h). Prop. Reg. § 1.707-1(c).

ii. Amount. The amount of the p’ship’s deduction includes the amount the service provider must include in GI. § 83(h).

f. Section 83(b) Electioni. The Election. Service provider may elect to include the FMV

of property received at the time of transfer less any amount paid for the property. If this election is made, there is no requirement that the property be transferrable and not subject to a subst. risk of forfeiture. If the property is forfeited, no deduction is allowed. § 83(b).

ii. Treatment as a Partner. If Service Provider does not make the § 83(b) election, then the service provider is not treated as a partner during the period that the partnership interest is not vested. If she does make the § 83(b) election, then she is treated as a partner immediately upon the partnership’s transfer of the interest. Prop. Reg. § 1.761-1.

iv. Problem (pp. 59-60). C is offered a capital interest in a partnership whose sole asset is a commercial building with a fair market value of $150,000 and an adjusted basis of $90,000. The building has been depreciated on the straight line method. A and B have $45,000 outside bases in their respective partnership interests. C has performed real estate management services for the partnership over the past year and has agreed to perform additional services in the future.

Assets Liabilities and Partners’ CapitalAdjusted

BasisBook Value

Tax Capital

Book Capital

Building $90k $150k Liabilities noneCapital:

A $45k $75kB $45k $75k

$90k $150k $90k $150k

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1. (a) What are the tax consequences to C and to the partnership (i.e., A and B) if in year one C receives a one-tenth capital interest in the partnership as compensation for his management services over the past year?

a. § 83(a): C has $15k GI immediately (b/c the p’ship interest is transferable and not subject to substantial risk of forfeiture)

b. C takes a “tax-cost basis” of $15k (the amount included in GI)c. Prop. Reg. § 1.721-1(b)(4)(i): p’ship takes a deduction

i. § 83(h): the deduction = amount C included in GIii. Prop. Reg. § 1.83-3(l)(1): liquidation value = $15k ($150k

building * 1/10 interest)d. § 706(d): deduction allocated to Partners A and Be. § 705: deduction decreases basis by $7,500

i. A and B’s Basis = $45k AB – $7,500 = $37,500Assets Liab. and Partners’ Capital

Adjusted Basis

Book Value

Tax Capital

Book Capital

Building $90k $150k Liab. noneCaptial:

A $37.5k $67.5kB $37.5k $67.5kC $15k $15k

$90k $150k $90k $150k2. (c) What result in (a), above, if, C receives his interest as compensation for

services to be rendered in the succeeding three years provided, however, that if C ceases to render services before the end of year three, C or any transferee of C must relinquish his interest in the partnership. Assume for this problem that the building will have a value of $450,000 and an adjusted basis of $90,000 at the end of year three.

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a. Year of Initial P’ship Interest Transferi. § 83(a): subject to substantial risk of forfeiture

1. § 83(c)(1): subject to subst. risk of forfeiture2. § 83(c)(2): not transferable3. Thus, C has no GI in current year

ii. § 83(h): p’ship has no GI1. C hasn’t realized GI2. Not realizable event

b. Three Years Lateri. C has $45k GI (FMV of interest transferred)

1. (Liquidation if p’ship makes election)ii. C’s outside basis = $45k (tax cost basis)

iii. Prop. Reg. § 1.721-1(b)(2): p’ship d/n recognize any gain on this transfer of p’ship interest

c. Gets $45k deductioni. A and B decrease basis by $22,500

d. A and B’s Basisi. Original basis = $75k

ii. Increase by $300k ($150 each) for revaluation of buildingiii. Decrease by $22,500 b/c of deductioniv. $75k + $150k – $22,500 = $202,500

Assets Liab. and Partners’ CapitalAdjusted

BasisBook Value

Tax Capital

Book Capital

Building $90k $450k Liab. noneCaptial:

A $22.5k $202.5kB $22.5k $202.5kC $45k $45k

$90k $450k $90k $450ke. Partner C should have elected under § 83(b) in Year 1

i. C would have had $15k GIii. C would have had $15k outside basis

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iii. If C sold her interest later for $45k, the $30k gain would be a capital gain

c. Receipt of a Profits Interest for Servicesi. Current Law

1. Historical Backgrounda. Negative Implication. Reg. § 1.721-1(b) provides that the receipt of a

capital interest by a partner is a taxable event. Courts made the negative implication that the receipt of a profits interest was not taxable.

b. Diamond v. Commissioner. Kargman entered into a K to purchase an office building. Diamond agreed to arrange a mortgage loan to acquire the building; in exchange she was entitled to 60% of profits/losses. Diamond sold the p’ship interest to a 3d party, trying to recognize a short-term gain. HELD: the receipt of a profits interest is a taxable event. The profits interest here was easily valued and were exchanged for past services.

i. Double Taxation. This causes the holder of a profits interest to be taxed on receipt of the interest and then taxed again when the income is actually earned.

2. Revenue Procedure 93-27a. General Rule. If a person receives a profits interest for the provision

of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will not treat the receipt of such an interest as a taxable event for the partner or the partnership. Rev. Proc. 93-27 § 4.01.

b. Exceptions. This revenue procedure does not apply:i. (1) If the profits interest relates to a substantially certain and

predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease;

ii. (2) If within two years of receipt, the partner disposes of the profits interest; or

iii. (3) If the profits interest is a limited partnership interest in a “publicly traded partnership” within the meaning of section 7704(b) of the I.R.C. Rev. Proc. 93-27 § 4.02.

3. Revenue Procedure 2001-43a. Requirements

i. Treat Service Provider as Owner. The partnership and the service provider must treat the service provider as the owner of the interest from the date of its grant, and the service provider must take into account the distributive share of all items associated with the interest for the entire period during which the service provider has the interest.

ii. No Deduction. Neither the partnership nor any partner may deduct any amount for the FMV of the interest either upon the grant of the interest or when it becomes substantially vested

iii. Rev. Proc. 93-27 Satisfied. All the other requirements of Rev. Proc. 93-27 must be satisfied.

b. Effecti. Determination of Profits Interest. The determination of

whether an interest granted to a service provider is a profits

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interest is tested at the tiem the interest is granted, even if that interest is not substantially vested under § 83.

ii. Non-Taxable Events. The IRS will not treat the grant of a nontaxable profits interest, or the event that causes the interest to be substantially vested under § 83, as a taxable event.

iii. Section 83(b) Election Not Needed. Thus, a § 83(b) election would not be needed if such a partnership interest were not substantially vested at the time it was granted.

4. Problem 1 (p. 73). The AB partnership is a law firm. C, an associate in the firm, is offered a one-third partnership interest in the future profits of the partnership. C is not required to make any capital contribution. Is C taxable upon his admission to the partnership?

a. C is probably not taxable under Rev. Proc. 93-27 § 4.01. He’s providing services in anticipation of being a partner. He doesn’t meet the exceptions as long as he doesn’t transfer his interest w/in 2 yrs.

5. Problem 2 (p. 74). C, an experienced real estate manager, receives a nonforfeitable one-tenth profits interest in the AB general partnership, whose sole asset is a commercial building with a value of $1,000,000 in return for his agreement to render management services in his capacity as a partner. Net rentals from the building recently have been averaging $100,000 per year. C has been asked to manage the building in the hope that his expertise will increase the rental income and ultimately lead to a profitable sale of the property.

a. (a) What are the tax consequences to C upon receipt of the profits interest?

i. C may be taxed1. The steady net rentals may be a “substantially

certain and predictable stream of income” under Rev. Proc. 93-27 § 4.02(1).

2. C would then have GI under § 83 in the amount of the FMV of property (less what he paid—0)

3. P’ship would have a deductionii. Arg that C is not taxed

1. Net rentals depend on the level of services (not predictable stream of income)

2. High-quality debt securities and high-quality net leases provide passive income.

b. (e) What result to C and to the partnership in (a), above, if C’s profits interest was subject to forfeiture until C rendered services for the partnership for a period of five years?

i. Rev. Proc. 2001-43: Rev. Proc. 93-27 still applies (C not taxed)ii. Proposed Regulations

1. Supersede Current Law. The treasury issued proposed regulations addressing a partner’s receipt of a partnership interest (both capital and profits interests) for services. When these regulations become final, they will supersede Rev. Proc. 93-27 and Rev. Proc. 2001-43.

2. Problem 2 (p. 74). C, an experienced real estate manager, receives a nonforfeitable one-tenth profits interest in the AB general partnership, whose sole asset is a commercial building with a value of $1,000,000 in return for his agreement to render management services in his capacity as a partner. Net rentals from the building recently have been averaging $100,000 per year. C has been asked to manage the building in the hope that his expertise will

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increase the rental income and ultimately lead to a profitable sale of the property.

a. (a) What are the tax consequences to C upon receipt of the profits interest?

i. Prop. Reg. § 1.721-1(b)(1): p’ship interest = property for §83ii. § 83(a): partner taxed on FMV prop. received – amount paid

iii. Prop. Regs.: p’ship may elect to use liquidation value1. Liquidation value: how much would partner get

p’ship sold its assets and liquidated?2. C would get nothing b/c she has no capital interest

iv. If p’ship d/n elect liquidation value, use current value of future profits

b. (e) What result to C and to the partnership in (a), above, if C’s profits interest was subject to forfeiture until C rendered services for the partnership for a period of five years?

i. § 83(a): C has income in the amount of FMV – amount paid (0)

ii. Suppose C d/n make an §83(b) election1. §83(a): to not have income currently, has to be

subject to subst. risk of forfeiture and nontransferable

a. §83(c)(1): rights to full enjoyment of property conditioned on future performance of subst. services

b. Assume, non transferable (rights of transferee subject to restrictions)

c. C will have GI when interest vestsiii. Proposed Regs: unless service provider makes § 83(b)

election w/in 30 days, C is not a partner1. Note: different than 2001-43 (d/n worry about

§83(b) election)iv. 5 Years Later

1. Interest vests2. §83(a): C subject to FMV prop – what he paid3. FMV: liquidation if p’ship makes election

IV. Organization and Syndication Expensesa. General Rule. Except as provided in subsection (b), no deduction is allowed for amounts paid to

organize a partnership, or amounts paid to promote the sale of a partnership interest (“syndication expenses”). § 709(a).

i. Syndication Expenses Examples1. Fees paid to a broker to sell partnership interests2. Fees paid to the SEC to register a publicly traded limited partnership

b. Exception. The partnership can elect to deduct in the year it begins business the lesser of: (i) the amount of organizational expenses of the partnership, or (ii) $5,000, reduced by the amount by which the organizational expenses exceed $50,000. § 709(b)(1)(A).

i. Example 1. Limited partnership spends $1,000 as a filing fee to the Secretary of State. The partnership can deduct all $1,000 (b/c it’s the lesser of organizational expenses or $5k).

ii. Example 2. Limited partnership spends $6,000 as a filing fee to the Secretary of State. The partnership can deduct only $5,000 currently. The remaining $1,000 must be amortized over 180 months.

iii. Example 3. Limited partnership spends $53,000 as a filing fee with Secretary of State and to have attorney draft the limited partnership agreement. The partnership can

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deduct only $2,000 currently. The remaining $51,000 must be amortized over 180 months.

c. No Exception for Syndication Expenses. Note there is no exception for syndication expenses (i.e., a p’ship cannot deduct and amortize syndication expenses under § 709(b)). Thus, syndication expenses are subject to the general rule of § 709(a): no deduction.

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PART 3: OPERATIONS OF A PARTNERSHIP: GENERAL RULES

I. Tax Consequences to the Partnership: Aggregate and Entity Principlesa. The Partnership as an Entity

i. Determining and Reporting Income. The Code treats a partnership as an entity for purposes of determining and reporting taxable income.

1. Determining Income. The partnership must determine its taxable income. See § 703(a).

a. A partnership generally determines its taxable income in the same manner as an individual, with certain exceptions. See § 703(a).

b. Each partner must take into account his or her distributive share of partnership taxable income, whether the income is distributed or not. See § 702(a).

2. Reporting Income. A partnership must report its taxable income by filing an informational tax return (Form 1065). See § 6031(a).

a. The return generally is due by the 15th day of the 4th month following the close of the partnership’s taxable year. Reg. § 1.6031-1(e)(2).

ii. Treatment as Entity. To determine partnership taxable income, the partnership is treated as a separate entity as follows:

1. Elections. The partnership generally must make all elections. See § 703(b). E.g., elections to use method of accounting and method of determining depreciation.

a. Demirjian v. Commissioner. P’ship was forced to sell an office building; money was distributed to the partners. Partners individually elected under § 1033 (nonrecognition) to reinvest the proceeds in similar property. HELD: p’ship is taxable b/c all computations that affect taxable income must be made by the p’ship, not individually.

2. Character. Character of tax items is determined at the partnership level. See § 702(b).

a. Example. Suppose p’ship holds land as investment (capital asset), and a partner is a dealer in land (i.e., land would be inventory in his hands). If p’ship sells the land, the type of gain is capital gain.

b. Exception. Under Section § 724, if certain types of property (receivables, inventory and capital loss property) are contributed to a p’ship by a partner, that property retains the character it had in the partner’s hands.

3. Holding Period. Holding period is determined at the partnership level. See Rev. Rul. 68-79.

a. Example. Suppose a p’ship held corporate stock (capital asset) for more than 1 yr. Suppose the partner purchased the p’ship interest 3 mo. ago. P’ship sells the stock. The gain from sale is LTCG.

4. Unified Audit Procedures. IRS audits of “TEFRA partnerships” are done at the p’ship level. See §§ 6221–34.

a. Note: “TEFRA partnerships” generally have ≥ 10 partners.5. Taxable Year. A p’ship must select its own taxable year. See § 706(b)(1)(A).

b. The Taxable Yeari. Partnership Treated as Taxpayer. The taxable year of a partnership shall be determined

as though the partnership were a taxpayer. § 706(b)(1)(A).ii. Required Taxable Year. The p’ship must use the required taxable year. Determine if

the p’ship has any of the following taxable years. See § 706(b)(1)(B).1. Majority Interest Taxable Year. The taxable year shall be the taxable year (if

any) which, on each testing day, constituted the taxable year of 1 or more

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partners having (on such day) an aggregate interest in partnership profits and capital of more than 50 percent. See §§ 706(b)(1)(B)(i), 706(b)(4)(a)(i).

a. Further Change Not Required for 3 Years. If the majority interest taxable year changes, the partnership will not be required to change to another taxable year for either of the 2 taxable years following the year of the change. See § 706(b)(4)(B).

2. Principal Partners’ Taxable Year. If there’s no majority interest taxable year, the p’ship’s taxable year will be the taxable year of all of the principal partners of the partnership (i.e., all partners who owns at least a 5% interest). See §§ 706(b)(1)(B)(ii), 706(b)(3).

3. Least Aggregate Deferral. If there’s no majority interest taxable year or principal partners’ taxable year, the taxable year is the one that produces the least aggregate deferral of income. Reg. § 1.706-1(b)(2)(C). The taxable year is the taxable year of one of the partners which results in the least aggregate deferral. Reg. §1.706-1(b)(3). The aggregate deferral for a particular year is equal to the sum of the products determined by multiplying the month(s) of deferral for each partner that would be generated by that year and each partner’s interest in partnership profits for that year. Id. The p’ship gets its pick if there’s more than one qualifying taxable year. Id. See I.b.v. Problem (p. 103), part (g), infra.

iii. Business Purpose. A p’ship may use a taxable year different from the required taxable year if it establishes a business purpose. Any deferral of income to partners is not a business purpose. § 706(b)(1)(C).

1. Natural Business Year. A natural business year exists if 25% or more of the partnership’s gross receipts for the selected year are earned in the last two months. The test must be satisfied in each of the preceding three 12-month periods that correspond to the requested fiscal year. Rev. Proc. 2006-46.

2. Facts and Circumstances Test. Taxpayer convenience is insufficient to satisfy the business purpose requirement. Rev. Rul. 85-57.

a. Example. The [partnership] desires to use a tax year ending September 30 . . . to issue timely tax information . . . to its owners to facilitate the filing of timely returns by its owners. . . . [This reason is one] of convenience to the taxpayer [and is] insufficient to establish that the business purpose requirement for a requested tax year has been met.” Rev. Rul. 85-57.

iv. Section 444 Election. A partnership may elect to have a taxable year other than the required taxable year. § 444(a).

1. Deferral Period ≤ 3 Months. The deferral period of the taxable year cannot be more than 3 months. See § 444(b)(2).

a. Deferral Period. “Deferral period” means the months between (A) the beginning of the new taxable year, and (B) the close of the 1st required taxable year ending within such year. § 444(b)(4).

i. Example. If the required taxable year is the calendar year, then the p’ship could elect Sept. 30, Oct. 31, or Nov. 30.

2. Required Payments. Partnerships making the § 444 election are subject to required payments to the gov’t under § 7519. Congress is attempting to require an electing partnership to pay (and in effect keep “on deposit”) an amount of tax roughly approximating the tax that the partners would have paid on their income for any deferral period if a § 444 election had not been made.

v. Problem (p. 103). What taxable year must Partnership adopt under § 706(b) in each of the following alternatives? Unless stated to the contrary, assume Partnership is a newly formed partnership.

1. (a) All partners of Partnership are calendar year taxpayers.

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a. P’ship would use the calendar yearb. § 706(b)(1)(B)(i),706(b)(1)(4)(B) : majority interest taxable year is

calendar year (b/c 100% aggregate interest uses calendar year).2. If partners believe that the partnership will have substantial income and they

are free to choose, what taxable year should they select for the partnership?a. P’ship would choose January 31. The 2008 tax return would include

p’ship items for the period Feb. 1, 2007–Jan. 31, 2008. In effect, it’s an interest free loan on tax liability.

3. What if they expect the partnership to have substantial losses?a. P’ship would choose December 31. The partners would be able to use

all losses accumulated that year.4. (b) Partnership has a 20% corporate general partner which uses a July 31 fiscal

year and 20 individual 4% limited partners all of whom are on a calendar year?a. P’ship would use the calendar yearb. § 706(b)(1)(B)(i),706(b)(1)(4)(B) : majority interest taxable year is

calendar yeari. 20 partners * 4% = 80% aggregate interest uses calendar year

5. (c) What result in (b), above, if, on the first day of year four, 10 of the limited partners sell their interests to the corporate general partner?

a. P’ship would use July 31 fiscal yearb. § 706(b)(1)(B)(i),706(b)(1)(4)(B) : majority interest taxable year is July

31 fiscal yeari. 20% original interest + [10 * 4%] = 60% interest uses July 31

fiscal year6. (d) What result in (b), above, if 10 of the limited partners use a September 30

fiscal year and the other 10 use a calendar year?a. P’ship would use July 31 fiscal yearb. § 706(b)(1)(B)(i),706(b)(1)(4)(B): no majority interest taxable yearc. § 706(b)(1)(B)(ii), 706(b)(3): taxable year of all of the principal

partners of the partnership (i.e., all partners who owns at least a 5% interest)

i. Corp. general partner is only principal partner; uses July 31 fiscal year

7. (e) What result in (b), above, if Partnership wants to adopt a September 30 fiscal year under § 706(b) in order to have sufficient time to gather tax information for its calendar year partners? May Partnership adopt a September 30 fiscal year in some other manner? If so, with what cost?

a. Under part (b), the p’ship is req’d to use the majority interest taxable year as its required taxable year.

b. Rev. Rul. 85-57: the reason for using the different taxable year is one of convenience, not a business purpose.

c. P’ship could elect under § 444 to choose a Sept. 30 fiscal year if it makes pmts to the gov’t under § 7519.

i. § 444(b)(2): deferral period must be ≤ 3 monthsii. § 444(b)(4): Oct. 1–Dec. 31 = 3 months

8. (f) What result in (b), above, if over the prior five years Partnership has been in the retail business and does 20% of its annual business in December and 10% of its business in January in post-Christmas sales. Partnership has been using a calendar year. It wishes to change to a January 31 fiscal year. May it do so? If so, is a § 444 election and a § 7519 “required payment” necessary?

a. P’ship could establish a natural business year under the business purpose exception.

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i. Rev. Proc. 2006-46: here, 30% of gross receipts are earned in the last 2 months

b. P’ship doesn’t have to make a § 444 election. Section 444 was designed when p’ship cannot establish a business purpose.

9. (g) What result if Partnership has two partners, A and B, each of whom has a 50 percent interest in partnership profits, if A uses a fiscal year ending June 30 and B uses a fiscal year ending July 31?

a. § 706(b)(1)(B)(i),706(b)(1)(4)(B): no majority interest taxable yearb. § 706(b)(1)(B)(ii), 706(b)(3): no taxable year of all of the principal

partners of the partnershipc. Least Aggregate Deferral–6/30

Assuming the adoption of AB’s June 30 fiscal year:

PartnerTaxable

YearProfits

InterestMonths of Deferral

Interest X Deferral

A 6/30 50% 0 0B 7/31 50% 1 0.5

Aggregate Deferral 0.5d. Least Aggregate Deferral–7/31

Assuming the adoption of AB’s July 31 fiscal year:

PartnerTaxable

YearProfits

InterestMonths of Deferral

Interest X Deferral

A 6/30 50% 11 5.5B 7/31 50% 0 0

Aggregate Deferral 5.5e. P’ship will have June 30 taxable year

II. Tax Consequences to the Partnersa. General Rules

i. Partnership Return. A p’ship must file an informational return. See § 6031(a). This return is due by the 15th day of the 4th month after the close of the p’ship’s taxable year. Reg. § 1.60031-1(e)(2).

1. Copies to Partners. The p’ship also informs the partners of its tax items on a Form K1. See § 6031(b).

ii. Partner’s Return1. Included Partnership Items. P’ship items for the p’ship’s taxable year that

ends w/in the partner’s taxable year are included in the partner’s taxable income. § 706(a).

2. Character Determined at Partnership Level. Character of p’ship items included in a partner’s distributive share under § 702(a)(1)–(7) is determined at the p’ship level. See § 702(b).

3. Gross Income. Partner’s GI includes his distributive share of p’ship GI (+ distributive share of separately stated items). See § 702(c).

iii. Partnership Taxable Income. P’ship taxable income is computed in the same manner as an individual except (1) items described in §702(a) are separately stated, and (2) a p’ship cannot take certain deductions. See § 703(a).

1. Policy for § 703(a)(1). The items in § 702(a) are separately stated b/c they may affect partners’ tax liability differently, depending on their tax profiles. When the partner sees this separately stated item on Form K1, she will combine that item with other sources of that income to determine the overall tax effect.

2. Policy for § 703(a)(2). Some of the deductions are for individuals only. Many of the deductions listed are subject to limitations. The limitations should apply at the individual partner level.

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3. Computing Taxable Income. Generally, taxable income = gross income – deductions. § 63(a).

iv. Categorizing Tax Items. A p’ship’s tax items will fall into one of three categories: Combined (a.k.a. “Bottom Line”) Items, Separately Stated Items, or Other Items.

1. Separately Stated Items. Per §703(a)(1), the following items are separately stated:

a. § 702(a)(1)–(6)i. STCG and STCL. Gains/losses from sales/exchanges of capital

assets held for not more than 1 year. § 702(a)(1).ii. LTCG and LTCL. Gains/losses from sales/exchanges of capital

assets held for more than 1 year. § 702(a)(1).1. NLTCG/L. Partners take into account their

distributive share of net LTCG and LTCL of the p’ship. Reg. § 1.702-1(a)(2).

iii. § 1231 Gain/Loss. Gains/losses from sales/exchanges of § 1231 property. § 702(a)(3).

iv. Charitable Contributions. § 702(a)(4).v. Qualified Dividends. § 702(a)(5).

b. § 702(a)(7). Other items provided by the Regs:i. More Separately Stated Items. Reg. 1.702-1(a)(8)(i) lists

additional items to be separately stated.ii. Broad “Catch-all.” A p’ship must separately state any item

which, if separately taken into account by a partner, would result in an income tax liability for that partner, or for any other person, different from that which would result if that partner did not take the item into account separately. Reg. 1.702-1(a)(8)(ii).

1. Investment Interest. B/c deductions for investment interest is limited to the amount of net investment income, this is separately stated under Reg. § 1.702-1(a)(8)(ii). See § 163(d)(1).

2. Combined (“Bottom Line”) Items. A p’ship must separately state taxable income or loss, exclusive of the separately stated items in §702(a)(1)–(7). § 702(a)(8).

a. Examples. Gross receipts from inventory sales and COGS (think AR and AB of inventory); § 1245 gain.

3. Other Items. “Other Items” include charitable contributions and tax-exempt interest.

v. Adjusting Outside Basis1. Policy. To ensure a single level of tax, partners’ outside basis in p’ship interests

are adjusted for income/loss. This makes outside basis conform to FMV.2. STEP ONE: Make Increases to Basis. Reg. § 1.704-1(d)(2). Outside basis is

increased by a partner’s distributive share of partnership income and tax-exempt income. § 705(a)(1)(A), (B).

3. Make Decreases to Basis. Reg. § 1.704-1(d)(2). Outside basis in decreased by p’ship distributions and a partner’s distributive share of p’ship losses and nondeductible p’ship expenditures not chargeable to the capital account.

a. STEP TWO: Decrease Basis by Distributions. See Reg. § 1.703-1(d)(2) (silent as to the order of basis decreases except that losses are taken last); Reg. § 1.1367-1(f) (providing that among basis decreases in subchapter S corp stock, distributions are taken first).

b. STEP THREE: Decrease Basis by Noncapital Nondeductible Expenses. See Reg. § 1.703-1(d)(2) (silent as to the order of basis decreases

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except that losses are taken last); Reg. 1.1367-1(f) (providing that among basis decreases in subchapter S corp stock, noncapital nondeductible expenses are taken second).

c. STEP FOUR: Decrease Basis by Losses. Reg. 1.703-1(d)(2).i. § 702(a) Deductible Items. Note “losses” refers to items

listed in § 702(a) that are deduction items. This includes:1. STCL. § 702(a)(1).2. LTCL. § 702(a)(2).3. § 1231 losses. § 702(a)(3).4. Other items of loss. § 702(a)(7).5. Taxable items not separately stated. § 702(a)(8).

vi. Problem (pp. 106–07). A and B, both calendar year noncorporate taxpayers, are equal partners in the AB Partnership, which had the following income and expenses during its (business purpose) taxable year that ended on July 31 of the current year:

Gross receipts from inventory sales $100,000Cost of goods sold 30,000Salaries paid to nonpartners 10,000Depreciation 12,000Advertising expenses 8,000Interest expense paid on investment margin account maintained by AB (see § 163(d)) 6,000Gain from the sale of machine held for two years:

§ 1245 gain 8,000§ 1231 gain 2,000

Dividends 7,000Charitable contributions 800Tax-exempt interest 500STCG on a sale of stock 6,000LTCG on a sale of stock held for two years 4,000LTCL on a sale of stock held for two years 2,000§1231 gain on casualty to machine held for two years 1,000

1. (a) How and when will AB, A and B report the income and who will be liable for the taxes?

a. What and when will AB, A and B file with the IRS?i. § 6031: p’ship files an informational return and informs

partners of their shares of p’ship tax itemsii. § 706(a): partners’ taxable income includes p’ship items

for the p’ship taxable year that ends w/in the partner’s taxable year

Combined Items. § 702(a)(8).Income Deductions

Gross receipts (inventory)

100k Salaries 10k

COGS (30k) Depreciation 12k§ 1245 gain 8k Advertising 8k

78k 30k48k Combined Net Income

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Separately Stated ItemsIncome Deductions

§ 1231 gain 2k Investment Interest

6k

Dividends 7kSTCG 6kNet LTCG 2k§ 1231 gain on machine casualty

1k

18k

Other ItemsCharitable Contributions 800Tax-Exempt Interest 500

b. AB’s taxable income is $48k combined income and the listed separately stated items.

c. § 702(c): A and B would include their distributive share of $78k + distributive share of separately stated items.

2. (b) Assume this is the first year of partnership operations, A’s basis in his partnership interest is $70,000 and B’s basis in her partnership interest is $40,000. What will be the tax consequences of AB’s first year of operations to A and B?

a. STEP ONE: Increases to Basisi. 24k bottom line income. § 705(a)(1)(A).

ii. 9k separately stated income. § 705(a)(1)(A).iii. 250 tax exempt income. § 705(a)(1)(B).

b. STEP TWO: Decrease Basis by Distributionsi. 400 charitable contribution. § 705(a)(2)(B).

c. STEP THREE: Decrease Basis by Losses (incl. § 702(a) deductible items)i. 3k separately stated deductions (investment interest).

§ 705(a)(2)(A).A B

Initial Basis 70k 40kBottom line income 24k 24kSeparately Stated income 9k 9kTax exempt income 250 250Charitable contribution (400) (400)Investment interest (3k) (3k)Ending outside basis 99,850 69,850

3. (c) What would be the result in (b), above, if the partnership distributed $20,000 in cash to each partner at the end of the year?

A BInitial Basis 70k 40kBottom line income 24k 24kSeparately Stated income 9k 9kTax exempt income 250 250Distribution (20k) (20k)Charitable contribution (400) (400)Investment interest (3k) (3k)Ending outside basis 79,850 49,850

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4. (d) Would it matter if the §1231 gain on the sale of the machine would have been ordinary income if A had sold it individually?

a. No, character is determined at the p’ship level. § 702(b).b. Electing Large Partnerships

i. Effect of ELP Election. If a p’ship is an ELP, most limitations that effect the computation of income apply at the p’ship level. See § 773(a)(3). E.g., an ELP can deduct charitable contributions, and applies limitations at the p’ship level.

ii. ≥100 partners. P’ships with ≥100 members may elect to have ELP rules apply.iii. No Service Partnerships. Service p’ships cannot take advantage of ELP rules. § 775(b).

III. Limitations on Partnership Lossesa. Basis Limitations

i. Policy: Only Deduct Losses on Previously Taxed Investment. The partnership loss limitations attempt to allow T only to deduct losses to the extent that T has basis in those losses. Essentially they are specific applications of § 165(b) (basis for determining the amount of a deduction for any loss is the AB of property).

ii. Loss Limitation. A partner’s distributive share of partnership loss is allowed to the extent of a partner’s outside basis at the end of the p’ship year in which such loss occurred. § 704(d).

1. Excess Carried Forward. Any excess of losses over outside basis are carried forward and allowed as a deduction when the partner has sufficient basis. See § 704(d).

iii. Allocate Basis to Distributive Share of Losses. If a partner’s distributive share of aggregate items of loss exceed outside basis, the limitation on loss must be allocated to his distributive share of each such loss. Allocate basis by the proportion that each loss bears to the total losses. See Reg. §1.704-1(d)(2), III.a.v. Problem (p. 110), part (d), infra.

iv. Transfer of Suspended Loss1. Terminates on Sale. If a partner sells his partnership interest, the seller’s

previously deferred losses will disappear and do not carry over to the buyer. Sennett v. Commissioner.

2. Gift: Unclear. Where a partner gives his partnership interest to a 3d party, it is unclear if the suspended loss transfers. See III.a.v. Problem (p. 110), part (e), infra.

v. Problem (p. 110). C and D are partners who share income and losses equally. C has an outside basis of $5,000 in his partnership interest and D has an outside basis of $15,000 in his partnership interest.

1. (a) During the current year the partnership has gross income of $40,000 and expenses of $60,000. What are the tax results to C and D?

a. $20k loss = $10k distributive share of loss per partnerb. § 704(d): distributive share of loss allowed is allowed to the extent of

outside basis; any excess of loss over basis is carried forward to deduct when there’s sufficient basis

i. C takes $5k deduction; $5k carried forwardii. D can deduct $10k

c. § 705(a)(2)(A): outside basis is decreased by losses of p’shipi. C’s basis decreased to zero

ii. D’s basis decreased to $5kiii. Note: these losses are considered last in the order of

increases/decreases to outside basis2. (b) What are the results to C and D in the succeeding year when the

partnership has $20,000 of net profits?a. $20k net profits = $10k eachb. § 705(a)(1): outside basis increased by distributive share of p’ship

income

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i. C’s basis increased from 0 to $10kii. D’s basis increased from $5k to $15k

c. § 704(d): C’s $5k loss carry over is allowed as a deductiond. § 705(a)(2)(A): outside basis decreased by losses of p’ship

i. C’s basis decreased from $10k to $5k3. (c) How might C have alleviated his problem in the first year?

a. C could have contributed $5k cash or property w/ AB of $5ki. § 722: contributions of money/property increase basis

b. Not clear whether C could write a p/notei. Parachi v. U.S. (in corporate context): promising to pay corp.

increases basisii. But §722 says basis = money + property contributed, and a

p/note has a zero basisc. Partnership could borrow money

i. § 752: an increase in partner’s share of p’ship liabilities is treated as a cash contribution to p’ship

ii. But, if there no business purpose for borrowing, the IRS may disallow a basis increase and deduction

4. (d) What result in (a), above, if the net $20,000 loss consists of $15,000 of ordinary loss and $5,000 of long-term capital loss?

a. Partnership Taxable Incomei. § 703: calculated like individual, except §702(a) items are

separately statedii. § 702(a)(8): $7.5k distributive share of ordinary loss

iii. § 702(a)(2): $2.5k distributive share of LTCL (separately stated)

b. Allocate C’s $5k Basisi. $5k basis * [$7.5k ordinary loss/$10k total loss] = $3,750

ordinary loss deductibleii. $5k basis * [$2.5k LTCL/$10k total loss] = $1,250 LTCL

deductible5. (e) What result to S, C’s son, in (a), above, if C gives his interest in the

partnership to S on the first day of a year in which the partnership has profits of $20,000?

a. If C sells the p’ship interest to a 3d party:i. Sennett v. Comm’r: the suspended loss terminates

ii. C effectively benefits from the suspended loss by not having to reduce his basis to negative $5k

b. If C gives the p’ship interest to S:i. Arg to Shift the Loss

1. If we don’t allow S to deduct the suspended loss; nobody will realize it

2. There will be a permanent disconnect btwn inside and outside basis

ii. Arg to Not Shift the Loss1. § 1015 generally permits the shifting of gains, but

not lossesb. At-Risk Limitations

i. Policy. After Crane v. Commissioner, promoters marketed tax shelters so that investors would be limited partners of p’ships that took on a lot of NR debt to buy depreciable assets. The resulting losses would flow through to the partners to offset income from other sources. In response, Congress added the at-risk limitations to losses in § 465.

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ii. General Rule. For individuals engaged in an activity to which this section applies, any loss from such activity for the taxable year shall be allowed only to the extent of the aggregate amount with respect to which the taxpayer is at risk for such activity at the close of the taxable year. § 465(a)(1).

1. Carry Forward Extra Losses. Excess (not allowed) losses are treated as a deduction allocable to such activity in the next taxable year (if the partner has a sufficient amount at risk). § 465(a)(2).

2. Adjustments to Amount At Risk. Similar to the effect of losses and gains on outside basis, a partner’s amount at risk will increase to the extent of income and cash contributions, and will decrease to the extent of losses allowed.

iii. Activities to Which § 465 Applies1. Enumerated List. Section 465 applies to a taxpayer engaged in the activity of:

a. (A) holding, producing, or distributing motion picture films or video tapes,

b. (B) farming,c. (C) leasing any section 1245 property,d. (D) exploring for, or exploiting, oil and gas resources, ore. (E) exploring for, or exploiting geothermal deposits. §465(c)(1).

2. Carrying on a Trade or Business or for the Production of Income. Section 465 applies to each activity engaged in by T in carrying on a trade or business or for the production of income. § 465(c)(3)(A).

iv. Amount At Risk1. General Rule. T is at risk for an activity w/ respect to amounts including—

a. (A) amounts of money and AB of property contributed by T to the activity, and

b. (B) borrowed with respect to such activity. § 465(b)(1).2. Borrowed Amounts. T is at risk for amounts borrowed for use in an activity to

the extent he–a. (A) is personally liable for repayment, orb. (B) has pledged property, other than property used in such activity, as

security for such borrowed amount (to the extent of net FMV). § 465(b)(2).

3. Qualified Nonrecourse Financinga. General Rule. T is at risk for T’s share of qualified nonrecourse

financing which is secured by real property. § 465(b)(6)(A).b. Defined. Qualified nonrecourse financing means financing–

i. (i) borrowed by T w/ respect to the activity of holding real property,

ii. (ii) borrowed by T from a “qualified person” or gov’t,iii. (iii) if no person is personally liable for re-pmt, andiv. (iv) that’s not convertible. § 465(b)(6)(B).

c. Qualified Person. A “qualified person” is a person in the business of lending money which is not–

i. (I) a related person w/ respect to T,ii. (II) a person from which T acq’d the property (or a related

person to such person),iii. (III) a person who receives a fee w/ respect to T’s investment

in the property (or a related person to such person). § 49(a)(1)(D)(iv); see § 465(b)(6)(D)(i).

d. Related Person with Respect to Ti. Related Person. “Related person” includes brothers, sisters,

spouse, ancestors and lineal descendants. §§ 49(a)(1)(D)(v), 465(b)(3)(C)(i), 267(b)(1), (c)(4).

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ii. Exception: Commercially Reasonable Loan. Section 49(a)(1)(D)(iv)(I) doesn’t apply if the financing is commercially reasonable and on substantially the same terms as loans involving unrelated persons. § 465(b)(6)(D)(ii).

v. Problem 1 (p. 114). LP is a limited partner in a newly formed partnership which is engaged in the following activities:

1. (i) A research and development activity to which LP contributed $10,000 cash; LP’s share of partnership nonrecourse liability attributable to this activity is $10,000. LP’s share of loss from the research and development activity is $12,000 for the current year.

2. (ii) A motion picture production activity to which LP contributed $20,000 cash; LP’s share of income from this activity for the current year is $25,000.

3. LP’s outside basis at the beginning of the year was $40,000, and his share of net gain for the year was $13,000. What are the tax consequences to LP under § 465?

4. R&D Activitya. Activity to which §465 Applies

i. § 465(c)(3)(A): section 465 applies to all activities engaged in by T in carrying on a trade/business or for the production of income

b. Amount At Riski. § 465(b)(1)(A): money + AB property contributed by T to the

activity1. $10k cash contributed

ii. § 465(b)(1)(B): amounts borrowed1. § 465(b)(2): if personally liable or pledged property

other than property used in such activity as security2. Here, LP has no personal liability on NR debt

iii. Amount At Risk = $10kc. Deduction

i. LP can only deduct $10k of the $12k lossii. § 465(a)(2): extra $2k carries forward

d. BasisOriginal Basis $40k+ Share of Income $25k–Share of Loss ($12k)Outside Basis $53k

e. Reduce Amount At Riski. Amount at risk decreases from $10k to zero

5. Motion Picture Activitya. § 465 limits losses, not gainsb. §465(b)(1): LP’s amount at risk = $20kc. $25k share of income increases that amount to $45k

vi. Problem 2 (pp. 114–15). The ABC equal limited partnership (in which A is a general partner and B and C are limited partners) purchased an apartment building for $540,000, paying $90,000 cash (contributed equally by the partners to the partnership) and financing the balance with a $450,000 nonrecourse loan secured by the building. Assume that A, B and C are all unrelated and that the partnership holds no other assets. To what extent are each of the partners at risk if the loan is:

1. (a) From a commercial bank in which none of the parties owns an interest.a. § 465(b)(6)(A): T is at risk w/ respect to qualified nonrecourse

financing secured by real property

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b. § 465(b)(6)(B): “qualified nonrecourse financing” means financing–i. (i) borrowed by T w/ respect to the activity of holding real

property,ii. (ii) borrowed by T from a “qualified person” or gov’t,

iii. (iii) no person is personally liable for re-pmt, andiv. (iv) not convertible.

c. §§ 49(a)(1)(D)(iv); 465(b)(6)(D)(i): “qualified person” is a person in the business of lending money which is not–

i. (I) a related person w/ respect to T,ii. (II) a person from which T acq’d the property,

iii. (III) a person who receives a fee w/ respect to T’s investment in the property.

d. Here, the loan meets the § 465(b)(6)(B) req’s; commercial lender is a “qualified person” under §49(a)(1)(D)(iv).

e. Amount At Risk = $180ki. § 465(b)(1): $90k/3 = $30k contribution of money

ii. § 465(b)(6)(A): $450k/3 = $150k share of liability2. (b) From the seller of the apartment complex.

a. § 49(a)(1)(D)(iv)(II): seller is not “qualified person”b. NR loan is not qualified nonrecourse financingc. Partners are not at-risk for the NR loand. § 465(a)(1), (2): loss not allowed; carried forwarde. Amount At Risk = $30k each (money contributed)

3. (c) From B’s brother, who is in the money lending business and makes the loan at a rate of interest 25% below comparable rates charged to unrelated borrowers.

a. § 49(a)(1)(D)(iv)((I): “qualified person” is in the bus. of lending money and not a related person to w/ respect to T

b. §§ 49(a)(1)(D)(v), 465(b)(3)(C)(i), 267(b)(1), (c)(4): “related person” includes brothers, sisters, spouse, ancestors and lineal descendants.

c. Here, B’s brother is a related person w/ respect to Bd. § 465(b)(6)(D)(ii): Section 49(a)(1)(D)(iv)(I) doesn’t apply if the

financing is commercially reasonable and on substantially the same terms as loans involving unrelated persons

e. Here, the loan was made at an interest rate that’s 25% below comparable rates

f. B’s brother is not a qualified person w/ respect to Bi. B’s amount at risk = $30k

g. A and C may argue that “related person w/ respect to T” should be read to mean a person related to Partner A and C

i. Answer is not clearii. Even if B’s brother loans the money at this interest rate, it

may be qualified nonrecourse financing to A and C4. (d) The same as (c), above, except the loan is at regular commercial rates of

interest.a. Here, the exception in § 465(b)(6)(D)(ii) appliesb. The loan is qualified nonrecourse financing

c. Passive Loss Limitationsi. Section 469 Policy. Section 469 attempts to cut off passive investors’ ability to take tax

benefits from activity in a partnership and use them to shelter income from other activities.

ii. Taxpayers Subject to §469. Section 469 passive loss limitations apply to, inter alia, individuals (e.g., partners). See § 469(a)(2).

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iii. General Rule. Passive activity loss is not allowed. § 469(a)(1)(A).1. Disallowed Losses: Carry Forward. Disallowed losses are carried forward the

next year and deducted to the extent there’s passive activity income. See § 469(b).

2. Dispositions of Entire Interest in Passive Activity. If a partner disposes of his entire interest or if the p’ship disposes of the passive activity, disallowed losses may be deducted in full. § 469(g)(1)(A).

iv. Passive Activity Loss. “Passive activity loss” means the amount by which the aggregate losses from all passive activities for the taxable year, exceed the aggregate income from all passive activities. § 469(d).

1. Passive Activity. “Passive activity” means any activity–a. (A) which involves the conduct of any trade or business, andb. (B) in which the taxpayer does not materially participate. § 469(c)(1).

2. Material Participation. T “materially participates” in an activity if:a. > 500 Hours. T participates in the activity for more than 500 hours

during such year. Temp. Reg. § 1.469-5T(a)(1).b. Substantially All Participation. T’s participation in the activity for the

taxable year constitutes substantially all of the participation in such activity of all individuals (including non-owners) for such year. Temp. Reg. § 1.469-5T(a)(2).

c. More Participation than Others + 100 Hours. T participates for more than 100 hours during the taxable year, and such participation is not less than the participation of others (including non-owners). Temp. Reg. § 1.469-5T(a)(3).

d. Significant Participation Activity + Aggregate 500 Hours. The activity is a significant participation activity for the taxable year and T’s aggregate participation in all significant participation activities > 500 hours. Temp. Reg. § 1.469-5T(a)(4).

i. Significant Participation Activity. A “significant participation activity” is one:

1. (i) that is a trade/business in which T significantly participates, and

2. (ii) where T does not “materially participate” under the other tests. See Temp. Reg. § 1.469-5T(c)(1).

3. 100 Hours. T significantly participates in an activity if T participates for > 100 hours. Temp. Reg. § 1.469-5T(c)(2).

e. Material Participation for 5/10 Previous Years. T materially participated in the activity for any five taxable years during the previous ten taxable years. Temp. Reg. § 1.469-5T(a)(5).

f. Personal Service Activity + Material Participation for 3 Previous Years. The activity is a personal service activity and T materially participated in the activity for any three previous taxable years. Temp. Reg. § 1.469-5T(a)(6).

i. Personal Service Activity. An activity is a “personal service activity” if it involves the performance of personal services in–

1. (1) the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; or

2. (2) any other trade/business in which capital is not a material income-producing factor. Temp. Reg. § 1.469-5T(d).

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g. Facts/Circumstances. Based on facts/circumstances, T’s participation in the activity is regular, continuous, and substantial. § 469(h)(1); Temp. Reg. § 1.469-5T(a)(7).

3. Limited Partnership Interests. T shall not be treated as materially participating in any activity of a limited partnership. Temp. Reg. § 1.469-5T(e)(1).

a. Exception if Materially Participates. Temp. Reg. § 1.469-5T(e)(1) does not apply where T is treated as materially participating under Temp. Reg. § 1.469-5T(a)(1), (5), or (6).

b. Exception for General Partners. T’s partnership interest shall not be treated as a limited p’ship interest if the individual is a general partner in the p’ship. Temp. Reg. § 1.469-5T(e)(3)(ii).

v. Portfolio Income. In determining income/loss from an activity, portfolio income (e.g., dividends, losses from sale of marketable securities) is not taken into account. § 469(e)(1).

vi. Rental Activity1. Rental Activity = Passive Activity. “Passive activity” includes rental activity. §

469(c)(2).2. Exceptions for Rental Real Estate Activity

a. § 469(c)i. § 469(c)(2) Doesn’t Apply. If the req’s in § 469(c)(7)(B) are

met, § 469(c)(2) doesn’t apply. § 469(c)(7)(A).ii. Requirements

1. > ½ of Personal Services. More than one-half of the personal services performed in trades or businesses by T must be performed in real property trades or businesses in which T materially participates. § 469(c)(7)(B)(i).

2. > 750 Hours. T performs more than 750 hours of services during the taxable year in real property trades or businesses in which T materially participates. § 469(c)(7)(B)(ii).

b. § 469(i)i. § 469(a) Doesn’t Apply. Section 469(a) does not apply (up to

$25k) to passive activity loss for rental real estate activities where T actively participated in such taxable year. § 469(i)(1), (2).

1. Phase out. This $25k limitation is phased out based on AGI. See § 469(i)(3).

ii. Limited Partners Do Not Actively Participate. No interest as a limited partner in a limited partnership will be treated as an interest where T actively participates. § 469(i)(6)(C).

vii. Working Interests in Oil and Gas Property. “Passive activity” does not include any working interest in any oil and gas property which T holds directly or through an entity which does not limit the liability of T with respect to such interest. § 469(c)(3)(A).

viii. Problem 1 (pp. 121–22). Producer owns both a 40% interest as a general partner and a 20% interest as a limited partner in PG-13 Associates, a motion picture production partnership which also pays Producer a $100,000 annual salary for her service as a full-time (1,500 hours per year) producer. After deducting Producer’s salary, the partnership has a $300,000 net loss in the current year. Producer’s aggregate outside basis for her partnership interests at the beginning of the year is $350,000. Producer’s outside basis is attributable to cash contributed to PG-13 Associates.

1. Share of Partnership Loss = $180ka. 40% * 300k = $120k as general partner

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b. 20% * 300k = $60k as limited partner2. Effect of Loss

a. § 705(a)(2)(A): losses decrease basisb. $350k original outside basis – $180k loss = $170k ending outside basis

3. Loss Limitationsa. §704(d): loss limited to outside basis

i. $180k loss allowed by $350k basisb. § 465: loss limited to amount at risk

i. $180 loss allowed by $350k amount at risk (cash contributed)c. Note: loss limitations do not affect ending outside basis!

4. (a) What are the tax consequences to Producer from her interests in PG-13 Associates for the current year?

a. § 469(a)(2): section 469 applies to producer (individual)b. § 469(a)(1): passive activity loss not allowedc. § 469(c): passive activity is an activity which involves conduct of a

trade/business and where T d/n materially participatei. Motion picture production = trade/business

ii. General Partner Interest1. Temp. Reg. § 1.469-5T(a)(1): materially participates

b/c participated for > 500 hoursiii. Limited Partner Interest

1. Temp. Reg. § 1.469-5T(e)(1): T is not treated as materially participating in any activity of a limited partnership.

2. Temp. Reg. § 1.469-5T(e)(3)(ii): a p’ship interest is not treated as a limited partnership interest if general partner

3. Since Producer materially participates under Temp. Reg. § 1.469-5T(a)(1), his limited p’ship interest has no effect.

iv. Producer materially participates in activityv. Activity is not a passive activity

d. Loss is allowed5. (b) What result in (a), above, if Producer spends most of her time farming and

only devotes 300 hours during the year to PG-13?a. Maybe “materially participates” under Temp. Reg. § 1.469-5T(a)(4)

(significant participation activity).b. May “materially participate” under Temp. Reg. § 1.469-5T(a)(2), (3), or

(7) if we had more facts.c. If this fails all the “materially participate” tests, it is a disallowed

passive activity lossi. §469(b): the loss would be suspended and deductible in the

future when the p’ship has passive activity incomed. Assume for the rest of the problem that partner does not materially

participate in part (b).6. (c) What result in (b), above, if Producer had devoted 1,500 hours to PG-13

during each of the previous five years?a. Temp. Reg. § 1.469-5T(a)(5): materially participates b/c materially

participated in 5 of last 10 yearsi. Temp. Reg. § 1.469-5T(a)(6): may be a personal service

activityb. Not passive activity loss; allowed

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7. (d) What result in (b), above, if the partnership’s loss for the year is only $200,000 because it also realizes $60,000 of dividend income and $40,000 of net gains from sales of marketable securities?

a. § 469(e)(1): this portfolio income is treated as a separate activityb. Passive activity loss stays at $300k

8. (e) What result in (b), above, if Producer also has $75,000 of income from an interest in a “burned out” real estate limited partnership interest?

a. Note: a “burned out” partnership is one whose assets are fully depreciated and is currently generating income for its partners

b. § 469(a): passive activity loss not allowedc. §469(d)(1): “passive activity loss” = loss from passive activities –

income from passive activitiesd. § 469(c): passive activity = trade/bus in which T does not materially

participatee. Temp. Reg. § 1.469-5T(e)

i. (1): if limited partner, not materially participatingii. (2): exception if materially participates under Temp. Reg. §

1.469-5T(a)(1), (5) or (6).1. Not satisfied here

f. Assuming it’s a rental real estate activity:i. § 469(c)(2): rental activity is “passive activity”

ii. § 469(c)(7) exception1. § 469(c)(7)(A): effect: § 469(c)(2) d/n apply2. § 469(c)(7)(B): req’s: > ½ of personal services

performed by T are performed in real property trades or businesses in which T materially participates, and T performs > 750 hours during the taxable year in real property trades/businesses in which T materially participates

3. No facts to indicate this exception appliesiii. § 469(i) exception

1. § 469(i)(1), (2): effect: § 469(a) d/n apply to (up to $25k) losses for rental real estate activities in which T actively participated

2. § 469(i)(6)(C): no interest as a limited partner in a LP shall be treated as an interest w/ respect to which T actively participates

3. No facts to indicate this exception appliesiv. § 469(d)(1): “passive activity loss” = loss from passive

activities – income from passive activities1. $180k disallowed loss – $75k passive income from LP

= $105k carry forward9. (f) What result in (b), above, if Producer also has a $25,000 loss from a rental

real estate limited partnership interest?a. § 469(a): passive activity loss not allowedb. §469(d)(1): “passive activity loss” = loss from passive activities –

income from passive activitiesc. § 469(c): passive activity = trade/bus in which T does not materially

participated. Temp. Reg. § 1.469-5T(e)

i. (1): if limited partner, not materially participatingii. (2): exception if materially participates under Temp. Reg. §

1.469-5T(a)(1), (5) or (6).

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1. Not satisfied heree. § 469(c)(2): rental activity is “passive activity”f. § 469(c)(7) exception

i. § 469(c)(7)(A): effect: § 469(c)(2) d/n applyii. § 469(c)(7)(B): req’s: > ½ of personal services performed by T

are performed in real property trades or businesses in which T materially participates, and T performs > 750 hours during the taxable year in real property trades/businesses in which T materially participates

iii. No facts to indicate this exception appliesg. § 469(i) exception

i. § 469(i)(1), (2): effect: § 469(a) d/n apply to (up to $25k) losses for rental real estate activities in which T actively participated

ii. § 469(i)(6)(C): no interest as a limited partner in a LP shall be treated as an interest w/ respect to which T actively participates

iii. No facts to indicate this exception appliesh. Disallowed loss = $180k original disallowed loss + $25k passive loss

from LP = $205k carry forward10. (g) What result in (b), above, if Producer also has a $50,000 loss from an

investment in a general partnership that owns a working interest in an oil and gas property?

a. § 469(c)(3)(A): “passive activity” does not include any working interest in any oil and gas property which the taxpayer holds directly or through an entity which does not limit the liability of T w/ respect to such interest.

i. Here, T is a general partnerii. Loss is not passive

b. $50k loss is not limited by § 46911. (h) Same as (g), above, except Producer holds her interest in the oil and gas

partnership as a limited partner?a. § 469(c)(3)(A): “passive activity” does not include any working interest

in any oil and gas property which the taxpayer holds directly or through an entity which does not limit the liability of T w/ respect to such interest.

i. Here, T is a limited partner in a p’shipii. Exception not met

b. Temp. Reg. § 1.469-5T(e)(1), (2): limited partnership interest is not materially participating unless materially participate under Temp. Reg. § 1.469-5T(a)(1), (5), or (6).

i. T does not materially participateii. Loss is passive

c. Disallowed loss = $180k original + $50k LP loss = $230kix. Problem 2 (p. 122). During the current year LP has investments in four limited

partnerships as follows:1. (i) A motion picture production limited partnership in which LP has an outside

basis of $10,000 attributable to LP’s cash contribution to the partnership. LP’s distributive share of loss in this partnership for the current year is $25,000.

2. (ii) An equipment leasing limited partnership in which LP has a $100,000 outside basis (attributable to a $15,000 cash contribution and an $85,000 nonrecourse liability). LP’s share of loss for the year is $20,000.

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3. (iii) A real estate limited partnership in which LP has a positive outside basis and his share of partnership income is $30,000 for the year.

4. (iv) A research and development limited partnership in which LP has an outside basis of $60,000, attributable to his $60,000 cash contribution to the partnership. LP’s share of the partnership’s loss for the year is $40,000.

5. Consider to what extent LP may deduct his share of losses from these partnerships for the current year, assuming he has no carryovers under Sections 704(d), 465 or 469.

Share of Loss/Income

Basis in P’ship

Interest

§ 465 Amount at Risk

Passive Activity Loss/ Income

Motion picture LP

($25k)– $15k suspended

§ 704(d)

$10k– $10k

0

$10k (cash contr)($10k) (b/c of ded.)

0

($10k)

Equipment Leasing LP

($20k)– $5k suspended §

465

$100k($20k)$80k

$15k (cash contr)($15k)

0

($15k)

Real Estate LP

$30k N/A N/A $30k

R&D LP ($40k) $60k($40k)$20k

$60k (cash contr)($40k) (ded.)

$20k

($40k)

6. Passive Activity Loss (Carry Forward) = ($35k)a. Loss from Passive Activity = ($65k)

i. Activity (i) = ($10k)ii. Activity (ii) = ($15k)

iii. Activity (iv) = ($40k)b. Income from Passive Activity = $30k

7. Allocate $35k disallowed amount to passive activitiesa. Activity (i): $10k/$65k * $35k = $5,385b. Activity (ii): $15k/$65k * $35k = $8,077c. Activity (iv): $40k/$65k * $35k = $21,538

8. Reg. 1.469-1T(f)(2): w/in each activity, disallow a portion of each deductiona. In activity (i): $5,385/$10k of each deduction is disallowedb. In activity (ii): $8,077/$15k of each deduction is disallowedc. In activity (i): $21,538/$40k of each deduction is disallowed

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PART 4: PARTNERSHIP ALLOCATIONS

I. Introductiona. Partnerships vs. Corporations

i. Corporations. In corporations, rights associated with shares of stock determine voting power, rights to distributions and rights upon liquidation. In order to vary the rights among the SHs, shares would have to be transferred or more stock issued.

ii. Partnerships. In partnerships, the rights of the partners generally are determined by the partnership agreement. Varying the rights of partners is as easy as amending the agreement. Partners are generally free to divide tax items among whomever they want.

b. Subchapter K’s Approach to Allocations of Income and Deductionsi. General Rule. A partner’s distributive share of income, gain, loss deduction and credit is

determined by the partnership agreement. See § 704(a).ii. Limitation. Each partner’s “distributive share” of the items above is determined in

accordance with the “partner’s interest in the partnership” if:1. The partnership agreement does not allocate these items among the partners,

or2. The partnership agreement does allocate them, but the allocation does not

have “substantial economic effect.” See § 704(b).II. Special Allocations Under Section 704(b)

a. Background: The Substantial Economic Effect Concepti. Special Allocations. “Special allocations” are allocations which are disproportionate to

the amount of capital each partner has put in.ii. Section 704(b) Applicability

1. Specific Items. Section 704(b) applies to allocations of specific items of partnership income, gain, loss, deduction or credit, i.e., those listed in § 702(a)(1)–(7).

2. “Bottom Line” Items. Section 704(b) also applies to allocations of “bottom line,” nonseparately stated income or loss of the partnership, i.e., the income or loss listed in § 702(a)(8).

b. The Section 704(b) Regulations: Basic Rulesi. Economic Effect

1. General Rulesa. General Principles and Organization of the § 704(b) Regulations.

Under Reg. § 1.704-1(b)(1)(i), if the partnership agreement allocates a tax item to a partner, there are three ways for the allocation to be respected under § 704(b):

i. The allocation can have substantial economic effect under Reg. § 1.704-1(b)(2).

ii. The allocation can be in accordance with the partner’s “interest in the partnership,” as determined by taking into account all facts and circumstances, under Reg. § 1.704-1(b)(3).

iii. The allocation can be deemed to be in accordance with the partner’s interest in the partnership under special rules in Reg. § 1.704(b)(4) and 1.704-2.

b. Two Part Test. A two-part analysis must be applied at the end of each partnership taxable year to allocations made for that year. Reg. § 1.704-1(b)(2)(i).

i. Does the allocation have economic effect? Reg. § 1.704-1(b)(2)(ii)

ii. If it has economic effect, is the economic effect substantial? Reg. § 1.704-1(b)(2)(iii).

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c. Economic Effect General Principle. Generally, an allocation has economic effect if it is consistent with the underlying economic arrangement of the partners. Reg. § 1.704-1(b)(2)(ii)(a).

d. Basic Test (“The Big Three”). Allocations of income, gain, loss, or deduction (or item thereof) to a partner will have economic effect if the partnership agreement provides for:

i. Maintenance of capital accounts in accordance with Reg. 1.704-1(b)(2)(iv);

ii. Liquidating distributions to be made in accordance with the partners’ positive capital account balances; and

iii. An unconditional deficit restoration obligation. Reg. § 1.704-1(b)(2)(ii)(b).

e. Capital Account Maintenancei. See II.a.ii.3. Maintaining Capital Accounts, supra.

ii. Contribution of Promissory Notes. If a promissory note is contributed to a partnership by partner who is the maker of such note, such partner’s capital account will be increased with respect to such note only when there is a taxable disposition of such note by the partnership or when the partner makes principal payments on such note. This shall not apply if the note is readily tradable on an established securities market. Reg. § 1.704-1(b)(2)(iv)(d)(2); see Reg. § 1.704-1(b)(5) Example 1(ix).

f. Alternate Test for Economic Effecti. Requirements. Reg. § 1.704-1(b)(2)(ii)(d)(1)–(3).

1. The first two requirements of the basic test for economic effect are met.

2. The partner has no/limited deficit restoration obligation.

3. The partnership agreement contains a “qualified income offset” (QIO)

ii. Effect. An allocation will be considered to have economic effect to the extent such allocation does not cause or increase a deficit balance in such partner’s capital account (in excess of any limited dollar amount of such deficit balance that such partner is obligated to restore). Reg. § 1.704-1(b)(2)(ii)(d).

g. Obligations to Restore a Deficit. If a partner is not expressly obligated to restore the deficit balance in his capital account, such partner nevertheless will be treated as obligated to restore the deficit balance in his capital account to the extent of the outstanding principal balance of any promissory note (of which such partner is the maker) contributed to the partnership by such partner. Reg. § 1.704-1(b)(2)(ii)(c)(1).

h. Expected Distributions. In determining the extent to which an allocation causes/increases a deficit balance in excess of any deficit restoration obligation, the partner’s capital account will be reduced for expected distributions and increases to the partner’s capital account. Reg. § 1.704-1(b)(2)(ii)(d)(6).

i. Qualified Income Offset. A QIO provides that where unexpected distributions create an impermissible deficit, she will be allocated items of income or gain sufficient to eliminate such deficit balance as quickly as possible. Reg. § 1.704-1(b)(2)(ii)(d) (flush language after (6)).

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j. Problem 1 (pp. 161–62). A and B each contribute $100,000 upon formation of a limited partnership. A is a general partner and B is a limited partner. The partnership purchases an office building on leased land for $200,000 and elects straight-line cost recovery. Assume (for simplicity) that the property has a 10-year recovery period. The partnership agreement allocates all items of income and loss equally with the exception of the cost recovery deductions, which are allocated entirely to B. Assume (perhaps unrealistically) that both partners are unconditionally obligated to restore a deficit to their capital accounts upon a liquidation of the partnership.

i. (a) Assume that apart from cost recovery deductions, the partnership’s rental income is equal to its operating expenses. What must the partners’ respective capital account balances be at the end of year one if the allocation of cost recovery deductions is to have economic effect?

1. Reg. § 1.704-1(b)(2)(iv): increase capital accounts by cash contributed

a. Beginning capital account balances = $100k cash contributed

2. Reg. § 1.704-1(b)(2)(iv): decrease capital accounts by allocations of partnership loss and deduction

a. B’s capital account decreases by $20k depreciation deduction

Assets Liability and Capital AccountsBuilding $200k Liab: 0Depr. ($20k) Capital Accounts

A $100kB $100k

–$20k$80k

$180k $180kii. (b) Assume the partnership sells the building on January 1 of

year two and immediately liquidates. Again, with an eye toward qualifying the allocation, how must the proceeds be distributed if the building is sold for $180,000?

1. Reg. § 1.704-1(b)(2)(ii)(b)(2): liquidating distributions made according to partners’ positive capital account balances

2. A: $100k3. B: $80k

iii. For $200,000?1. $200k AR – $180k AB = $20k RG2. Reg. § 1.704-1(b)(2)(iv)(b): increase capital accounts

by allocations to him of partnership gaina. Allocate $20k RG according to the p’ship

agreement ($10k to each)

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Assets Liability and Capital AccountsCash $200k Liab: 0

Capital AccountsA $100k

+ $10k$110k

B $80k+$10k$90k

$200k $200k3. Reg. § 1.704-1(b)(2)(ii)(b)(2): liquidating

distributions made according to partners’ positive capital account balances

4. A: $110k5. B: $90k

iv. (c) Assume the agreement further provides that gain on disposition will be allocated to B to the extent of the cost recovery deductions specially allocated to her. What result when the partnership sells the building on January 1 of year two for $200,000?

Assets Liability and Capital AccountsCash $200k Liab: 0

Capital AccountsA $100kB $80k

+$20k$100k

$200k $200k1. Reg. § 1.704-1(b)(2)(ii)(b)(2): liquidating

distributions made according to partners’ positive capital account balances

2. A: $100k3. B: $100k

v. (d) Assume that B is not required to restore a deficit in her capital account, but the partnership agreement includes a “qualified income offset.” If the partnership continues to operate the building, what is the result to A and B in year one?

Assets Liability and Capital AccountsBuilding $200k Liab: 0Depr. ($200) Capital Accounts

A $100kB $80k

$180k $180k1. Reg. § 1.704-1(b)(2)(ii)(b)(3): fails basic economic

effect test b/c no unconditional deficit restoration obligation

2. Reg. § 1.704-1(b)(2)(ii)(d): if (1) first two req’s in basic economic effect test are met, and (2) has no or limited deficit restoration obligation, and (3) the

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p’ship agreement contains a QIO, the allocation is considered to have economic effect to the extent it does not cause/increase a deficit balance in excess of any limited deficit restoration obligation

a. Meets all requirements for the alternative test for economic effect

vi. In year six?Assets Liability and Capital Accounts

Building $200k Liab: 0Depr. ($120) Capital Accounts

A $100kB ($20k)

$80k $80k1. Reg. § 1.704-1(b)(2)(ii)(d): this violates the third

prong of the alternative test for economic effect2. Reg. § 1.704-1(b)(1)(i): must reallocate in

accordance with the partners’ interests in the partnership

vii. (e) What results in both years under the facts of (d), above, if in addition B has contributed her promissory note for $100,000 to the partnership?

1. Reg. § 1.704-1(b)(2)(iv)(d)(2): if a promissory note is contributed to a partnership by a partner, such partner’s capital account will be increased only when there is a taxable disposition of such note by the partnership or when the partner makes principal payments on such note

a. P/note has no effect on capital accounts2. Reg. § 1.704-1(b)(2)(ii)(d): if alternative test for

economic effect is met, the allocation will be considered to have economic effect to the extent such allocation does not cause or increase a deficit balance in excess of any limited dollar amount of such deficit balance that such partner is obligated to restore

a. Reg. § 1.704-1(b)(2)(ii)(c)(1): a partner is treated as obligated to restore a deficit balance to the extent of the outstanding principal balance of any promissory note contributed to the partnership by the partner

b. Thus, allocations to B will have economic effect to the extent of $100k (the amount of the promissory note)

3. Note: this isn’t really helpful b/c by the end of year 5, B’s outside basis = 0. § 704(d) suspends further deductions.

viii. Suppose in year 7, the partnership expects to make a distribution of $100k to each partner.

1. Reg. § 1.704-1(b)(2)(ii)(d): if alternative test for economic effect is met, the allocation will be considered to have economic effect to the extent

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such allocation does not cause or increase a deficit balance in excess of any limited dollar amount of such deficit balance that such partner is obligated to restore

2. Reg. § 1.704-1(b)(2)(ii)(d)(6): in determining the extent of deficit capital accounts caused or increased, a partner’s capital account is reduced for expected distributions and expected increases in capital accounts

3. If B gets a $100k distribution, B’s capital account decreases from $0 to ($100k).

4. Thus, B cannot take the $20k depreciation deductionix. Suppose instead in year 7 the partnership makes an

unexpected $100k distribution to each partner.1. B’s capital account decreases from $0 to ($120)

(impermissible).2. Reg. § 1.704-1(b)(2)(ii)(d): QIO provides that if a

partner unexpectedly receives a distribution that creates an impermissible deficit, she will be allocated items of income or gain sufficient to eliminate such deficit balance as quickly as possible.

3. Here, the partnership would allocate income items of $20k to eliminate the impermissible excess deficit

2. Reallocations When an Allocation Lacks Economic Effect Because of the Absence of a Deficit Restoration Obligation

a. Partner’s Interest in the Partnership. If a partnership agreement provides for an allocation of income, gain, loss, deduction, or credit to a partner but such allocation does not have substantial economic effect, then the partner’s distributive share of such tax item shall be determined in accordance with such partner’s interest in the partnership. Reg. § 1.704-1(b)(1)(i).

b. Agreement to Share Economic Benefits/Burdens. “Partner’s interest in the partnership” signifies the manner in which the partners have agreed to share the economic benefit or burden corresponding to the tax item allocated. Reg. § 1.704-1(b)(3)(i).

c. Facts and Circumstances. The determination of a partners’ interest in a partnership shall be made by taking into account all facts and circumstances relating to the economic arrangement of the partners. Reg. § 1.704-1(b)(3)(i).

d. Per Capita Presumption. All partners’ interest in the partnership are presumed to be equal (determined on a per capita basis). However, the presumption may be rebutted by T or the IRS by establishing facts/circumstances that show that the partners’ interests in the partnership are otherwise. Reg. § 1.704-1(b)(3)(i).

e. Factors Considered. In determining a partner’s interest in the partnership, the following factors are among those that will be considered:

i. (a) The partners’ relative contributions to the partnership,ii. (b) The interests of the partners in economic profits and

losses (if different than that in taxable income or loss),iii. (c) The interest of the partners in cash flow and other non-

liquidating distributions, and

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iv. (d) The rights of the partners to distributions of capital upon liquidation. Reg. § 1.704-1(b)(3)(ii).

f. Certain Determinations. If the first two requirements of the basic test are met, and all or a portion of an allocation of income, gain, loss, or deduction does not have economic effect, the partners’ interests in the partnership with respect to the portion of the allocation that lacks economic effect will be determined by comparing the manner in which distributions (and contributions) would be made if all partnership property were sold at book value and the partnership liquidated (1) in the year of the allocation, with (2) the result if the partnership liquidated in the prior year. Reg. § 1.704-1(b)(3)(iii).

g. Problem. In Problem 1(d) (p. 161) above, what reallocation, if any, is necessary in year 6?

i. Year 5Assets Liability and Capital Accounts

Building $200k Liab: 0Depr. ($100) Capital Accounts

A $100kB $0

$100k $100kii. Year 6

Assets Liability and Capital AccountsBuilding $200k Liab: 0Depr. ($120) Capital Accounts

A $100kB ($20k)

$80k $80kiii. Reg. § 1.704-1(b)(1)(i): if a partnership agreement provides

for an allocation of income, gain, loss, deduction, or credit to a partner but such allocation does not have substantial economic effect, then the partner’s distributive share of such tax item shall be determined in accordance with such partner’s interest in the partnership.

iv. Reg. 1.704-1(b)(3)(iii): If the first two requirements of the basic test are met, and an allocation of deduction does not have economic effect, the partners’ interests in the partnership is determined by comparing what distributions (and contributions) would be made if all partnership property were sold at book value and the partnership liquidated (1) in the year of the allocation, with (2) the result if the partnership liquidated in the prior year.

1. Constructive Liquidation at Year 5A B

Distributions 100 0Contributions 0 0

2. Constructive Liquidation at Year 6A B

Distributions 80 0Contributions 0 0**b/c no deficit restoration obligation

58

v. Since A bears the economic burden associated with the depreciation; allocate all year 6 depreciation to A

h. What would be the result in year 6 if the partnership agreement did not contain a qualified income offset?

i. Reg. § 1.704-1(b)(2)(ii)(3): cannot satisfy the 3d prong of the basic economic effect test

ii. Reg. § 1.704(b)(2)(ii)(d)(3): cannot satisfy the 3d prong of the alternate economic effect test

iii. Reg. § 1.704-1(b)(1)(i): if a partnership agreement provides for an allocation of income, gain, loss, deduction, or credit to a partner but such allocation does not have substantial economic effect, then the partner’s distributive share of such tax item shall be determined in accordance with such partner’s interest in the partnership.

iv. Reg. 1.704-1(b)(3)(iii): If the first two requirements of the basic test are met, and an allocation of deduction does not have economic effect, the partners’ interests in the partnership is determined by comparing what distributions (and contributions) would be made if all partnership property were sold at book value and the partnership liquidated (1) in the year of the allocation, with (2) the result if the partnership liquidated in the prior year.

1. Years 1–5a. B bears the economic burden associated

with the depreciation deductionsb. Respect the allocations

2. Year 6a. Reallocate to A

3. Even though it’s the same result as with the QIO, it’s a good idea to have the QIO so you can use the alternate economic effect test

ii. Substantiality1. Generally. The substantiality requirement asks whether partners are merely

shifting items with different tax characteristics among themselves without changing the economic result.

2. Order of Substantiality Tests. First, (depending on the timing of the allocations) apply either the Shifting Tax Consequences Test or the Transitory Allocation Test. Then, apply the After Tax Test. Finally, apply the General Test.

3. Shifting Tax Consequences Test. The economic effect of an allocation is not substantial if, at the time the allocation becomes part of the partnership agreement, there is a strong likelihood that

a. (1) the net increases/decreases recorded in the partners’ capital accounts will not differ substantially than what they would be in the absence of the allocations, AND

b. (2) the total tax liability of the partners will be less than if the allocations were not contained in the partnership agreement. Reg. § 1.704-1(b)(2)(iii)(b).

4. Transitory Allocation Test. If a partnership agreement provides for the possibility that one or more allocations (“original allocation”) will be largely offset by one or more other allocations (“offsetting allocation”), the economic effect of these allocations are not substantial if at the time the allocations become part of the partnership agreement there is a strong likelihood that

59

a. (1) the net increases/decreases recorded in the partners’ capital accounts will not differ substantially from what it would have been in the absence of the allocations, AND

b. (2) the total tax liability of the partners will be reduced from what it would otherwise be. Reg. § 1.704-1(b)(2)(iii)(c).

5. After Tax Test. The economic effect of an allocation is not substantial if, at the time the allocation becomes part of the partnership agreement,

a. (1) the after-tax economic consequences of at least one partner may , in present value terms, be enhanced compared to such consequences if the allocation were not contained in the partnership agreement, and

b. (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation were not contained in the partnership agreement. Reg. § 1.704-1(b)(2)(iii)(a) (second sentence).

6. General Test. The economic effect of an allocation is substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Reg. § 1.704-1(b)(2)(iii)(a) (first sentence).

7. Problem 2 (p. 162). C and D are equal partners in a general partnership formed to design and produce clothing for sale to retailers located throughout Europe and the United States. D is a nonresident alien. At the beginning of the tax year, the relative dollar amounts of United States and foreign source income cannot be predicted. Any foreign source income allocated to D is exempt from United States taxation. Assume that all of the following allocations have economic effect.

a. (a) What result if the partnership agreement provides that all U.S. source income will be allocated to C, and all foreign source income will be allocated to D?

i. Shifting Tax Consequences Test1. There is no strong likelihood that the net

increases/decreases in capital accounts would not differ substantially b/c income cannot be predicted.

2. See Reg. § 1.704-1(b)(5) Example 10(i).ii. After Tax Test

1. The after-tax consequences of D may be enhanced b/c D is tax exempt on foreign income.

2. There is not a strong likelihood that the after-tax economic consequences of no partner will be substantially diminished b/c we cannot predict the amounts of foreign and U.S. income.

iii. General Test1. There is a reasonable possibility that the allocation

will affect substantially the dollar amounts to be received by the partners.

b. (b) What result if the agreement provides that all income will be shared equally but that D will be allocated all the foreign source income up to the dollar amount of her 50% share of income?

i. Shifting Tax Consequences Test1. There is a strong likelihood that net

increases/decreases in capital accounts would not differ substantially

2. Example

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With AllocationTotal C D

Foreign $50k 0 $50kUS $100k $75k $25k

$150k $75k $75k

Without Allocation: $150k * ½ = $75k each3. There is a strong likelihood that the total tax liability

is reduced b/c of the allocation. (Although we probably need to know more about the partners’ tax profiles.)

ii. Thus, the economic effect of the allocations is not substantialiii. See Reg. § 1.704-1(b)(5) Example 10(ii).iv. Allocate in accordance with the partners’ interests in the

partnership. Allocate ½ of the foreign source income to C and D each; allocate ½ of the U.S. income to C and D each.

c. (c) Assume, instead, that at the beginning of the tax year it can be predicted that the relative dollar amounts of U.S. and foreign source income will be roughly equal. What result if the agreement provides, as in (a), above, that all U.S. source income shall be allocated to C, and all foreign source income shall be allocated to D?

i. Shifting Tax Consequences Test1. There is a strong likelihood that net

increases/decreases in capital accounts will not differ substantially. This is b/c the amounts of foreign and U.S. source income are roughly the same.

2. ExampleWith Allocation

Total C DForeign $75k 0 $75kUS $75k $75k 0

$150k $75k $75k

Without Allocation: $150k * ½ = $75k each3. There is a strong likelihood that the total tax liability

is reduced b/c of the allocation. This is b/c D won’t pay taxes on foreign source income. (Although we’d probably want additional facts about the tax profiles of the partners.)

ii. Thus, the economic effect of the allocation is not substantial.iii. Allocate in accordance with the partners’ interest in the

partnership. Each gets half of the foreign and US income.c. Allocations Attributable to Nonrecourse Debt

i. General Rule. Nonrecourse deductions must be allocated in accordance with the partners’ interests in the partnership. Reg. § 1.704-2(b)(1).

ii. Safe Harbor. Allocations of nonrecourse deductions are deemed to be in accordance with the partners’ interests in the partnership if:

1. (1) throughout the full term of the partnership, the basic or alternate test for economic effect is met;

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2. (2) the partnership agreement provides for allocations of NR deductions in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liabilities;

3. (3) the partnership agreement contains a minimum gain chargeback provision;4. (4) all other material allocations and capital account adjustments under the

partnership agreement are recognized under § 1.704-1(b). Reg. 1.704-2(e).iii. Nonrecourse Deductions. The amount of nonrecourse deductions equals the net

increase in partnership minimum gain during the year, reduced (but not below zero) by the aggregate distributions made during the year of proceeds of a nonrecourse liability that are allocable to an increase in partnership minimum gain. Reg. § 1.704-2(c).

1. Partnership Minimum Gain. The partnership minimum gain is any gain the partnership would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability. Reg. § 1.704-2(d)(1).

a. Net Increase/Decrease. The net increase/decrease in partnership minimum gain is determined by comparing the partnership minimum gain on the last day of the immediately preceding taxable year with the partnership minimum gain on the last day of the current taxable year. Reg. § 1.704-2(d)(1).

iv. Minimum Gain Chargeback. If there is a net decrease in partnership minimum gain, the minimum gain chargeback requirement applies and each partner must be allocated items of partnership income and gain for that year equal to that partner’s share of the net decrease in partnership minimum gain. Reg. § 1.704-2(f)(1).

1. Share of Net Decrease in Partnership Minimum Gain. A partner’s share of partnership minimum gain equals the sum of nonrecourse deductions allocated to that partner allocable to an increase in partnership minimum gain . . . . Reg. § 1.704-2(g)(1)(i).

a. Add to Limited Deficit Restoration Obligation. For purposes of the alternate economic effect test, a partner’s share of partnership minimum gain is added to the partner’s limited deficit restoration obligation. Reg. § 1.704-2(g)(1) (flush language).

v. Study Guide for Assignment 4F. Developer and Investor form a limited partnership in which Developer is the general partner and Investor is the limited partner. Neither partner makes a contribution to the partnership’s capital. The partnership purchases an office building for $100,000 using the $100,000 of loan proceeds that it borrows on a nonrecourse basis. The loan is secured by the building. The partnership depreciates the building on a straight-line basis over ten years. If we ignore the applicable convention, the partnership will have a $10,000 depreciation deduction each year. The partnership agreement allocates all items of income and deduction 10% to Developer and 90% to Investor. The partnership agreement contains a minimum gain chargeback provision.

1. (1) Who will bear the economic burden of the depreciation? In considering this question, assume that the partnership sells the building for its book value immediately after the partnership’s first taxable year. Who will receive the proceeds of the sale, and what does this tell you concerning who bears the economic burden of the depreciation?

a. If the partnership sells the building after the first taxable year, the lender gets the proceeds of the sale (i.e., $90k).

i. $100k AR – $90k AB = $10k RGb. Since the loan is nonrecourse, the lender bears the economic burden

of the depreciation.

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2. (2) What is the general rule in the regulations concerning how nonrecourse deductions must be allocated, and what “safe harbor” do the regulations provide?

a. Reg. § 1.704-2(b)(1): NR deductions must be allocated in accordance with the partners’ interests in the partnership

b. Reg. § 1.704-2(e) provides a safe harbor. See II.c.ii. Safe Harbor, supra.3. (3) Is the partnership eligible for the safe harbor set forth in the regulations?4. (4) In its first taxable year, what is the amount of the partnership’s nonrecourse

deductions? In answering this question, consider:a. What is the general rule concerning how to determine the amount of

the partnership’s nonrecourse deductions?i. Reg. § 1.704-2(c): net increase in p’ship minimum gain

reduced by aggregate distributions of proceeds of a NR liability allocable to an increase in p’ship minimum gain

b. Is there any partnership minimum gain at the beginning of the partnership’s first taxable year? Immediately after the end of the partnership’s first taxable year?

i. Reg. § 1.704-2(d)(1): p’ship minimum gain is any gain the p’ship would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability

ii. Beginning of Year 11. $100k AR – $100k AB = 0

iii. End of Year 11. $100k AR – $90k AB = $10k

iv. Net increase in partnership minimum gain = $10kv. Partnership nonrecourse deductions = $10k (i.e., the

depreciation deduction is a NR deduction)c. Suppose you took out an additional $5k in NR debt and took a

distributioni. Reg. § 1.704-2(c): p’ship NR deductions = net increase in

p’ship minimum gain reduced by aggregate distributions of proceeds of a NR liability allocable to an increase in p’ship minimum gain

ii. $15k increase in p’ship minimum gainiii. ($5k) distribution of proceeds of NR liability allocable to an

increase in p’ship minimum gainiv. Thus, partnership’s NR deductions = $10k

5. (5) What is a minimum gain chargeback provision, and what does it require? To test your understanding of the provision’s effect, assume that, immediately after the close of the partnership’s first taxable year (i.e., at the beginning of year 2), the partnership transfers the building to a purchaser who pays no cash, but who takes the property subject to the nonrecourse liability. How much gain must be allocated to each partner?

a. Reg. § 1.704-2(f): if there is a net decrease in partnership minimum gain, the minimum gain chargeback requirement applies and each partner must be allocated items of partnership income and gain for that year equal to that partner’s share of the net decrease in partnership minimum gain

i. If the partnership transfers the building to a purchaser who takes property subject to NR liability, $10k gain must be allocated to the partners

1. $100k AR – $90k AB = $10k RG

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b. Reg. § 1.704-2(g)(1)(i): a partner’s share of partnership minimum gain equals the sum of nonrecourse deductions allocated to that partner allocable to an increase in partnership minimum gain

i. Depreciation deductions allocated:1. Developer: $1k2. Investor: $9k

ii. Partners will get these amounts of the $10k RGiii. Partners’ capital accounts will be brought up to zero

6. (6) Do a balance sheet for the partnership (that shows only book accounts) as of the beginning of its first taxable year, and as of the end of its first taxable year. What is Investor’s book capital account at the end of the first year? Is the agreed allocation of the depreciation to Investor in the first year permissible under either the primary or alternate economic effect test?

a. Beginning of Year 1Assets Liability and Capital Accounts

Building $100k LiabilitiesNote Payable $100kCapital Accounts

Dev. 0Inv. 0

$100k $100kb. End of Year 1

Assets Liability and Capital AccountsBuilding $100k LiabilitiesDep. ($10k) Note Payable $100k

Capital AccountsDev. ($1k)Inv. ($9k)

$90k $90kc. If the safe harbor requirements are met, the allocation will be deemed

to be in accordance with the partners’ interests in the partnership. See Reg. § 1.704-2(e).

d. Basic Test for Economic Effecti. Reg. § 1.704-1(b)(2)(ii)(b): Investor unlikely to agree to an

unconditional deficit restoration obligatione. Alternate Test for Economic Effect: if requirements are met, an

allocation has economic effect if it does not cause or increase a deficit balance in excess of any limited deficit restoration obligation

i. Reg. § 1.704-2(g)(1) (flush language): for purposes of the alternate economic effect test, a partner’s share of partnership minimum gain is added to the partner’s limited deficit restoration obligation

ii. Investor’s capital account does not decrease below ($9k); thus, the depreciation deduction allocation has economic effect

7. Suppose the partners contributed an additional $10,000 at the beginning of Year 1.

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Assets Liability and Capital AccountsCash $20k LiabilitiesBuilding $100k Note Payable $100k

Capital AccountsDev. $10kInv. $10k

$120k $120ka. Assume that during the year, the partnership paid $2,000 in wages

(deductible). According to the partnership agreement, allocate 10% to Developer, 90% to Investor.

i. Developer’s Capital Account1. Begins at $10k2. Allocate depreciation of $1k3. Allocate wage deduction of $2004. Ends at $8.8k

ii. Investor’s Capital Account1. Begins at $10k2. Allocate depreciation of $9k3. Allocate wage deduction of $1.8k4. Ends at ($800)

Assets Liability and Capital AccountsCash $18k LiabilitiesBuilding $100k Note Payable $100kDep. ($10k) Capital Accounts

Dev. $8.8kInv. ($800)

$108k $120kb. Can we allocate wage deductions to investor?

i. Basic Test for Economic Effect: Investor is unlikely to agree to an unconditional deficit restoration obligation.

ii. Alternate Test for Economic Effect: if requirements are met, an allocation has economic effect if it does not cause or increase a deficit balance in excess of any limited deficit restoration obligation

1. Reg. § 1.704-2(g)(1) (flush language): for purposes of the alternate economic effect test, a partner’s share of partnership minimum gain is added to the partner’s limited deficit restoration obligation

iii. Investor’s capital account does not decrease in excess of his limited deficit restoration obligation of $9k. Thus, the negative capital account balance does not trigger the QIO (b/c doesn’t go negative impermissibly).

III. Allocations With Respect to Contributed Propertya. Introduction

i. Subchapter K’s Approach to Allocations of Income and Deductions1. General Rule. Under § 704(a), a partner’s distributive share of income, gain,

loss, deduction and credit is determined by the partnership agreement.2. Limitation. Under § 704(b), each partner’s “distributive share” of the items

above is determined in accordance with the “partner’s interest in the partnership” if:

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a. The partnership agreement does not allocate these items among the partners, or

b. The partnership agreement does allocate them, but the allocation does not have “substantial economic effect”

3. Another Limitation. Another limit is provided in § 704(c).ii. Contributed Property. Under the regulations, "income, gain, loss, and deduction with

respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution. § 704(c)(1)(A).

iii. Methods of Allocation. Allocations with respect to § 704(c) property must be made using a reasonable method that is consistent with the purpose of § 704(c). Reg. § 1.704-3(a)(1). Methods that are generally reasonable are: the traditional method, the traditional method with curative allocations, and the remedial method. See Reg. § 1.704-3(b)–(d).

iv. Property-by-Property Basis. Section 704(c) generally applies on a property-by-property basis. Reg. § 1.704-3(a)(2).

v. Section 704(c) Property. Property is § 704(c) property if at the time of contribution its book value differs from the contributing partner’s adjusted tax basis. Reg. § 1.704-3(a)(3)(i).

vi. Application to Contributed Property. Section 704(c) applies only if the partner’s contribution of property is governed by § 721. Reg. § 1.704-3(a)(5).

vii. “Small Disparity” Exception. The partnership can ignore § 704(c) if the disparity between the property’s book value and its adjusted tax basis is a “small disparity.” Reg. § 1.704-3(e)(1)(i).

1. “Small Disparity.” A disparity between book value and adjusted tax basis is a small disparity if:

a. The book value of all properties contributed by one partner during the partnership taxable year does not differ from the adjusted tax basis by more than 15% of the adjusted tax basis, and

b. The total gross disparity does not exceed $20,000. Reg. § 1.704-3(e)(1)(ii).

b. Sales and Exchange of Contributed Propertyi. Traditional Method

1. Allocate Built-In Gain/Loss to Contributor. If the partnership sells section 704(c) property and recognizes gain or loss, built-in gain or loss on the property is allocated to the contributing partner. Reg. § 1.704-3(b)(1).

a. Built-In Gain/Loss. The built-in gain on section 704(c) property is the excess of the property’s book value over the contributing partner’s adjusted tax basis upon contribution. Reg. § 1.704-3(a)(3)(ii).

2. Ceiling Rule. The total [tax] income, gain, loss or deduction allocated to the partners for a taxable year with respect to a property cannot exceed the total partnership income, gain, loss, or deduction with respect to that property for the taxable year. Reg. § 1.704-3(b)(1).

ii. Remedial Allocation Method1. Generally. First, the partnership determines the partners’ distributive share of

book items. The partnership then allocates the corresponding tax items recognized by the partnership, if any, using the traditional method. If the ceiling rule causes the book allocation of a noncontributing partner to differ from the tax allocation, the partnership creates a remedial item of income, gain, loss, or deduction equal to the full amount of the difference and allocates it to the noncontributing partner. The partnership simultaneously creates an offsetting remedial item in an identical amount and allocates it to the contributing partner. Reg. § 1.704-3(d)(1).

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2. Type of Allocations. Remedial allocations have the same tax attributes as the tax item limited by the ceiling rule. Reg. § 1.704-3(d)(3).

3. No Effect on Partnership. Remedial items do not affect the partnership’s computation of its taxable income or inside bases. Reg. § 1.704-3(d)(4)(i).

4. Effect on Partners. Remedial items have the same effect as actual tax items on a partner’s tax liability. Reg. § 1.704-3(d)(4)(ii).

iii. Traditional Method with Curative Allocations. To correct distortions created by the ceiling rule, a partnership using the traditional method may make reasonable curative allocations. A curative allocation is an allocation of tax item that differs from the corresponding book item. Reg. § 1.704-3(c)(1).

iv. Character of Certain Tax Items1. General Rule. Generally, character of gain/loss is determined at the

partnership level. But § 724 provides some exceptions.2. Contribution of Unrealized Receivables. In the case of property that was an

unrealized receivable in the hands of the partner before it was contributed to the p’ship, any gain/loss recognized by the p’ship on disposition is treated as ordinary income/loss. § 724(a).

a. Unrealized Receivable. “Unrealized receivables” includes, to the extent not previously includible in income, any rights to payment for goods delivered (if inventory) or services rendered. §§ 724(d)(1), 751(c).

3. Contribution of Inventory Items. In the case of property that was an inventory item in the hands of the partner before it was contributed to the p’ship, any gain/loss recognized by the p’ship on a disposition within 5 years after contribution is treated as ordinary income/loss. § 724(b).

a. Inventory Item. “inventory items” means:i. (1) property of the p’ship described in § 1221(a)(1),

ii. (2) property of the p’ship which, on sale or exchange by the partnership, would be considered property other than a capital asset and other than property described in §1231, and

iii. (3) property held by the p’ship which, if held by the selling or distrbutee partner, would be considered property of the type described in (1) or (2). §§ 724(d)(2), 751(d).

4. Contribution of Capital Loss Itemsa. Loss treated as Capital Loss. Any loss recognized by the p’ship on the

disposition of capital loss property within 5 years of contribution is a capital loss. § 724(c) (flush language).

b. Capital Loss Property. This rule applies to property contributed by a partner that was a capital asset in his hands immediately before the contribution. § 724(c)(1), (2).

v. Problem 1 (p. 195). A, B and C form an equal partnership. A contributes accounts receivable for services rendered (A.B.—$0, F.M.V.—$10,000); B, a real estate dealer, contributes lots held primarily for sale (A.B.—$5,000, F.M.V.—$10,000); and C, an investor, contributes land (A.B.—$20,000, F.M.V.—$10,000). Unless otherwise stated, the partnership is not a dealer in receivables or land, all contributed assets have been held long-term by the partners prior to contribution, and the traditional method of allocation is applied with respect to all contributed property. What tax results in the following alternative transactions:

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Assets Liability and Capital AccountsTax Book Tax Book

A/R 0 $10k Liabilities: none

Lots (land) $5k $10k Capital Accounts

Land $20k $10k A 0 $10kB $5k $10kC $20k $10k

1. (a) The partnership sells the receivables contributed by A for $10,000?a. Book Gain: $10k AR – $10k AB = 0b. Tax Gain: $10k AR – 0 AB = $10k

i. Reg. § 1.704-3(b)(1): allocate built-in gain to contributing partner

ii. Reg. § 1.704-3(a)(3)(ii): built-in gain = $10kc. Ceiling Rule

i. The ceiling rule does not apply the amount we’re allocating, $10k, does not exceed the p’ship tax gain.

d. Character of the Tax Gaini. § 724(a): any gain/loss recognized by a disposition of a

contributed unrealized receivable is ordinary incomeii. §§ 724(d)(1), 751(c): “unrealized receivable” includes rights

to payment for services renderediii. Thus, the income that flows to A is ordinary


Cash $10k $10k Liab: noneLots (land) $5k $10k Capital AccountLand $20k $10k A $10k $10k

B $5k $10kC $20k $10k

2. (b) The partnership sells the lots contributed by B for $10,600?a. Book Gain: $10.6k AR – $10k AB = $600

i. Allocate according to the p’ship agreement ($200 each)b. Tax Gain: $10.6k AR – $5k AB = $5.6k

i. Built-In Gain1. Reg. § 1.704-3(b)(1): allocate built-in gain to

contributing partner2. Reg. § 1.704-3(a)(3)(ii): built-in gain = $5k

ii. Remaining Gain1. $5.6k tax gain – $5k built-in gain = $6002. Allocate equally among partners

c. Ceiling Rulei. The ceiling rule does not apply; the amount we’re allocating,

$5.6k, does not exceed the p’ship tax gain.d. Character of the Tax Gain

i. § 724(b): any gain/loss recognized by a disposition of a contributed inventory item within 5 years of contribution is ordinary income/loss

ii. Thus, the income that flows to the partners is ordinary

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A/R 0 $10k Liab: noneCash $10.6k $10.6k Capital AcctsLand $20k $10k A $200 $10.2k

B $10.2k $10.2kC $20.2k $10.2k

3. (c) The partnership sells the lots contributed by B for $9,100?a. Book Loss: $9.1k AR – $10k AB = ($900)

i. Allocate according to the p’ship agreement (equally)b. Tax Gain: $9.1k AR – $5k AB = $4.1k

i. Reg. § 1.704-3(b)(1): allocate built-in gain to contributing partner

c. Ceiling Rulei. Reg. § 1.704-3(b)(1): tax gain/loss allocated cannot exceed

total gain/lossii. A and C

1. Since we allocated a $300 book loss to A and C, we’d like to allocate a $300 tax loss. But, we cannot do this under the ceiling rule b/c there is no p’ship tax loss.

iii. B1. B has a claim on $9.7k (after the book loss allocation)2. B’s basis contributed was $5k3. Thus, B’s true tax gain is $4.7k4. But, under the ceiling rule, we can only allocate

$4.1k of gain to B.Assets Liability and Capital Accounts

Tax Book Tax BookA/R 0 $10k Liab: noneLots (land) $5k $10k Capital AcctLand $20k $10k A 0 $9.7k

B $9.1k $9.7kC $20k $9.7k

4. (d) Same as (c), above, except that partnership elects to use the remedial method of allocation.

a. Reg. § 1.704-3(d)(1): under the remedial method, create offsetting tax allocations to negate the ceiling rule

i. A and C: ($300) allocationii. B: $600 allocation


A/R 0 $10k Liab: noneLots (land) $5k $10k Capital AcctLand $20k $10k A ($300) $9.7k

B $9.7k $9.7kC $19.7k $9.7k

5. (e) The partnership is a real estate dealer and sells the land contributed by C for $17,000?

a. Book gain = $7k

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i. Allocate according to p’ship agreement ($2,333 each)ii. Increase book capital accounts

b. Tax loss = ($3k)i. Built-in loss allocated to C

c. Ceiling Rulei. A and B: We would like to give $2,333 of tax gain to match

book allocation (but can’t do that b/c of the ceiling rule)ii. C: We would like to allocate 3k of book loss (but can’t b/c of

the ceiling rule)1. Now, C has a claim on 12,3332. Amount C contributed was 20k3. We would like to allocate a 7,667 tax loss to C

(12,333–20k) (but can only allocate 3k tax loss b/c of the ceiling rule)

d. Character of 3k Lossi. General rule: determine character at p’ship level

1. Loss would be ordinary under this ruleii. Exception: 724(c): contributions of capital loss property

1. Capital loss to the extent of the built-in loss2. Thus, 3k is a capital loss that flows through to C,

even though the p’ship is a dealer in real estate6. (g) Would the result in any of the above transactions change if all sales had

occurred six years after the property was contributed?a. Yesb. § 724(b), (c): special characterization rules for contributed inventory

and capital loss property only apply if the property was disposed of within 5 years of contribution

i. After 5 years, determine character at the p’ship levelii. Disposition of inventory item: loss would be capital

iii. Disposition of land: loss would be ordinaryc. Note: contributed unrealized receivables (§724(a)) doesn’t have a 5-

year windowIV. Allocations of Partnership Liabilities

a. Introductioni. Increase in Partner’s Liabilities. Any increase in a partner’s share of partnership

liabilities (or the partner’s assumption of partnership liabilities) is treated as a contribution of money by the partner. § 752(a).

1. Increases Basis. A partner’s outside basis shall be the amount of money and AB of property contributed. See § 722.

ii. Decrease in Partner’s Liabilities. Any decrease in a partner’s share of partnership liabilities (or the partnership’s assumption of the partner’s liabilities) is treated as a distribution of money to the partner. § 752(b).

1. Distributions Decrease Basis. Outside basis is decreased (but not below zero) by cash/property distributions by the p’ship. §§ 705(a)(2), 733.

2. Distributions in Excess of Basis. A distribution results in a gain to a partner to the extent that the distribution exceeds outside basis. § 731(a)(1).

iii. Policy. The policy of §752 is to try to give each partner enough basis in the partnership to take deductions that result from the liability.

iv. Liability Defined. An obligation is a liability for purposes of §752 to the extent the obligation:

1. Creates or increases the obligor’s basis in any of its assets (including cash),2. Gives rise to an immediate deduction to the obligor, or

a. E.g., accrued wages payable for an accrual method taxpayer

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3. Gives rise to an expense that is not deductible in computing taxable income and is not a capital expenditure (i.e., §705(a)(2)(B) amounts).

a. E.g., if a p’ship accrues tax liability to a foreign country b. Recourse Liabilities

i. Recourse vs. Nonrecourse Liabilities1. Recourse. A partnership liability is a recourse liability to the extent that any

partner bears the economic risk of loss for that liability under § 1.752-2. Reg. § 1.752-1(a)(1).

2. Nonrecourse. A partnership liability is a nonrecourse liability to the extent that no partner bears the economic risk of loss for that liability under § 1.752-2. Reg. § 1.752-1(a)(2).

ii. Economic Risk of Loss. A partner’s share of a recourse partnership liability equals the portion of that liability for which the partner bears the economic risk of loss. Reg. § 1.752-2(a).

1. Constructive Liquidation. A partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner would be obligated to make a payment to any person (or a contribution to the partnership) because that liability becomes due and payable and the partner would not be entitled to reimbursement from another partner. Reg. § 1.752-2(b)(1).

a. What Hypothetically Happens. Upon a constructive liquidation:i. All of the partnership’s liabilities become payable in full;

ii. With the exception of property contributed to secure a partnership liability, all of the partnership’s assets, including cash become worthless;

iii. The partnership disposes of all of its property for no consideration (except relief from liabilities for which the creditor’s right to repayment is limited solely to one or more assets of the partnership);

iv. All items of income, gain, loss, or deduction are allocated among the partners; and

v. The partnership liquidates. Reg. § 1.752-2(b)(1).2. Property Contributed to Secure a Partnership Liability

a. Has Value in Constructive Liquidation. In the constructive liquidation, all p’ship property becomes worthless, except property contributed to secure a p’ship liability. Reg. § 1.752-2(b)(1)(ii)

b. Indirect Pledges. A partner bears the economic risk of loss for a partnership liability to the extent of the value of any property that the partner contributes to the partnership solely for the purpose of securing a partnership liability. Reg. § 1.752-2(h)(2).

i. Must Allocate to Contributor. Contributed property is not treated as contributed solely for the purpose of securing a partnership liability unless substantially all items of income, gain, loss, and deduction attributable to the contributed property are allocated to the contributing partner. Reg. § 1.752-2(h)(2).

ii. Greater than Share of Other Items. Contributed property is not treated as contributed solely for the purpose of securing a partnership liability unless the allocation is generally greater than the partner’s share of other significant items of partnesrhip income, gain, loss, or deduction. Reg. § 1.752-2(h)(2).

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c. No Promissory Notes. For purposes of (h)(2), a promissory note of the partner or related person that is contributed to the partnership shall not be taken into account unless the note is readily tradeable on an established securities market. Reg. § 1.752-2(h)(4).

3. Reimbursement. A partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person . . . and the partner would not be entitled to reimbursement from another partner. Reg. § 1.752-2(b)(1). A partner’s obligation to make a payment is reduced to the extent that the partner is entitled to reimbursement. Reg. § 1.752-2(b)(5).

4. Deemed Satisfaction of Obligation. It is assumed that all partners who have obligations to make payments actually perform those obligations. Reg. § 1.752-2(b)(6).

iii. Problem 1 (p. 214). A, B and C each contribute $20,000 to form the ABC general partnership. The partnership agreement satisfies the primary test for economic effect under Section 704(b). Partnership profits and losses are allocated 40% to A, 40% to B and 20% to C. The partnership uses its $60,000 cash and borrows an additional $40,000 on a recourse basis and purchases land for $100,000.

Assets Liability and Capital AccountsLand $100k Liabilities:

note/payable$40k

Capital AccountsA $20kB $20kC $20k

1. (a) How will the $40,000 liability be allocated and what will be each partner’s outside basis?

a. Reg. § 1.752-1(a)(1): a p’ship liability is a recourse liability to the extent that any partner bears the economic risk of loss for that liability under § 1.752-2

b. Reg. § 1.752-2(b)(1): a partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner would be obligated to make a payment

i. The $40k is due right nowii. The land becomes worthless

iii. P’ship disposes of land for no consideration1. $0 AR – $100k AB = $100 RL

iv. $100k loss allocated among the partners1. Special allocation satisfies primary test for economic

effectallocate loss according to the agreementPartner Beg.

Capital Account

Share of Loss

Ending Capital

AccountA 20k (40k) (20k)B 20k (40k) (20k)C 20k (20k) 0

2. Note: negative capital accounts are OK b/c of the unconditional deficit restoration obligation

v. The partnership liquidatesc. Since A and B are under an obligation to restore their negative capital

accounts of ($20) back to zero, they have a payment obligation

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d. Thus, at least one partner bears the economic risk of loss for this liability

e. Thus, this is a recourse liabilityf. Reg. § 1.752-2(a): a partner’s share of recourse p’ship liability equals

the portion of that liability for which the partner bears the economic risk of loss

i. § 752(a): increase in partner’s share of p’ship liability is considered as a contribution of money to the p’ship

ii. § 722: partner’s basis in his partnership interest = money + AB of property contributed

iii. A has a $20k share of liabilityiv. B has a $20k share of liabilityv. C has a 0 share of liability

Partner Beg. Outside

Basis

Increased/Decreased Share of Liability

End. Outside

BasisA $20k $20k $40kB $20k $20k $40kC $20k 0 $20k

2. (b) What result in (a), above, if A, B and C had contributed $10,000, $20,000 and $30,000 respectively, to the ABC partnership?

a. B/c special allocation satisfies basic test for economic effect, $100k loss allocated according to p’ship agreement

Partner Beg. Capital Account

Share of Loss End. Capital Account

A $10k ($40k) ($30k)B $20k ($40k) ($20k)C $30k ($20k) 10k

b. $50k is paid in to restore capital accounts, but $10k goes to C on constructive liquidation

c. Total paid in = $50ki. A contributes $30k/$50k = 60%

ii. B contributes $20k/$50k = 40%d. 60% of A’s and 40% of B’s contribution goes to pay off the p’ship

liabilityi. A: 60% * 40k = 24k (risk of loss)

ii. B: 40% * 40k = 16k (risk of loss)e. Share of Liability

Partner Beg. Outside Basis


End. Outside Basis

A $10k $24k $34kB $20k $16k $36kC $30k $0 $30k

3. (c) What result in (a), above, if A and B are limited partners who are not obligated to restore a capital account deficit but the partnership agreement includes a qualified income offset?

a. Same $100k loss to p’shipb. Constructive Liquidation

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Partner Beg. Capital Account

Share of Loss End. Capital Account

A $20k ($40k) ($20k)B $20k ($40k) ($20k)C $20k ($20k) $0

i. Reg. § 1.704-1(b)(2)(ii)(d): to have economic effect under the alternate test, the allocation cannot cause or increase a deficit capital account in excess of a partner’s limited deficit restoration obligation

1. As limited partners, A and B have no deficit restoration obligation

2. Thus, these allocations do not have economic effect3. Reg. § 1.704-1(i): reallocate in accordance with the

partners’ interests in the p’shipc. Reallocate in Accordance with Interests in the P’ship

i. Reg. § 1.704-1(b)(3)(iii): if first 2 parts of the basic test are met, compare the manner in which distributions and contributions would be made if the p’ship liquidated at the end of the current year and at the end of the previous year

1. Since there is no previous year, look at the situation just before the partnership assets were deemed worthless

Distribution To(Contribution By)

A B C

“Previous” Year $20k $20k $20kEnd of Current Year 0 0 ($40k)Difference = Share of $100k Loss

$20k $20k $60k

ii. Capital AccountsPartner Beg.

Capital Account

Share of Loss End. Capital

AccountA $20k ($20k) $0B $20k ($20k) $0C $20k ($60k) ($40)

iii. Share of Liability1. § 752(a): increase in partner’s share of p’ship

liability is considered as a contribution of money to the p’ship

2. § 722: partner’s basis in his partnership interest = money + AB of property contributed


Basis


End. Outside

BasisA $20k $0k $20B $20k $0k $20C $20k $40k $60k

d. Note: limited partners normally don’t have any share of recourse liabilities of the partnership

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4. (d) What result in (c), above, if A contributes $15,000 of stock to the partnership as security for the liability and all income, gain or loss on the stock is allocated to A?

a. Note: we’re assuming A’s basis in stock = $15kAssets Liability & Capital Accounts

Land $100k Liab: note payable $40kStock $15k Capital Accounts

A $35kB $20kC $20k

$115k $115kb. Constructive Liquidation

i. Reg. § 1.752-2(b)(1)(ii): all p’ship assets are worthless, except property contributed to secure a partnership liability (see § 1.752-2(h)(2))

ii. Reg. § 1.752-2(h)(2): a partner is considered to bear the economic risk of loss for a partnership liability to the extent the partner contributes property to secure a partnership liability

1. Reg. § 1.752-2(h)(2): must allocate tax items attributable to contributed property to contributing partner

a. Here, all income, gain or loss on the stock is allocated to A

2. Reg. § 1.752-2(h)(2): allocation must be generally greater than the partner’s share of other significant items of partnership income, gain, loss or deduction

a. Here, the allocation is greater than A’s normal 40% of p’ship items

3. Thus, partner bears economic risk for $15kiii. Allocate $100k loss

Partner Beg. Capital

Account

Share of Loss

End. Capital

AccountA $35k ($40k) ($5k)B $20k ($40k) ($20k)C $20k ($20k) 0

1. Reg. § 1.704-1(b)(2)(ii)(d): since the allocation creates deficit capital accounts and A and B have no deficit restoration obligation, this allocation does not have economic effect

2. Reallocate in accordance with partners’ interests in the p’ship

c. Reallocate in Accordance with Interests in P’shipi. Reg. § 1.704-1(b)(3)(iii): if first 2 parts of the basic test are

met, compare the manner in which distributions and contributions would be made if the p’ship liquidated at the end of the current year and at the end of the previous year


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A B C

“Previous” Year $35k $20k $20kEnd of Current Year

0 0 ($25k)

Difference = Share of $100k Loss

$35k $20k $45k


Capital Account

Share of Loss

End. Capital

AccountA $35k ($35k) $0B $20k ($20k) $0C $20k ($45k) ($25)

iii. Share of Liability1. § 752(a): increase in partner’s share of p’ship


2. § 722: partner’s basis in his partnership interest = money + AB of property contributedPartner Beg.

Outside Basis


End. Outside

BasisA $35k $15k* $50B $20k $0k $20C $20k $25k $45k

*Reg. § 1.752-2(h)(2): partner bears the economic risk of loss for a partnership liability to the extent of the value of any property that the partner contributes to the partnership solely for the purpose of securing a partnership liability

5. What result if A contributes his $15,000 note as security for the liability?Assets Liability & Capital Accounts

Land $100k Liability: note/payable $40kP/note $15k Capital Accounts

A $20k*B $20kC $20k

$115k $100k*Reg. § 1.704-1(b)(2)(iv)(d)(2): a contributed promissory note does not increase the contributor’s capital account until there is a taxable disposition of the note or when the partner makes principal payments on such note

a. Constructive Liquidationi. Reg. § 1.752-2(b)(1)(ii): all p’ship assets are worthless, except

property contributed to secure a partnership liability (see § 1.752-2(h)(2))

ii. Reg. § 1.752-2(h)(2): a partner is considered to bear the economic risk of loss for a partnership liability to the extent

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Note: not verified

the partner contributes property to secure a partnership liability

iii. Reg. § 1.752-2(h)(4): for purposes of (h)(2), a contributed promissory note shall not be taken into account unless the note is readily tradeable on an established securities market

iv. Thus, A doesn’t bear the economic risk of loss of the p/note under Reg. § 1.752-2(h)(2)

1. But, under Reg. § 1.704-2(b)(2)(ii)(b), (c)(1) the p/note is a limited restoration obligation of A

v. Allocate $100k lossPartner Beg.

Capital Account

Share of Loss

End. Capital

AccountA $35k ($40k) ($5k)B $20k ($40k) ($20k)C $20k ($20k) 0

1. Reg. § 1.704-1(b)(2)(ii)(d): since the allocation creates a deficit capital account for B and B has no deficit restoration obligation, this allocation does not have economic effect

2. Reallocate in accordance with partners’ interests in the p’ship

b. Reallocate in Accordance with Interests in P’shipi. Reg. § 1.704-1(b)(3)(iii): if first 2 parts of the basic test are

met, compare the manner in which distributions and contributions would be made if the p’ship liquidated at the end of the current year and at the end of the previous year



A B C

“Previous” Year $20k $20k $20kEnd of Current Year

($15k) 0 ($25k)

Difference = Share of $100k Loss

$35k $20k $45k


Capital Account

Share of Loss

End. Capital

AccountA $20k ($35k) ($15k)*B $20k ($20k) $0C $20k ($45k) ($25k)

*note: the negative capital account is OK b/c of the limited deficit restoration obligation

iii. Share of Liabilities1. § 752(a): increase in partner’s share of p’ship


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This is a guess

Note: not verified

2. § 722: partner’s basis in his partnership interest = money + AB of property contributedPartner Beg.

Outside Basis


End. Outside

BasisA $20k $15k $35kB $20k $0k $20kC $20k $25k $45k

6. (e) What result in (c), above, if A personally guarantees the $40,000 liability?a. Reimbursement Issue

i. Reg. § 1.752-2(b)(1): a partner bears the economic risk of loss for a partnership liability to the extent that, if the partnership constructively liquidated, the partner or related person would be obligated to make a payment to any person . . . and the partner would not be entitled to reimbursement from another partner

ii. Reg. § 1.752-2(b)(5): a partner’s obligation to make a payment is reduced to the extent that the partner is entitled to reimbursement

iii. If A has subrogation rights (i.e., he steps into the shoes of the lender, and can go after p’ship assets and C’s assets), A does not bear the economic risk of loss for the $40k liability

iv. A would have to waive these subrogation rights to bear the economic risk of loss

b. Deemed Satisfaction of Obligationi. Reg. § 1.752-2(b)(6): it is assumed that all partners who have

obligations to make payments actually perform those obligations

ii. If the terms of the guarantee make the lender exhaust the p’ship assets and C’s assets, it’s assumed the lender will get satisfaction from these sources and will not have to go after A

1. We assume that C will make payment on the liability (even if he’s insolvent)

iii. To get around this, A would have to give the direct right to go after himself, irrespective of whether he’s exhausted the p’ship assets or C’s assets

c. Nonrecourse Liabilitiesi. Partner’s Share of Nonrecourse Liabilities. A partner’s share of nonrecourse liabilities

equals the sum of:1. Partnership Minimum Gain. The partner’s share of partnership minimum gain

under § 704(b). Reg. § 1.752-3(a)(1).a. Defined. The amount of PMG is the aggregate amounts of any gain

the p’ship would realize if it disposed of property subject to a NR liability for no consideration other than full satisfaction of the liability. Reg. § 1.704-2(d)(1).

b. Book Value. If p’ship property subject to a NR liability has a book/tax disparity, the PMG determination is made w/ reference to the property’s book value. Reg. § 1.704-2(d)(3).

2. Section 704(c) Gain. Gain that would be allocated to the partner under § 704(c) if the p’ship disposed of all p’ship property subject to one or more NR liabilities of the p’ship in full satisfaction of the liabilities and for no other consideration. Reg. § 1.752-3(a)(2).

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3. “Excess” Nonrecourse Liabilities. Nonrecourse liabilities not allocated under Reg. § 1.752-3(a)(1), (2) as determined in accordance with the partner’s share of partnership profits. Reg. § 1.752-3(a)(3).

a. Partnership Agreement. The p’ship agreement may specify the partners’ interests in p’ship profits for purposes of allocating excess NR liabilities provided the interests so specified are reasonably consistent with allocations (that have SEE) of some other significant item of p’ship income or gain. Reg. § 1.752-3(a)(3).

ii. Problem 2 (p. 214–15). G and L form a limited partnership. G, the general partner, contributes $10,000 and L, the limited partner, contributes $90,000. The partnership purchases a building on leased land, paying $100,000 cash and borrowing $900,000 on a nonrecourse basis from a commercial lender, securing the loan with a mortgage on the building. The terms of the loan require the payment of market rate interest and no principal for the first ten years. Assume for convenience that the building is depreciable at the rate of $50,000 per year for twenty years, and that other partnership income equals expenses for the years in question. The partnership agreement contains a qualified income offset, and G is required to make up any capital account deficit. Except as otherwise required by a minimum gain chargeback provision, the agreement allocates profit and loss 90% to L and 10% to G until such time as the partnership recognizes items of income and gain that exceed the items of deduction and loss that it has recognized over its life. Subsequent partnership income and losses are allocated equally between G and L. Assume that it is reasonably anticipated that the equal allocation will begin after ten years. The partnership agreement states that G and L each has a 50% interest in partnership profits for purposes of §752.

Assets Liabilities and Capital AccountsBuilding $1M Liab.: note payable $900k

Capital AccountsG $10kL $90k

$1M $1M1. (a) How is the $900,000 liability allocated in year one?

a. Reg. § 1.752-3(a)(1)–(3): partner’s share of NR liabilities =i. Partner’s share of partnership minimum gain

ii. Gain allocated to the partner under § 704(c) if p’ship disposed of all p’ship property in full satisfaction of the liabilities and for no other consideration

iii. Partner’s share of “excess” NR liabilities as determined in accordance with the partner’s share of p’ship profits

b. Beginning of Year 1i. No PMG

1. Reg. § 1.704-2(d)(1): p’ship minimum gain is gain the p’ship would realize if it disposed of the property for no consideration other than the full satisfaction of the liability

2. Reg. § 1.704-2(d)(3): if p’ship property subject to NR liabilities has a tax-book disparity, use the property’s book value for PMG

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3. Here, if the p’ship sold the building, it would have a $100k RL

ii. No § 704(c) Gain1. There is no contributed property

iii. “Excess” NR Liability Allocated in Accordance with Partners’ Share of Profits

1. Reg. § 1.752-3(a)(3): p’ship agreement may specify the partners’ interests in p’ship profits for purposes of allocating excess NR liabilities provided the interests are reasonably consistent w/ allocations (that have SEE) of some other significant item of p’ship income or gain

2. Here, the p’ship agreement provides that the partners have a 50% interest in p’ship profits for purposes of § 752

a. This is consistent with the anticipated profits sharing arrangement

iv. Note: unlike recourse liabilities, limited partners normally have a share in the p’ship’s NR liabilities

Assets Liab. & Capital AccountsBuilding $1M Liab: note/p $900k

Capital AccountsG $10kL $90k

$1M $1Mv. Outside Basis


Basis


End. Outside

BasisG $10k $450k $460kL $90k $450k $540k

c. End of Year 1i. No PMG

1. Reg. § 1.704-2(d)(1): p’ship minimum gain is gain the p’ship would realize if it disposed of the property for no consideration other than the full satisfaction of the liability


3. Here, if the p’ship sold the building, it would have a $50k RL




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Assets Liab. & Capital AccountsBuilding $1M Liab: note/p $900kDep. ($50k) Capital

AccountsG $5kL $45k

$950k $950kiv. Outside Basis


Basis

Inc/Dec Share of Liability

Loss (from dep.)

End. Outside

BasisG $460k 0 ($5k) $455kL $540k 0 ($45k) $495k

1. § 705(a)(2): share of loss increases basisd. End of Year 2

i. No PMG1. Reg. § 1.704-2(d)(1): p’ship minimum gain is gain

the p’ship would realize if it disposed of the property for no consideration other than the full satisfaction of the liability


3. Here, if the p’ship sold the building, it would have no gain or loss






Assets Liab. & Capital AccountsBuilding $1M Liab: note/p $900kDep. ($100k) Capital

AccountsG 0L 0

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$900k $900kiv. Outside Basis

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Basis

Inc/Dec Share of Liability

Loss (from dep.)

End. Outside

BasisG $455k 0 ($5k) $450kL $495k 0 ($45k) $450k

2. (b) How will the liability be allocated at the end of year three?a. $50k PMG

i. Reg. § 1.704-2(d)(1): p’ship minimum gain is gain the p’ship would realize if it disposed of the property for no consideration other than the full satisfaction of the liability

ii. Reg. § 1.704-2(d)(3): if p’ship property subject to NR liabilities has a tax-book disparity, use the property’s book value for PMG

iii. Here, if the p’ship sold the building, it would have a $50k RG1. Allocate according to other profits/losses (90%/10%)

b. No § 704(c) Gaini. There is no contributed property

c. “Excess” NR Liability Allocated in Accordance with Partners’ Share of Profits

i. “Excess” NR liability = $900k – $50k = $850kii. Reg. § 1.752-3(a)(3): p’ship agreement may specify the

partners’ interests in p’ship profits for purposes of allocating excess NR liabilities provided the interests are reasonably consistent w/ allocations (that have SEE) of some other significant item of p’ship income or gain

iii. Here, the p’ship agreement provides that the partners have a 50% interest in p’ship profits for purposes of § 752

1. This is consistent with the anticipated profits sharing arrangement

iv. Share of “excess” liability = $425k eachG L

PMG $5k $45k“Excess” Liability $425k $425k

$430k $470kd. Compared to the end of year 2:

i. G has a $20k decrease in liabilitiesii. L has a $20k increase in liabilities


Basis


Loss (from dep.)

End. Outside

BasisG $405k ($20k) ($5k) $425kL $465k $20k ($45k) $425k

V. Allocations Where Partners’ Interests Vary During the Yeara. Look to Regulations. If there is a change in any partner’s interest in the partnership, each

partner's distributive share of partnership tax items for the taxable year must be determined using any method prescribed by regulations. § 706(d)(1).

b. Methods Prescribed by Regulations. Reg. § 1.706-1(c)(2)(ii).i. Interim Closing of the Books Method (default). At the time the change in interests

occurs, the partnership closes its books, i.e., treats the date of change as if it were the end of a taxable year, and allocates tax items accordingly.

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ii. Proration Method (elective method). Tax items are treated as arising ratably throughout the year.

c. Example

i. Allocation of the $120,000 Loss (Interim Closing of the Books Method)A B C D

$72k (January–June)

$24k $24k $24k 0

$48k (July–December)

$12k $12k $12k $12k

Total $36k $36k $36k $12kii. Allocation of the $120,000 Loss (Proration Method)

A B C D$60k (January–June)

$20k $20k $20k 0

$60k (July–December)

$15k $15k $15k $15k

Total $35k $35k $35k $15k* Under the proration method, the $120,000 loss is allocated equally throughout the year ($10,000 per month in this example), and is allocated among the outstanding interests.

d. Historical Abuse of Section 706(d)(1)i. Partnerships using the cash method of accounting would defer paying deductible items,

such as interest, until the end of the partnership taxable year.ii. A new partner would be admitted just before the payment, and the partnership would

allocate the deductible item using the interim closing of the books method.iii. This had the effect of giving the new partner a significant share of the deductible item,

although only a small portion of it was attributable to the period after the new partner’s admission.

e. Congress’s Response: Section 706(d)(2)–(3)i. § 706(d)(2)(A): if the partnership has an “allocable cash basis item,” then the item must

be assigned to each day during the period in which it arose, and allocated in accordance with the partners' interests on those days.

1. In effect, it makes a cash-method taxpayer use the accrual method for these items

ii. § 706(d)(2)(B): an allocable cash basis item is any of the following for which the partnership uses the cash method of accounting:

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1. Interest2. Taxes3. Payments for services or the use of property4. Any other item specified in regulations

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PART 5: TRANSACTIONS BETWEEN PARTNERS AND PARTNERSHIPS

I. Payments for Services and the Use of Propertya. Introduction

i. Transactions Between Partners and Partnerships1. Partners sometimes deal with the partnership other than in their capacity as

partners.2. Transactions in which a partner might act in a non-partner capacity in a

transaction with the partnership include the partner’s:a. provision of servicesb. loan of money, orc. rental or sale of property

3. Before Congress enacted subchapter K in 1954, there was uncertainty concerning whether, for federal tax purposes, a partner could engage in a transaction with his partnership in a nonpartner capacity, i.e., as if the partner were a third party.

4. In 1954, Congress enacted subchapter K, including § 707, which was meant to clarify the law in this area.

ii. Three Categories of Transactions. Congress has created three categories of transactions between a partner and a partnership:

1. Partner provides services or use of property while acting in his capacity as a partner, and the amount the partner receives is determined with reference to partnership income.

a. §§ 702, 704: partner takes into account his distributive shareb. Timing determined by § 706(a)c. Distributions to partner governed by § 731

2. Transactions between a partner and the partnership in which the partner is acting other than in his capacity as a partner.

a. Treat this transaction as btwn the p’ship and an outsider. § 707(a)(1).3. Same as #1, but the amount the partner receives is determined without

reference to partnership income.a. Hybrid approach of “guaranteed payments” under § 707(c)

b. Partner Acting in Nonpartner Capacityi. A partner is likely to be regarded as acting in a partner capacity if the partner provides

services that are ongoing and integral to the partnership’s business.1. A partner’s provision of general managerial services would fall into this

category. See Pratt v. Comm’r (concluding that general partners who managed shopping center owned by partnership were acting in their capacity as partners).

ii. A partner is more likely to be found not to be acting as a partner when the partner provides services that require the partner's special expertise, e.g., as a lawyer, accountant, or investment advisor. See Rev. Rul. 81-301 (concluding that partner acted in a non-partner capacity in providing investment advisory services to partnership).

iii. Hypothetical – Differences Between Partners and Non-Partners

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1. Affects Charactera. If A is not acting as a partner (under § 707(a)(1)), the amount paid to A

becomes a deductible expense to the p’ship (deductible against OI).i. $6k OI – $1k ded. = $5k OI

ii. Allocable Income = $5k OI and $4k LTCGA (50%) B (50%)

$5k OI $2.5k OI $2.5k OI$4k LTCG $2k LTCG $2k LTCG

$1k GI (compensation)

b. If A is acting as a partner (1st category above), A gets $1k allocation; split $9k equally. This effectively makes the sharing arrangement 55%/45%.

i. Allocable Income = $6k OI and $4k LTCGA (55%) B (45%)

$6k OI $3.3k OI $2.7k OI$4k LTCG $3.2k LTCG $1.8k LTCG

2. Affects Timinga. If A is not acting as a partner:

i. § 267(a)(2), (e): a deduction may not be taken prior to the year in which the amount is includible in GI of the payee

ii. Assuming the p’ship makes the pmt, it’s includible in GI by A and deductible by p’ship in the current year

b. If A is acting as a partner:i. § 706(a): items are taken into account in partner’s tax year

where the p’ship’s tax year ends, whether or not receivedii. § 731: if p’ship makes pmt to A, it’s a distribution

3. Affects Allowance of a Partner to be Classified as an Employeea. If A is not acting as a partner, he could claim he’s an employee and is

entitled to tax benefits. See Armstrong v. Phinney.i. E.g., exclusions on group term life insurance, health insurance

benefits (§§ 105, 106), meals and lodging (§ 119), fringe benefits (§ 132)

c. Disguised Paymentsi. Problem 1 (p. 240). A (a cash method taxpayer) is an equal partner in the ABCD

partnership (an accrual method taxpayer) and has a $10k outside basis in her

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partnership interest. A owns depreciable personal property (adjusted basis—$2,000; fair market value—$15,000; fair rental value—$1,000 per year) which the partnership will use in its business. Before any of the transactions described below, the partnership has $10,000 of net income each year. What result in the following alternatives?

1. (a) A leases the property to the partnership for three years. The partnership will pay A $1,000 per year for three years for the use of the property.

a. A is not acting as a partner. He is renting property to the p’ship.b. § 707(a)(1): treat as if the transaction is btwn the p’ship and an

outsider. Business expenses to partnership. c. When the p’ship pays the $1k rent:

i. $10k net income – $1k rent ded. = $9k net income to divide among the partners

A B C D$2.25k $2.25k $2.25k $2.25k

$1k rental income

2. (b) What result in (a), above, if the rental payments are made on January 31 of the year following accrual?

a. § 267(a)(2), (e): p’ship can’t take the deduction until the partner includes the pmt in GI

b. $10k net income to allocate among partnersA B C D

$2.25k $2.25k $2.25k $2.25kc. When p’ship pays $1k rent in year 2:

i. Partner includes in GI (b/c he’s a cash method taxpayer)ii. P’ship takes $1k deduction

iii. Same result as in part (a)3. (c) A transfers the property to the partnership, which will use it for three years

and transfer it back to A at the end of that period. The partnership makes a special allocation of its first $1,000 of net income to A. What result to A?

a. What’s the entrepreneurial risk to A?i. If the pmt is pretty certain, tends to look like a disguised pmt

under §§ 707(a)(2)(A); 707(a)(1). Payment is pretty certain so likely a disguised payment. Benefit to PR only, not the PNS. No deduction to the PNS.

ii. If there is entrepreneurial risk, treat it as pmt to a partner acting as a partner w/ reference to p’ship income (1st category above)

b. § 707(a)(2)(A): disguised paymenttreat as a transaction in § 707(a)(1)

i. Same result as in parts (a) and (b), disguised paymentii. If p’ship makes pmt this year:

1. P’ship takes $1k deduction2. A has $1k GI3. Remaining is allocated among partners

iii. If defers pmt, defers deductionc. If there is a level of entrepreneurial risk; treat A as a partner

i. First $1k is allocated to A. The remaining is allocated equally among A, B, C, and D

A B C D$2.25k $2.25k $2.25k $2.25k

$1k

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allocationii. Character is determined at p’ship level

iii. Timing is governed by § 706(a)iv. A’s basis is increased by $3,250, then decreased by $1k when

p’ship makes the pmt to A4. What if instead, the first $3,000 of the first year’s net income and no

subsequent income in excess of her one-quarter share is allocated to A?a. If A is acting in his capacity as partner:

i. Allocate $10k1. $3k goes to A2. $7k allocated equally among partners

A B C D$3k

$1.75k $1.75k $1.75k $1.75kb. If A is not acting as a partner (disguised pmt)

i. $3k pmt paid to A is pre-paid rentii. § 263: capital expenditure; take deduction ratably each year

iii. Year 11. $10k income – $1k deduction = $9k income to

allocateA B C D

$3k$2.25k $2.25k $2.25k $2.25k

c. Advantage of A acting as a partner:i. Has the effect of giving p’ship a current deduction for what is

really a capital expenditured. Note: 3 years of rent has a greater risk of being a disguised pmt

ii. Problem 2 (p. 240). Consider the following example adapted from the legislative history of § 707(a)(2)(A):

1. A commercial office building constructed by a partnership is projected to generate gross income of at least $100,000 per year indefinitely. Architect, whose normal fee for architectural services is $40,000, contributes cash for a 25% interest in the partnership and receives both a 25% distributive share of net income for the life of the partnership and an allocation of $20,000 of partnership gross income for the first two years of partnership operations after the property is leased. The partnership expects to have sufficient cash available to distribute $20,000 to Architect in each of the first two years, and the agreement requires such a distribution.

2. What factors are most important in determining whether the $20,000 allocation of gross income to Architect is a share of profits or a § 707(a)(2)(A) payment?

3. General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984. Factors to determine whether a partner receives pmt as a partner are:

a. Entrepreneurial risk (risk of payment)i. Here, there’s little risk

b. Whether the partner status of the recipient is transitoryc. Whether the allocation and distribution are close in time to the

partner’s performance of services for or transfer of property to the partnership

i. Here, the allocation is pretty close to the services

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d. Whether the recipient became a partner to obtain tax benefits for himself or the partnership which would not have been available if he had rendered services to the partnership in a third party capacity

e. Whether the value of the recipient’s interest in general and continuing partnership profits is small in relation to the allocation in question

i. Here, the pmt is a fairly high allocation ($20k of $100k net income) + 25% share

f. Whether the requirement that capital accounts be respected under § 704(b) makes income allocations which are disguised pmts for capital economically unfeasible and therefore unlikely to occur

d. Guaranteed Paymentsi. Problem 1 (p. 250). The AB equal partnership is in a highly speculative business in which

profits fluctuate widely. For the current year the partnership has profits of $20,000, of which $12,000 is ordinary income and $8,000 is long-term capital gain. A and B share profits and losses equally unless otherwise provided. A renders services to the partnership which are continuous, related to the function of the partnership and not in the nature of a capital expenditure.

1. (a) What result to A, B, and AB if A worked for the partnership and was required to be paid $15,000 per year for his services regardless of the income of the partnership?

a. A is acting as a partneri. Activity is integral and ongoing

ii. Here, this is a “guaranteed pmt” under § 707(c)b. P’ship has $3k loss

i. $12k OI – $15k guaranteed pmt to A = $3k lossA (50%) B (50%)

Ordinary Income $15k*Ordinary loss ($1.5k) ($1.5k)LTCG $4k $4k

c. *Reg. 1.707-1(c) (2d sentence): partner must include guaranteed pmt as ordinary income for his taxable year within or with which ends the p’ship taxable year in which the partnership deducted such pmts as paid or accrued under its method of accounting

i. If p’ship used the accrual method and accrues the deduction in year 1, but doesn’t make pmt until year 2, partners includes the pmt in GI in year 1

2. (b) What result in (a), above, if A’s services relate to the improvements on land owned by the partnership?

a. A’s pmt is a capital expenditure; not deductible by p’shipb. Ordinary income = $12kc. LTCG = $8kd. A includes the pmt in GI when it’s made (assuming he’s a cash

method taxpayer)A (50%) B (50%)

Ordinary Income $15kOrdinary loss ($6k) ($6k)LTCG $4k $4k

3. (c) What results if A renders the services under an agreement that he will receive $15,000 or 50% of the profits before taking into account any guaranteed payments, whichever is greater, and the profits are $20,000, consisting of $12,000 of ordinary income and $8,000 of long-term capital gain?

a. A’s distributive share of p’ship income = $20k * 50% = $10k

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b. A’s guaranteed pmt is the extra $5kc. P’ship ordinary income = $12k – $5k guaranteed pmt ded. = $7kd. LTCG = $8ke. Total p’ship income = $15kf. A is entitled to $10k/$15k = 2/3; B is entitled to 1/3

A (2/3) B (1/3)Guaranteed pmt $5k$7k Ordinary Income $4,667 $2,333$8k LTCG ($5,333) ($2,667)

g. See Rev. Rul. 69-180 (using this method to solve a similar problem)4. (d) What result in (a) and (c), above, if A’s compensation is not for services but

is received as a guaranteed return on A’s contributed capital to the partnership?

a. Same resultb. § 707(c): guaranteed pmts include pmts for use of capital

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PART 6: SALES AND EXCHANGES OF PARTNERSHIP INTERESTS

I. Consequences to the Selling Partnera. STEP ONE: Determine total gain or loss realized.

i. AR – AB = RG (RL). § 1001.ii. Amount Realized

1. Cash and Property. AR = money + FMV of property received. § 1001(b).2. Liability Relief. If a p’ship interest is sold, the reduction in the transferor

partner’s share of p’ship liabilities is treated as an amount realized under § 1001. § 752(d); Reg. 1.752-1(h).

iii. Adjusted Basis1. Cash and Property. Outside basis = money + AB property contributed. § 722.2. Share of Partnership Liability. Any increase in a partner’s share of p’ship

liabilities shall be considered as a contribution of money to the p’ship. §752(a). Outside basis [is increased] by contributions of money. § 722.

3. Share of Partnership Income. Where a partner sells her entire interest, the partner’s outside basis is increased by her share of p’ship taxable income. Reg. § 1.706-1(c)(2)(ii); § 705(a)(1)(A).

b. STEP TWO: Determine portion of gain (loss) that is ordinary under § 751.i. STEP 2(A): Determine partner’s capital gain (loss) in absence of § 751. This is going to

be the same answer as STEP ONE. See § 741.ii. STEP 2(B): Determine partner’s share of ordinary income under § 751 by doing a

hypothetical sale.1. Hypothetical Sale. Ordinary income/loss under § 751 is the income/loss from

§751 property allocated to the partner if the p’ship sold its property for an amount equal to FMV.

2. § 751 Propertya. Unrealized Receivables

i. Defined. “Unrealized receivable” includes, to the extent not previously includible in income under the p’ship’s method of accounting, any right to payment for:

1. (1) goods delivered, or to be delivered, to the extent they’re not capital assets, or

2. (2) services rendered, or to be rendered. § 751(c).ii. §§ 1245 and 1250 Property. “Unrealized receivables” also

include section 1245 property and section 1250 property. § 751(c) (flush language).

b. Inventory Items. “Inventory items” means:i. (1) p’ship property described in § 1221(a)(1),

ii. (2) property that’s not a capital asset and not section 1231 property, and

iii. (3) p’ship property which, if held by the selling partner, would be considered property of the type described in (1) or (2). § 751(d).

c. Tiered Partnerships. In determining whether p’ship property is § 751 property, the p’ship is treated as owning its proportionate share of the property of any other p’ship in which it is a partner. § 751(f).

iii. Capital Gain = STEP 2(A) – STEP 2(B). In the case of a sale/exchange of an interest in a partnership, gain/loss is capital, except as provided in §751. § 741.

c. Problem 1 (pp. 275–76). Partner A owns a one-third interest in the ABC cash method, calendar year general partnership, which manufactures and sells inventory. A, B and C, the original partners, each made initial cash contributions of $75,000. All income has

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been distributed as earned. On January 1st, A sells his interest in the partnership to D. Consider the tax consequences of the sale to A, assuming he has owned his partnership interest for several years. The balance sheet of the ABC partnership (which is to be used in all parts of this problem unless the facts indicate to the contrary) is as follows:

Assets Liabilities and Partners’ CapitalAB FMV AB FMV

Cash $45k $45k Liab: noneInventory $75k $90k Capital:A/R 0 $45k A $75k $135kCapital Asset $105k $225k B $75k $135k

C $75k $135k$225k $405k $225k $405k

i. Consider the tax consequences to A on his sale in each of the following alternative situations:

ii. (a) A sells his interest for $135,000 cash.1. STEP ONE

a. $135k AR – $75k AB = $60k gainb. If there’s no liabilities, tax capital accounts should equal partners’

basis in the partnership2. STEP TWO(A)

a. Capital gain (loss) in absence of § 751 = $60ki. § 741: gain/loss from sale of a p’ship interest is capital

3. STEP TWO(B)a. Hypothetical Sale of § 751 Property

Inventory Accounts ReceivableAR $90kAB ($75k)Gain $15k

AR $45kAB (0)Gain $45k

b. Total Gain = $60kc. A’s share = $20kd. A has § 751 ordinary income of $20k

4. § 741: $60k gain – $20k OI = $40k capital gaina. Since A held the p’ship interest for several years, it’s LTCG

5. Note: if A had contributed the accounts receivable, the built-in gain of $45k would be allocated to A in the hypothetical sale under § 704(c)

iii. (b) Each partner originally contributed $150,000 cash (and assume each has an outside basis of $150,000), and the capital asset has a basis to the partnership of $330,000. A sells his interest to D for $135,000 cash.

1. STEP ONEa. $135k AR – $150k AB = $15k loss

2. STEP TWO(A)a. Capital gain (loss) in absence of § 751 = $15k



AR $45kAB (0)Gain $45k

i. Note: § 751 property does not include capital assetsb. Total Gain = $60kc. A’s share = $20k

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d. A has § 751 ordinary income of $20k4. § 741: $15k loss – $20k OI = $35k LTCL

iv. (c) Each partner originally contributed only $45,000 cash instead of $75,000, and the capital asset was purchased and held subject to a $90,000 liability. A sells his interest to D for $105,000 cash.

1. STEP ONEa. $135k AR – $75k AB = $60k gainb. AR

i. § 1001(b): $105k cash receivedii. § 752(d); Reg. 1.752-1(h): $30k liability relief

c. ABi. § 722: $45k cash contributed

ii. §§ 752; 722: $30k share of liability2. STEP TWO

a. Same result as part (a)v. (d) The sale occurs on March 31, one quarter of the way through the year, at a time

when A’s share of partnership income through March 31 (all ordinary income) is $30,000. It is agreed that D will pay A $165,000 for his interest and also will acquire A’s right to income. Asked under the interim closing method how will we calculate.

1. STEP ONEa. $165k AR – $105k AB = $60k gainb. AR

i. § 1001(b): $165k cash receivedc. AB

i. $75k original outside basisii. $30k income through March 31

1. § 706(c)(2)(A): p’ship taxable year closes w/ respect to a partner upon sale of her entire interest

2. Reg. § 1.706-1(c)(2)(ii): where a partner sells her entire interest, the partner shall include . . . his distributive share of items in § 702(a)

a. § 702(a)(7) includes OI3. § 705(a)(1)(A): outside basis is increased by

partner’s share of p’ship taxable income2. STEP TWO

a. Same result as part (a)d. Problem 2 (p. 276). Assume the same basic facts as in Problem 1, except the ABC partnership is

an accrual method partnership so that the accounts receivable have an adjusted basis of $45,000 and A has an outside basis of $90,000.

i. Assume Partner A sell his p’ship interest for $135k1. STEP ONE

a. $135k AR – $90k AB = $45k gain2. STEP TWO(A)

a. Capital gain (loss) in absence of § 751 = $45kii. (a) A sells his interest to D on January 1.



AR $45kAB ($45k)Gain 0

i. Accounts Receivable

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1. A/R not an ”unrealized receivable” b/c it is includible in income under p’ship’s method of accounting. Because PNS is on the accrual method, therefore PNS will have a basis in the assets.

2. A/R is an “inventory item” b/c it is a non-capital asset. For purposes of our constructive sale.

b. Total Gain = $15kc. A’s share = $5kd. A has § 751 ordinary income of $5k

2. $45k gain – $5k OI = $40k LTCGiii. (b) What result in (a), above, if the partnership held the inventory as a capital asset, but

A is a dealer in that type of property?1. Same result as part (a)2. § 751(d)(3): “inventory item” includes p’ship property that would be

considered property described in (1) or (2) if held by the partnera. If held by A, the property would be property described in § 1221(a)(1)

(§ 751(d)(1))iv. (c) What result in (a), above, if the partnership owns no inventory but has a 50% interest

in another partnership (partnership #2), whose only assets are inventory with a basis of $150,000 and a value of $180,000?

1. Same result as part (a), calculation is the same. ½ 150k (90k) ½ 180k (90k) 2. § 751(f): in determining whether p’ship property is § 751 property, the p’ship

is treated as owning its proportionate share of the property of any other p’ship in which it is a partner.

a. P’ship #1 owns 50% of P’ship #2b. P’ship #2 owns inventory—$150k AB; $180k FMVc. Treat P’ship #1 as owning inventory w/ $75k AB and $90 FMV

i. Same as in part (a)v. (d) What result in (a), above, if in addition the partnership had a contract worth $30,000

to perform real estate management services for the next ten years?1. STEP TWO(B)

a. The contract is a §751 asseti. See Ledoux v. Commissioner (contract to operate dog track

was an unrealized receivable under § 751(c)(2) b/c it was a right to pmt for services to be rendered)Treated as an accounts receivable

b. Hypothetical Sale of § 751 PropertyInventory Accounts Receivable Contract

AR $90kAB ($75k)Gain $15k

AR $45k (prof added 30k here, no separate K) AB ($45k)Gain 0 (30k)

AR $30kAB 0Gain $30k

c. Total Gain = $45kd. A’s share = $15ke. A has § 751 ordinary income of $15k

2. $45k gain – $15k OI = $30k capital gainII. Consequences to the Buying Partner

a. General Rule: Basis in P’ship Property Unadjusted. If there is a transfer of a partnership interest, no adjustment can be made to the basis of partnership property unless:

i. A § 754 election is in effect, or

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ii. The partnership has a “substantial built-in loss” immediately after the transfer. § 743(b).

1. Substantial Built-In Loss. A partnership has a substantial built-in loss if the partnership’s adjusted basis in partnership property exceeds by more than $250,000 the fair market value of the property. § 743(d)(1).

iii. Income to Partner. Since the bases in p’ship assets are not adjusted, upon disposition of assets, the partner will recognize her distributive share of income/loss, even though she paid for it in buying the p’ship interest.

b. The § 754 Electioni. Effect of Election. A § 754 election adjusts inside basis of p’ship assets. See §§ 754, 743.

When the p’ship disposes of the asset, New Partner does not have flow-through income. Reg. § 1.743-1(j)(3)(i).

1. Personal to Partner. The basis adjustment only adjusts the basis of the transferee. No adjustment is made to the common basis of p’ship property. Reg. § 1.743-1(j)(1).

ii. Procedure of Making the Election1. Partnership makes the election. § 754.2. Written Statement. Election is made in a written statement filed w/ the

partnership return for the taxable year during which the distribution or transfer occurs. The stmt shall (i) set forth the name and address of the p’ship, (ii) be signed by any one of the partners, and (iii) contains a declaration that the p’ship elects under § 754. Reg. § 1.754-1(b)(1).

3. Applies Until Revocation. A § 754 election applies to property distributions and transfers of p’ship interests in the taxable yr in which the election is made and in all subsequent p’ship taxable years unless the election is revoked. Reg. § 1.754-1(a).

a. How to Revoke. P’ship may revoke w/ the approval of the district director for the internal revenue district in which the p’ship return is req’d to be filed. Reg. § 1.754-1(c).

iii. Subsequent Transfers. A transferee’s basis adjustment is determined w/o regard to any prior transferee’s basis adjustment. Reg. § 1.743-1(f).

1. Book Capital Accounts Transfer. The book capital account of the transferor carries over to the transferee. Reg. § 1.704-1(b)(2)(iv)(l), (m).

c. Basis Adjustment under § 754i. Determine Total Basis Adjustment Under § 743(b)(1). Increase AB of p’ship property by

the excess of:1. Transferee’s basis in p’ship interest, over

a. Cost Basis. The basis in a partnership interest acquired other than by contribution is determined by §§ 1011 and 1012 (cost basis rules). § 742.

2. Transferee’s Proportionate Share of AB of Partnership Propertya. Transferee’s interest in previously taxed capital, plus

i. Previously Taxed Capital. Reg. 1.743-1(d)(1).1. Distribution of cash in hypothetical liquidation2. Increased by tax loss allocated3. Decreased by tax gain allocated

b. Transferee’s share of p’ship liabilities. Reg. § 1.743-1(d)(1).ii. Allocate Basis Adjustment Among Partnership Assets Under §755. Reg. 1.755(a)(1).

1. (1) Determine FMV of p’ship assets under Reg. § 1.755-1(a)(2)–(5)2. (2) Allocate basis adjustment among two classes:

a. (A) Capital gain propertyb. (B) Ordinary income property

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c. Order. First determine the amount of basis adjustment allocated to ordinary income property. The amount of basis adjustment to capital gain property is generally the remaining basis adjustment. Reg. § 1.755-1(b)(2)(i).

3. (3) Allocate basis adjustment among assets in each classd. Problem 1 (pp. 291–92). On January 1 on year one, Nupartner purchased a one-third interest in

a partnership for $40,000. At the time of purchase the partnership had the following assets:

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A.B. F.M.V.Accounts Receivable $0 $30,000Land 60,000 90,000

i. (a) If § 754 had not been elected by the partnership, what is the result to Nupartner upon collection of the receivables? First look for big substantial loss, no loss here, gain on both.

1. P’ship has $30k ordinary income2. Nupartner’s has a $10k distributive share (PR’s share of OI, Distribution is

something very different) of ordinary incomeii. (b) What result to Nupartner in (a), above, if the partnership had made a § 754 election?

1. Determine Total Basis Adjustment Under 743(b)(1). Increase AB of p’ship property by excess of:

a. Transferee’s basis in p’ship interest, overi. Here, cost basis of $40k

b. Transferee’s proportionate share of AB of p’ship propertyi. Reg. 1.743-1(d)(1): transferee’s interest in previously taxed

capital (plus 0 liabilities)ii. Distribution of cash in hypothetical liquidation

1. Here, $30k cash from A/R + $90k cash from land = $120k total / 3 = $40k

iii. Increase by tax loss allocated1. Here, that’s 0

iv. Decrease by tax gain allocated1. Allocated gain = $20k

a. A/R: 30k AR – 0 = 30kb. Land: 90k AR – 60k AB = 30kc. $30k + $30k = 60k / 3 = 20k

c. Increase AB of p’ship property by: 40k – [$40k – 20k] = 20kd. So 10k AB in Accounts Receivable for new partner, and 30k AB in land

for the new partner. (60k/3 = 20 +10k) 2. Allocate the Basis Adjustment Among P’ship Assets under § 755

a. (1) Determine FMV of p’ship assets under 1.755-1(a)(2)–(5)i. Here, we’re told what the value is

b. (2) Allocate basis adjustment among two classes:i. (A) Capital gain property

1. Land falls under this, assuming it’s not a dealer in land

ii. (B) Ordinary income property1. A/R is ordinary income property

iii. Reg. § 1.755-1(b)(2)(i): Order of Allocation: first determine allocation to OI property, then total basis adjustment – allocation to OI property = allocation to capital gain property

1. Here, 10k would be allocated to OI property2. $20k – $10k = $10k allocated to capital gain property

c. (3) Allocate basis adjustment among assets in each classi. Here, only one asset per class

iii. (c) Who makes a § 754 election? When and how must the election be made?1. § 754: p’ship make the election2. Reg. § 1.754-1(b)(1)

a. Election is made in a written statement filed w/ the partnership return for the taxable year during which the distribution or transfer occurs

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i. The stmt shall (i) set forth the name and address of the p’ship, (ii) be signed by any one of the partners, and (iii) contains a declaration that he p’ship elects under § 754.

b. The return must be filed by the 15th day of the 4th month after the taxable yr ends

3. Reg. § 1.754-1(a): a § 754 election applies to property distributions and transfers of p’ship interests in the taxable yr in which the election is made and in all subsequent p’ship taxable years unless the election is revoked

4. Reg. § 1.754-1(c): p’ship may revoke w/ the approval of the district director for the internal revenue district in which the p’ship return is req’d to be filed.

iv. (d) Should Nupartner have conditioned his purchase of the partnership interest upon a § 754 election?

1. Yes, as long as the assets are appreciated2. Where the assets’ FMV < AB, the incoming partner would not want the p’ship

to take the §754 election (special basis decrease)v. (e) Will Nupartner’s purchase and the § 754 election have any immediate tax impact on

the remaining old partners? May affect later distributions, will talk about later. 1. No, it will not have an immediate effect2. Reg. § 1.743-1(j)(1): the basis adjustment is personal to Nupartner3. If the old partners sell their interests:

a. Their transferee’s may be affected by a § 754 electionb. The election may make the interests less desirable if the assets are

depreciated4. A § 754 election requires the p’ship to adjust the basis of assets distributed to

the partners (more later)vi. (f) Will the § 743(b) basis adjustment affect Nupartner in situations other than on

collection of partnership income or sales of partnership property?1. Reg. § 1.743-1(j)(4): basis adjustments affect depreciation deductions2. Reg. § 1.743-1(g): basis adjustments affect the basis in assets distributed from

the p’ship3. New PR’s basis in property for most purposes.

vii. (g) At the end of year three, the partnership had earnings, all of which had been distributed, and it continued to hold the identical accounts receivable and land, each of which had the same basis and fair market value. Assuming no § 754 election, what result to Nupartner if, before the receivables are collected, he sells his partnership interest to Buyer for $40,000?

1. STEP ONE: Determine total gain/loss to selling partnera. $40k AR – $40k AB = $0

2. STEP TWO: Determine portion of gain (loss) that is ordinary under § 751.a. STEP 2(A): Determine partner’s capital gain (loss) in absence of § 751.

i. This is $0b. STEP 2(B): Determine partner’s share of ordinary income under § 751

by doing a hypothetical sale.i. Hypothetical Sale. Ordinary income/loss under § 751 is the

income/loss from §751 property allocated to the partner if the p’ship sold its property for an amount equal to FMV.

1. § 751(c): A/R are unrealized receivables2. $30k – $0 = $30k / 3 = $10k allocated gain from A/R3. $10k ordinary income

c. Capital Gain = STEP 2(A) – STEP 2(B). In the case of a sale/exchange of an interest in a partnership, gain/loss is capital, except as provided in §751.

i. $0 – $10k = $10k capital loss

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viii. (h) What result to Nupartner in (g), above, if the partnership had made a § 754 election?1. STEP ONE: Determine total gain/loss to selling partner

a. $40k AR – $40k AB = $02. STEP TWO: Determine portion of gain (loss) that is ordinary under § 751.

a. STEP 2(A): Determine partner’s capital gain (loss) in absence of § 751.i. This is $0

b. STEP 2(B): Determine partner’s share of ordinary income under § 751 by doing a hypothetical sale.

i. Because of the § 754 election, Nupartner realizes no income on the sale of the A/R. Nupartner has 10k new basis, 10k gain-10k basis = 0, Gets to use basis allocation.

ii. Ordinary income = $0c. Capital Gain = STEP 2(A) – STEP 2(B). In the case of a sale/exchange of

an interest in a partnership, gain/loss is capital, except as provided in §751.

i. $0 – $0 = $0 capital gain/loss §741 ix. (i) What is Buyer’s inside basis in (h), above?

1. Reg. § 1.743-1(f): a transferee’s basis adjustment is determined w/o regard to any prior transferee’s basis adjustment

2. Thus, Buyer would go through the same analysis in part (b). All the numbers are the same, so it will be the same inside basis.

x. (j) If the partnership properly maintained capital accounts and the selling partner’s capital account prior to the sale of his interest was $20,000, what is Nupartner’s capital account upon purchase of his one-third interest for $40,000 if:

1. (i) a § 754 election were in effect; (ii) a § 754 election were not in effect.2. The answer is the same under either scenario3. Reg. § 1.704-1(b)(2)(iv)(l), (m): book capital account of the transferor carries

over to the transfereea. Thus, Nupartner’s capital account is the same as the selling partner’s:

$20kb. 754 election only relates to the basis, it does not affect the capital

account. (Capital account: ledger of how much money the PNS owes to the PR).

xi. (k) If a § 754 election is in effect, will each new purchasing partner create havoc for the partnership’s accountant?

1. Yes. It will be burdensome if the p’ship has a lot of assets or a lot of transfers in p’ship interests.

2. Reg. § 1.754-1(c)(1): may permit revocation of a § 754 election when it becomes an administrative burden

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PART 7: OPERATING DISTRIBUTIONS

I. Introductiona. Operating (“Current”) Distributions are distributions to someone who continues to be a partner

after distribution. Cf. liquidating distributions.II. Consequences to the Distributee Partner

a. Nonrecognition Rules on the Distributioni. Nonrecognition by Partner. Generally, in distributions by a p’ship to a partner, gain/loss

is not recognized. § 731(a)(1).1. Exception: Distribution of Money. Gain or loss is recognized to the extent that

any money distributed exceeds the AB of the partner’s interest in the p’ship immediately before distribution. § 731(a)(1).

a. Marketable Securities Treated as Money. “Money” in § 731(a)(1) includes marketable securities. § 731(c).

b. Advances and Draws. Advances or drawings of money or property are treated as current distributions made on the last day of the p’ship taxable year for the distributee partner. Reg. § 1.731-1(a)(1)(i).

2. Capital Gain. Any gain/loss recognized under § 731(a)(1) is considered gain/loss from sale/exchange of the p’ship interest from the distributee partner. § 731(a) (flush language).

ii. Transferred Basis in Land. The basis of property (other than money) distributed by a p’ship to a partner (in operating distribution) is its AB to the p’ship immediately before such distribution. § 732(a)(1).

1. Limited to Basis in P’ship Interest After Cash Distribution. The basis a partner takes in distributed property cannot exceed AB of such partner’s interest in the p’ship reduced by any money distributed in the same transaction. § 732(a)(2). See § 732(c) (how to allocate basis in p’ship interest in distribution of multiple assets).

2. New Transferee Partners. For a partner who acquired his interest by transfer where a § 754 election was not in effect, w/in 2 years of the transfer, the partner can elect to treat AB of distributed property as if a § 754 election was in effect. § 732(d).

a. Example. Nupartner joins ABC p’ship. P’ship has A/R: AB = $0, FMV = $90k. W/in 2 yrs of Nupartner joining, p’ship distributes 1/3 of the A/R to Nupartner. Here, Nupartner could elect to treat his AB in the A/R as if a § 754 election was in place. Under the adjustments to basis under § 743, Nupartner’s basis in the A/R = $30k.

iii. Effect on Partner’s Interest in the Partnership. For operating distributions, the AB of a partner’s interest in the p’ship is reduced (but not below zero) by—

1. (1) money distributed to the partner, and2. (2) AB to such partner of distributed property other than money. § 733.

iv. Nonrecognition by Partnership. P’ship does not recognize gain/loss on distribution of property, including money. § 731(b).

v. Problem 1 (p. 304). On July 1, the ABC Partnership, a calendar year partnership, distributes to each of its equal partners $10,000 in cash and land with a value of $10,000 and a basis of $5,000. A, B and C have outside bases of $20,000, $10,000 and $5,000 respectively. The partnership has the following assets prior to the distribution:

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Assets A.B. F.M.V.Cash $50,000 $50,000Accounts Receivable 0 20,000Inventory 20,000 30,000Land 30,000 60,000Building 10,000 50,000

1. (a) Discuss the tax consequences of the distribution to A, B, and C, each of whom has owned his partnership interest for several years.

a. Partner Ai. Cash Distribution

1. § 731(a)(1): gain/loss not recognized unless cash distributed > AB of partner’s interest in p’ship before distribution

a. Here, $10k cash < $20k AB in p’ship interestb. Nonrecognition

2. § 733(1): in operating distributions, AB of partner’s interest in p’ship is reduced by money distributed

a. Basis in p’ship interest = $20k – $10k = $10kii. Land Distribution

1. § 731(a)(1): nonrecognition (b/c not cash)2. § 732(a)(1): partner’s basis in distributed property =

p’ship’s AB immediately before the distributiona. Basis in land = $5k

3. § 733(2): in operating distributions, AB of partner’s interest in p’ship is reduced by partner’s AB in distributed property

a. Basis in p’ship interest = $10k – $5k = $5kb. Partner B

i. Cash Distribution1. § 731(a)(1): gain/loss not recognized unless cash

distributed > AB of partner’s interest in p’ship before distribution

a. Here, $10k cash = $10k AB in p’ship interestb. Nonrecognition

2. § 733(1): in operating distributions, AB of partner’s interest in p’ship is reduced by money distributed

a. Basis in p’ship interest = $10k – $10k = $0ii. Land Distribution

1. § 731(a)(1): nonrecognition (b/c not cash)2. § 732(a)(1): partner’s basis in distributed property =

p’ship’s AB immediately before the distribution3. § 732(a)(2): partner’s basis in distributed property

cannot exceed AB of such partner’s interest in the p’ship reduced by any money distributed in the same transaction

a. Basis in p’ship interest reduced by cash distribution = $0

b. Basis in land = $04. § 733(2): in operating distributions, AB of partner’s

interest in p’ship is reduced (but not below zero) by partner’s AB in distributed property

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a. Basis in p’ship interest = $0 – $0 = $0c. Partner C

i. Cash Distribution1. § 731(a)(1): gain/loss not recognized unless cash

distributed > AB of partner’s interest in p’ship before distribution

a. Here, $10k cash > $5k AB in p’ship interestb. C recognizes $5k gainc. § 731(a)(1) (flush language): capital gaind. LTCG b/c C owned p’ship interest for several

years2. § 733(1): in operating distributions, AB of partner’s

interest in p’ship is reduced (but not below zero) by money distributed

a. Basis in p’ship interest = $0ii. Land Distribution

1. Same result as Partner B2. (b) What result to C if he receives the land first and the cash in a subsequent

separate distribution on October 1?a. Land Distribution

i. § 731(a)(1): nonrecognition (b/c property, not cash)ii. § 732(a)(1): partner’s basis in distributed property = p’ship’s

AB immediately before the distribution 1. Basis in land = $5k

iii. § 732(a)(2) limitation d/n apply b/c the distributions are not in the same transaction

iv. § 733(2): in operating distributions, AB of partner’s interest in p’ship is reduced (but not below zero) by partner’s AB in distributed property

1. Basis in p’ship interest = $5k – $5k = $0b. Cash Distribution

i. § 731(a)(1): gain/loss not recognized unless cash distributed > AB of partner’s interest in p’ship before distribution

1. Here, $10k cash > $0 AB in p’ship interest2. C recognizes $10k gain

ii. § 733(1): in operating distributions, AB of partner’s interest in p’ship is reduced (but not below zero) by money distributed

1. Basis in p’ship interest = $03. (c) What result to C in (b), above, if the cash distribution on October 1 is a draw

against his share of partnership income, which is $20,000 for the year?a. Land Distribution

i. Same result as part (b)b. Cash Distribution

i. Reg. § 1.731-1(a)(ii): advances/draws treated as current distributions on last day of p’ship taxable yr

ii. § 705(a): at the end of the p’ship taxable year, AB of partner’s interest in the p’ship is (1) increased by his distributive share of income, and (2) decreased by distributions.

1. $5k original AB in p’ship interest + $20k distributive share of income – $5k land distribution – $10k cash distribution = $10k AB in partnership interest

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iii. § 731(a)(1): no gain recognitionb. Consequences on Subsequent Sales of Distributed Property

i. Sale/Exchange of Certain Distributed Property1. Unrealized Receivables. A partner who disposes of distributed unrealized

receivables has ordinary income/loss. § 735(a)(1).2. Inventory items. A partner who disposes of distributed inventory items, if

within 5 years from the date of distribution, recognizes ordinary income/loss. § 735(a)(2).

ii. Holding Period for Distributed Property. For distributed property (other than for the inventory 5-yr window), the partner tacks the p’ship’s holding period. § 735(b).

iii. Problem (in syllabus). Return to Problem 1 on page 304 and, assuming that the partnership makes the following pro rata operating distributions rather than the distributions described in the problem, and that the distributed assets would be capital assets in A’s hands, consider the following alternative questions:

1. What result if the partnership distributes to Partner A all of its accounts receivable, which A collects six years later?

a. Distribution of A/Ri. § 731(a)(1): nonrecognition (b/c property, not cash)

ii. § 732(a)(1): basis in A/R = p’ship’s AB = $0iii. § 733(2): AB of partner’s interest in p’ship is reduced by

partner’s AB in distributed property1. Basis in p’ship interest = $20k – $0 = $20k

b. Holding Periodi. § 735(b): for distributed property, partner tacks the holding

period of the p’shipc. When Partner A collects the receivables:

i. § 735(a)(1): A recognizes $30k ordinary income2. What result if the partnership distributes to Partner A all of its inventory, which

A sells six years later?a. Distribution of Inventory

i. § 731(a)(1): nonrecognition (b/c property, not cash)ii. § 732(a)(1): basis in inventory = p’ship’s AB = $20k

iii. § 733(2): AB of partner’s interest in p’ship is reduced by partner’s AB in distributed property

1. Basis in p’ship interest = $20k – $20k = $0b. When Partner A sells the inventory:

i. If Partner A sold the inventory 4 years after distribution:1. § 735(a)(2): A recognizes $10k ordinary income

ii. If Partner A sold the inventory 6 years after distribution:1. Use general tax principles2. If the inventory is inventory in Partner A’s hands,

then A recognizes $10k ordinary income3. If the inventory is a capital asset in Partner A’s

hands, then A recognizes $10k LTCGIII. Consequences to the Distributing Partnership

a. Impact on Inside Basisi. General Rule. Generally, the basis of p’ship property is not adjusted b/c of a

distribution of property. § 734(a).ii. Exception: Section 754 Election. If the p’ship made a §754 election, increase the AB of

undistributed property on the p’ship books as follows.1. STEP ONE: Determine Total Basis Adjustment Under §734(b). Increase AB of

p’ship property by—a. Any gain recognized to the distributee partner under § 731(a)(1)

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b. If § 732(a)(2) applies, the excess ofi. P’ship’s basis in distributed property over

ii. The distributee partner’s basis in that asset2. STEP TWO: Allocate Basis Adjustment Among Partnership Assets Under §

755. See Reg. § 1.755-1(a)(1).a. (1) Determine FMV of p’ship assets under Reg. § 1.755-1(a)(2)–(5)b. (2) Allocate basis adjustment between classes: Capital Gain Property

and Ordinary Income Propertyi. Distributed Cash. Where a distribution under § 734(b)(1)(A)

results in an adjustment to undistributed p’ship property, the adjustment is allocated only to capital gain property. Reg. § 1.755-1(c)(1)(ii).

ii. Distributed Property. Where a distribution under § 734(b)(1)(B) results in an adjustment to undistributed p’ship property, the adjustment is allocated to remaining p’ship property of a similar character. Reg. § 1.755-1(c)(1)(i).

1. Carryover Adjustment. If an increase in the basis of undistributed property cannot be made b/c the p’ship owns no property of the character required to be adjusted, or b/c the basis of all the property of a like character has been reduced to zero, the adjustment is made when the p’ship subsequently acquires property of a like character to which an adjustment can be made. Reg. § 1.755-1(c)(4).

c. (3) Allocate the basis adjustment to assets in each classi. Property with Unrealized Appreciation. An increase in basis

must be allocated to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation (but only to the extent of each property’s unrealized appreciation). Reg. § 1.755-1(c)(2)(j).

ii. Remaining Increase. Any remaining increase must be allocated among the properties w/in the class in proportion to their FMVs. Reg. § 1.755-1(c)(2)(j).

b. Problem (p. 313). The ABC partnership has three equal partners, A, B, and C, and the following balance sheet:

Assets Liabilities and Capital AccountsA.B. F.M.V. A.B. F.M.V.

Cash $60,000 $60,000 Liab: noneCapital Asset #1 90,000 60,000 Capital AccountsCapital Asset #2 40,000 60,000 A $70,000 $80,000Capital Asset #3 20,000 60,000 B 70,000 80,000

C 70,000 80,000$210,000 $240,000 $210,000 $240,000

i. A receives capital asset #1 in an operating distribution. A has a one-ninth interest worth $20,000 in the partnership capital and profits after the distribution.

ii. (a) What results to A and the partnership if there is no §754 election? Reconstruct the balance sheet after the distribution.

1. Partner Aa. See II. Consequences to the Distributee Partner, supra.b. § 731(a)(2): gain/loss is not recognized on the transfer of property c. Basis in Capital Asset #1

i. § 732(a)(1): general rule—A takes a transferred basis

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ii. § 732(a)(2): limitation—basis shall not exceed partner’s basis in p’ship

1. Here, A has $70k basis in his p’ship interest2. A’s basis in Capital Asset #1 = $70k

d. Basis in P’ship Interesti. § 733: reduce by AB partner takes in distributed property

ii. $70k original AB in p’ship interest – $70k A’s AB in Capital Asset #1 = 0

e. Book Capital Accounti. Reg. § 1.704-1(b)(2)(iv)(b): partner’s capital account is

decreased by FMV property distributed to himii. $80k original book capital account – $60k FMV Capital Asset

#1 = $20k2. Partnership

a. §731(b) no gain/loss recognition3. Balance Sheet


Cash $60k $60k Liab: noneCapital Asset #2 $40k $60k Capital AccountsCapital Asset #3 $20k $60k A $0 $20k

B $70k $80kC $70k $80k

$120k $180k $140k $180k4. The Problem

a. $20k of basis associated w/ Capital Asset #1 has disappeared, 754 election would avoid this.

b. If the p’ship sold off Capital Assets #2 and #3i. The p’ship would realize $60k gain

ii. Capital accounts only have $40k gain to allocateiii. A is undertaxed; B and C are overtaxed

Partner Outside Basis Share of $60k GainA (1/9) $0 $6,667B (4/9) $70k $26,667C (4/9) $70k $26,667

c. If the p’ship is liquidated, the partners are correctly allocated gain:

Partner Outside Basis

Share of $60k Gain

Ending Outside

Basis

Distribution Gain/ (Loss)

A (1/9) $0 $6,667 $6,667 $20k $13,333B (4/9) $70k $26,667 $96,667 $80k ($16,667)C (4/9) $70k $26,667 $96,667 $80k ($16,667)

iii. (b) What results to A and the partnership if the partnership has made a § 754 election? Reconstruct the balance sheet after the distribution.

1. Partner Aa. Same result as part (a).

2. Partnershipa. Same result as part (a).

3. Adjustment to Undistributed Propertya. STEP ONE: Determine Total Adjustment Under § 734(b)

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i. Increase AB of p’ship property by—1. Any gain recognized to the distribtee partner under

§ 731(a)(1)a. Here, there is no gain recognized to Partner

A under § 731(a)(1).2. If § 732(a)(2) applies, the excess of p’ship’s basis in

distributed property over the distributee partner’s basis in that asset

a. $90k – $70k = $20kb. STEP TWO: Allocate Basis Adjustment Among Partnership Assets

Under § 755i. (1) Determine FMV of p’ship assets under Reg. § 1.755-1(a)

(2)–(5)1. Here, FMV is given

ii. (2) Allocate basis adjustment between classes: Capital Gain Property and Ordinary Income Property

1. Reg. § 1.755-1(c)(1)(i): where a distribution under § 734(b)(1)(B) results in an adjustment to undistributed p’ship property, the adjustment is allocated to remaining p’ship property of a similar character

2. Here, this is Capital Assets #2 and #3iii. (3) Allocate the basis adjustment to assets in each class

1. Reg. § 1.755-1(c)(2)(j): an increase in basis must be allocated to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation (but only to the extent of each property’s unrealized appreciation)

2. Unrealized Appreciationa. Capital Asset #2: $60k FMV – $40k AB =

$20kb. Capital Asset #3: $60k FMV – $20k AB =

$40kc. Total Appreciation = $60k

3. Allocate Adjustmenta. Capital Asset #2

i. $20k basis adjustment * ($20k/$60k) = $6,667

ii. $40k original basis + $6,667 adjustment = $46,667

b. Capital Asset #3i. $20k basis adjustment *

($40k/$60k) = $13,333ii. $20k original basis + $13,333

adjustment = $33,3334. Balance Sheet


Cash $60k $60k Liab: noneCapital Asset #2 $46,667 $60k Capital AccountsCapital Asset #3 $33,333 $60k A $0 $20k

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(80k-60k)

B $70k $80kC $70k $80k

$140k $180k $140k $180kiv. (c) How should any basis adjustment be allocated among the partners?

1. If p’ship sold Capital Assets #2 and #3a. Total gain = $40k

i. A (1/9): 4,444ii. B (4/9): 17,778

iii. C (4/9): 17,778b. But, A should be allocated 20k; B and C should be allocated 10k each

2. How could the partners fix this?a. Change p’ship agreementb. Special allocation of the gain from assets #2 and #3

i. Gain on assets of #2 and #3 are allocated:1. A: 20k2. B: 10k3. C: 10k

c. BUT, does this special allocation has substantial economic effect?i. Economic Effect

1. Mechanical test; just need the right provisions in p’ship agreement and comply w/ them

ii. Substantiality1. Will the allocation affect substantially the dollar

amounts the partners will receive?a. No b/c the book/tax disparity is corrected

on liquidation2. But, the allocation may be respected b/c it’s not

based on tax-avoidance motivationsIV. Mixing Bowl Transactions

a. Distributions of Contributed Property to Another Partneri. Contributing Partner

1. Gain/Loss Recognition. If contributed property is distributed to another partner w/in 7 years of contribution, contributing partner is treated as recognizing gain/loss under § 704(c)(1)(A) if property had been sold for FMV. § 704(c)(1)(B)(i).

2. Character of Gain/Loss. If contributed property is distributed to another partner w/in 7 years of contribution, the character of the gain/loss is the character of gain/loss that results if the property was sold by the p’ship to the distributee. § 704(c)(1)(B)(ii).

a. Partnership Level. Character of gain/loss is determined at the p’ship level. § 702(b).

3. Basis in Contributing Partner’s Interest in the Partnership. If contributed property is distributed to another partner w/in 7 years of contribution, contributing partner’s basis in his interest in the p’ship is adjusted to reflect any gain/loss recognized. § 704(c)(1)(B)(iii).

ii. Distributee Partner. See II. Consequences to the Distributee Partner, supra.1. Nonrecognition. Generally, in distributions by a p’ship to a partner, gain/loss is

not recognized. § 731(a)(1).

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a. Exception: Distribution of Money. Gain or loss is recognized to the extent that any money distributed exceeds the AB of the partner’s interest in the p’ship immediately before distribution. § 731(a)(1).

b. Exception: Distribution of Other Property to Contributing Partner. See IV.b. Distributions of Other Property to the Contributing Partner, infra.

2. Basis in Distributed Property. The basis of property (other than money) distributed by a p’ship to a partner (in operating distribution) is its AB to the p’ship immediately before such distribution. § 732(a)(1).

a. Adjust Basis Before Distribution. Adjustments to the basis of a partner’s interest the partnership are made before the distribution. § 704(c)(1)(B)(iii).

3. Basis in Partnership Interest. For operating distributions, the AB of a partner’s interest in the p’ship is reduced (but not below zero) by—

a. (1) money distributed to the partner, andb. (2) AB to such partner of distributed property other than money. §

733.b. Distributions of Other Property to the Contributing Partner

i. Gain/Loss Recognition. In the case of any distribution by a p’ship to a partner, such partner is treated as recognizing gain in an amount equal to the lesser of—

1. (1) the excess of (A) FMV of property distributed over (B) AB of partner’s interest in the p’ship, OR

2. (2) the net pre-contribution gain of partner. § 737(a).a. Net Precontribution Gain. “Net precontribution gain” means any gain

the distributee partner would have recognized under § 704(c)(1)(B) if all the property he contributed w/in 7 years of the distribution was distributed to another partner. § 737(b).

ii. Character of Gain/Loss. The character of such gain is determined by reference to the proportionate character of the net precontribution gain. § 737(a) (flush language).

iii. Basis Adjustments1. Basis in P’ship Interest. AB of partner’s interest in the p’ship is increased by

the amount of any gain recognized by such partner under (a). § 737(c)(1).a. Increased Before Distribution. For purposes of determining the basis

of the distributed property, such increase shall be treated as occurring immediately before the distribution. § 737(c)(1).

2. Basis in Asset Distributed. The basis of property (other than money) distributed by a p’ship to a partner (in operating distribution) is its AB to the p’ship immediately before such distribution. § 732(a)(1).

a. Distribution Decreases Basis. AB of distributee’s interest in the p’ship is reduced (but not below zero) by AB partner takes in the property. § 733(2).

3. Partnership’s Basis in Contributed Property. Adjustments made to p’ship’s basis in contributed property referred to in subsection (b) to reflect gain recognized under subsection (a). § 737(c)(2).

c. Problem (pp. 318–19). A, B, and C form the equal ABC partnership by contributing the following real properties, all of which are held as an investment by both the partners and the partnership:

Partner Property A.B. FMV.A #1 $2,000 $10,000B #2 $5,000 $10,000C #3 $10,000 $10,000

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i. Assume that ABC uses the “traditional method” of allocation under Reg. § 1.704-3(b). What are the tax consequences to the partners in the following transactions, assuming the partners’ outside bases and ABC’s inside basis in the land are unchanged at the time of each transaction, if the ABC partnership:

ii. (a) Sells property #1 for $10,000.1. Partner A

a. Gain/Loss Recognitioni. Reg. § 1.704-3(b)(1): “traditional method” of making § 704(c)

allocations req’s that built-in gain/loss is attributed to the contributing partner

ii. § 704(c)(1)(A): gain from contributed property shall be shared so as to take into account the variation btwn AB of property to the p’ship and its FMV at time of contribution

iii. $10k FMV – $2k AB = $8k built-in gainiv. A recognizes $8k gain

b. Character of Gaini. § 702(b): determine character at the p’ship level

ii. P’ship holds the property as investmentiii. Assume p’ship held the property for many yearsiv. Gain is LTCG

c. A’s Basis in P’ship Interesti. § 705: increase basis in p’ship interest

ii. A’s basis in p’ship interest = $2k + $8k = $10kiii. (b) Distributes property #1 to C six years after formation of the partnership.

1. Partner Aa. Gain/Loss Recognition

i. § 704(c)(1)(B)(i): if contributed property is distributed to another partner w/in 7 years of contribution, contributing partner is treated as recognizing gain/loss under § 704(c)(1)(A) if property had been sold for FMV

ii. Here, built-in gain = $8kiii. A recognizes $8k gain

b. Character of Gaini. § 704(c)(1)(B)(ii): if contributed property is distributed to

another partner w/in 7 years of contribution, the character of the gain/loss is the character of gain/loss that results if the property was sold by the p’ship to the distributee

ii. Here, gain = LTCG1. See part (a)

c. Basis in Contributing Partner’s Interest in the P’shipi. § 704(c)(1)(B)(iii): if contributed property is distributed to

another partner w/in 7 years of contribution, contributing partner’s basis in his interest in the p’ship is adjusted to reflect any gain/loss recognized

ii. Here, A recognized $8k gainiii. A’s basis in p’ship interest = $2k + $8k = $10k

2. Partner Ca. Gain/Loss Recognition

i. § 731(a)(1): in the case of distributions, partner does not recognize gain/loss, except to the extent money distributed > AB of the partner’s interest in the p’ship

ii. Here, C does not recognize gain/lossb. Basis in Distributed Property

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i. § 732(a)(1): partner takes transferred basisii. § 704(c)(1)(B)(iii): adjustments to property’s basis are made

before the distributioniii. Basis of Property #1 = $2k + $8k = $10kiv. C takes a $10k basis in the property

c. Basis in P’ship Interesti. § 733(2): AB in partner’s interest in the p’ship is reduced by

basis the partner takes in the distributed propertyii. C’s basis in partnership interest = $10k – $10k = 0

iv. (c) Distributes property #3 to A six years after formation of the partnership.1. Partner C

a. The property Partner C contributed does not have a built-in gainb. § 704(c)(1)(B) is not triggered (i.e., it results in zero gain for C)

2. Partner Aa. Gain Recognition

i. § 737(a): partner is treated as recognizing gain in an amount equal to the lesser of—

1. (1) the excess of (A) FMV of property distributed over (B) AB of partner’s interest in the p’ship, OR

a. Here, $10k – $2k = $8k2. (2) the net pre-contribution gain of partner

a. § 737(b): “net precontribution gain” means gain the distributee partner would recognize under § 704(c)(1)(B) if all the property he contributed w/in 7 years of the distribution was distributed to another partner

b. Here, contributed asset had a built-in gain of $8k

c. A would’ve recognized $8k gainii. A recognizes $8k gain

b. Character of Gain/Lossi. § 737(a): character is determined by reference to the

proportionate character of the net precontribution gainii. Here, gain is LTCG

c. Basis Adjustmentsi. Basis in P’ship Interest

1. § 737(c)(1): AB of partner’s interest in the p’ship is increased by the amount of any gain recognized by such partner under (a)

a. Basis in p’ship interest = $2k + $8k = $10k2. § 733(2): AB of distributee’s interest in the p’ship is

reduced by AB partner takes in the propertya. Basis in p’ship interest = $10k – $10k = 0

ii. Basis in Asset Received1. § 732(a)(1): distributee takes transferred basis

a. A’s basis in Property #3 = $10kv. (d) Distributes property #2 to A six years after formation of the partnership.

1. Partner Ba. Gain/Loss Recognition

i. § 704(c)(1)(B)(i): if contributed property is distributed to another partner w/in 7 years of contribution, contributing

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partner is treated as recognizing gain/loss under § 704(c)(1)(A) if property had been sold for FMV

ii. Here, built-in gain = $5kiii. B recognizes $5k gain

b. Character of Gaini. § 704(c)(1)(B)(ii): if contributed property is distributed to

another partner w/in 7 years of contribution, the character of the gain/loss is the character of gain/loss that results if the property was sold by the p’ship to the distributee

ii. § 702(b): character is determined at the p’ship leveliii. Here, gain = LTCG

c. Basis in Contributing Partner’s Interest in the P’shipi. § 704(c)(1)(B)(iii): if contributed property is distributed to

another partner w/in 7 years of contribution, contributing partner’s basis in his interest in the p’ship is adjusted to reflect any gain/loss recognized

ii. Here, B recognized $5k gainiii. B’s basis in p’ship interest = $5k + $5k = $10k

d. Basis in Property Distributedi. § 704(c)(1)(B)(iii): if contributed property is distributed to

another partner w/in 7 years of contribution, AB of distributed property is adjusted to reflect any gain/loss recognized

ii. Basis in Parcel #2 = $5k + $5k = $10k2. Partner A

a. Gain Recognitioni. § 737(a): partner is treated as recognizing gain in an amount

equal to the lesser of—1. (1) the excess of (A) FMV of property distributed

over (B) AB of partner’s interest in the p’ship, ORa. Here, $10k – $2k = $8k

2. (2) the net pre-contribution gain of partnera. § 737(b): “net precontribution gain” means

gain the distributee partner would recognize under § 704(c)(1)(B) if all the property he contributed w/in 7 years of the distribution was distributed to another partner

b. Here, contributed asset had a built-in gain of $8k

c. A would’ve recognized $8k gainii. A recognizes $8k gain

b. Character of Gain/Lossi. § 737(a): character is determined by reference to the

proportionate character of the net precontribution gain1. Determine character at p’ship level w/ reference to

contributed propertyii. Here, gain is LTCG

c. Basis Adjustmentsi. Basis in P’ship Interest

1. § 737(c)(1): AB of partner’s interest in the p’ship is increased by the amount of any gain recognized by such partner under (a)

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a. Basis in p’ship interest = $2k + $8k = $10k2. Basis in Distributed Property

a. § 732(a)(1): distributee takes transferred basis

b. A’s basis in Property #2 = $10k3. § 733(2): AB of distributee’s interest in the p’ship is

reduced by AB partner takes in the propertya. Basis in p’ship interest = $10k – $10k = 0

ii. P’ship’s Basis in Contributed Property1. § 737(c)(2): p’ship’s basis in contributed property is

adjusted to reflect gain recognized under (b)a. Basis in Property #1 = $2k + $8k = $10k

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PART 8: LIQUIDATING DISTRIBUTIONS AND TERMINATIONS

I. Introductiona. Alternatives for a Partner Leaving a Partnership

i. Liquidation of the partner’s interest in the partnership. See § 736.ii. Sale of the partner’s partnership interest. See §§ 741, 751(a). See PART 6: SALES AND

EXCHANGES OF PARTNERSHIP INTERESTS, supra.1. Sale could be to other partners, or to a third party.

II. Liquidation of a Partner’s Interesta. Classification of Payments to a Retiring Partner

i. Payments from the partnership to a retiring partner can be classified as either:1. Payment for the partner’s interest in partnership property, or

a. Such payments are treated as distributions to the partner under §§ 731, 732. § 736(b)(1).

2. Pmt for something else (e.g., for a partner’s services, or as a departing bonus)a. Such payments are treated either as a distributive share of partnership

income or as guaranteed payments under § 704(c). § 736(a).b. Determining Whether Payments are Subject to § 736(b) or § 736(a)

i. If capital is a material income producing factor for the partnership:1. A liquidating payment falls under § 736(b)(1) to the extent of the FMV of that

partner’s share of partnership assets, anda. The partners can agree on the FMV of the partner’s interest in

partnership assets (including goodwill). As long as it’s an arm’s-length agreement, the Service will respect it. See Reg. § 1.736-1(b)(1).

2. The portion of the payment in excess of that FMV falls under §736(a).3. E.g., in businesses with large inventories capital is a material income producing

factor, whereas it is not in a service partnership.4. Example. Partner A retires from a p’ship where capital is a material income

producing factor.Assets Liabilities and Capital Accounts

AB FMV Tax FMVCash $33,000 $33,000 Liabilities $0 $0Goodwill $0 $30,000 Capital

AccountsLand $3,000 $30,000 A $12,000 $31,000

B $12,000 $31,000C $12,000 $31,000

$36,000 $93,000 $36,000 $93,000a. If A gets $31k, it’s treated as a distribution under § 736(b)b. If A gets $32k:

i. $31k is treated as a distribution under §736(b)ii. $1k is treated as a guaranteed payment under §736(a)

ii. If capital is not a material income producing factor for the partnership, and if the retiring partner is a general partner, then the special rules of § 736(b)(2) apply. See § 736(b)(3).

1. Section 736(b)(1) does not apply (i.e., § 736(a) applies) to amounts paid for:a. Unrealized receivables, andb. Goodwill of the partnership, unless the p’ship agreement provides for

a payment for goodwill (“unstated goodwill”). § 726(b)(2).2. Example. Using the balance sheet from the last example, assume the capital is

not a material income producing factor. A is a general partner.a. Here, there is “unstated goodwill”b. If A gets a $31k payment:

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i. $10k is unstated goodwill; subject to § 736(a)ii. $21k is treated as a distribution; subject to § 736(b)

c. If the p’ship agreement provided for pmt of goodwill (stated goodwill), it’s subject to § 736(b)

c. Distributions. See PART 7. OPERATING DISTRIBUTIONS, supra.i. Partnership: Nonrecognition. No gain/loss is recognized to a partnership on a

distribution to a partner of property, including money. § 731(b).ii. Distributee Partner

1. Gain/Loss Recognizeda. Gain Recognition. A distributee partner does not recognize gain,

except to the extent that any money distributed exceeds the partner’s interest in the p’ship. § 731(a)(1).

b. Loss Recognition. Where a distributee partner only receives money or unrealized receivables or inventory (§ 751 assets), loss is recognized to the extent the AB of his p’ship interest exceeds the sum of money and § 751 assets received. § 731(a)(2).

2. Basis of Distributed Assets. Basis in distributed property is equal to AB of partner’s interest in the p’ship reduced by any money distributed. § 732(b).

3. Allocation of Basisa. § 751 Property. First allocate basis in distributed property to AB

unrealized receivables and inventory items. § 732(c)(1)(A)(i).b. Other Distributed Property. Then, assign remaining basis to other

distributed property. § 732(c)(1)(B)(i).c. Increase/Decrease. To the extent any increase/decrease in basis is

req’d to have AB of other distributed properties equal remaining basis, increase/decrease as appropriate. § 732(c)(1)(B)(ii).

i. Increasing Other Distributed Property’s Bases1. Unrealized Appreciation. First allocate any increase

to property w/ unrealized appreciation in proportion to (and to the extent of) their unrealized appreciation. § 732(c)(2)(A).

2. FMV. Then, allocate the increase in proportion to their respective FMVs. § 732(c)(2)(B).

4. Character of Gain/Lossa. Inventory: Ordinary Income/Loss W/in 5 Years. Gain/loss on the

sale/exchange of distributed inventory, within 5 years of distribution is ordinary income/loss. § 735(a)(2).

b. Tacked Holding Period. A partner includes the p’ship’s holding period in determining his holding period of distributed property. § 735(b).

d. Problem 1 (p. 336). The ABC partnership, which has not made a § 754 election, has the following balance sheet:


Cash $90,000 $90,000 Liab: noneInventory 15,000 30,000 Capital AccountsLand (Parcel #1) 100,000 60,000 A $85,000 $70,000Land (Parcel #2) 50,000 30,000 B 85,000 70,000

C 85,000 70,000$255,000 $210,000 $255,000 $210,000

i. (a) In liquidation of his interest, A receives one-third of the inventory and Parcel #1. What are the tax consequences of this distribution to A and the partnership?

1. Partner A

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a. Capital is a material income producing factor for the p’shipi. There is a lot of inventory and land

ii. Liquidating payment is treated as a distribution under § 736(b)(1) to the extent of the FMV of that partner’s share of partnership assets

1. $10k inventory + $60k land = $70k A’s FMV in interest in p’ship property

b. Gain/Loss Recognizedi. Gain Recognition

1. § 731(a)(1): no gain recognized (b/c not cash)ii. Loss Recognition

1. § 731(a)(2): no loss recognition (b/c received property other than cash and § 751 assets)

iii. Basis of Distributed Assets1. § 732(b): basis in distributed property is an amount

equal to AB of partner’s interest in the p’ship reduced by any money distributed

a. $85k – 0 = $85k2. § 732(c)(1)(A)(i): first allocate basis in distributed

property to extent of AB of § 751 property in the PNS

a. Allocate $5k to inventory3. § 732(c)(1)(B)(i): then, assign remaining basis to

other distributed propertya. Allocate $80k to Parcel #1

AB FMVInventory $5k $10kLand #1 $80k $60k

c. Character of Gain/Lossi. § 735(a)(2): if A sold the inventory w/in 5 years of the

distribution, it would treated as ordinary gain/lossii. If A sold Parcel #1, his use would determine the character

iii. § 735(b): A takes a tacked holding period2. Partnership

a. § 731(b): nonrecognition3. Checking Your Work

a. $70k distributed property – $85k AB in p’ship interest = $15k loss, because property consists of only cash and 751 property.

b. A did not recognize any loss, so he should have $15k loss built-in to the distributed assets

i. Inventory: $10k FMV – $5k AB = $5k built-in gainii. Land #1: $60k FMV – $80k AB = $20k built-in loss

iii. $5k – $20k = $15k net built-in loss4. Ending Balance Sheet


Cash $90k $90k Liab: noneInventory $10k $20k Capital AccountsLand (Parcel #2) $50k $30k B $85k $70k

C $85k $70k$150k $140k $170k $140k

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ii. (b) In liquidation of his interest, A again receives one-third of the inventory and also receives $60,000 cash. What are the tax consequences of this distribution to A and the partnership?

1. Partner Aa. Capital is a material income producing factor for the p’ship

i. There is a lot of inventory and landii. Liquidating payment is treated as a distribution under §

736(b)(1) to the extent of the FMV of that partner’s share of partnership assets

1. $10k inventory + $60k cash = $70k A’s FMV in interest in p’ship property

b. Gain/Loss Recognizedi. Gain Recognition

1. § 731(a)(1): no gain recognized (b/c cash received does not exceed AB in p’ship interest)

ii. Loss Recognition1. § 731(a)(2): where a distributee partner only

receives cash or § 751 assets, loss is recognized to the extent the AB of his p’ship interest exceeds the sum of money and § 751 assets received

a. Basis A Takes in Distributed Propertyi. § 732(b): basis in distributed

property = AB of partner’s interest in the p’ship – money distributed

ii. $85k – $60k = $25kb. Allocate Basis

i. § 732(c)(1)(A)(i): first allocate to inventory in amount of p’ship’s AB

ii. Allocate $5k to inventory2. $85k – [$60k + $5k] = $20k loss

iii. If the p’ship made a § 754 election, adjust AB in p’ship property down by $20k

2. Partnershipa. § 731(b): nonrecognition

iii. (c) Why is recognized loss under § 731(a)(2) limited to liquidating distributions and further restricted with regard to the nature of the distribution?

1. Loss is not recognized in operating distributions b/c the distributions do not represent a closed and completed transaction. The distributee partner still remains a partner after the distribution. In liquidating distribution there is no up-side potential.

2. Restricting losses to distributions where partner receives cash and § 751 property:

a. Congress tried to prevent gain/loss recognition, except when there’s no other choice

i. E.g., where partner receives cash distribution and has zero basis in p’ship interest

b. Congress permits losses when it cannot or does not want to build-in losses to distributed property

i. Suppose Partner has AB in p’ship interest of $100; receives $60 cash in liquidating distribution

1. Partner recognizes $40 loss2. Can’t defer loss

ii. Suppose partner receives $60 in inventory instead

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1. Here, Congress chose not to build-in the loss and preserve the capital gain/loss character in the property

iv. (d) What result to A in (b), above, if the inventory were worth $120,000 rather than $30,000, A’s interest were worth $100,000 and A received $60,000 of cash and his one-third of the inventory?

1. Gain/Loss Recognizeda. Gain Recognition

i. § 731(a)(1): no gain recognized (b/c cash does not exceed AB in p’ship interest)

b. Loss Recognitioni. Same result as part (b)

ii. A realizes $20k lossc. Basis in Distributed Assets (1/3 of the inventory)

AB FMV GainInventory $5k $40k $35k

2. Checking Your Worka. $100k FMV distributed property – $85k AB in p’ship interest = $15k

gainb. A recognized $20k lossc. $15k gain – ($20k loss) = $35k built-in gain

i. Inventory has a $35k built-in gaine. Problem 2 (p. 336). Partnership distributes Capital Asset #1 (inside basis—$5,000, f.m.v.—

$40,000) and Capital Asset #2 (inside basis—$10,000, f.m.v.—$10,000) to Partner A in liquidation of A’s interest in Partnership. Prior to the distributions, A has a $55,000 outside basis. Determine partner A’s basis in the two capital assets following the liquidation distribution.

i. § 732(b): basis in distributed property is an amount equal to AB of partner’s interest in the p’ship reduced by any money distributed

1. $55k – 0 = $55kii. § 732(c)(1)(A)(i): first allocate basis in distributed property to AB unrealized receivables

and inventory items1. Here there are no §751 assets

iii. § 732(c)(1)(B)(i): then, assign remaining basis to other distributed property1. Capital Asset #1: allocate $5k basis2. Capital Asset #2: allocate $10k basis

iv. § 732(c)(1)(B)(ii): then, to the extent any increase/decrease in basis is req’d to have AB of other distributed properties equal remaining basis, increase/decrease as provided in § 732(c)(2), (3)

v. § 732(c)(2)(A): first allocate any increase to property w/ unrealized appreciation in proportion to their unrealized appreciation (to the extent of each property’s unrealized appreciation)

1. Here, Capital Asset #1 has unrealized appreciation of $35kvi. § 732(c)(2)(B): then, allocate the increase in proportion to their respective FMVs

1. $55k basis – $5k – $10k – $35k = $5k basis remaining2. Capital Asset #1: $5k * ($40k/$50k) = $4k3. Capital Asset #2: $5k * ($10k/$50k) = $1k

P’ship’s AB Unrealized Appreciation

FMV Total Basis

Capital Asset #1 $5k $35k $4k $44kCapital Asset #2 $10k $1k $11k

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PART 9: S CORPORATIONS AND THEIR SHAREHOLDERS

I. Introductiona. Development of Subchapter S

i. Congress enacted Subchapter S in 1958ii. Congress’s stated purpose:

1. To create a regime like subchapter K, so that businesses could choose either the corporate form of doing business or the partnership form without major differences in tax consequences.

2. However, there are significant differences between subchapters K and S that business participants should consider in choosing between these regimes.

iii. Subsequent legislation has made significant changes to Subchapter S. Generally, this legislation has:

1. Made subchapter S more closely resemble subchapter K, and2. Relaxed the eligibility rules for status as an S corporation.

b. The Future of Subchapter Si. Business participants typically desire:

1. Limited liability2. Pass-through tax treatment

ii. Traditional options:1. Limited partnership (subchapter K)2. Subchapter S corporation (subchapter S)

iii. Newer options:1. Limited liability company (LLC)2. Limited liability partnership (LLP)

iv. Today, under the check-the-box regulations, domestic, unincorporated business organizations with two or more members can choose to be subject to:

1. Subchapter S (or subchapter C)2. Subchapter K

v. Is there still a need to maintain two different passthrough regimes (subchapter K and subchapter S) in the Code?

II. Eligibility for S Corporation Statusa. S Corporation vs. C Corporation. An “S corporation” is a small business corporation which elects

under § 1362. § 1361(a)(1). A “C corporation” means all other corporations. § 1361(a)(2).b. Small Business Corporation. A “small business corporation” is a:

i. Domestic corporationii. Which is not an “ineligible corporation”

iii. Which has1. No more than 100 shareholders2. Only shareholders who are individuals, estates, and certain types of trusts and

tax-exempt organizationsa. See § 1361(c)(2).

3. No nonresident alien shareholders, and4. Not more than one class of stock. § 1361(b)(1).

c. Ineligible Corporation. “Ineligible corporation” means a corporation which is [in the list of corporations subject to their own tax schemes.] § 1361(b)(2).

d. 100 Shareholdersi. Husband and Wife = One Shareholder. For purposes of the 100 shareholder limit,

husband and wife are treated as one shareholder. § 1361(c)(1)(A)(i).1. Form of Ownership Irrelevant. Stock owned by a H and W is treated as if

owned by one shareholder, regardless of the form in which they hold the stock. Reg. § 1.1361-1(e)(2).

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ii. Members of a Family = One Shareholder. For purposes of the 100 shareholder limit, members of a family are treated as one shareholder. § 1361(c)(1)(A)(ii).

1. “Members of a Family.” “Members of a family” means a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendant. § 1361(c)(1)(B)(i).

2. Common Ancestor. An individual is not a common ancestor if, on the applicable date, the individual is more than 6 generations removed from the youngest generation of shareholders who would be members of the family. § 1361(c)(1)(B)(ii).

e. Types of Shareholdersi. Wholly Owned Subsidiaries

1. Q-Sub Requirements. A “qualified subchapter S subsidiary” (“Q-sub”) means any domestic corporation which is not an ineligible corporation, if—

a. (i) 100% of the stock is held by the S corporation, andb. (ii) the S corporation elects to treat such corporation as a qualified

subchapter S subsidiary. § 1361(b)(3)(B).2. Effect

a. Not Separate. A corporation which is a qualified subchapter S subsidiary shall not be treated as a separate corporation. § 1361(b)(3)(A)(i).

b. Tax Items Absorbed. Assets, liabilities, and items of income, deduction and credit of the Q-sub are treated as such items of the S corporation. § 1361(b)(3)(A)(ii).

ii. Estate Includes Individual Bankruptcy Estate. § 1361(c)(3).f. One Class of Stock

i. Identical Distribution/Liquidation Rights. A corporation is treated as having only one class of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds. Reg. § 1.1361-1(l)(1).

1. Look to Governing Documents. The determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on the corporate charter, articles of incorporation, bylaws, applicable state law and binding agreements relating to distribution and liquidation proceeds. Reg. § 1.1361-1(l)(2)(i).

ii. Voting/Nonvoting Irrelevant. For purposes of the eligibility requirements, a corporation is not treated as having more than 1 class of stock solely b/c there are differences in voting rights among the shares of common stock. § 1361(c)(4).

iii. Straight Debt Safe Harbor1. Historical Reclassification. Before the safe debt safe harbor, the IRS

reclassified nominal S corporation debt owed to shareholders as a second class of stock, causing the corporation to lose its S status.

2. Straight Debt ≠ Second Class of Stock. An obligation that satisfies the straight debt safe harbor is not treated as a second class of stock even if it is considered equity under general principles of Federal tax law. § 1361(c)(5)(A); Reg. § 1.1361-1(l)(5)(iv).

a. Recharacterization for Unreasonably High Debt. If a straight debt obligation bears a rate of interest that is unreasonably high, an appropriate portion of the interest may be recharacterized and treated as a payment that is not interest. Reg. § 1.1361-1(l)(5)(iv).

3. “Straight Debt.” “Straight debt” means any written unconditional promise to pay on demand or on a specified date a sum certain in money if—

a. (i) the interest rate is not contingent on profits, the borrower’s discretion, or similar factors,

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b. (ii) there is no convertibility into stock, andc. (iii) the creditor is an individual (other than a non-resident alien), an

estate, certain trusts, or a person which is actively and regularly engaged in the business of lending money. § 1361(c)(5)(B).

4. Subordination Not Dispositive. The fact an obligation is subordinated to other debt of the corporation does not prevent the obligation from qualifying as straight debt. Reg. § 1.1361-1(l)(5)(ii).

g. Problem 1 (handout). Z Corporation is a corporation organized under Texas law that, except as otherwise provided below, has 115 share of voting common stock outstanding. In each of the following alternative situations, determine whether Z is eligible to elect S corporation status:

i. (a) Z has 99 individual shareholders, each of whom owns one share of Z stock. The remaining 16 shares are owned by A and her husband, B. Of their 16 shares, they own 10 shares as community property and each spouse owns 3 shares as separate property.

1. § 1361(b)(1)(A): corporation cannot have more than 100 shareholders2. § 1361(c)(1)(A)(i): husband and wife are treated as one shareholder3. Reg. § 1.1361-1(e)(2): stock owned by a H and W is treated as if owned by one

shareholder, regardless of the form in which they hold the stock4. Z Corporation can elect S corporation status

ii. (b) Same as (a), above, except that A and B are brothers who own their 16 shares as joint tenants with right of survivorship.

1. § 1361(b)(1)(A): corporation cannot have more than 100 shareholders2. § 1361(c)(1)(A)(ii): members of a family are treated as one shareholder

a. § 1361(c)(1)(B)(i): “members of a family” means a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendant

b. § 1361(c)(1)(B)(ii): an individual is not a common ancestor if, on the applicable date, the individual is more than 6 generations removed from the youngest generation of shareholders who would be members of the family

3. Here, A and B are lineal descendants of their parents (a common ancestor)4. Z Corporation can elect S corporation status

iii. (c) Z has 100 shares of Class A voting common stock and 50 shares of Class B nonvoting common stock outstanding. Apart from the differences in voting rights, the two classes of common stock have equal rights with regard to dividends and liquidation distributions. Z also has an authorized but unissued class of nonvoting stock that would be limited and preferred as to dividends. The Class A common stock is owned by four individuals and the Class B common stock is owned by E and F (a married couple) as tenants-in-common.

1. § 1361(b)(1)(D): corporation cannot have more than one class of stock2. Voting/Nonvoting

a. § 1361(c)(4): for purposes of eligibility requirements, a corporation is not treated as having more than 1 class of stock solely b/c there are differences in voting rights among the shares of common stock

b. Thus, there the voting/nonvoting distinction is not treated as more than one class of stock

3. Unissued Sharesa. Reg. § 1.1361-1(l)(1): a corporation is treated as having only one class

of stock if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds

b. Thus, we don’t take unissued shares into account4. Z Corporation can elect S corporation status

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iv. (d) Same as (c), above, except that Z enters into a binding agreement with its shareholders to make larger annual distributions to shareholders who bear heavier state income tax burdens. The amount of the distributions is based on a formula that will give the shareholders equal after-tax distributions.

1. § 1361(b)(1)(D): corporation cannot have more than one class of stock2. Reg. § 1.1361-1(l)(1): a corporation is treated as having only one class of stock

if all outstanding shares of stock of the corporation confer identical rights to distribution and liquidation proceeds

a. Reg. § 1.1361-1(l)(2)(i): the determination of whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds is made based on [governing documents and] binding agreements relating to distribution and liquidation proceeds

b. Reg. § 1.1361-1(l)(2)(vi) Example 6: the agreement alters the rights to distribution proceeds so that those rights are not identical

3. Z Corporation is treated as having more than one class of stock4. Z Corporation cannot elect S corporation status

v. (e) Z has four individual shareholders, each of whom owns 100 shares of Z common stock for which each paid $10 per share. Each shareholder also owns $25,000 of 15-year Z bonds. The bonds bear interest at 3% above the prime lending rate established by the Chase Manhattan Bank, adjusted quarterly, and are subordinated to general creditors of Z.

1. § 1361(c)(5)(A): straight debt is not treated as a second class of stock2. § 1361(c)(5)(B): “straight debt” means any written unconditional promise to

pay on demand or on a specified date a sum certain in money if—a. (i) the interest rate is not contingent on profits, the borrower’s

discretion, or similar factors,b. (ii) there is no convertibility into stock, andc. (iii) the creditor is an individual (other than a non-resident alien), an

estate, certain trusts, or a person which is actively and regularly engaged in the business of lending money

3. Here, the debt fits into the safe harbor4. Reg. § 1.1361-1(l)(5)(ii): the fact an obligation is subordinated to other debt of

the corporation does not prevent the obligation from qualifying as straight debt5. Z Corporation can elect S corporation status

III. Election, Revocation and Terminationa. Subchapter S Election

i. Election Mechanics1. Election Statement. An election stmt must identify the election being made,

set forth the name, address, and taxpayer identification number of the corporation, and be signed by a person authorized under § 6037. Reg. § 1.1362-6(a)(1).

2. File Form 2553. A small business corporation makes an election under § 1362(a) to be an S corporation by filing a completed Form 2553. Reg. § 1.1362-6(a)(2)(i).

3. All Shareholders (At Time of Election) Consent. An election is valid only if all persons who are shareholders in such corporation on the day on which such election is made consent to such election. § 1362(a)(2).

a. Effect on Timely Election. A timely election is treated as made for the following year if 1 or more of the persons who held stock in the corporation during such taxable year and before the election was made did not consent to the election. § 1362(b)(2)(B)(ii).

ii. Filing Deadline. An election may be made by a small business corporation1. (A) during the preceding taxable year, or

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2. (B) on or before the 15th day of the 3d month of the taxable year. § 1362(b)(1).

iii. Effect of Late Filing. An election after the 15th day of the 3d month of the taxable year is treated as made for the following taxable year. § 1362(b)(3).

1. Reasonable Cause. The Secretary may treat a late election as timely if it determines there was reasonable cause for the failure to timely make such election. § 1362(b)(5). The form of the request is a private letter ruling. See Rev. Proc. 2004-48; 2007-62 for the procedure.

b. Revocationi. > ½ of Shares Must Consent. An election may be terminated by revocation if

shareholders holding more than one-half of the shares of stock of the corporation on the day on which the revocation is made consent to the revocation. § 1362(d)(1)(A), (B).

1. Includes Non-Voting Stock. Non-voting stock is included in the shareholder consent requirement. Reg. §§ 1.1362-2(a)(1); 1.1362-6(a)(3)(i).

c. Terminationi. Ceases to be Small Business Corporation. An election is terminated when such

corporation ceases to be a small business corporation. § 1362(d)(2)(A).1. Termination is Effective Immediately. § 1362(d)(2)(B).

ii. Inadvertent Termination. If1. (1) an election

a. (A) was not effective by reason of a failure to meet § 1361(b) or to obtain shareholder consents, or

b. (B) an election was terminated under § 1361(d)(2) or (3),2. (2) the Secretary determines that the termination was inadvertent,3. (3) no later than a reasonable period of time after discovery of the

circumstances resulting in such ineffectiveness or termination, steps were taken—

a. (A) so that the corporation is a small business corporation, orb. (B) to acquire the required shareholder consents, and

4. (4) the corporation and all shareholders consent to make adjustments required by the Secretary,

5. Then, such corporation shall be treated as an S corporation. § 1367(f).6. Procedure. The corporation would make a private letter ruling for relief. Reg.

§ 1.1362-4(c).d. No Election for 5 Years. If a small business corporation made an election and such election was

terminated or revoked, such corporation shall not be eligible to make an election for 5 taxable years after the termination is effective. § 1362(g).

e. Taxable Year of an S Corporationi. Calendar Year. Generally, S corporations must use a calendar taxable year. § 1378(a),

(b)(1).ii. Business Purpose. An S corporation can choose another taxable year if the corporation

can establish a business purpose for using that other period. § 1378(b)(2).iii. Different Taxable Year. If an S corporation cannot establish a business purpose for a

different taxable year, then it can, within limits, choose a different taxable year pursuant to § 444 if it pays an entity-level tax calculated under § 7519.

f. Problem 2 (handout). On January 1 of Year 1, individuals A, B and C, who are unrelated, validly formed Corporation X under Texas law. The three individuals are equal shareholders. You can assume that A, B and C are all U.S. citizens.

i. (a) How would Corporation X elect to be treated as a subchapter S corporation?1. Reg. § 1.1362-6(a)(1): an election stmt must identify the election being made,

sets forth the name, address, and taxpayer identification number of the corporation, and be signed by a person authorized under § 6037

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2. Reg. § 1.1362-6(a)(2)(i): a small business corporation makes an election under § 1362(a) to be an S corporation by filing a completed Form 2553

ii. (b) If Corporation X is to be treated as a subchapter S corporation for Year 1, by what point in time must the election be made?

1. § 1362(b)(1)(B): an election may be made any time during the taxable year on or before the 15th day of the 3d month of the taxable year

2. The election must be mailed by March 15. See § 7502(a).iii. What happens if Corporation X fails to make a timely election?

1. § 1362(b)(3): an election after the 15th day of the 3d month of the taxable year is treated as made for the following taxable year

a. Corporation X would be a C corporation in the current taxable year2. § 1362(b)(5): the Secretary may treat a late election as timely if it determines

there was reasonable cause for the failure to timely make such electioniv. (c) Who must consent to the election? Would your answer be different if A and B held

voting stock and C held nonvoting stock?1. § 1362(a)(2): an election is valid only if all persons who are shareholders in

such corporation on the day on which such election is made consent to such election

2. Voting/nonvoting stock does not matterv. (d) Assume that Corporation X made a valid subchapter S election for Year 1. In Year 2,

shareholder A wishes to revoke the S election. Can A do so? Would your answer be different if A held voting stock and B and C held nonvoting stock?

1. § 1362(d)(1)(A), (B): an election may be terminated by revocation if shareholders holding more than one-half of the shares of stock consent

a. Thus, A alone cannot revoke the S election2. Reg. § 1.1362-2(a)(1): non-voting stock is included in the shareholder consent

requirement3. Reg. § 1.1362-6(a)(3)(i): non-voting stock is taken into account for the

revocation statementvi. (e) Assume that Corporation X made a valid subchapter S election for Year 1. In Year 3, A

died and A’s shares in the corporation passed to A’s son and only heir, F, who is a citizen and resident of France.

1. (i) What effect would F’s ownership of the shares have on Corporation X’s status as an S corporation?

a. § 1362(d)(2)(A): an election is terminated when such corporation ceases to be a small business corporation

i. § 1362(d)(2)(B): termination is effective immediatelyb. AA’s estate

i. § 1361(b)(1)(B): a small business corporation cannot have as a shareholder a person (other than an estate, etc.) who in not an individual

ii. Thus, Corporation X remains a small business corporationc. A’s estateF

i. § 1361(b)(1)(C): a shareholder cannot be a nonresident alienii. Thus, Corporation X’s S election terminated

2. (ii) What measures could be taken to preserve Corporation X’s status as an S corporation?

a. This should have been addressed as a planning matteri. Buy-sell agreement

1. Upon a shareholder’s death, the decedent’s shares shall be bought by the remaining shareholders or the corporation

ii. Restrictions on stock transfers

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1. No shareholder can transfer shares w/o the consent of others

2. Or, shareholders can only transfer shares to permissible classes of people

b. § 1367(f)—Ifi. (1)(B) an election was terminated under § 1361(d)(2) or (3),

ii. (2) the Secretary determines that the termination was inadvertent,

iii. (3) no later than a reasonable period of time after discovery of the circumstances resulting in such termination, steps were taken—

1. (A) so that the corporation is a small business corporation, and

iv. (4) the corporation and all shareholders consent to make adjustments required by the Secretary,

v. Then, such corporation shall be treated as an S corporationc. This likely entails (1) getting the shares out of F’s hands, (2) F agreeing

to be taxed as a shareholder, and (3) treating F as a shareholder for the period he held the shares

IV. Treatment of the Shareholdersa. Taxable Income. The taxable income of an S corporation shall be computed in the same manner

as in the case of an individual, except that–i. (1) the items described in § 1366(a)(1)(A) are separately stated,

1. Items that Affect Tax Liability. Items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect a shareholder’s tax liability. § 1366(a)(1)(A).

ii. (2) the deductions in § 703(a)(2) are not allowed,iii. (3) § 248 applies (referring to deducting organizational expenditures),iv. (4) § 291 applies (referring to reductions of certain tax benefits). § 1363(b).

b. Shareholder’s Taxable Income. A shareholder takes into account her pro rata share of the corporation’s

i. (A) items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect a shareholder’s tax liability, and

ii. (B) nonseparately stated items. § 1366(a)(1).iii. Pro Rata. Each shareholder’s pro rata share of any item is the sum of the amount

determined1. (A) by assigning an equal portion of such item to each day of the taxable year,

and2. (B) then by dividing that portion pro rata among the shares outstanding on

such day. § 1377(a)(1).c. Loss Limitations

i. Basis Limitation. The aggregate amount of losses and deductions taken into account by a shareholder shall not exceed the sum of–

1. (A) the AB of the shareholder’s stock in the S corporation (determined with regard to § 1367(a)(1), (2)(A)), and

2. (B) the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder. § 1366(d)(1).

ii. Guarantees. S corp shareholders don’t get a basis increase by personally guaranteeing liability. Harris v. United States. The court requires an economic outlay (e.g., if shareholders paid on the guarantee) in order to deem it a capital contribution.

iii. If Allocated Basis Exceeds Limitation1. Allocate Basis. If shareholder’s pro rata share of aggregate losses/deductions

exceeds loss limitation, then the limitation is allocated in an amount that bears

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the same ratio to the amount of the limitation as the loss or deduction bears to the total of the losses and deductions. Reg. § 1.1366-2(a)(4).

2. Carry Over Excess. Any loss/deduction which is disallowed is carried over indefinitely until there’s sufficient AB in stock or indebtedness. § 1366(d)(2)(A).

d. Basis in Stocki. Increases. AB in stock is increased by:

1. (A) items in items of income in § 1366(a)(1)(A), [and]2. (B) nonseparately computed income under §1366(a)(1)(B). § 1367(a)(1).

ii. Decreases. Basis decreased (but not below zero) by: . . .1. (B) items of loss in § 1366(a)(1)(A), and2. (C) nonseparately computed loss under § 1366(a)(1)(B). § 1367(a)(2).

iii. Order of Adjustments. The order of adjustments is:1. (1) increases in basis2. (4) decreases for items of loss or deduction in § 1367(a)(2)(B) and (C). Reg. §

1.1367-1(f).e. Basis in Indebtedness

i. Losses (In Excess of AB of Stock) Decrease Basis. Where items in § 1367(a)(2)(B)–(E) exceed the shareholder’s basis, such excess reduces the shareholder’s basis in indebtedness of the S corporation to the shareholder. § 1367(b)(2)(A).

ii. Restoration of Basis. If there is a reduction in the shareholder’s basis in the indebtedness of an S corporation to a shareholder, any net increase is applied to restore such reduction in basis before it increases the shareholder’s basis in the stock of the S corporation. § 1367(b)(2)(B).

f. Problem 3 (handout). Assume the same basic facts of Problem 2, above, i.e., Corporation X has three equal shareholders, A, B and C. Corporation X made a valid subchapter S election effective as of January 1, Year 1. At the beginning of Year 2, A, B and C had a basis in their Corporation X stock of $20,000, $10,000 and $5,000, respectively. In addition, during Year 2, shareholder C made a loan to Corporation X in the amount of $2,000. During Year 2, Corporation X had the following tax items:

Tax-exempt interest: $3,000Ordinary income: $40,000Depreciation: $58,000Long-Term Capital Gain: $10,000Long-Term Capital Loss: $19,000

i. (a) What is X Corporation’s taxable income for Year 2?1. § 1363(b): the taxable income of an S corporation shall be computed in the

same manner as in the case of an individual, except that–a. (1) the items described in § 1366(a)(1)(A) are separately stated . . .

2. § 1366(a)(1)(A): items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder

Separate Items Combined ItemsIncomeTax-exempt income $3k

IncomeOrdinary income $40k

DeductionsNet LTCL* ($9k)

DeductionsDepreciation ($58k)Combined loss ($18k)

*Reg. § 1.1366-1(a)(2)(i): net capital gains and lossesii. (b) How will the shareholders take these items into account for Year 2?

1. § 1366(a)(1): a shareholder takes into account her pro rata share of the corporation’s

a. (A) separately stated items

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b. (B) nonseparately stated items.2. § 1377(a)(1): each shareholder’s pro rata share of any item is the sum of the

amount determineda. (A) by assigning an equal portion of such item to each day of the

taxable year, andb. (B) then by dividing that portion pro rata among the shares

outstanding on such day.Separate Items Combined Items

IncomeTax-exempt income $1k/partner

Combined loss ($6k)/partner

DeductionsNet LTCL* ($3k)/partner

iii. (c) Will each shareholder be able to take the full amount of these items into account?1. § 1366(d)(1): the aggregate amount of losses and deductions taken into

account by a shareholder shall not exceed the sum of–a. (A) the AB of the shareholder’s stock in the S corporation (determined

with regard to § 1367(a)(1), (2)(A)), andb. (B) the shareholder’s adjusted basis of any indebtedness of the S

corporation to the shareholder.2. See part (d).

A B CShareholders’ AB in stock (taking into account § 1367(a)(1))

$21,000 $11,000 $6,000

Shareholders’ AB in indebtedness $2,000

Loss Limitation $21,000 $11,000 $8,0003. C: $9k allocated loss (see part (d)) exceeds $8k loss limitation

a. Reg. § 1.1366-2(a)(4): if shareholder’s pro rata share of aggregate losses/deductions exceeds loss limitation, then the limitation is allocated in an amount that bears the same ratio to the amount of the limitation as the loss or deduction bears to the total of the losses and deductions

i. Net LTCL: ($3k/$9k) * $8k = $2,667ii. Ordinary loss: ($6k/$9k) * $8k = $5,333

b. § 1366(d)(2)(A): any loss/deduction which is disallowed is carried over indefinitely until there’s sufficient AB in stock or indebtedness

i. $9k loss allocation – $8k loss limitation = $1k carried over4. Note: the at risk limitation (§ 465) and passive activity loss limitation also apply

iv. Would your answer be any different if, during Year 2, Corporation X borrowed $100,000 from a bank to fund operations?

1. § 1366(d)(1)(B): debt to a bank is not indebtedness of the S corporation to the shareholder

v. Would your answer be any different if shareholder C personally guaranteed the bank loan?

1. Harris v. United States: S corp SHs don’t get basis increase by personally guaranteeing liability

a. An economic outlay (e.g., if shareholders paid on the guarantee) is deemed a capital contribution

vi. (d) What adjustments to basis are necessary at the end of Year 2?1. § 1367(a)(1): basis increased by:

a. (A) items in items of income in § 1366(a)(1)(A), and

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b. (B) nonseparately computed income under §1366(a)(1)(B) . . .2. § 1367(a)(2): basis decreased by: . . .

a. (B) items of loss in § 1366(a)(1)(A), andb. (C) nonseparately computed loss under § 1366(a)(1)(B) . . .

3. Reg. § 1.1367-1(f): order of adjustments is:a. (1) increases in basisb. (2) decreases for distributionsc. (3) decreases for noncapital, nondeductible expensesd. (4) decreases for items of loss or deduction in § 1367(a)(2)(B)

and (C)A B C

Initial stock basis $20,000 $10,000 $5,000Tax exempt income

$1,000 $1,000 $1,000

$21,000 $11,000 $6,000Net LTCL ($3,000) ($3,000) ($3,000)Ordinary loss ($6,000) ($6,000) ($6,000)AB in stock $12,000 $2,000 $0

4. Basis in indebtednessa. C’s AB in the $2k indebtedness = $0

i. § 1367(b)(2)(A): where items in § 1367(a)(2)(B)–(E) exceed the shareholder’s basis, such excess reduces the shareholder’s basis in indebtedness of the S corporation to the shareholder

ii. He has offset this basis by $2k of lossb. Restoration of basis

i. § 1367(b)(2)(B): if there is a reduction in the shareholder’s basis in the indebtedness of an S corporation to a shareholder, any net increase is applied to restore such reduction in basis before it increases the shareholder’s basis in the stock of the S corporation

V. Distributions to Shareholdersa. Application of Subchapter C. Subchapter C applies to an S corporation unless otherwise

provided, or if subchapter C would be inconsistent with subchapter S. § 1371(a).b. Accumulated Earnings and Profits? A S corporation accumulates earnings and profits if (1) it was

a C corporation before, or (2) it acquired a C corporation and inherited earnings and profits. Rules on distributions of property depend on whether the S corporation accumulated earnings and profits. § 1368(a).

i. If No Earnings and Profits. Where there’s no accumulated earnings and profits:1. (1) the distribution is not included in GI to the extent it does not exceed AB of

stock2. (2) if the distribution exceeds AB of stock, such excess is gain from

sale/exchange of property. § 1368(b).ii. If Earnings and Profits

1. Portion up to AAA—Treat Under § 1368(b). If an S corporation has accumulated earnings and profits, the portion of the distribution which does not exceed the accumulated adjustments account shall be treated in the manner provided by § 1368(b). § 1368(c)(1).

a. AAA. AAA is an account of the S corporation which is generally adjusted in a manner similar to adjustments under § 1367. § 1368(e)(1).

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2. Portion up to Accumulated Earnings and Profits = Dividend. The portion of the distribution that remains after § 1368(c)(1) is treated as a dividend to the extent it does not exceed accumulated earnings and profits. § 1368(c)(2).

3. Remaining Treated Under § 1368(b). Any portion of the distribution remaining after the application of § 1368(c)(2) is treated in the manner provided by § 1368(b). § 1368(c)(3).

4. Election to Distribute Accumulated Earnings and Profits First. An S corporation may, w/ the consent of all “affected shareholders,” elect to have § 1368(c)(1) not apply. § 1368(e)(3)(A).

c. Distribution of Appreciated Property. If a corporation distributes appreciated property (other than an obligation of such corporation) to a shareholder, the corporation recognizes gain as if such property were sold to the distributee at its FMV. § 311(b). Otherwise, the corporation recognizes no gain/loss. § 311(a).

i. Gain Flows Through. Basis increased by . . . nonseparately computed income under §1366(a)(1)(B). § 1367(a)(1)(B).

ii. Take Basis Adjustment Into Account for Distributions. In any distribution, AB of stock is determined w/ regard to the adjustments provided in §1367(a)(1). § 1368(d) (flush language).

iii. Amount of the Distribution = FMV Received. § 301(b).1. FMV Basis. § 301(d).

d. Problem 1 (p. 446). Ajax Corporation is a calendar year taxpayer which was organized two years ago and elected S corporation status for its first taxable year. Ajax’s stock is owned one-third by Dewey and two-thirds by Milt. At the beginning of the current year, Dewey’s basis in his Ajax shares was $3,000 and Milt’s basis in his shares was $5,000. During the year, Ajax will earn $9,000 of net income from operations and have a $3,000 long-term capital gain on the sale of 100 shares of Exxon stock. What results to Dewey, Milt and Ajax in the following alternative situations?

i. Basis in Stock1. § 1367(a)(1): AB in stock is increased by:

a. (A) items in items of income in § 1366(a)(1)(A), [and]b. (B) nonseparately computed income under §1366(a)(1)(B).

Dewey (1/3) Milt (2/3)Initial stock basis $3k $5kOrdinary income $3k $6kLTCG $1k $2kAB in stock $7k $13k

ii. (a) On October 15, Ajax distributes $5,000 to Dewey and $10,000 to Milt.1. § 1368(a): distribution of property is treated the manner provided in (b) or (c)2. § 1368(b): where there’s no accumulated earnings and profits:

a. (1) the distribution is not included in GI to the extent it does not exceed AB of stock

3. Dewey: $5k distribution does not exceed $7k basis in stock4. Milt: $10k distribution does not exceed $13k basis in stock5. Effect on Basis in Stock

Dewey (1/3) Milt (2/3)Original AB in stock $7k $13kDistribution ($5k) ($10k)AB in stock $2k $3k

iii. (b) On October 15, Ajax distributes $8,000 to Dewey and $16,000 to Milt.1. § 1368(a): distribution of property is treated the manner provided in (b) or (c)2. § 1368(b): where there’s no accumulated earnings and profits:

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a. (1) the distribution is not included in GI to the extent it does not exceed AB of stock

b. (2) if the distribution exceeds AB of stock, such excess is gain from sale/exchange of property

3. Dewey: $8k distribution – $7k basis in stock = $1k gain4. Milt: $16k distribution – $13k basis in stock = $3k gain5. Effect on Basis in Stock

Dewey (1/3) Milt (2/3)Original AB in stock $7k $13kDistribution ($8k) ($16k)AB in stock $0 $0

iv. (c) Ajax distributes a parcel of land with a basis of $9,000 and a fair market value of $8,000 to Dewey and a different parcel with a basis of $13,000 and fair market value of $16,000 to Milt.

1. § 1371(a): Subchapter C applies to an S corporation unless otherwise provided, or if subchapter C would be inconsistent with subchapter S

2. Distribution of Parcel to Milta. § 311(b): if a corporation distributes appreciated property (other than

an obligation of such corporation) to a shareholder, the corporation recognizes gain as if such property were sold to the distributee at its FMV

i. $16k FMV – $13k AB = $3k RGii. Gain flows through to Milt and Dewey

b. § 1367(a)(1)(B): basis increased by nonseparately computed income under §1366(a)(1)(B)

Dewey (1/3) Milt (2/3)Original AB in stock $7k $13kGain on land distributed by Corporation X

$1k $2k

AB in stock $8k $15kc. § 1368(d) (flush language): in any distribution, AB of stock is

determined w/ regard to the adjustments provided in §1367(a)(1)d. § 1368(b)(2): distribution in excess of basis in stock is gain from

sale/exchange of propertyi. § 301(b): amount of the distribution = FMV received

1. § 301(d): Milt takes a FMV basisii. $16k FMV basis in property – $15k AB in stock = $1k LTCG

3. Distribution of Parcel to Deweya. § 311(b) does not apply (b/c not appreciated property)b. § 311(a) (general rule): no gain or loss is recognized to a corporation

on a distribution of stock/propertyc. Dewey has no gain/lossd. § 301(b): amount of the distribution = FMV received = $8k

Dewey (1/3) Milt (2/3)Original AB in stock $8k $15kDistribution ($8k) ($16k)AB in stock $0 $0

v. (d) On October 15, Ajax distributes its own notes to Dewey and Milt. Dewey receives an Ajax five year, 12% note with a face amount and fair market value of $8,000 and Milt receives an Ajax five year, 12% note with a face amount and fair market value of $16,000.

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1. Ajaxa. No gain from distributionb. § 311(b): “other than obligation of such corp”

2. Same result as part (b), except there are no corporate tax consequencesDewey (1/3) Milt (2/3)

Original AB in stock $7k $13kDistribution ($8k) ($16k)AB in stock $0 $0

e. Problem 2 (pp. 446–47). P Corporation was formed ten years ago by its two equal shareholders, Nancy and Opal, and elected S corporation status at the beginning of the current year. On January 1, Nancy had a $1,000 basis in her P stock and Opal had a $5,000 basis in her stock. P has $6,000 of accumulated earnings and profits from its prior C corporation operations and has the following results from operations this year:

Gross Income $32,000Long-term capital gain 4,000Salary Expense 18,000Depreciation 8,000

i. What are the tax consequences to Nancy, Opal and P Corporation in the following alternative situations?

ii. (a) On November 1, P distributes $5,000 to Nancy and $5,000 to Opal.1. Taxable Income of S Corporation

a. § 1363(b): taxable income of an S corporation is computed in the same manner as in the case of an individual, except that—

i. (1) items described in § 1366(a)(1) are separately statedb. Separate Items

i. LTCG: 4kc. Combined Items

i. $32k GI – $18k salary ded. – $8k depreciation ded. = $6k OI2. § 1368(c)(1): if an S corporation has accumulated earnings and profits, the

portion of the distribution which does not exceed the accumulated adjustments account shall be treated in the manner provided by § 1368(b)

a. § 1368(e)(1): AAA is an account of the S corporation which is generally adjusted in a manner similar to adjustments under § 1367

b. $32k GI + $4k LTCG – $18k salary ded. – $8k depreciation ded. = $10k AAA

c. Here, $10k distributions = $10k AAAd. Treat $10k distributions under § 1368(b)e. § 1368(b): distribution is not included in GI to the extent it does not

exceed AB in stocki. § 1368(d) (flush language): in any distribution, the AB of

stock shall be determined w/ regard to adjustments provided in § 1367(a)(1)

ii. Reg. § 1.1367-1(f): adjustments [to basis] are made in the following order—(1) any increase in basis . . . (2) any decrease in basis attributable to a distribution . . .

Nancy OpalInitial Stock Basis 1k 5k6k ordinary income 3k 3k4k LTCG 2k 2kAB in stock 6k 10kDistribution (5k) (5k)

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AB in stock 1k 5kiii. (b) Same as (a), above, except that P distributes $10,000 to Nancy and $10,000 to Opal.

1. Total amount of distribution = $20k2. § 1368(c)(1): if an S corporation has accumulated earnings and profits, the

portion of the distribution which does not exceed the accumulated adjustments account shall be treated in the manner provided by § 1368(b)

a. Here, AAA = $10k (see part (a))b. The first $10k is treated under § 1368(b) (no gain unless > AB in stock)

3. $20k – $10k = $10k remaining4. § 1368(c)(2): the portion remaining after application of § 1368(c)(1) is treated

as a dividend to the extent it does not exceed accumulated earnings and profitsa. Here, accumulated earnings and profits (given) = $6kb. The next $6k is treated as a dividend (gross income to Nancy and Opal)

5. $10k – $6k = $4k remaining6. § 1368(c)(3): any remaining after application of § 1368(c)(2) is treated under §

1368(b)a. § 1368(b): no gain unless > AB in stockb. See table below

Nancy OpalInitial Stock Basis 1k 5k6k ordinary income 3k 3k4k LTCG 2k 2kAB in stock 6k 10k$10k Distribution§ 1368(c)(1)

(5k) (5k)

AB in stock 1k 5k$4k Distribution§ 1368(c)(3)

($2k) ($2k)

AB in stock 0 0c. § 1368(b)(2): Nancy has $1k capital gain

f. Problem 3 (p. 447). How do the tax rules governing distributions of appreciated property by an S corporation differ from the rules governing similar distributions by partnerships? Why? Which approach is preferable?

S Corporation PartnershipDistribution of appreciated property

§ 301: distributee takes FMV basis§ 311(b): recognize gain immediately

§ 732(a)(1): distributee takes transferred basisGain is deferred until partner disposes of property

Cash distributions § 1368(b): no gain unless exceeds AB in stock

§ 731(a)(1): no gain unless exceeds AB in p’ship interest

Effect of liabilities on basis § 1367: no effect §§ 752, 722: increased share of p’ship liabilities increases AB in p’ship interest

VI. Taxation of the S Corporationa. S Corporation Not Taxed Unless Code Provides. [E]xcept as otherwise provided in this

subchapter, an S corporation shall not be subject to the taxes imposed by this chapter. § 1363(a).

b. Tax on Certain Built-in Gainsi. Requirements. If for any taxable year beginning in the recognition period an S

corporation has a net recognized built-in gain (NRBIG), a tax is imposed under §1363(b). § 1374(a).

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1. Recognition Period. “Recognition period” means the 10 year period beginning with the 1st day of the 1st taxable year for which the corporation was an S corporation. § 1374(d)(7).

2. NRBIG. “Net recognized built-in gain” means, with respect to any taxable year in the recognition period, the lesser of—

a. (i) the amount which would be the taxable income of the S corporation for such taxable year if only recognized built-in gains and recognized built-in losses were taken into account, or

b. (ii) such corporation’s taxable income for such taxable year (determined as provided in § 1375(b)(1)(B)). § 1374(d)(2).

c. RBIG. “Recognized built-in gain” means any gain recognized during the recognition period on the disposition of any asset except to the extent that the S corporation establishes that—

i. (A) such asset was not held by the S corporation as of the beginning of the 1st taxable year for which it was an S corporation, or

ii. (B) such gain exceeds the excess of—1. (i) FMV of such asset as of the beginning of such 1st

taxable year, over2. (ii) AB of the asset at that time. § 1374(d)(3).

3. Carryover. If, the amount referred to in § 1374(d)(1)(A)(i) exceeds the amount in § 1374(d)(1)(A)(ii), such excess will be treated as a RBIG in the succeeding taxable year. § 1374(d)(2)(B).

ii. Computing Tax. The amount of tax imposed by (a) = 35% * NRBIG. § 1374(b)(1).iii. Treat as a Loss. A tax imposed under § 1374 is treated as a loss; the character of such

loss is determined by allocating the loss proportionately among the recognized built-in gains giving rise to the tax. § 1366(f)(2).

c. Passive Activity Lossi. Requirements. If for the taxable year, an S corporation has—

1. (1) accumulated earnings and profits at the close of such taxable year, and2. (2) gross receipts more than 25% of which are passive investment income, then

there is a tax imposed. § 1375(a).3. Gross Receipts. Gross receipts means the total amount received or accrued

under the method of accounting used by the corporation in computing its taxable income. Reg. § 1.1362-2(c)(4)(i).

a. Net Capital Gains. In the case of dispositions of capital assets, gross receipts from such dispositions are taken into account to the extent of the capital gain net income therefrom. § 1362(d)(2)(B)(i).

4. Passive Investment Income. “Passive investment income” means gross receipts derived from royalties, rents, dividends, interest, and annuities. § 1362(d)(3)(C)(i).

ii. Tax Imposed. If the requirements are met, tax is computed by multiplying the excess net passive income by 35%. § 1375(a) (flush language).

1. Excess Net Passive Income. § 1375(d)(1)(A).

a. Net Passive Income. “Net passive income” means (A) passive investment income, reduced by (B) deductions which are directly connected w/ the production of such income. § 1375(d)(2).

iii. Losing S Corporation Eligibility. An S corporation’s subchapter S election is terminated if the corporation—

1. Has accumulated E&P at the close of each of three consecutive tax years, and

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= net passive income * (passive investment income – 25% gross receipts)passive investment income

2. Has gross receipts for each of these three years more than 25% of which are passive investment income. § 1362(d)(3)(A).

d. Problem 1 (p. 453). Built-in Corporation (“B”) was formed in 2000 as a C corporation. The shareholders of B elected S corporation status effective as of January 1, 2004, when it had no Subchapter C earnings and profits and the following assets:

Asset Adjusted Basis F.M.V.Land $30,000 $20,000Building 10,000 35,000Machinery 15,000 30,000

i. For purposes of this problem, disregard any cost recovery deductions that may be available to B. Consider the shareholder and corporate level tax consequences of the following alternative transactions:

1. Gain on sale of property: $50k AR – $10k AB = $40k RGii. (a) B sells the building for $50,000 in 2005; its taxable income for 2005 if it were not an S

corporation would be $75,000.1. § 1374(a): if for any taxable year beginning in the recognition period an S

corporation has a NRBIG, a tax is imposed under §1363(b)2. § 1374(d)(7): “recognition period” means the 10 year period beginning with

the 1st day of the 1st taxable year for which the corporation was an S corpa. Here, this is 2 years after the S corp election became effective

3. § 1374(d)(2): “net recognized built-in gain” means, with respect to any taxable year in the recognition period, the lesser of—

a. (i) the amount which would be the taxable income of the S corporation for such taxable year if only recognized built-in gains and recognized built-in losses were taken into account, or

i. § 1374(d)(3): “recognized built-in gain” means any gain recognized during the recognition period on the disposition of any asset except to the extent that the S corporation establishes that—

1. (B) such gain exceeds the excess of—a. (i) FMV of such asset as of the beginning of

such 1st taxable year, overb. (ii) AB of the asset at that time

2. $40k RG – [$35k FMV at beginning of 1st taxable yr – $10k AB] = $15k

3. RBIG = $40k – $15k = $25kb. (ii) such corporation’s taxable income for such taxable year

(determined as provided in § 1375(b)(1)(B))i. Here, this is $75k (given)

c. NRBIG = $25k4. § 1374(b)(1): tax liability = 35% * NRBIG

a. 35% * $25k = $8,7505. § 1366(f)(2): a tax imposed under § 1374 is treated as a loss; the character of

such loss is determined by allocating the loss proportionately among the recognized built-in gains giving rise to the tax.

iii. (b) Same as (a), above, except that B’s taxable income for 2005 if it were not an S corporation would be $20,000.

1. Same analysis as part (a), except the corporation’s taxable income determined under § 1375(b)(1)(B) is $20k instead of $75k

2. § 1374(d)(2): NRBIG = $20k (lesser than $25k RBIG)3. § 1374(d)(2)(B): the extra $5k is carried over to the next year as a RBIG4. § 1374(b)(1): tax liability = 35% * NRBIG

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a. 35% * $20k = $7,000e. Problem 2 (p. 453). S Corporation elected S corporation status beginning in 2001 and will

have Subchapter C earnings and profits at the close of the current taxable year. This year, S expects that its business operations and investments will produce the following tax results:

Gross income from operations $75,000Business deductions 60,000Tax-exempt interest 23,000Dividends 12,000Long-term capital gain from the sale of investment real property 35,000

i. (a) Is S Corporation subject to the § 1375 tax on passive investment income? If so, compute the amount of tax.

1. § 1375(a): if for the taxable year, an S corporation has—a. (1) accumulated earnings and profits at the close of such taxable year,

andb. (2) gross receipts more than 25% of which are passive investment

income, then there is a tax imposed. § 1375(a).2. Here, there was subchapter C earnings and profits3. Gross Receipts

a. Reg. § 1.1362-2(c)(4)(i): gross receipts means the total amount received or accrued under the method of accounting used by the corporation in computing its taxable income

b. § 1362(d)(2)(B)(i): take into account net capital gainsc. $75k GI + $23k tax-exempt interest + $12k dividends + $35k LTCG =

$145 gross receipts4. Passive Investment Income

a. § 1362(d)(3)(C)(i): “passive investment income” means gross receipts derived from royalties, rents, dividends, interest, and annuities

b. $12k dividends + $23k tax exempt interest = $35k passive investment income

5. $35k passive investment income/$145k gross receipts = 24.14%6. No tax imposed under § 1375(a)

ii. (b) Same as (a), above, except that S receives an additional $5,000 of tax-exempt interest.

1. Here, gross receipts = $150k and passive investment income = $40ka. $40k/$150k = 26.67%b. Tax is imposed under § 1375(a)

2. § 1375(a): tax imposed = excess net passive income * 35%3. § 1375(d)(1)(A): “excess net passive income” = net passive income * [(passive

investment income – 25% gross receipts)/passive investment income]a. § 1375(d)(2): “net passive income” means (A) passive investment

income, reduced by (B) deductions which are directly connected w/ the production of such income.

i. $40k passive investment income – 0 = $40k net passive investment income

b. $40k * [($40k – 25% * $150k)/$40k] = $2,500 excess net passive income

4. $2,500 * 35% = $875 tax imposed

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