Вы находитесь на странице: 1из 74

ALWAYS NOTE ASSUMPTIONS RE: HOW P-TSHP AGREEMENT DIVIDES INCOME P-SHIP FORMATION & OPERATIONS

P-SHIP FORMATION (CH.1, 2) Choice of Entity Partnership ( P-ship ) o 761(a): Partnership includes any syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on  Profit-sharing sign of a P-ship  Except:  Any Corp, trust, or estate;  Investment purposes only or use of property may be exempted if the income of members may be adequately determined Corp ( Corp ) o The tax structure of Corps is much more simple. o Publicly traded entities always taxed as Corps o A P-ship cannot merge into a Corp, unless the owners of the P-ship own 80% or more of the Corp Limited Liability Company o Single Member LLC  For Federal tax purposes, disregarded as an entity that s separate from its owner  Instead, taxed as an extension of its owner  Tax nothing

Check the box o If only one owner:  Entity treated as a tax nothing, even if called a corporation  For tax purposes Entity treated like a sole proprietorship (e.g., no need for a TIN)  For liability purposes Entity generally treated as the entity chosen (see state law)  Single owner could be an individual, Corp, LLC, trust, etc.  However, most single owners apply for a TIN and lose this advantage If two or more owners:  Treas. Reg. 301.7701-2, 301.7701-3  Is the entity called a corporation under the applicable state law? x YES: o Reg. 301.7701-2(b): The entity is taxed as a Corp under Subchapter C. x NO: o Is the entity a foreign entity?  YES: y The entity defaults to being taxed as a Corp under Subchapter C.  NO: y The entity defaults to being taxed as a P-ship under Subchapter K. y The entity however may elect to be treated as a Corp ( association ) under Subchapter C.

Organization/Syndication Expenses 709 | Treatment of Organization/Syndication Fees o 709(a)  General Rule No deductions allowed by P-ship or Ptrs for any expenses related to x Organizing P-ship; or x Promoting or selling any P-ship interests 709(b)(1)  Exceptions If P-ship elects to apply this subsection, it can deduct (in year P-ship business begins) the lesser of: x Amt of org expenses w/ respect to P-ship; OR x 5k, less amt of org expenses in excess of 50k (but not below 0) o NOTE: Remainder of expenses not deducted can be amortized over 180 months 709(b)(3) Org Expenses, defined  Expenses applicable in this section are those that are: x Incidental to P-ship s creation x Are chargeable to capital account x Are amortizable over life and incidental to P-ship s creation

CONTRIBUTIONS TO P-SHIP (CH.2) Contributions of Property Non-Recognition Principles (in general) o 721 | Non-recognition of Gain/Loss ( G/L ) on contribution  721(a) General Rule No G/L recognized by P-ship or Ptrs when Ptr contributes prop in exchange for P-ship int  721(b) Special Rule Non-recognition does not apply if P-ship treated as investment company under 351 Control not a requirement

o o

When non-recognition will not apply  If Ptr acts in his individual capacity (and not as a Ptr) in transacting w/ P-ship x If Ptr provides services for P-ship or transfers prop to his P-ship & acts as outsider x If Ptr transfers prop to P-ship where: o P-ship assumes liability on behalf of Ptr; AND o That assumption is treated as a distribution from P-ship to contributing Ptr x If Ptr contributes appreciated stocks/securities or other appreciated prop to P-ship o Where P-ship treated as an investment company under 351  1001(a) Amt of Recognition x G/L from sale/exchange of property AR AB

Basis Rules o Treatment of Contributed Property ( Prop )  INSIDE BASIS P-ship s basis in its assets x 723 | Basis of prop contributed to a P-ship (i.e., Inside Basis) o AB of prop as it was to contributing Ptr + o Any G recognized by contributing Ptr where P-ship treated as investment co under 721(b) Definition of Property o Not defined in subchapter K o Thus, rely on 351 for guidance:  Property INCLUDES: y Money, y Goodwill, y Intangibles (accts receivable, patents, loans)  Property DOES NOT INCLUDE: y Services rendered by Ptr for P-ship

Treatment of Ptr s Interest  OUTSIDE BASIS Ptr s basis in his P-ship interest x 722 | Basis of contributing Ptr s interest (i.e., Outside Basis) o Amt of money contributed + o AB of prop contributed (as it was in Ptr s hand) + o Any G recognized by contributing Ptr where P-ship treated as investment company under 721(b)

EXAMPLE: Rev. Rul. 99-5  Issue: x x

A owns 100% of LLC; What are tax consequences when a single member LLC becomes an entity w/ more than 1 owner & is classified as a P-ship for tax purposes?

Situation 1 x FACTS o o o o x HELD: o

B purchases 50% of A s ownership interest in the LLC for 5k A does not contribute any of that 5k to the LLC A & B continue to operate the LLC as co-owners A & B are not related Entity Consequences  LLC converted a P-ship when B purchases A s interest  B s purchase of 50% of A s ownership treated as purchase of 50% interest in each of LLC s assets which are treated as directly held by A  Immediately after B s purchase; A & B treated as contributing their respective interests in those assets to a P-ship in exchange for 50% ownership interest in the P-ship Tax Consequences  1001 A recognizes G/L on sale of 50% interest to B  721(a) No G/L recognized by A or B after converting disregarded entity to P-ship  722 Ptrs basis in P-ship interests: y B s basis (in his P-ship interest) 5k y A s basis (in P-ship interest) his basis as it was in the LLC s assets (divided by 2, to constitute 50%)  723 Basis of prop contributed to P-ship y The AB of that prop in A s & B s hand immediately after sale

Situation 2 x FACTS o o o o x HELD o

B contributes 10k to LLC, in exchange for 50% ownership interest (in LLC) LLC uses all of 10k contributed by B for use in its business A & B continue to operate LLC as co-owners A & B are not related Entity Consequences  B treated as contributing to P-ship in exchange for a P-ship interest  A treated as contributing all of LLC s assets in exchange for a P-ship interest Tax Consequences  721(a) No G/L recognized by A or B (because converted disregarded entity to P-ship)  722 y B s basis in P-ship interest? 10k y A s basis in P-ship? His basis as it was in the LLC  723 y Basis of prop contributed by A? The same as it was to A y Basis of prop contributed by B? 10k

Contributions of Services General Rules & Concepts o o A Ptr s contribution of services to a P-ship is most likely a taxable event to both the Ptr and P-ship A Ptr who receives a P-ship interest in exchange for rendering services (past, present, or future) must include its value in Gross Income ( GI ) under 61(a)  Contributing Ptr s tax cost basis in P-ship interest Amt included in GI  Amt included in GI depends on whether Ptr receives a Capital Interest or Profits Interest x Capital Interest Ptr entitled to a share of P-ship s net assets in event P-ship liquidated x Profits Interest Ptr entitled to share of future earnings (including G on sale of prop) o Gives him no current right to a distribution of a share of the P-ship s capital in event of liquidation EXAMPLE o P, I, & M form P-ship  Contributions? y P & I each contributes 60k; y M contributes his expertise in managing.  P-ships total net worth? y 120k. y Ptrs agree to share profits/losses equally.  If M receives 1/3 interest in exchange for his services then he receives a capital interest  P & I each relinquish 20k of their capital accounts, which then goes to M s capital account; thus each Ptr now has 1/3 interest (capital account of 40k)  Thus if P-ship liquidated, M w/ get 40k  If M has a zero capital account then he only has a profits account  M only receives 1/3 of future profits earned by the P-ship  If P-ship liquidates, M will not receive anything. o If prop transferred to person in exchange for services  Excess of [FMV of prop] over [Amt paid for prop] Included in GI of person who performed services If Ptr receives a P-ship interest in exchange for services he provides  Ptr will recognize OI on value of those services

Receipt of Capital Interest o Rules  83 | Property Transferred in connection with Services Rendered x 83(a) General Rule - If prop transferred to person in exchange for service: o Excess of [FMV of prop] over [Amt paid for prop] Included in GI or person who performed services  Amt included in GI determined at time recipient of prop has full right to it (or the prop is not subject to a substantial risk of forfeiture  Rule does not apply if prop is sold (or disposed of) in an arm s length transaction before he has transfer rights (I think not an arm s length trans) 83(b) Election to be included in GI in year of transfer o Any person who performs services & receives prop in connection w/ those services can elect to include the value of prop received in the same tax year he receives the prop (rather than waiting until he has full transfer rights and its no longer subject to forfeiture)  GI inclusion = FMV of prop rec d over the amt paid for it o If this is election made:  83(a) does not apply  And if prop ends up being forfeited no deduction allowed w/ respect to forfeiture o Taxpayer Strategy:  If current value is minimal upon receipt, TP may choose to elect income realization now on the small value, and then if prop appreciates substantially and is sold, TP will get preferential Capital Gains rate 83(c) Special Rules o Substantial Risk of Forfeiture  Full right to prop conditioned on future performances to be rendered o Transferability of Property  Rights in prop only transferable if not subject to substantial risk of forfeiture 83(h) Deduction by Employer o The person who rec d the services is allowed a deduction (under 162)  Deduction goes to P-ship if services performed for P-ship  Deduction goes to Ptr if services performed for Ptr o Amt of Deduction = amt included in GI determined under (a) or (b) for person who received prop in exchange for performing services o NOTE: No deduction if Ptr performs services that should otherwise be capitalized

REG. 1.83-6(b) Recognition of G/L x for prop transferred in connection w/ services rendered: o transferor of prop recognizes G to extent that amt rec d is greater than his basis in the prop transferred x when deduction allowed under 83(h) o G/L recognized on diff btw  amt paid + amt allowed as deduction; AND  TP s basis in the prop + any G recognized on transfer of prop (where amt rec d > basis)

EXAMPLE:  P & I contribute 60k each 6

 

P-ship s sole asset is land (FMV = 120k; AB = 45k) P-ship transfers 1/3 interest to M 2-step Transaction: 1. Transfer of 1/3 interest in land from P-ship to M = compensation for his services o This is taxable transfer of appreciated prop by P-ship to M in exchange for services under 83 Taxable sale/exchange of prop o [1/3 FMV] less [1/3 of AB] = 40k 15k = 25k Gain (Transfer of prop to satisfy an obligation = taxable disposition - Davis 2. M contributes that interest back to the P-ship o Tax-free contribution of M s 40k interest in land back to P-ship under 721 o Tax-free contribution of M s 40k interest in P-ship transferred to P-ship under 723

EXAMPLE  Jan 1: x x x x x x  Oct 4: x x x x

O is owner of a horse farm T is a horse trainer T tells O to buy a horse (named IC ). O does; pays 10k for horse Horse gets allergies O offers T 50% interest in IC to cure horse (so upon O s recovery of his investment and T & O will be Ptrs) IC is cured O recouped entire investment; IC now worth 60k Thus, P-ship formed on this date In exchange for past services, O transfers T FMV of 30k & AB of 5k o Tax consequences to T y T includes FMV of compensation (so 30k) in GI - 83(a)  T takes tax cost basis (of 30k) in the interest of the horse  T then transfer s his interest in horse to the P-ship; takes a 30k basis in his P-ship interest 722  This results in no G/L to T - 721  NOTE T s basis is 30k because that was the value of the horse when transferred to him (not 5k because the AB does not transfer) Tax consequences to O  When TP transfers appreciated prop to satisfy an obligation, must recognize the inherent G in that prop - 704(c) y Thus O must recognize G of 25k when he transfers T s interest in IC to T  O gets a 30k a deduction under 83(h) because the transfer was pmt for services rendered by T y T s services performed for benefit of O (not P-ship so O gets any related deduction)  O transfers his interest in IC to P-ship & takes 5k interest in his P-ship interest - 722 y Ptr s AB in his interest is the AB as it was to him (thus he bought it at 10k, and transferred , so his AB becomes 5k) Tax consequences to P-ship  No G/L on formation - 721  Takes transferred basis in IC of 35k (30k from T & 5k from O) - 723

Receipt of Profits Interest o o Diamond Rule Made the receipt of a profits interest as compensation for services performed a taxable event Rev. Rul. 93-27 If a Ptr (or person anticipating becoming a Ptr) receives a mere profits interest in a P-ship for services rendered to/for benefit of the P-ship; AND the Ptr performs those services in his capacity as a Ptr, then the receipt of the interest is NOT taxable event to the Ptr OR the P-ship;  EXCEPTIONS: x If the profit interest has a fairly certain income stream x The profit interest is in a PTP x The service Ptr disposes of the interest within 2 years of receipt

Contributions of Debt/Property Encumbered with Liabilities General Rule & Concept: o Ptrs outside basis must reflect liabilities in connection w/ (i.e. 752 will apply in the following cases):  Prop subject to liability is transferred to P-ship; OR  P -ship incurs or pays off a liability Tax implications generally will need to be made if P-ship borrows money or a Ptr contributes prop encumbered by debt  If Ptr contributes prop subject to debt; to extent he is relieved of the debt by the P-ship; its treated as a cash distribution to him by P-ship x NOTE: THIS TRIGGERS OPERATING RULES OF P-SHIP DISTRIBUTIONS UNDER 731 - 734; SEE SECTION ON DISTRIBUTIONS x Contributing Ptr s outside basis decreases by amt of distribution/liability relieved of (but not below 0) x Noncontributing Ptrs outside basis is then increased by amt of liability the P-ship picked up o Treated as contributing cash to P-ship o Amt of liability must be allocated among the noncontributing Ptrs Debt Allocations:  GPs will share recourse liabilities equally  LPs typically obligated to extent obligated to contribute to P-ship in the future  LLCS members will share liabilities according to their profit sharing arrangements  In case of NRL; asset tied to loan is repossessed to pay of debt 752 | Treatment of Certain Liabilities  752(a) Increase in Ptr s Liabilities if Ptr s share of P-ship s liabilities increases or if Ptr s assumption of P-ship liabilities increases, amt of increase treated as contribution of money to P-ship from Ptr x Increases Ptr s outside basis under 722  752(b) Decrease in Ptr s Liabilities - if Ptr s share of P-ship s liabilities decreases or if Ptr s assumption of liabilities decreases, amt of decrease treated as distribution of money to Ptr by P-ship x Decreases Ptr s outside basis under 705(a) & 733  752(c) Property subject to Liability if prop is subject to a liability; then the owner of that prop is the obligor on that debt, regardless if recourse or nonrecourse x Amt of liability can t be > FMV of prop (this is expansion of Crane Doctrine) EXAMPLE: Ptr contributes Prop subject to Debt  P-ship now treated as obligor on that debt 752(c)  Non-contributing Ptrs increase their outside bases 752(a)  Contributing Ptr decreases his outside basis due to the deemed cash distribution reflected by the P-ship relieving him of his debt obligation on that prop 752(b)

Contributions of Prop subject to Recourse Liabilities IN GENERAL o RULES 

REG 1.752-1(a)(1) - liability is recourse to extent any Ptr bears economic risk of loss for that liability x Ptr s share of recourse liab = portion of liab for which the Ptr bears risk of loss x Ptr bears risk of loss to extent that Ptr w/b req d to pay liab if P-ship couldn t Constructive Liquidation Test x Key is to do a constructive liquidation of the P-ship; to extent any Ptr is responsible for repaying a liab; that Ptr has the economic risk of loss o Note: all nonrecourse liabilities s/b rid of first before determining who bears the risk on recourse liabilities x Constructive Liquidation o P-ship s liab are due & payable in full o All P-ship s assets are worthless (including cash) o All P-ship assets disposed of in taxable transaction for zero consideration o P-ship allocates all items of income, G/L for last taxable year o P-ship liquidates

EXAMPLE  Facts x

A contributes land w/ FMV of 150k, AB = 50k, subject to RL (recourse liab) = 30k in exchange for 50% interest in new P-ship AB x B contributes 120k in cash in exchange for other 50% interest P-ship Assets P-ship net worth x Cash = 120k A (contr of land net RL) = 120k B (contr of cash) = 120k x Land = 120k (bk val. 150k less 30k RL) x Total = 240k Total 240k Treatment of Liab x P-ship assumes 30k RL - 752(c); & AB are = owners o A bears risk of 15k o B bears risk of 15k o NOTE: If A remains personally liable, then B does not bear the economic risk REG. 1.7522(b)(3)(iii) x Result: A relieved of 15k of debt, B liabilities increase by 15k o 15k relief treated as cash distribution to A by P-ship - 752(b) o 15k increase to B treated as contribution to P-ship by B - 752(a) Determination of Basis x A s outside basis o 50k AB in land contributed - 722 o <15k> Less: portion of liab treated as cash distr in relief of debt 733(1) o 35k A s outside basis x B s outside basis o 120k amt of cash contributed - 722 portion of liab treated as cash contribution by B - 722 o 15k o 135k B s outside basis

10

Contributions of Prop subject to Recourse Liabilities IN EXCESS OF BASIS o RULES  

General Rule: any G recognized b/c of contribution of prop w/ a RL in excess of its AB results from constructive cash distribution from P-ship, not from the contribution of prop by the Ptr 731(a)(1) Ptrs - Ptr recognizes G on deemed cash distributions made to him by P-ship in amt cash that exceeds AB of his P-ship interest x Thus, excess RL over AB treated as cash dist, and G is recognized to distributee Ptr in amt of the excess Flush language of 731(a); 741 Character of G/L G recognition under 731 treated as sale/exchange of P-ship interest of distributee Ptr; 741 treats G/L from sales/exchanges of P-ship interests as capital G

EXAMPLE  Facts x A contributes land w/ FMV = 150k; AB = 10k; subject to RL = 30k in exchange for 50% interest in P-ship x B contributes 120k in cash in exchange for other 50%  P-ship Assets x 120k cash x 120k land (book value of 150k less 30k RL) x 240k total  P-ship Net Worth / Contributed Capital x 120k A contr land (net RL) x 120k B contr cash 120k x 240k total  Treatment of Liab x P-ship assumes 30k RL under 752(c) & AB are = owners o A bears risk of 15k o B bears risk of 15k x Result: A relieved of 15k of debt, B liabilities increase by 15k o 15k relief treated as cash distribution to A by P-ship - 752(b) o 15k increase to B treated as contribution to P-ship by B - 752(a)  Determination of basis x A s outside basis o 10k AB in land contributed o <10k> Less: amt of liab treated as cash distr/relief of debt, NOT BELOW 0 - 733 o 0 A s outside basis o 5k Excess liab over AB  treated as cash distr - 731(a)(1)  treated as G from sale/exchange of P-ship interest flush lang 731(a)  Treated as Capital G - 741  Note: 722 & 733 permit increase in basis by amt of G recognized under 721(b) at such time which does not include a hypothetical cash distr thus; Ptr can t increase his basis by the excess RL over his AB b/c its treated as a hypothetical cash distr. x B s outside basis o 120k amt of cash contributed - 722 o 15k portion of liab treated as cash contribution by B - 722 o 135k B s outside basis

11

Contributions of prop subject to non-recourse liabilities IN GENERAL o RULES  

REG 1.752-1(a)(2) - liability is nonrecourse if no Ptr bears economic risk of loss x none of the Ptrs are personally liable REG 1.752-3(a)(3) NRL generally allocated among Ptrs in accordance w/ their share of profits (& not losses) x P-ship interests in profits determined by taking into account all facts/circumstances relating to economic arrangement of Ptrs 704(c)(1)(A) - NOTE: if Ptr contributes appreciated prop to P-ship, precontribution G allocated to contributing Ptr

EXAMPLE  Facts x

A contributes land w/ FMV = 150k; AB = 50k; subject to NRL = 30k in exchange for 50% interest in new Pship (AB) x B contributes 120k in cash in exchange for other 50% P-ship Assets x 120k cash x 120k land (book value of 150k less 30k NRL) x 240k total P-ship Net Worth / Contributed Capital x 120k A contr land (net NRL) x 120k B contr cash 120k x 240k total Result x To Ptr A o considered to be relieved of 15k of debt, thus deemed to be 15k cash distr by P-ship - 752(b) o A s outside basis in his P-ship interest is reduced by amt of deemed cash distr - 733  50k beginning AB; AB of land contributed amt of cash distribution  (15k)  35k A s AB in his outside basis x To Ptr B o Remaining 15k allocated to B (b/c they are = Ptrs, assumed); B considered to have made 15k cash contribution - 752(a) o B s outside basis in his P-ship interest increases by amt of cash contribution - 722  120k beginning cash contribution 722  + 15k deemed cash contribution from liability assumption 752(a)  135k B s AB in his outside basis

12

Contributions of prop subject to non-recourse liabilities IN EXCESS OF BASIS o RULES 

REG 1.752-3(a)(3) NRL generally allocated among Ptrs in accordance w/ their share of profits (& not losses) x P-ship interests in profits determined by taking into account all facts/circumstances relating to economic arrangement of Ptrs Tufts Doctrine if prop that is subject to a NRL in excess of its AB is disposed of; the AR is at least amt of NRL regardless of value of prop; thus the AR will always include FMV + amt of debt x So if prop FMV in this case was 0 at disposal; 30k = AR x If prop FMV was 150k at time of disposal; 180k = AR REG. 1.752-3(a)(2) a Ptr who contributes prop subject to NRL is first allocated the portion of the liab that = the amt of G that w/b recognized under the 704(c)(1)(A) precontribution rules if the prop was sold at time of contribution for an amt = to the NRL x Balance then allocated according to Ptr share of P-ship profits (see above reg; -3(a)(3) 704(c)(1)(A) ( Amt that NRL exceeds AB at time of contribution is minimum G guaranteed to be recognized by Pship upon disposition of the prop subject to NRL; thus its considered to be precontribution G and must be allocated to contributing Ptr at time of disposition

EXAMPLE  Facts x

A contributes land w/ FMV = 150k; AB = 10k; subject to NRL = 30k in exchange for 50% interest in new Pship (AB) x B contributes 120k in cash in exchange for other 50% x AB sells land for 0$ P-ship Assets x 120k cash x 120k land (book value of 150k less 30k RL) x 240k total P-ship Net Worth / Contributed Capital x 120k A contr land (net RL) x 120k B contr cash 120k x 240k total Result x 30k AR = amt of NRL prop is subject to Tufts x <10k> AB of land x 20k G recognized on disposition of land o note, this is minimum amt of G to be recognized; if P-ship disposed of land at a FMV above 0, that amt also included in AR which w/ increase amt of G recognized Allocation of Liabilities x 20k of NRL attributable to G; thus allocated to A REG 1.752-3(a)(2) o b/c this is considered precontribution G, 20k of NRL allocated to A - 704(c)(1)(A)  this is b/c at time of contribution AB was 10 and NRL was 30, thus G guaranteed to be at least 20k at time of contribution x Remaining amt of liabilities o Allocated according to Ptrs share of profits - REG 1.752-3(a)(3) o Total NRL = 30k less 20k to A; leaves 10k of NRL to allocate to both A & B o Assuming 50/50 share, each is allocated 5k of the NRL; thus net effect is that 5k of the NRL is reallocated to B  Impact on Basis y Ptr A o A s basis decreases by the 5k debt relief allocated to B 752(b), 733 o Beg. AB of 10k less 5k = 5k AB y Ptr B o B s basis increases by 5k deemed contribution 752(a), 722 o Beg AB of 120k + 5k = 125k

13

Contributions of Unrealized Receivables/Inventory Items Characterization 724 | Character of G/L on Contributed Unrealized Receivables, Inventory Items, & Capital Loss Property o 724(a) Unrealized Receivables if Ptr contributes these to P-ship; any G/L recognized by P-ship on a subsequent disposition is treated as ordinary income/loss 724(b) Inventory Items if Ptr contributes these to P-ship; any G/L recognized by P-ship on subsequent disposition (if w/in 5yr of date of contribution) treated ad ordinary income/loss 724(c) Capital Loss Property if Ptr contributes a capital asset to P-ship where its AB > FMV; any L recognized by P-ship on subsequent disposition (if w/in 5 yrs of date of contribution) is capital loss  Keeps you from contributing a capital asset that will be inventory in the hands of the P-ship which will be ordinary

Definitions 751 | Unrealized Receivables & Inventory Items o 751(c) Unrealized Receivables includes any rights to pmts for the following items & such pmts not yet included in the Pship s income  751(c)(1) - goods delivered, to be delivered  751(c)(2) - services rendered, to be rendered  751(c) flush language - 1245 prop (i.e. any prop subject to recapture; i.e. depreciation which is OI) x Note: unrealized receivable includes 1245 prop for purposes of 731, 732, 741, & 751; BUT NOT 736 x Note: UR generally have an AB of zero 751(d) Inventory Items  Includes P-ship inventory items if in the aggregate they have appreciated substantially in value x substantially appreciated if their FMV > 120% of their AB  Specifically includes: x 751(d)(1) 1221(a)(1) prop x 751(d)(2) any other prop which on sale/exchange by the P-ship is not 1231 prop or capital asset x 751(d)(3) any other P-ship prop which (if held by selling/distributee Ptr) w/b considered inventory under (1) or (2) o i.e. everything except recapture items  Note: if a Ptr owns prop & is deemed a dealer in that item & then sells it treated as inventory item

14

OPERATIONS OF A P-SHIP (CH.3) General Rules Entity Treatment o Aggregate v. Entity  In General x Subchapter K provides mixture of aggregate and entity principles x 701 adopts aggregate approach by providing that P-ship is not a taxable entity  Pure Aggregate x P-ship is aggregate of relationships btw the Ptrs w/ respect to both o P-ship s business; AND o P-ship s property x Distribution of property to Ptr has no tax effect. o It gives the Ptr what is already hers o moves the property from one of the Ptr s pockets (the share of P-ship property pocket) to another (the property owned directly pocket) x Contribution of appreciated property should have a partial tax effect o Gave 50% for 50% of other s property o Tax half of the appreciation gain x Distribution of property corresponding with a decrease in ownership should affect both Ptrs o Exchanging difference in ownership for the share of property no longer owned by Ptr  Pure Entity x P-ship is its own taxable entity x Contribution of appreciated property should have a full tax effect. o Giving 100% for 50% share of P-ship. Tax fully the appreciation gain. x Distribution of property corresponding with a decrease in ownership should affect that Ptr. o Redemption by the P-ship of a P-ship interest in exchange for the property Tax to P-ship and A  Subchapter K ( 701-777) takes neither a pure aggregate nor a pure entity approach x It is often a response to abuses in the past x Contribution of appreciated property is viewed as to a transparent pass-through entity and no tax is computed at that time x Distribution of property corresponding with a decrease in ownership should affect both Ptrs o Distributions of non-cash property by a P-ship to a Ptr are tax free, with appropriate basis rules to assure that such treatment did not effect permanent tax avoidance. x The original model was for small closely held businesses with few Ptrs. General Rule:  P-ships treated as entities for purposes of: x Reporting & determining income or loss x Admin & judicial procedures x Taxable year (may differ from each individual Ptr s tax year)

15

Taxable Year o 706(a) Year in which P-ship income included all IGLDC earned by P-ship for any taxable year of P-ship ending w/in or w/ Ptr s tax year is included in that Ptr s GI 706(b)(1)| Taxable year of a P-ship  706(b)(1)(A) P-ship s taxable year determined as if P-ship was a TP  706(b)(1)(B) P-ship can t have a taxable year other than: o The majority interest taxable year o Taxable year of all principal Ptrs if no majority interest tax year exists o Calendar year if no majority interest tax year or if no tax year of all principal Ptrs exists  706(b)(1)(C) P-ship can elect a different tax year other than what is in (B) if it can establish a business purpose 706(b)(2) Ptr s taxable year - A Ptr can t change his taxable year from that of the P-ship s unless he can establish a business purpose 706(b)(3) Principal Ptr a principal Ptr is a Ptr having an interest of 5% or more in P-ship profits or capital x Principal Ptr is any Ptr having an interest of at least 5% in the P-ship s profits or capital 706(b)(4) Majority interest taxable year  706(b)(4)(A)(i) Majority interest taxable year defined - A taxable year where on any of the testing days 1+ Ptrs had an aggregate interest of 50% in P-ship s profits & capital x Testing days = o First day of P-ship taxable year OR o Days during a period prescribed by Secretary Regs: 1.706-1(b)  (1) taxable year of P-ship determined as if P-ship is TP  (2) P-ship can have a taxable year other than its req d taxable year under 707(b)(1)(B) if: x Makes election under 444, x Elects a 52-53 week year x Or makes an election by establishing a business purpose  (3)(i) Taxable year that results in the least aggregate deferral of income is the taxable year of 1+ Ptrs

Assignment of Income EXAMPLE: Schneer Case  Facts: Schneer was an associate at a law firm decided to move to another firm, he made a deal where he w/ get a % of the fees generated by the services he brought in from the old P-ship  Issue: How w/ the fees be treated b/c they w/b paid to the P-ship and not him; thus assignment of income issue x Was it earned at P-ship level or Ptr level? x If at P-ship level, old or new?  Held: Fees were earned at the P-ship level; specifically the new firm he joined

16

Tax Consequences Determination of Tax Liability o General Rule on Computation  P-ship Operating Income 702(c) x The P-ship s operating income is computed, deductions determined, and then subtracted to get the P-ships net income o This net income amt should EXCLUDE all items listed out in 702(a) o This net income is then divided according to the PA; or if silent or provides an allocation method that lacks substantial economic effect, then the net income is divided in accordance to their P-ship interests o Each Ptr then reports their share of P-ship operating income in their GI on their individual return  Separately Stated Items 702(a) x These items are listed in 702(a) x These items are accounted for separately and are included in the Ptr s individual return in the same nature in which they are determined EXAMPLE: Rather than including a LTCG in the P-ship operating income, the Ptr instead reports his distributive share of the G as a LTCG on his individual return x Note: Each Ptr s distributive share of separately stated items is also determined in accordance w/ the PA; or their P-ship interests if the PA is silent or provides improper allocation methods

701 | Ptrs , not P-ships, Subject to Tax  P-ships not liable for tax, all Ptrs in that P-ship are liable for tax in own individual capacity  REG. 1.707-1 Even though P-ship not subject to tax, must still file a information return under 6031 x EXCEPTION: 2 instances where a P-ship subject to tax o PTPs taxed as a Corp under 7704 o Check the box P-ships (those that are treated as extensions of their Corp owners and are disregarded as a separate entity) 702 | Income & Credits of Ptr  702(a) General Tule Each Ptr takes into account separately his distributive share of the P-ship s: x G/L from sale/exchange of ST capital assets (held for 1 yr or less) x G/L from sale/exchange of LT capital assets (held for more than 1 yr) x G/L from sale/exchange of 1231 assets (assets used in a T/B) x Charitable contributions x Dividends under 1(h)(11) x Foreign taxes x Other items of IGLDC prescribed in the regs x Taxable income or loss not required to be accounted for separately  702(b) Character of items in distributive share Determined at P-ship level; thus in same manner as incurred by Pship x Spaghetti Factory & University Example income from Spaghetti Factory is taxed to university because maintains its form as earned by Spaghetti Factory.

17

EXAMPLE: Rev. Rul. 68-79 o Issue: Whether a Ptr s distributive share of a capital G s/b treated as LTCG o Facts: A, B, C are = Ptrs in ABC P-ship; ABC bought 300 shares of X stock; 6 months later A sold his interest to D; 3 months later ABC sold the X stock at a G, D s individual HP was only 3 months, but the P-ship s HP was 9 months o Rules:  Stock held < 6 months is treated as ST; > 6 months is LT - 1222  Character of G/L is determined at P-ship level - 702(b) o Hold: D s distributive share of the G on the sale of X stock is characterized LTCG  o 702(c) Gross Income of Ptr Ptr includes his distributive share of P-ship GI in his own GI

703 | P-ship Computation  703(a) Income & Deductions Taxable income of a P-ship computed in same manner as individual; EXCEPT THAT: x Items listed in 702(a) must be separately stated; AND x The following deductions not available to the P-ship o 151 personal exemptions o 901 foreign taxes o 170 charitable deductions o 172 NOL deduction o 211 and on relating to itemized deductions o 611 oil and gas depletion  703(b) Elections of P-ship Any election affecting computation of P-ship s taxable income is elected by P-ship except for 108 & 617 elections

Determination of Ptr s Interest (OUTSIDE BASIS) o 705 | Determination of Ptr s Interest  705(a) General Rule AB of Ptr s interest in P-ship is his basis determined: x 705(a) The basis first determined under: o 722 Relating to contributions to P-ship (see above); OR o 742 Relating to transfers of P-ship interests (see below) x 705(a)(1) Plus: his distributive share of: o P-ship taxable income under 703(a)  This includes G recognized by P-ship on sale of assets o Tax exempt income x 705(a)(2) Minus (BUT NOT BELOW 0): o Distributions made by P-ship under 733 o His distributive share of P-ship losses  Includes L recognized by P-ship on sale of assets o Nondeductible expenses of P-ship

18

3 Limitations on P-ship Losses (NOTE: APPLY LIMITATIONS IN THIS ORDER) Basis Limitations o 704(d) Limitation on Allowance of lLoss - A Ptr cannot deduct losses in excess of her outside basis.  Otherwise, a Ptr would be claiming losses in excess of her investment.  This limitation just defers deductions; if it applies, any excess loss c/b carried forward indefinitely & utilized when Ptr acquires add l outside basis , e.g., from income, contribution, or P-ship borrowing.  This 704(d) capture never ages, it is constantly renewed Legislative Goal This attacks the deferral benefit of a tax shelter by denying temporarily losses without gain  If debt is recourse, only basis of GPs w/ increase. x Loss deductions trapped under 704(d) for LPs EXAMPLE  A s basis in his P-ship interest = 1k; his share of P-ship losses = 1.2k  Thus Ptr s loss is limited to 1k  Remaining 200 is suspended until he contributes additional capital or increases his share of P-ship liabilities; both of which w/ increase his basis under 722, 752(a) o REG. 1.704-1(d) Limitation on Allowance of Losses If a P-ship has both ordinary & capital losses; Ptr s L allocated to reflect the makeup of the P-ship s L EXAMPLE  A Ptr s basis in his P-ship interest is 1,000 & his share of P-ship L is 1,200  Under 704(d) allowable L limited to his basis; so 1k  If, of that $1,200 L, 900 is ordinary & 300 is STCL the Ptr s $1,000 allowable L is characterized as follows: x 900/1200 x 1000 = 750 ordinary loss x 300/1200 x 1000 = 250 STCL  200 can be carried over; 150 Ordinary loss and 50 STCL x 900 750 = 150 x 300 250 = 50

19

At-Risk Limitations o 465 | Deductions Limited to Amt at Risk  465(a) | Limitation to Amt at Risk x 465(a)(1) General Rule a TPs (or Ptr s) deductible losses from various business and investment activities are limited to the amt that he is at risk w/ respect to any one of those activities o Note: the rules are applies separately to each activity in which a P-ship is engaged x 465(a)(2) Carry-Forward Rules excess loss not deductible in the current taxable year is permitted to be carried forward & can be deducted when: o TP becomes at risk o P-ship disposes of activity o TP disposes of his P-ship interest x REG. 1.465-1(e) NOTE If a Ptr s loss is deferred, i.e. he is not at risk for those amts, his basis is still reduced by amt of L (this is a proposed reg)  465(b) | At-Risk Amounts x Amts considered At-Risk o Contributions  465(b)(1)(A) - Amt of TP s cash contributions to activity  465(b)(1)(B) - Amt of AB of prop contributed by TP to activity o Borrowed Amts  465(b)(2)(A) - Amts borrowed by TP for use in activity, if borrowed amt is a RL; y Also includes his share of P-ship RL related to the activity  465(b)(2)(A) - Amts borrowed by TP for use in the activity where he secured the debt x Amts NOT considered At-Risk o 465(b)(3) Amts borrowed from any person who has an interest in the activity; EXCEPT:  The person having the interest is a creditor  A Corp borrows from its SH; i.e. the SH has the interest o 465(b)(4) - TP not at risk w/ respect to any NRL or where TP has no economic risk  465(c) Types of activities to which At-Risk rules apply (Ptr must actively participate) x Film & video x Farming x Leasing 1245 prop x Exploring/exploiting gas resources x Exploring/exploiting geothermic deposits  465(d) Definition of Loss loss = excess of deductions over income of the at risk activity (the deductions include all allowable deductions, including both amts at risk and not at risk) after loss amt determined, then at risk limitation applied  465(e) | Recapture of Loss where At-Risk Amt < 0 x TP can t go negative, this prevents him from assuming risk then withdrawing EXAMPLE  Ptr s share of farming operations includes a 1.5k loss  Ptr is 50% Ptr in farming activity; and P-ship has 1K RL in connection w/ the farming activity; Ptr s share is 500k  Thus Ptr can only deduct 500 of the loss - so long as it first meets basis limitations under 704(d)

20

Passive loss limitations o Overview / Concept  Legislative Intent: x 469 enacted to restrict TPs from using deductions & other losses generated from certain passive investment activities to shelter income from other sources x does not disallow excess losses forever, just postpones them How It Works: x the income & losses from each of a TP s passive activities are first computed then combined x in any taxable year, passive activity losses can be deducted only to extent of TP s income from passive activities for that year - 469(a)(1)(A) x any excess loss over income c/b c/f & deducted in following tax year o subject to same limitations (so loss can only be deducted in the following year to the extent of passive activity income for that year)

469 | Passive Activity Losses & Credits Limited  469(a) Disallowance, general rule x 469(a)(1) Losses or credits earned from a passive activity are disallowed to TP x 469(a)(2) Disallowance for: o individuals, estates, trusts o closely held C-Corp o personal service Corps  NOTE: DOES NOT APPLY TO PUBLICLY TRADED C-CORPS   469(b) Disallowance carries to next taxable year; i.e. carry forward permitted (c) Passive Activity, defined x 469(c)(1) any activity involving conduct of T/B in which TP does not materially participate x 469(c)(2) passive activity includes rental activity 469(d)(1) Passive Activity Loss means amt by which aggregate losses for all passive activities exceeds income for all passive activities 469 (e)(1)(A) Income not treated as income from a passive activity x GI from interest, dividends, annuities, royalties not derived in OCB o Expenses (except interest) directly allocable to such income x G/L not derived in OCB attributed to disposition of prop o Producing income such as interest, dividends, annuities, royalties o Held for investment 469(g)(1) Rules for disposing entirely of a passive activity x If all G/L recognized on disposition; then excess of o Any loss from the activity o Over net income or G from all other passive activities x Is treated as a loss not from the passive activity 469(h) Material Participation x Defined o 469(h)(1) TP treated as materially participating if TP involved in ops of activity which is:  Regular  Continuous  Substantial o 469(h)(2) No interest in a lmtd P-ship as a LP is treated as having materially participated 21

o x

469(h)(5) Spousal participation is taken into account to determine if a TP materially participates

Test for Material Participation o (1) TP participates 500+ hours o (2) TP s participation in activity constitutes substantially all of the participation in the activity by any individual for the year o (3) TP devotes 100+ hours during taxable year & his participation isn t less than any other s o (4) Activity is a significant participation activity  A T/B activity  TP participates 100+ hrs  TP does not satisfy any other test  TP s aggregate participation in all significant activities > 500 hours o (5) TP materially participated in activity for any 5 of 10 taxable years immediately preceding the tax year o (6) Activity is a personal service activity  Activity mostly involves performance of services in fields such as: y Health, law, engineering, architecture, accounting  & TP materially participated in activity in any of 3 taxable years preceding tax year o (7) Based on facts/circumstances TP s participation in the activity during tax year is regular, continuous, & substantial With respect to Limited Ptrs o General Rule  Presumes all LP interests are activities in which TP does not materially participate o Exceptions  Regs do provide some aspects where LP may be considered to materially participate: y Participate 500+ hours during tax year y Materially participated in any of 5 tax years in preceding 10 tax years y Activity is personal service activity & TP materially participated in any 3 of the tax years preceding the taxable year y An LP who is also a GP & meets any one of the 7 tests for material participation is treated as materially participating w/ respect to both the GP & LP interests y LP s share of income rec d for performance of services (i.e. by salary or guaranteed pmt) is NOT treated as income from a passive activity

22

P-SHIP ACCOUNTING (CH.2, 4) Ptr Capital Account Concept o o o Ptr s capital accounts s/ reflect their equity in the firm Reflects what each Ptr s/ receive if his interest is liquidated Does not always accurately reflect current FMV of Ptr s investment  Balance sheet only balances if reflects historical costs x Book value does not always = FMV x Book historical cost/basis does not always = tax cost/basis  Thus no depreciation/appreciation realized until asset sold and G/L recognized Contributions s/b reported at FMV for book purposes

Computation o Fundamental Equation  Assets = Liabilities + Ptrs Capital Accounts (or net worth) Formula  Begins with: x Amt of cash contributed + FMV of prop contributed  Increased by: x Ptr s share of profits  Decreased by: x Ptr s share of P-ship losses x Amt of cash distributed to Ptrs x Ptr w/drawals x FMV of prop distributed to Ptrs NOTE: Anything that happens to inside basis must also be reflected in the outside basis & vice versa b/c we are either moving money into or out of P-ship which will affect the basis of the Ptr s separate P-ship basis

23

EXAMPLE: o A, B, & C contribute 60k in securities (AB = 40), 30k of land, & 10k of cash respectively to form ABC  Total contribution = 100k in assets  Mirror on other side of BS = 100k of contributed capital (i.e. equity or net worth)  P-ship interests: A @ 60%; B @ 30%; C @ 10% Assets Cash Securities Land Total AB 10k 40k 30k 80k Bk Val. 10k 60k 30k 100k = Liab & Cap. a/c Cap: A Cap: B Cap: C Total AB 40K 30K 10K 80k Bk Val. 60K 30K 10k 100k

Year 1: ABC earns 10k in profits, sells land for 40k; all Ptrs share in profits according to their capital a/c balances (based on book value)  So cash increases to 60k (10k starting, plus 40k for land, plus 10k for profits earned)  20k to be allocated to Ptrs a/c (both on AB & Bk value) G on land = 10k (40k FMV 30k AB) & 10k profits earned x A: 20k x 60% = 12k x B: 20k x 30% = 6k x C: 20k x 10% = 2k Assets Cash Securities Land Total AB 60K 40K 0K 100k Bk Val. 60K 60K 0K 120k = Liab & Cap. a/c Cap: A Cap: B Cap: C Total AB 52K 36K 12K 100k Bk Val. 72K 36K 12k 120K

Year 2: ABC borrows 30k from bank  Cash increases by 30k both AB and Bk value  Liabilities increase by 30k for Bk value only  Each Ptr s capital a/c @ bk value is unaffected  Each Ptr s basis in his P-ship interest increases by his share of the new P-ship liabilities in accordance w/ his P-ship interest x A: 30k x 60% = 18k x B: 30k x 30% = 9k x C: 30k x 10% = 3k Assets Cash Securities Land Total AB 90K 40K 0K 100k Bk Val. 90K 60K 0K 120k = Liab & Cap. a/c Cap: A Cap: B Cap: C Liability Total AB 70K 45K 15K 0 130k Bk Val. 72K 36K 12k 30K 150K

Year 3: ABC makes 60k distribution to Ptrs in accordance to their P-ship interests 24

 

Cash will decrease by 60k Capital accounts (both AB and Bk value) will decrease by the following: x A: 60k x 60% = 36k x B: 60k x 30% = 18k x C: 60k x 10% = 6k Assets Cash Securities Land Total AB 30k 40K 0K 70K Bk Val. 30k 60K 0K 90K = Liab & Cap. a/c Cap: A Cap: B Cap: C Liability Total AB 34K 27K 9K 0 70K Bk Val. 36K 18K 6K 30K 90K

Year 4: P-ship sells the securities, which are now worth 160k  G realized FMV of 160k less AB of 40k = 120k x At time of contribution, pre-contribution G of 20k (Bk value = 60k less AB of 40k) x Pre-contribution G of 20k allocated entirely to Ptr that contributed that asset o Thus 20k of G allocated to A s AB a/c balance - 704(c)(1)(A) x Remaining 100k G allocated to each Ptr in accordance w/ their P-ship interest o A: 100k x 60% = 60k o B: 100k x 30% = 30k o C: 100k x 10% = 10k  Securities decrease to 0, both AB and Bk value  Cash increases by 160k, amt securities sold for  Each Ptrs cap a/c balance increased by proportionate share of G; however A s bk value does not reflect the precontribution G b/c it was reflected when the securities were first put on the BS at time of contribution Assets Cash Securities Land Total AB 190k 0K 0K 190k Bk Val. 190k 0K 0K 190k = Liab & Cap. a/c Cap: A Cap: B Cap: C Liability Total AB 114k 57K 19K 0 190K Bk Val. 96K 48K 16K 30K 190K

25

P-SHIP ALLOCATIONS (CH. 4) Special Allocations General Rules o 704(b) | Determination of Distributive Share A Ptr s distributive share of IGLDC is determined according to his interest in the P-ship if:  704(b)(1) - The PA does not provide otherwise; OR  704(b)(2) - The allocation to the Ptr under the PA lacks Substantial Economic Effect (SEE) P-ship Agreements (PAs)  Most allocations not tax driven, but by economic considerations  761(c) | P-ship Agreement Permits any modifications to the PA to be made up to the item for filing the P-ship s tax return x This permits Ptrs to make special allocations o Special allocations allocations that differ from the Ptr s respective interests in the P-ship capital EXAMPLE: Orrisch v. Commissioner o Issue: Whether tax effect can be given to the PA that stated one of the parties to the agreement w/ get the special allocation to accelerated depreciation deduction o Held: NO The amts of each of the Ptrs depreciation deduction s/b determined according to the ratio used in computing their distributive share of P-ship P/L when the allocation provision is for tax avoidance

26

Special Allocations under the Regs o General Rules  REG. 1.704-1(b)(1)(i) Basic Principal - General rule is to give effect to special allocation provision in a PA so long as it has SEE, but there are 2 other ways it can still be respected if lacks SEE; thus 3 ways allocation will be respected: x (1) REG. 1.704-1(b)(2) The allocation provision has substantial economic effect o This is a safe harbor, if the allocation has SEE, it will be respected o If not then it will be reallocated in accordance w/ the Ptr s economic interests (i.e. in accordance w/ the Ptr s interest in the P-ship) o NOTE: This is best option for P-ship b/c it guarantees certainty the allocation will be respected x (2) REG. 1.704-1(b)(3) Taking account of all facts & circumstances, allocation is in accordance w/ the Ptr s interest in the P-ship o This establishes default rules which allocations must meet if they fail the SEE x (3) REG. 1.704-1(b)(4) allocation is pursuant a special rule in REG. 1.704-1(b)(4) & under REG. 1.704-2 o The allocations can t have SEE w/in the meaning of the regs and will be deemed in accordance w/ the Ptr s interests in the P-ship and thus the allocation will be valid if the special rules are followed  REG. 1.704-1(b)(4) governs revaluations  REG. 1.704-2 governs nonrecourse deductions  REG. 1.704-1(b)(1)(i) Thus, if an allocation fails all tests, IGLDC will be reallocated in accordance with the Ptr s interest in the P-ship  REG 1.704-1(b)(2)(i) Special allocations tested annually to determine its validity for entire year it involves  REG 1.704-1(b)(5) An allocation can be void one year, valid another; OR part of an allocation can be void while the other part valid all in the same year Special Considerations  The Ptrs have until the end of the P-ship tax year to add in special allocation provisions x Thus, the KEY is to look at PA at end of P-ship tax year  Special allocations are not conclusive w/ respect to tax treatment; just b/c the allocation is respected does not mean it will get past loss limitations  Allocations are also governed by 704(c), 706(c), & 743(b) but special allocations under 704(b) regs are the most substantial under Subchapter K  Certain allocations that will not have SEE: x Allocations of depreciation recapture x Allocations of tax credits

27

3 ways to give effect to Special Allocations: o REG. 1.704-1(b)(2) Safe Harbor Rule: Substantial Economic Effect Test (2-part test) x But NOTE: economic test is very mechanical and the substantiality test is very subjective)  Economic Effect x REG. 1.704-1(b)(2) (ii)(a) RULE: Allocation must be consistent w/ underlying economic arrangement, thus if an economic benefit or burden runs w/ the allocation, then the Ptr receiving that allocation must also receive the benefit or the burden x 3 tests to determine Economic Effect: o REG. 1.704-1(b)(2)(ii)(b) Basic Test: 3 REQUIREMENTS TO HAVE ECONOMIC EFFECT:  Capital Account Requirement P-ship maintains its capital accounts pursuant to REG. 1.704-1(b)(2)(iv); i.e. each Ptr s capital account y Increased by: o Amts of money contributed by Ptr o FMV of prop contributed (net of liabilities relieved) by Ptr o Allocations of P-ship income/G to Ptr y Decreased by: o Amt of money distributed to Ptr o FMV of prop distributed to Ptr (net of liabilities Ptr assumes) o Allocations to him of expenses, deductions, losses of P-ship y Note: There must be economic reality behind adjustment to each capital account Liquidation Requirement Any distribution made in connection w/ a liquidation can only be made to extent there is a positive account balance Deficit Makeup Requirement If after liquidation a Ptr has a negative account balance, he must restore the deficit y This can be done by inserting a simple clause in PA or by local statute that imposes an unconditional obligation on Ptr to restore balance y Thus, he can still be allocated losses/deductions w/out limitations and these allocations will be respected even though the allocation creates or increases a deficit EXAMPLE o G & L form general P-ship, each contributing 50; PA allocates all losses to L; first yr of P-ship it incurs a 60 loss; PA allocation meets SEE o L s beginning balance is 50, the 60 loss allocation creates a 10 deficit; b/c PA req d L to restore any deficits, the allocation is respected o P-ship assets are 100 less 60 loss = 40 book value; if it liquidates, L must contribute 10, this brings it to 50, this 50 then distributed to G and L then bears the entire 60 loss (which makes sense pursuant to the PA) EXAMPLE o Same as above except G is gen Ptr and L is limited Ptr; first 2 requirements of basic test met, but L has no restoration obligation if her acct goes below 0 (note; allocation provision still allocates all losses to L) o The allocation can t be given effect b/c if the P-ship liquidates, there is only 40 bk value to distribute (100 beg. Less 60 loss); this 40 goes to G, and now G suffers 10 of loss since L has no obligation to contribute the deficit; thus G bears part of the burden of the allocation which is inconsistent w/ the allocation provision o REG. 1.704-1(b)(2) (ii)(d) Alternative Test 28

RULE: Allocation considered to have economic effect if P-ship: y 1) Maintains capital accounts properly y 2) Makes liquidating distributions according to positive account balances y 3) PA contains a qualified income offset provision; AND o Deficit restoration is a specified amt o Deficit rest req d ASAP where unforeseen distributions creates deficit y 4) Allocation does not create or increase a deficit in a Ptr s capital account in excess of the Ptr s obligation to restore a deficit GOAL: Still allows allocation to pass even though PA lacks an unlimited restoration provision, so long as the Ptr has a positive balance in her capital account EXAMPLE y G & L form general P-ship, G contributes 60, L 40, PA allocates all losses to L and requires L restore any deficit in her a/c not to exceed 10; L has no other obligations & P-ship has loss of 25 for 1st 2 yrs y P-ship Balance Sheet G 60 L 40 (25) (25) (10)

Original contribution st 1 yr loss nd 2 yr loss Ending a/c balance y y y y

60

Because L has a deficit of 10, she s req d to contribute 10 If P-ship liquidates, net book value is 50 (60 of G less 10 of L s deficit) thus, her 10 contribution brings the book value up to 60 Entire 60 can be distributed to G, and thus L bears entire 50 loss The limited restoration provision meets the alternative economic test in this case and thus the allocation provision allocating all losses to L will sustain b/c it matches the economic realities w/ the account balances

EXAMPLE y Same as above except P-ship makes distribution to of 20 to L in 3rd year; BS: G 60 L 40 (25) (25) (20) (30)

Original contribution st 1 yr loss 2nd yr loss 3rd yr distribution Ending a/c balance y y

60

L only agreed to restore a deficit of 10; this would leave her acct balance at (20) If P-ship liquidates, book value of P-ship is 40 (60 of G less 20 deficit of L). This entire 40 w/ go to G & b/c the allocation provision provides L s/ bear all the losses, in this case, the allocation provision can not stand b/c it does not match the economic realities of the Ptr s a/c balances o G contributed 60 and is entitled to 60 upon liquidation, but only gets 40; thus G is essentially bearing 20 of the loss that is attributable to L

REG. 1.704-1(b)(2) (ii)(i) Economic Effect Equivalency Test  RULE: P-ship s allocations are by definition to be consistent w/ the Ptrs interest in the Pship (least significant of the 3 tests)

29

EXAMPLE: y G & L form P-ship, G has 90% interest, L has 10% interest y PA allocation provisions allocate 90% of depreciation deductions to G; absent all other items of the economic effect test, the allocations still stands b/c its consistent w/ their ownership interests  Substantiality x REG. 1.704-1(b)(2) (iii) RULE: An allocation is substantial if there is a reasonable possibility it will affect substantially the dollar amts rec d by the Ptrs independent of tax considerations o When an allocation is not substantial:  PRE-TAX CONSIDERATIONS y If the only effect of an allocation is to reduce taxes w/out substantially affecting the Ptr s pre-tax distributive shares, the economic effect of the allocation is not substantial o Shifting Tax Consequences Offsetting allocations occur w/in same taxable year o Transitory Allocations Offsetting allocations span over 2+ taxable years

AFTER-TAX CONSIDERATIONS y RULE: If the after-tax effect of an allocation is to benefit 1+ Ptrs financially w/out adversely affecting any other Ptr, the allocation is not substantial EXAMPLE: o A & B form AB, each are 50% Ptrs, A is in 30% tax bracket, B is in 15% o AB P-ship earns 10k in tax-exempt interest & 10k in dividends; the PA allocates 90% of interest to A, and 10% to B; and 100% of dividends to B o Before taxes: A is allocated 9k & B is allocated 11k; result of allocation: A 9,000 0 9,000 0 9,000 B 1,000 10,000 11,000 (1,500) 9,500

Interest Dividends Pre-tax income Tax on dividends After-tax effect o

If there were no special allocations and they interest & dividends according to their interests; the following w/ result A 5,000 5,000 10,000 (1,500) 8,500 B 5,000 5,000 10,000 (750) 9,250

Interest Dividends Pre-tax income Tax on dividends After-tax effect o

RESULT: No substantiality b/c the after-tax consequences benefit at least one Ptr w/out adversely affecting the other (in fact, both are benefited by the allocation)

30

REG. 1.704-1(b)(3) Ptr s Interest in P-ship  Reallocation Rule, for the most part  If allocation lacks SEE, item must be reallocated in accordance w/ the Ptr s interests in the P-ship x Thus, the item will be allocated to those Ptrs who actually enjoy the economic benefit or bear the economic burden  Factors to Consider: x Relative contributions of Ptrs to the P-ship x Interests of Ptrs in economic profits/losses if they differ from their interests in taxable income/loss x Interests of Ptrs in cash flow & other nonliquidating distributions x Rights of Ptrs to distributions of capital upon liquidation

REG. 1.704-1(b)(4) Special Rules Test (see REG. 1.704-1(b)(4) & under REG. 1.704-2)  Allocations governed by these rules can t have SEE w/in meaning of the regs, but will be deemed to be in accordance w/ the Ptrs interests in the P-ship and therefore will be valid if the rules are followed

31

Allocations with respect to Contributed Property Statutes o 704(a) Effect of P-ship Agreement Ptr s distributive share of IGLDC, unless provided somewhere else in this chapter, is determined by the PA  If PA doesn t say how Ptrs s/ share, then distributive shares are in accordance w/ their interest % - 704(b) 704(c) | Contributed Property  704(c)(1)(A) When appreciated or depreciated prop is contributed to a P-ship; built-in G/L must be allocated to the Ptr that contributed that prop  704(c)(1)(B) If any prop contributed to P-ship is subsequently distributed w/in 7 yrs (other than to the original contributing Ptr), then: x 704(c)(1)(B)(i) Contributing Ptr recognizes G/L from sale of that prop in amt = the G/L which w/h/b allocated to him under (A) (i.e. the precontribution built-in G/L) if the prop sold for its FMV at time of distribution x 704(c)(1)(B)(ii) Character of G/L is same character as it w/b if P-ship sold it to distributee x 704(c)(1)(B)(iii) Adjustments s/b made to: o Contributing Ptr s AB in his P-ship interest; AND o To AB of the prop distributed (to reflect any G/L recognized)  704(c)(1)(C) If any prop contributed w/ a built-in loss, x 704(c)(1)(C)(i) That built-in L is only taken into account when allocating items to the Ptr that contributed that property

Book/Tax Disparities o Concept:  P-ship allocates income/loss in accordance to Ptr s P-ship interests; so long as allocation has SEE.  P-ship must allocate the items for book, and for tax.  Tax generally follows book. Exceptions:  2 circumstances that will create a disparity btw book & tax. x 1) contribution of 704(c) property to a P-ship o This is prop w/ a built-in G or L, meaning the prop s FMV and AB are not the same x 2) reverse 704(c) allocations o This is a revaluation of P-ship s assets, similar disparity created from those of 704(c) contributions.  Basically, prop is reflected at FMV for book even though no g/l recognized for tax. In General  When appreciate/depreciated property is contributed to P-ship; the built-in gain or loss must be taken into account for tax purposes by the contributing Ptr. 704(c)(1)(a).  Regs provide 3 methods for how to allocate contributed property so that as to take into account any built-in g/L at time of contribution.

32

(1) Traditional Method Reg. 1.704-3(b) o Rule: The traditional method of making 704(c) allocations is to allocate built-in loss or gain to the contributing Ptr to the extent of the sale. Reg.1.704-3(b).  Essentially, each Ptr s tax g/l matches book g/l Policy: Prevents shifting of income among Ptrs with different tax rates  These results may cause problems that cannot be resolved hereunder EXAMPLE: Book G, Tax G  A contributes land worth 100 & AB of 60, B contributes 100 cash. A & B are = Ptrs.  P-ship s BS as follows: Cap. Acct. Tax (AB) Book (FMV) Assets Tax (AB) Book (FMV) A 60 100 Cash 100 100  B 100 100 Land 60 100  Total 160 200 Total 160 200   Land increases in value and has FMV of 120, P-ship decides to sell the land. y Book G 120 100 = 20 y Tax G 120 60 = 60 Tax consequences. Reg.1.704-3(b). y Under PA Ptrs share 50/50, thus each is allocated 50% of book G o A 10 book G o B 10 book G y Each Ptr must be allocated amt of tax G to match book G o A 10 tax G o B 10 tax G o Remaining 40 tax G is allocated to A under traditional method b/c A contributed the built-in G prop.  i.e. at time prop contributed, built-in G = 40 which necessarily s/b 100% allocated to A upon disposition by P-ship.

EXAMPLE: Book L, Tax G  A contributes land worth 100 & AB of 60, B contributes 100 cash. A & B = Ptrs. BS: Assets Cash Land Total  Tax (AB) 100 60 160 Book (FMV) 100 100 200 Cap. Acct. A B Total Tax (AB) 60 100 160 Book (FMV) 100 100 200

Land decreases in value and has FMV of 70, P-ship decides to sell the land. y Book L 70 100 = (30) y Tax G 70 60 = 10 Tax consequences. Reg.1.704-3(b). y Under PA Ptrs share 50/50, thus each is allocated 50% of book L o A 15 book L o B 15 book L y No tax loss to match book loss, no book G to match tax G, B gets 0 of tax G. y A gets entire tax G of 10. Resulting BS: y Cash increases by sale of land, 70; land falls off y A s tax basis increases by 10 tax G, book drops by 15 book L y B s tax basis stays the same, and its book basis drops by 15 book L. y B now has a book/tax disparity.

33

Assets Cash Land Total 

Tax (AB) 170 0 170

Book (FMV) 170 0 170

Cap. Acct. A B Total

Tax (AB) 70 100 170

Book (FMV) 85 85 170

There is not enough tax gain to allocate to B to eliminate the book/tax disparity. The ceiling rule prevent allocation of gain that does not exist. o Ceiling Rule: a P-ship can only allocate gain/loss to the extent of gain/loss, income, or deduction that the P-ship actually recognizes Reg. 1.704-3(b)(1):

34

(2) Curative Allocation - Reg. 1.704-3(c) o o Purpose: To eliminate ceiling rule distortions Definition: An allocation of an item for tax purposes that differs from the allocation of the corresponding book item. Application: Only applies where the ceiling rule creates a book/tax disparity, it has no economic effect and is not reflected in Ptr s capital accounts.  2 Requirements: y (1) Curative allocation amt does not exceed amt necessary to offset effect of ceiling rule. Reg. 1.704-3(c)(1) (2) The income/loss allocated by this rule has same character & same tax consequences as the tax item affected by ceiling rule. Reg. 1.704-3(c)(3)(ii).

EXAMPLE:  A contributes land worth 100 & AB of 60, B contributes 100 cash. A & B are = Ptrs.  AB invests the 100 of cash in securities which appreciate to 150; land declines to a FMV of 70. y P-ship sells the land o Total book L = 30 o Total tax G = 10 y P-ship sells the stock o Total book G = 50 o Total tax G = 50  Ptr s assets are 150 + 70 = 220 in cash. Ptr s capital accounts as follows: A Book Basis 100 (15) 25 110 A Tax Basis 60 10 25 95 B Book Basis 100 (15) 25 110 B Tax Basis 100 0 25 125

Initial Bal. Land Sale Stock Sale End Bal.  

Ceiling rule created book/tax disparity for both Ptrs by 15. Because the stock sale had the same tax consequence for both book & tax & allocation does not exceed amt of ceiling limited item (i.e. the disparity of 15) , then the G can be reallocated for tax purposes: y Thus reallocate 15 of tax G from B to A. A s tax basis is now 95 + 15 = 110 & B s tax basis is now 125 15 = 110. The allocation resolves the disparity. y NOTE: The BOOK capital accounts are not affected, the allocation is for tax purposes only.

35

(3) Remedial Method - Reg. 1.704-3(d) o Purpose: Ignores the ceiling rule and allows P-ship to restore tax balances by creating the tax G or L of the needed type to offset book/tax disparities; basically P-ship creates offsetting tax allocations to match their book allocations. EXAMPLE:  A contributes land worth 100 & AB of 60, B contributes 100 cash. A & B are = Ptrs. Land declines in value to 70 and P-ship sells it. Book L of 30 and Tax G of 10. Under traditional method, account balances as follows: Cap. Acct. Tax (AB) Book (FMV) A 70 85 B 100 85 Total 170 170 Under the Remedial Method: y B could report a 15 tax L to bring her tax basis to 85, and thus match her book basis y A could report an offsetting G to bring her tax basis to 85, matching her book basis.

36

Allocations of Depreciated Property (Traditional Method)  Concept: No built-in G if land later disposed of at its useful life; thus must increase contributing Ptr s sahre of current income from that property which is done by allocating depreciation deduction to the non-contributing Ptrs. x Non-contributing Ptr receives tax depreciation up to her share of book depreciation x Any remaining tax depreciation over book depreciation is allocated to the contributing Ptr EXAMPLE x C & D form = P-ship; C contribute equip w/ basis of 80, value of 120; D contributes 120 in cash. Equipment has 10 yr useful life, and uses SL depreciation, 4 yrs remaining. BS as follows: Cap. Acct. Tax (AB) Book (FMV) A 80 120 B 120 120 Total 200 200 Both Ptr C and P-ship must recover their basis in the equip: o C s AB is 80 80/4 yrs dep = 20 depr/yr o P-ship s AB is 120 120/4 yrs is 30 depr. Yr  Each Ptr has 15 book depr per year  Non-contributing Ptr gets tax depreciation deduction = to book amt y D is noncontributing Ptr, thus gets 15 tax depreciation y C gets remaining tax depreciation, so 5  The 10 book/tax disparity is thus allocated to C and C has additional income of 10 each year, 10 x 4 yrs remaining on equip = 40 which reflects the built-in G (120 80 = 40) Assets Cash Equip Total Tax (AB) 120 80 200 Book (FMV) 120 120 200

37

Allocations of P-ship Liabilities 752 | Treatment of Liabilities o 752(a) Increase in Ptr s liabilities If Ptr s share of P-ship s liabilities increases or if Ptr s assumption of P-ship liabilities increases, amt of increase treated as contribution of money to P-ship from Ptr 752(b) Decrease in Ptr s Liabilities - If Ptr s share of P-ship s liabilities decreases or if Ptr s assumption of P-ship liabilities decreases, amt of decrease treated as distribution of money to Ptr by P-ship 752(c) Property subject to Liability If a Ptr contributes prop subject to a liability; that liability is allocated entirely to the contributing Ptr to extent of prop s FMV

In General o General Rules  An allocation of deduction only has to see SEE if Ptr allocating deduction bears the economic burden associated w/ it  This general rule is n/a for non-recourse debt b/c none of the Ptrs bear the economic burden associated with that debt; thus by definition allocations of NRL can t have SEE. Tufts Doctrine  Purchaser of property subject to NRL is THE SOLE OWNER of that property, thus, the P-ship must take the deductions associated w/ that NRL even though none of the Ptrs are economically at risk  When NR property is disposed of in a taxable transaction, the FULL amt of the liability must be included in the amt realized regardless of the value of the prop at that time  Result: When property subject to NRL is transferred, and the amt of NRL exceeds the prop s basis, the debtor (owner) is forced to include in income an amt = to the excess NRL over basis.

Regulations 1.704-2 o Impact of the Regs  Gives flexibility to Ptrs in allocating NRL  But issue is how much flexibility should they get? x LOTS of flexibility for allocating the NRL deductions x STRICT flexibility on allocating G that results from a Tufts transaction Rules  

Safe Harbor Provision that ensures allocations of NRD (non-recourse deductions) respected despite lacking 4 Requirements: x (1) PA must satisfy basis or alternate test for economic effect x (2) NRD must be allocated consistently w/ other significant P-ship items EXAMPLE:  NRD allocated 60/40 to A & B, depreciation is allocated 90/10 to A & B not consistent  NRD allocated 60/40 to A & B, depreciation is allocated 55/45 to A & B consistent x (3) PA contains minimum gain chargeback provision o Provision requires that those Ptrs who were allocated NRD report an offsetting amt of G when the P-ship disposes of the prop - THIS IS MOST IMPORTANT & THE FOCUS OF THIS SECTION x (4) All other allocations & capital account adjustments are respected under 1.704-1(b).

38

Definitions o P-ship Minimum Gain PMG  Definition: Minimum amt of G the P-ship w/ realize if it were to make a taxable disposition of prop secured by NRL EXAMPLE: P-ship sells prop w/ basis of 1,450 and subject to mortgage of 1,850. P-ship must recognize G to extent NRL exceeds the basis of prop disposed of. Thus, the PMG is 400.  2 ways to increase PMG x Cost Recovery Deductions o Where a property s depreciation deductions reduce the basis of the prop faster than the principal of the NRL is repaid. EXAMPLE:  P-ship s basis of prop at time secured mortgage was 1,850, and the prop was purchased w/ NR mortgage note for 1,850. Thus, no PMG at that time.  During first year, P-ship took 100 depreciation deduction, but made no pmt to the principal. Thus, the basis of the prop was now 1750 & the NRL still 1850, thus PMG = 100 x P-ship Borrows Funds by using its own prop as security for the loan EXAMPLE:  P-ship owns unencumbered land w/ value of 500 & basis of 200. P-ship borrows 350 in NRL using land as security. Prior to borrowing, no PMG.  After borrowing the funds, amt of NRL (350) exceeds the basis in the prop used to secure the financing (200). Thus PMG = 150. o Nonrecourse Deductions  Definition: Those deductions attributable to NR financing where no Ptr bears economic burden.  NRD = Annual net increase in the PMG less any nonrecourse distributions. x Nonrecourse distributions: if P-ship uses NR proceeds to make a distribution x Usually NRD are cost recovery deductions taken on encumbered prop EXAMPLE: o P-ship s basis of prop at time secured mortgage was 1,850, and the prop was purchased w/ NR mortgage note for 1,850. Thus, no PMG at that time. o During first year, P-ship took 400 depreciation deduction, and made no pmt on principal. Thus, the basis of the prop was now 1450 & the NRL still 1850, thus PMG = 400. In this case, the 400 increase in PMG is the NRD since there are no NR distributions. o Ptr s Share of PMG  Purpose: Each Ptr reports an amt of income or G = her share of NRD & distributions  How to determine: x EXCESS OF: Sum of NRD s allocated to Ptr + NRD Ptr rec d x OVER: Ptr s share of net decreases in PMG

39

EXAMPLE: x A & B form P-ship and agree to share IDLG 60 to A and 40 to B. P-ship sells prop w/ basis of 1,450 and subject to mortgage of 1,850. P-ship must recognize G to extent NRL exceeds the basis of prop disposed of. Thus, the PMG is 400. A s share of PMG is 400 x 60% = 240, B s share of PMG is 400 x 30% = 160. o Minimum G Chargeback Provision  Purpose: A Ptr who enjoyed benefit of NRD or distribution s/b req d to report a corresponding share of the PMG.  This provision requires that if there is a net decrease in PMG for a taxable year, each Ptr must be allocated an amt of income or G equal to her share of that decrease.  Most common reason for decrease in PMG x Disposition of encumbered property. x Contribution of capital by Ptr used to repay principal of a NRL

40

Allocations Where Ptr Interests Vary 706(c) | Closing of P-ship Year o 706(c)(1) General Rule unless a P-ship terminates, or unless otherwise provided in (c)(2); P-ship tax year does NOT close if:  A Ptr dies  A new Ptr joins  A Ptr liquidates his interest  A Ptr sells/exchanges his interest 706(c)(2) | Treatment of Dispositions  706(c)(2)(A) Disposition of Entire Interest If a Ptr s interest terminates completely (regardless if by death, liquidation, or otherwise), then the P-ship s taxable year closes  706(c)(2)(b) Disposition of Less-Than-Entire Interest P-ship taxable year does not close if x a Ptr sells/exchanges less than his entire interest in the P-ship; or x a Ptr s interest is reduced (i.e. by entry of a new Ptr, or partial liquidation of a Ptr s interest, etc.) 706(d)(1) Determination of distributive share when Ptr s interest changes each Ptr s distributive share of P-ship income/loss is determined by taking into account the Ptr s varying interest in the P-ship during the year

In General o Concept: Possible ways a P-ship interest c/ change during the year  1 Ptr c/ sell part or all of his interest  P-ship c/ issue new interests (thereby diluting others)  P-ship c/ redeem a P-ship s interest (thereby increasing the interests of other Ptrs) Issue: How to allocate in these instances? 2 methods.  (1) Pro Rata Allocations x P-ship items are pro-rated throughout the year & Ptr s share is based on number of days he was Ptr. EXAMPLE: S joins P-ship on December 1 & acquires 1/3 interest. P-ship is calendar year TP. P-ship income/loss is divided into 3. S s 1/3 share is then pro-rated by 1/12. Thus, S s allocation is 1/12 of 1/3 of the P-ships items.  (2) Interim Closing of the Books x Traces income/deduction items to that particular sement of the taxable year which they are paid/incurred EXAMPLE: S joins P-ship on Dec. 1 and acquires 1/3 interest; P-ship s tax year is calendar year basis. Thus, S is only allocated his 1/3 interest on items paid/incurred in the month of december.

41

P-SHIP TRANSACTIONS SALES/EXCHANGES


SALES/EXCHANGES OF SERVICES/PROPERTY (CH. 5)

Payments for Services & Use of Property In General o CONCEPT: Ptrs receive compensation for their services or for the use of their property, and this compensation is in addition to their distributive share so that their entire compensation is not wholly dependent upon the P-ship s success GOAL: Determine what capacity Ptr is acting:  As an unrelated 3P then 707(a) governs  In his capacity as a Ptr; and x Pmt is determined w/out respect to P-ship s income then pmt is guaranteed pmt & 707(c) governs x Pmt determined based on P-ship s income then pmt is distributive share and 704(b) governs NOTE: Main distinction in determining whether a Ptr is acting at arms length as unrelated 3P or in Ptr capacity is look at the duties he is performing  Managerial services Ptr capacity  Technical expertise non-Ptr capacity NOTE: On Character/Timing of Payments  If Pmts treated as Distributive Share x 702(b) Character of these pmts determined at P-ship level x 706(a) Pmts are reported by Ptrs in the year in which P-ship s taxable year ends  If Pmts treated as 707(a)(1) Pmts x Ptr & P-ship both determine character & timing of items as if dealing w/ unrelated parties o Thus 707(a)(1) pmts for services or use of prop are always ordinary income to recipient/Ptr o Taxed according to recipient s method of accounting o P-ship can deduct those pmts as business expense

42

3 Categories of Ptr/P-ship Transactions o 1. 707(a) Payments  In General x 707(a)(1) o Treats for all purposes the trans as one between P-ship & unrelated 3P; i.e. a trans btw strangers o Dealing with Ptr as if was not a Ptr x Types of 707(a) transactions: o Leases o Loans o Sales o Employment relationships x Timing / Character o Character of pmt depends on underlying transaction  Ordinary transactions leases, compensation, & loans  Capital transactions sales o Timing to Ptr: Recipient Ptr s method of accounting determines when to include 707(a) pmt in GI x Tax Treatment to P-ship o Depends on nature of expense to which it relates  267(a) Ordinary/necessary expenses deductible under P-ship s method of accounting  Capital expenses must be capitalized Rules x

x x

267(a)(2) Matching Income / Deductions of Payee - A P-ship can t take a deduction of a pmt to a Ptr until that Ptr includes it in his income o NOTE: This result is different if t were a guaranteed pmt  Then its treated as a distributive share  Ptr winds up on P-ship s accounting method so it w/h to include its guarantee pmt in GI at time P-ship accrues or deducts the guaranteed pmt 707(a)(1) Ptr NOT acting in capacity as Ptr, general rule If Ptr engages in a transaction w/ a P-ship other than in his capacity as a Ptr, the transaction considered to be btw P-ship and a non-Ptr Armstrong Rule Ptrs may render services to their P-ships in an EE capacity; a Ptr may stand in any one of a number of relationships w/ his P-ship; including: o Creditor / Debtor o Vendor / Vendee; AND o Employer/ Employee Pratt Rule A Ptr is acting as a Ptr when he performs services that are ongoing & integral to the P-ship s business; non-Ptr status more likely when he is acting in an independent capacity rendering services in a technical nature EXAMPLE: A is a Ptr of a P-ship that makes/sells T-shirts, A is Ptr primarily for his creative skills, B for his entrepreneurial skills; A also prepares the P-ships tax returns A is doing this in a nonPtr capacity

Anti-Avoidance Provision: Disguised Payments x General Rule: 707(a)(2) is Anti-Avoidance Provision to prevent TPs from: o 707(a)(2)(A) Disguising Pmts as Distributive Share or Ordinary Exp rather than Capital;  IF a P-ship: y Pays a Ptr for services or use of prop, and y Trans governed by 707(a)(1) (i.e. Ptr not acting in Ptr capacity), and y Expense is capital in nature  THEN: P-ship must treat pmt as if it were made to an unrelated 3P in a transaction & capitalize the expense rather than treat it as ordinary exp to get immediate deduction EXAMPLE: 43

ABC is an equal P-ship, constructing building for own use; A acts as general contractor in connection w/ building s construction; he is to receive 60k comp for his services; ACB earns only 60k that year  If A acting as Ptr: y P-ship distributes entire 60k to A and treats A as a Ptr, & it s a distributive share & A includes the 60k in OI and P-ship takes the deduction  If A is acting as an independent contractor y Pmt for services related to building construction non-deductible by P-ship & capitalized as part of the building s cost y A gets his 1/3 distributive share of 20k on top of the 60k for compensation, so he has a total of 80k of income y B & C each have a 20k distributive share also included in their income

2. Guaranteed Pmts - 707(c) Payments  In General x 707(c) Guaranteed Payments To the extent pmts determined w/out regard to P-ship income; such pmts to a Ptr for services or use of capital are considered to be made to a non-Ptr BUT only for purposes of: o 61(a) relating to GI o 263/162(a) relating to T/B expenses o Dealing with Ptr as a Ptr but giving a guaranteed payment x Concept o Pmts to Ptr in his capacity as Ptr o Where Ptr allowed P-ship to use his capital or he rendered services to P-ship o Pmts determined w/out regarding any of the P-ship s income x Taxation: o Taxed like 707(a) pmts for services or capital:  Treated as ordinary income to recipient  Deductible by P-ship subject to capitalization under 263 o Taxed like distributive shares in other respects:  Must be included in recipient s income under 706(a) on last day of P-ship s tax year regardless if actually rec d  Gaines Rule: TP must include guaranteed pmts in income even though the pmts were not rec d when the P-ship either accrues the deduction of the pmt, deducts the pmt, or capitalizes the pmts (if capitalization is necessary) x EXAMPLE: o A, B, C are = Ptrs in ABC P-ship; they share profits/losses equally o A is entitled to 10k pmt for services she performs; w/out regard to P-ship s income; B & C agree to bear burden of pmt in case P-ship does not have enough profits o ABC earns 6k in year 1, owes A 10k o A includes 10k in ordinary income, P-ship can deduct entire 10k which results in a 4k loss; the loss is allocated to B & C under 704(b) Guaranteed Pmts Satisfied by Transfers of Prop x Rev. Rul. 2007-40 i. ISSUE: Is a transfer of partnP-ship prop to a Ptr in satisfaction of a guar pmt under 707(c) a: y Sale or exchange under 1001; OR y A distribution under 731 ii. FACTS: P-ship purchased blackacre for 500k; A is entitled to guar pmt under 707(c) of 800k; Pship s AB in blackacre is 500k & FMV is 800k; P-ship transfers blackacre to A in satisfaction of the guar pmt to A iii. HELD: A transfer of P-ship prop in satisfaction of its obligation to make a guar pmt under 707(c) is a sale/exchange under 1001 & thus the non-recognition rules don t apply

Minimum Distributive Shares 44

RULE: P-ship may guarantee a service Ptr a minimum amt of P-ship income o If the distributive share exceeds the minimum guarantee, no part of the share is treated as guaranteed pmt  EXAMPLE: y A, B, C are = Ptrs in ABC P-ship; they share profits/losses equally y A is entitled to 1/3 of P-ship income but not less than 10k y ABC earns 60k y 1/3 of 60k is 20k which exceeds the 10k; thus entire 20k treated as distributive share under 704(b) o If minimum guarantee exceeds distributive share, excess pmt over distributive share is treated as a guaranteed pmt under 707(c) while the distributive share portion is governed by 704(b)  EXAMPLE y Same as above except ABC only makes 12k during the tax year y A s distributive share is 4k, but is owed 10k, thus the 6k remaining is a guaranteed pmt y A reports 4k as distributive share & 6k as ordinary income y B & C each get 4k distributive share less 3k deduction (reflecting their half of paying out the guaranteed pmt) to get 1k of net income

Summary Payment type 707(a) 707(c) 704(b) Character Accounting Method Pmt subject to 263 Yes Yes No

Ordinary or capital Ordinary Determined at P-ship level

Ptrs; 267(e) P-ships; 706(a) P-ship s; 706(a)

3. Pmts treated as Ptr s Distributive Share  In General x Pmt made to Ptr acting in his capacity as a Ptr and taking into account P-ship income x Timing / Character o Character of distributive pmt determined at P-ship level o Distributive share pmt must be included in Ptr s income on last day of the P-ship tax year, regardless if pmt actually rec d Determine Ptr s distributive share as their annual return on their P-ship interest; based on: x Capital contributions by Ptr x Services rendered by Ptr Refer to section in Guaranteed Pmts: Minimum Distributive Share

45

Sales & Exchanges of Property, between Ptrs & P-ships Sales & Exchanges with respect to Controlled P-ships o Rules 

 

707(a)(1) General Rule A bona fide sale or exchange of prop by a Ptr to a P-ship, or vice versa, is treated for tax purposes as a 707(a)(1) transaction btw unrelated parties x See section on pmts to Ptrs acting as unrelated 3Ps 707(b)(1) Sales & Exchanges of Prop w/ respect to Controlled P-ship - Disallows losses on sales/exchanges of prop btw P-ships & Ptrs who own directly or indirectly a more than 50% interest in capital or profits 453(g) Sale of Depreciable Prop to Controlled Entity Installment method can t be used where Ptr sells depreciable prop to P-ship or vice versa

Note 

707(b)(2) & 1239(a) work together to prevent abuses in transferring prop which are depreciable in order to give the buyer a step up in basis x Both Code ections characterize gain on sales/exchanges of prop btw Ptrs & controlled P-ships as OI

Disguised Sales o General Rules  707(a)(2) Anti-Avoidance Provision that prevens TPs from: x 707(a)(2)(B) Disguising certain sales/exchanges as non-recognition contributions/distributions Provides that if a Ptr transfers money or other prop to a P-ship & that P-ship makes a related transfer of money or other prop to that Ptr, the 2 transfers s/b treated as a sale/exchange of prop btw the P-ship and the Ptr acting in a non-Ptr capacity  REG 1.707 Provides that a contribution & related distribution s/b recast as a sale only when the combined effect of the contribution & distribution is to allow a Ptr to w/draw all or part of his equity in the transferred prop x EXAMPLES: o If transfer is simultaneous & clear that P-ship w/n/h made a distribution if the Ptr had not made the contribution SALE o Non-simultaneous transfers btw P-ship & Ptr (i.e. contribution by Ptr & subsequent distribution by P-ship to Ptr) made w/in 2 years SALE (presumed sale - REG 1.707-(3)(c)(1))  This is a rebuttable presumption o Transfers made more than 2 years apart NONRECONITION applies, not a sale (REG. 1.707-3(d))  This is a rebuttable presumption Tax Avoidance Mechanism  TPs seek complete nonrecognition of G by turning a sale/exchange into a contribution of prop followed/preceded by a related P-ship distribution x General tax avoidance transactions o Contributions of appreciated prop to a P-ship followed by:  Cash distribution to contributing Ptr  Distribution of diff prop to contributing Ptr  Distribution of the contributed prop to another Ptr o Each transaction designed by TP to avoid the built-in G that w/ otherwise be allocated to contributing Ptr Determining if it s a Disguised Sale  If timing & amt of a subsequent transfer can be determined at the time of an earlier transfer  If the transferring Ptr has a legally enforceable right to a subsequent distribution  If that Ptr s right to receive money or other prop for his contribution is secured

SALES/EXCHANGES OF P-SHIP INTERESTS (CH. 6) 46

Overview Seller o o

Must recognize G/L on sale of her interest = diff btw her amt realized & her outside basis Character of G/L is capital unless relates to 751 prop, then OI

Buyer o o

Takes cost basis in that interest = to purchase price he paid for the interest Inherits seller s  Capital Accounts (both tax and book) x NOTE: this means buying Ptr inherits any built-in G/L on prop that selling Ptr contributed; thus the buying Ptr will be allocated any G/L on that prop that was previously allocated to seller under 704(c) x See example # 2 in consequences to buying Ptr  Share of Inside Basis x NOTE: This will usually lead to a disparity btw buyer s outside basis and her share of inside basis, thus Pship can make 754 election and new Ptr/buyer gets a basis adjustment under 743(b) & 755 to eliminate disparity (see section above on tax/book disparities) x NOTE: If adjustment made under 743(b); adjustment is personal to buying Ptr & does not actually change the P-ship s inside basis in its assets

47

Consequences to Selling Ptr Rules o

741 | Recognition & Character of G/L on Sale/Exchange  G/L recognized to transferor Ptr on sale/exchange of his P-ship interest;  G/L characterized as capital x EXCEPTION: Unless S/E is attributable to 751 assets relating to receivables/inv items then G/L treated as OI 751 | Unrealized Receivables & Inventory Items  751(a) Sale/Exchange of P-ship Interest Amt of money or FMV of prop rec d by a transferor Ptr in exchange for all/part of his P-ship interest (attributable to unrealized receivables or inventory items of the P-ship) is considered the AR from sale/exchange & is treated as OI  751(c) Unrealized Receivables includes any rights to pmts for the following items & such pmts not yet included in the P-ship s income x 751(c)(1) - Goods delivered, to be delivered x 751(c)(2) - Services rendered, to be rendered x 751(c) flush language - 1245 prop (i.e. any prop subject to recapture; i.e. depreciation which is OI) o Note: Unrealized Receivable includes 1245 prop for purposes of 731, 732, 741 & 751; BUT NOT 736 o Note: Unrealized Receivable generally have an AB of zero  751(d) Inventory Items x Includes P-ship inventory items if in the aggregate they have appreciated substantially in value o Substantially appreciated if their FMV > 120% of their AB x Specifically includes: o 751(d)(1) 1221(a)(1) prop o 751(d)(2) any other prop which on sale/exchange by the P-ship is not 1231 prop or capital asset o 751(d)(3) any other P-ship prop which (if held by selling/distributee Ptr) w/b considered inventory under (1) or (2) (i.e. everything except recapture items) 752 | Treatment of Liabilities  752(d) Sale or Exchange of an Interest Where a P-ship interest sold/exchanged then liabilities treated in same manner as sales/exchanges of prop not associated w/ P-ships

Other Considerations o Selling Ptr s Amt Realized & Adjusted Basis must be divided btw:  Ordinary G/L on the Ptr s interest in 751 prop  Capital G/L on the Ptr s interest in other assets Distributee Ptr s Basis  takes a transferred basis from the P-ship (takes the AB as it was to the P-ship) under 732(a)(1)  Thus selling Ptr s basis in her share of the P-ship s 751 prop = her pro rata share of the P-ship s AB in that prop Part Ordinary, Part Capital results  You can have ordinary income & a capital loss (& vice versa) see EXAMPLE 2  You can NOT have a capital G & a capital L (they net together) Cash vs. 751 Prop  If Ptr receives cash instead of share of 751 assets, Ptr treated as if rec d 751 asset & sold it back to P-ship for cash

Examples 48

EXAMPLE # 1   ABC is = P-ship; each Ptr has 150 inside basis, A sells entire interest to D on 1/1 @ 300; ABC s Balance Sheet as follows: Assets Cash AR Inventory Equip (purchase cost = 200) Building Stock Goodwill Total  Book 110 0 90 50 70 130 0 450 FMV 110 60 180 140 250 70 90 900

Capital Accounts A B C Total

Book FMV 150 300 150 300 150 300 450 900

Allocate Ordinary & Capital G/L x G/L on total property o Total AR (FMV) 300 o Less: Total AB 150 o Total G 150 x Ordinary G/L on 751 property o Receivables  AR of 60 A s 1/3 share: y AB = 0; FMV = 20  Equip subject to recapture (FMV of 140 less BV of 50 = 90) A s 1/3 share y AB = 0; FMV = 30  Note: None of A s basis is attributable to 751 items, but 50 of FMV is o Inventory  Inventory w/ FMV of 180 & AB of 90 A s 1/3 share y AB = 30; FMV = 60  Note: 30 of A s AB attributable to inventory o Result  Total AR (FMV) of 751 items 20 + 30 + 60 = 110  Less: AB of 751 items 0 + 0 + 30 = 30  Total OI from 751 items = 80 x Capital G/L on remaining P-ship assets o Total G 150 o Less: Ordinary G 751 assets 80 o Net Capital G = 70

49

EXAMPLE # 2   DEF is = P-ship; D has outside basis & capital account of 500 DEF Balance Sheet Assets Unrealized receivables Land held for investment Total

Book 0 1,500 1,500

FMV 300 1,050 1,350

 

On Jan 1, D sells her interest to G for 450 Allocate Ordinary & Capital G/L x Total G/L o AR = 450 o AB = 500 o Overall loss = (50) x Ordinary G/L on 751 items o AR 1/3 of 300 = 100 o AB 0 o Ordinary G = 100 x Capital G/L on remaining P-ship assets o AR 450 total AR less 100 AR on 751 items = 350 o AB 500 o Capital L = (150) x Result: 50 of ordinary G and (150) of capital L

50

Consequences to Buying Ptr Rules o 742 Basis of Transferee Ptr s Interest If P-ship interest acquired other than by contribution (i.e. by sale/exchange) then transferee (new Ptr) basis determined under 1011 & following (WTF?) 743 | Optional Adjustment to Basis of P-ship Property  743(a) General Rule P-ship prop can t be adjusted for disparities resulting from transfer in P-ship interest unless: x 754 election in effect; OR x The P-ship has a substantial built-in L immediately following the transfer  743(b) Adjustment to Basis of P-ship Prop AB of P-ship prop: x Increased by: o Excess of New Ptr s outside basis (transferee Ptr s basis in his P-ship interest) o Over New Ptr s share of his inside basis (his proportionate share of the AB of P-ship prop) x Decreased by: o Excess of New Ptr s inside basis (his proportionate share of the AB of the P-ship prop) o Over New Ptr s outside basis (transferee Ptr s basis in his P-ship interest)  743(c) Allocation of Basis Where P-ship prop adjusted under 743(b); allocation of basis among P-ship prop is made in accordance w/ 755  743(d) Substantial Built-in Loss For purposes of this section, P-ship has a substantial built-in loss after a P-ship interest has been transferred if P-ship s AB in the P-ship prop exceeds its FMV by more than 250k 752(a) Increase in Ptr s Liabilities An increase in a Ptr s share of P-ship liabilities (including assumption of liabilities) is considered a contribution of cash by that Ptr to the P-ship 754 Manner of Electing Optional Adjustment to Basis of P-ship Prop If P-ship files election under this section; then the basis of its prop is adjusted under:  734 for distributions of prop  743 for transfers of P-ship interest  Note: The election is permanent & applies to all future distributions & P-ship transfers; it may be revoked subject to certain limitations prescribed by the regs 755 | Rules for Allocation of Basis  755(a) General Rule Any increase/decrease in AB of P-ship prop under 734 or 743: x FIRST: Divide adjustment btw capital assets/1231 assets and non-capital assets x SECOND: Allocate adjustment based upon transferee s share of depreciation/appreciation of those assets  755(b) Exception / Special Rule If increase/decrease in AB of P-ship prop arises from distribution of/transfer of interest attributable to a capital asset or 1231 prop; then allocation of increase/decrease s/b allocated .

754 Election, in general o This is key election to buying Ptr b/c most of the time a new Ptr s outside basis will suffer some disparity o P-ship adjusts basis of its assets w/ respect to the purchasing Ptr to account for the disparity o If election made, its permanent (& will affect all subsequent new Ptrs) o Election is good thing unless dealing w/ a large P-ship; then too cumbersome to track each basis of each Ptr o NOTE: A 754 election to adjust the basis of P-ship assets is only used in 2 instances:  A transfer of a P-ship interest  Distributions of prop

51

Examples EXAMPLE #1  AB is = P-ship; A & B each have outside basis & capital acct balance of 100; A sells her interest to X on Jan 1 for 300  AB s Balance Sheet Assets Inventory Land Total  Bk. Val. 100 100 200 FMV 200 400 600 Capital Accounts X B Total Bk Val 100 100 200 FMV 300 300 600

Result: NO 754 ELECTION IN PLACE x X paid 300 for her interest, so X s outside basis is 300 o 100 for inventory o 200 for land x X inside basis of each asset is 50; not the amt paid x Thus, this creates a 200 disparity btw X s outside & inside basis (w/out a 754 election in effect) o This disparity results in overtax of X if the P-ship sells its assets o If P-ship sells its assets immediately following X s purchase, it will have 100 ordinary G from inventory and 300 capital G from land; 50 of ordinary allocated to X and 150 of capital allocated to X for a total of 200; this 200 of G increases X s outside basis under 705(a)(1)(A) o X s outside basis was 300 and his share of the amt realized was also 300, thus she is recognizing 200 of G on her return but not actually recognizing any economic G; thus X overtaxed by 200  X has 2 choices; EITHER: y Take an offsetting loss deduction at time she disposes her P-ship interest; OR o Note: Ptr won t want this b/c it results in immediate G recognition y Make a 754 election to adjust the P-ship s basis in assets (for transferee Ptr only) see below result Result: WITH 754 ELECTION x Steps: o P-ship makes 754 election to adjust basis under 743 o P-ship adjusts basis of its assets for new Ptr under 743  Increases it by excess of Ptr s outside basis over his share of the inside basis; OR  Decreases it by excess of Ptr s share of inside basis over his excess basis o Ptr allocates the adjustment under 755 among the AB of his share of the assets according to capital/1231 assets and noncapital assets based on net appreciation/depreciation x Application o Assume P-ship sold its assets after X purchases his interest Assets Inventory Land Total o Basis 100 100 200 FMV 200 400 600 Appreciation 100 300 400 X s share of appreciation 50 150 200

Determine Adjustment:  X s outside basis = 300 (purchase price for his interest)  X s inside basis = 100 (50% x 100 + 50% x 100)  b/c outside basis > inside basis, adjustment is an increase y adjustment amt 300 100 = 200 (which is amt of appreciation/depreciation) Divide Adjustment (among capital & noncapital assets based on appreciation)  X s share of appreciation on noncapital assets = 50/200 = 25%  X s share of appreciation on capital assets = 150/200 = 75%  X s share of appreciation is his new basis in that asset

52

Impact:  If P-ship sells the land for 500; this results in total G of 200 to each Ptr y B has 200 G to report and increases his capital account by 200 y X can offset his G of 200 by his special basis in the land of 150 resulting in only 50 of G recognition and 50 increase in his capital account Summary:  Buying Ptr increases his basis in P-ship assets by amt of his share of appreciation/depreciation of the asset which is determined by excess of his outside basis over his inside basis (appreciation) or excess of his inside basis over his outside basis (depreciation)

EXAMPLE # 2 (Built-in G/L)  A & B form = P-ship; A contributes non-depreciable prop of 100 FMV & 50 AB; B contributes 100 cash  P-ship uses traditional method for making 704(c) allocations (not sure what this means) & 754 election in effect  A sells his interest to T for 100; T receives a 50 basis adjustment to that prop (T s outside basis = 100 over his inside basis of 50 = 50 adjustment; allocated to that prop)  P-ship sells the prop for 90 FMV; which results in a x 10 book loss (100 bk value less 90 FMV); & x 40 tax gain (90 FMV less 50 AB)  T allocated the 40 tax G under 704(c); b/c T has special basis of 50; this results in a 10 recognizable loss 40 G allocated over 50 special basis = (10)

53

P-SHIP DISTRIBUTIONS
OPERATING/CURRENT & LIQUIDATING DISTRIBUTIONS (CH. 7, 8) Statutes 731 | Extent of G/L Recognition on Distribution o 731(a) Ptrs  731(a)(1) Ptrs Ptr does not recognize G on distributions made to him by P-ship x EXCEPTION: Unless amt of cash distr exceeds the Ptr s basis in his P-ship interest; x AMT OF G recognition: Excess of cash dist over Ptr s AB in his P-ship interest  731(a)(2) Ptrs If P-ship makes distr to Ptr, no L recognition allowed x EXCEPTION: o If dist is in liquidation of that Ptr s interest; AND o Only money or 751 assets are distributed  751(c) Unrealized Receivables  751(d) Inventory Items x AMT OF L recognition: o Excess AB of Ptr s P-ship interest o Over sum of: Amt of money dist + basis of 751 items  Basis of 751 items is basis to distributee determined under 732  Flush language of 731(a); 741 Character of G/L distr where G/L recognized treated as a sale/exchange of P-ship interest of distributee Ptr; 741 treats G/L from sales/exchanges of P-ship interests as capital G/L x Except otherwise provided in 751 (relating to receivables/inventory items) o 751(a) Sales/Exchanges of P-ship Interests Where Ptr transfers all/part of his P-ship interest attributable to inventory items or unrealized receivables; then any cash rec d or FMV of prop rec d for exchange is AR; treated as ordinary G/L

731(b) - P-ships o 731(b) P-ships no G/L recognized to a P-ship on distribution of prop (including money) to a Ptr

731(c) Marketable Securities o 731(c)(1) - A distribution of marketable securities (except investment P-ships) is treated as a distribution of money:  To the extent of the FMV of the securities at the time of the distribution,  Net the distributee s share of appreciation in those securities 731(c)(6) Any G recognized by the distributee Ptr is treated as a capital G; unless marketable securities are unrealized receivables or inventory itmes, then treated as ordinary G 731(c)(4) If a Ptr recognizes G on distrib of marketable security; Ptr s basis in that security will be:  Its basis under 732 +  Amt of G recognized by distributee Ptr

732 Basis of Distributed Property Other Than Money o 732(a)(1,2) Distributions Other Than in Liquidation of a Ptr s Interest AB to Ptr is same as it was to P-ship immediately before distribution;  LIMITATION: AB to Ptr can t exceed his reduced outside basis; i.e.: x His outside basis (the AB of his interest in the P-ship) x Reduced by any money distributed in same transaction  APPLICATION: Only applies where P-ship distributes prop (non-cash) in a non-liquidating distribution

54

732(b) Distributions in Liquidation Basis of prop to Ptr (other than money) distributed by P-ship in a liquidation of the Ptr s interest is = Ptr s reduced outside basis; i.e.:  Ptr s outside basis (AB of Ptr s interest in P-ship)  Less any money distributed in same transaction 732(c) Allocation of Basis Basis of distributed properties s/b allocated in the following manner:  First to unrealized receivables and inventory items under 751(c), (d) x In an amt equal to AB of each item of prop to P-ship  If basis to be allocated (i.e. the Ptr s basis in the P-ship prop distributed) is < the sum of the AB of the prop to the Pship; then the latter s/b decreased to = the basis to be allocated  If basis to be allocated exceeds sum of AB of P-ship prop; excess basis s/b allocated to other distributed prop according to AB of each prop 732(d) Special P-ship Basis to Transferee  Allows the Ptr to adjust the basis in the underlying properties

733 Basis of Distributee Ptr s Interest o Where P-ship makes a non-liquidating distribution, Ptr s AB in his P-ship interest s/b reduced by: (BUT NOT BELOW ZERO)  733(1) amt of money distributed to such Ptr  733(2) amt of AB of prop distributed to Ptr (as determined by 732) If P-ship makes liquidating distribution, Ptrs interest is obviously reduced to 0

55

In General Capital Accounting Rules: o Concept: whenever prop distributed by P-ship; P-ship must recognize G/L inherent in the distributed prop for BOOK (and not tax) purposes How to do this? Reg. 1.704-1(b)(2)(iv)(e):  First: Adjust all Ptrs capital accounts to reflect allocation of built-in G/L inherent when contributed (that w/h/b recognized had there been a taxable disposition). 704(c)  Second: Balance of distributee s capital account is reduced by net FMV of distributed prop

Character of Distributed Property Upon Disposition, 735 o o Concept: Prevent conversion of P-ship OI into capital G by distributing prop to a Ptr Rule: When P-ship distributes property to a Ptr, any G/L recognized is capital. Flush language of 731(a); However, if the distributee Ptr later disposes of certain distributed party, he will have to recognize ordinary G/L on that disposition.  735 | Character of G/L on Disposition of Distributed Prop x 735(a)(1) Unrealized Receivables If distributed prop is unrealized receivable, any G/L recognized by distributee on later disposition is ordinary. 735(a)(1) x 735(a)(2) Inventory Items - If distributed prop is an inventory item under 751(d)(2) & is sold/exchanged w/in 5 years of being distributed, any G/L recognized by distributee on later disposition is ordinary. 735(a)(2)

Basis of P-ships Undistributed Prop o 734(a) Optional Adjustment to Basis of Undistributed Prop Unless a 754 election in place, P-ship s basis in its property (that was not distributed) is unaffected by a distribution  If 754 election is in effect: basis of P-ship prop not distributed must be adjusted by amt determined under 734(b) [see section below]. 734(a). *** See section below distributions that addresses the 734 basis adjustment. For purposes of applying the rules set forth below, assume that no 754 election is in place. ***

Recognition of Gain & Loss o Overview  Generally under 731 neither distributing P-ship or distributee Ptr recognizes G/L when P-ship distributes prop or money  Cash Distributions x Ptr reduces her outside basis by amt of money rec d. 733. x This preserves any inherent G/L in her P-ship interest  Property Distributions x Distributee s outside basis is allocated among both: o Property rec d; AND o Her continuing interest in the P-ship (if non-liquidating distribution). 732, 733. x Any pre-distribution built-in G/L in distributee s P-ship interest is preserved either in: o Prop rec d; OR o Continuing P-ship interest

56

Recognition of Gain  Rule: A Ptr only recognizes G in only one circumstance w/ respect to distributions: x When Ptr receives cash distribution in excess of outside basis, G recognized to extent of the excess. 731(a)(1). x NOTE: Unlike L recognition rule, G recognition is req d regardless of distribution type; thus IRRELEVENT whether distribution is operating or liquidating. Exception: Other distributions which have cash equivalence can also result in G recognition: x 1) Reduction of Liabilities o Rule: A reduction in a Ptr s share of P-ship liabilities is treated as a distribution of money. 752(b) o Result: Thus a Ptr may not receive an actual cash distribution, but the reduction in a Ptr s share of liabilities constitutes a constructive cash distribution & thus can result in recognition of G o EXAMPLE:  A s outside basis = 100, & receives a cash distribution of 75 that liquidates her P-ship interest, thus eliminates her 50 share of P-ship liabilities.  Under the transaction as a whole, A treated as receiving 125 cash distribution.  125 cash distribution less 100 outside basis = 25 excess cash distribution which must be recognized as capital G. 731(a)(1). 2) Distribution of Marketable Securities o Rule: Except for investment P-ships, marketable securities treated as cash, and thus a distribution of a marketable security is deemed to be a distribution of cash. 731(c). o Amt of Distribution, 731(c)(3)(b):  FMV of marketable security at time of distribution  Less: Ptr s share of net appreciation in those securities o Basis of Securities to Distributee, 731(c)(4):  Amt of basis determined under normal rules of 732  Plus: Any G recognized by distributee Ptr EXAMPLE:  AB is = P-ship; A has outside basis of 50; AB makes current distribution to A of marketable securities worth 100 FMV; and AB of 40 to P-ship.  A is treated as receiving 70 in cash y Determine net appreciation: o FMV of 100 x 50% = 50 FMV o AB of 40 x 50% = 20 o Ptr s share of FMV Ptr s share of AB = her share of net appreciation; 50 20 = 30 in net appreciation y Amt of distribution: FMV less share of appreciation, 731(c)(3)(b) o 100 30 = 70 y G recognition: Amt of excess cash distr over outside basis, 731(a)(1): o 70 50 = 20 y Basis to distributee: AB as it was to P-ship under 732 + any G recognized, 731(c)(4): o 40 + 20 = 60

57

Recognition of Loss  Rule: Ptr only recognizes loss in liquidating distributions, L is never recognized on a current, non-liquidating distribution. 731(a)(2). x L recognition still only applies under certain circumstances where there was a distribution of either, 731(a)(2): o Cash; or o Unrealized Receivables; or o Inventory Items x Amt of L recognition, 731(a)(2): o Excess of distributee s outside basis o Over sum of money distributed + Ptr s basis that she takes in the distributed prop x Character of L: Capital. 731(a)(2) x Purpose of L recognition: Recognition of L req d b/c deferral of the L is impossible to extent the distributee receives cash; & because deferral w/ permit the conversion of capital L (that s inherent in the P-ship interest) into ordinary loss if it were preserved in the distributed assets EXAMPLE # 1: x A has an outside basis of 125; and receives cash of 50 & AR w/ a basis & value of 50; all in a liquidating distribution. Total amt of distribution is 100 = amt of cash distribution of 50 + amt of prop distribution of 50 (FMV of prop at time of distribution). x Recognition: Distribution of cash/unrealized receivable, A must recognize entire loss. 731(a)(2) x Amt of L recognition: Distribution of 100 A s outside basis of 125 = (25) loss. 731(a)(2)(A), (B) x Character of L: Capital loss. Flush language of 731(a). x Tax consequences to P-ship: P-ship recognizes no G/L. 731(b). x End result: A recognizes (25) capital loss; P-ship recognizes no G/L.

58

Basis of Distributed Property o (1) Operating/Current Distributions  Issue: How to allocate: x Distributee s outside basis (as determined before the distribution), AND x Any money or other prop distributed, AND x The Ptr s continuing interest in the P-ship.  General Rules: x Distributee takes transferred basis in distributed prop. 732(a) x Distributee then must reduce her outside basis by; 733: o Any money rec d; AND o AB she takes in any prop distributed x Allocation in general o Ptr allocates her outside basis:  First to any money rec d  Then to any other distributed prop in an amt equal to the P-ship s basis in that prop  Finally, if any balance, remainder of outside basis allocated to continuing interest in P-ship o General Result: Outside basis is reduced by money rec d; then by AB of prop rec d, which leaves a reduced outside basis; i.e. the Ptr s remaining basis in her continued P-ship interest o Exceptional Result: Where the total AB of all prop distributed exceeds the Ptr s reduced outside basis (Ptr s basis in P-ship reduced by any money rec d) special allocation rules apply and the reduced outside basis must be allocated among the distributed properties according to 732(c) and distributee s outside basis is reduced to zero EXAMPLE #2: Pro Rata Distribution x ABC is an equal P-ship w/ assets worth 1200, & 0 liabilities. A has outside basis of 100. ABC has no income or loss for current year. Determine A s tax consequences. o ABC distributes 20 in cash to each Ptr.  A recognized no G/L. 731(a)  A s outside basis reduced by amt of cash distribution (100 20 ) and = 80. 733(1), 705(a)(2). o ABC distributes 20 to B & C and prop w/ FMV of 20 & AB of 15 to A.  A recognizes no G/L. 731(a).  A takes transferred basis in prop, so her AB in the distributed prop is 15. 732(a)(1).  A s outside basis is reduced by AB of prop rec d (100 15) and = 85. 733(2). EXAMPLE #3: Partial Liquidation x Same as above, except ABC distributes 200 of money &/or prop to A to reduce her interest in the P-ship from 33.33% to 20% (Net assets worth 1200; A s share was 400, distribution of 200 reduces A s interest to 200 & the P-ship now has 200 less of assets, so its net assets are now 1000; thus A s new share % is 200/1000, or 20%). Determine A s tax consequences based on whether 200 distribution is cash or prop. o (a) 200 Distribution is Cash  A s outside basis is 100, cash distribution of 200; excess distribution of cash = 100. A must recognize capital G of 100. 731(a)(1).  A s basis is reduced to zero. 100 outside basis amt of money distributed (100 100). 733(1). o (b) 200 Distribution is Capital Asset w/ FMV of 200, ABC has Basis of 40.  A recognizes no G/L. 731(a).  A takes transferred basis in capital asset of 40. 732(a)(1).  A s outside basis reduced by 40 (100 50); A s outside basis = 60. 733(2). o (c) Same as (b), Except ABC s Basis in the Capital Asset is 225  A recognizes no G/L. 731(a)  A s outside basis is 100 and AB of distributed prop is 225, but A s basis can only be reduced to zero, 733, thus excess of 125 remains. Basically, w/out a 754 election in place, this excess basis disappears and is no longer reflected either in the P-ship s inside basis or the prop distributed. So, the Ptr must allocate his outside basis among the prop he 59

rec d, since he only rec d one asset, then his entire 100 outside basis is allocated to the capital asset. 732(c)(2). The capital asset s AB is 100 and A s outside basis is zero. (d) ABC distributes 40 in cash, & capital asset w/ FMV of 160 & AB of 100. A s outside basis still zero and no income/loss.  A recognizes no G/L. 731(a).  Reduced outside basis outside basis (100) money rec d (40) = 60; AB of prop transferred is 100; 60 is < 100; thus A is limited to an AB of 60 in the prop distributed to him. 732(a)(2). (notice 40 in basis disappears w/out a 754 election in place).  A s basis in prop is 60 (determined above).  A s outside basis is 0. Outside basis less money rec d less AB of prop distributed. 733. y Outside basis = 100 y Reduced by money rec d = 60 y Reduced by AB = 60 (b/c AB allocated to distributed prop can t be more than the Ptrs reduced outside basis).

EXAMPLE #4: Liabilities x ABC is an equal P-ship w/ assets worth 1200. ABC borrows 600 to purchase 600 worth of assets. So assets = 1800, liabilities = 600. Ptr capital = 1200. A has outside basis of 100. ABC has no income or loss for current year. o A s outside basis is increased by her increase in her share of liabilities, thus 600 x 1/3 = 200, thus 100 + 200 = 300. A s outside basis is now 300. 752(a), 722. x ABC distributes 200 of money to A to reduce her interest in the P-ship from 33.33% to 20% o Total capital of Ptrs = 1200 less 200 distribution = 1000 Ptr total capital. o A s share is 400 reduced by 200 = 200. 200/1000 = 20%. o Because A s share reduced to 20%, A only assumes 20% of the liabilities.  600 total liabilities x 20% = 120. A s share was 200, thus A s liabilities were reduced by 80. (200 120). This 80 reduction in liabilities is a deemed distribution of cash to A. 752(b).  A s total cash distribution: 80 liability reduction + 200 actual cash distribution. $280.  A s outside basis is 300 before distribution (see above). Thus, A s outside basis reduced by amt of cash distribution. 300 280 = 20. 733(1).  b/c the cash distribution did not exceed her outside basis, no G recognized on the distribution. 731(a)(1). EXAMPLE #5: Liabilities x ABC is an equal P-ship w/ assets worth 1200. ABC buys a capital asset worth 275, by paying 200 in cash + 75 note. ABC distributes the asset to A (subject to the liability, thus A assumes the note) reducing A s interest from 33.33% to 20%. A has outside basis of 100. ABC has no income or loss for current year. o A s outside basis is increased by her increase in her share of liabilities, thus 75 x 1/3 = 25, thus 100 + 25 = 125. A s outside basis is now 125. 752(a), 722. o Total capital of Ptrs was 1200 + 275 for new asset 200 cash to pay for asset = 1275 P-ship assets. Less the 275 distribution = 1000 Ptr total capital. o Because A assumes the liability, liabilities drop from 75 to 0 (75 75), and the remaining 200 is reduced from A s capital account. A s share is 400 reduced by 200 = 200. Thus A s share: 200/1000 = 20%. o Because A assumes the remainder of the liability:  A s outside basis increases by 50 125 + 50 = 175. 752(a), 722.  B & C s outside basis drop by 25 each. 752(b). o A does not recognize G/L on the distribution b/c it was not a distribution of cash. 731(a). o A s basis in the capital asset is ordinarily 275, the AB as it was to the P-ship. 732(a)(1). But, A s outside basis is only 175, thus A s basis in the asset is limited and can only be 175. 732(a)(2).  Thus, w/out a 754 election in place, 100 of basis disappears o (2) Liquidating Distributions  General Rules x Basis rules for liqudiating distributions are different b/c distributee is closing out her investment in the Pship & thus won t have an outside basis after the distribution x To determine distributee Ptr s basis in the prop distributed: 60

Start: Distributee Ptr s reduced outside basis INSTEAD of P-ship s inside basis for those assets  Reduced outside basis Ptr s basis in the P-ship less any cash rec d in distribution  Rhus distributee Ptr takes exchanged basis rather than transferred basis Reduced outside basis is allocated among distributed prop under 732(c); thus similar limitation applies as in 732(a)(2) to current distributions  Allocation of outside basis among distributed properties y First to any unrealized receivables/inventory items o Amt distributed counted towards these items = P-ship s basis in them o If sum of P-ship s bases in these assets > reduced outside basis, reduced outside basis then allocated among assets in proportion to their bases y Remaining balance then allocated among other distributed prop in proportion to their AB to the P-ship; RESULT: o Receivables and inventory items may be stepped down, but never up o Other items can be stepped up or down

EXAMPLE: Liquidating Distributions x ABCD is an = capital P-ship w/ no liabilities. A has outside basis of 50. BS is as follows: Asset Cash Acct Rec Inventory Land cap asset Total o Boo k 20 0 20 160 200 FMV 20 40 40 60 160 A s share Bk 5 0 5 40 50

Determine tax consequences to A under each scenario:  P-ship distributes 40 to A. 10 of A/R & 10 of inventory & 20 of land. B/c P-ship is capital, then liquidating pmt to retiring Ptr is a distribution. 736(b). Thus distribution rules apply rather than rules of 736(a). y A s basis in each is: o A/R = 0 o Inventory = 5 o Land = 40 y A s outside basis of 50 > sum of AB to P-ship 45. A must allocate her outside basis to each asset: o First 0 to A/R. 732(c)(1) o Next 5 to inventory. 732(c)(1) o Remaining asset is land, remaining outside basis is 45 (50 0 5); thus land is allocated 45. 732(c)(2) y No G/L recognized. Not a cash distribution. 731(a).  P-ship distributes 20 in inventory & 40 in land. y A has no g/l. 731(a). y 10 allocated first to the inventory. 732(c)(1). y Remaining basis is 40, which is allocated to land. 731(c)(2).  P-ship distributes 20 of cash and 20 of a/r. y Because this is a liquidating distribution of cash and receivables, if the distributee Ptr s outside basis exceeds the distribution of cash + receivables, A gets to recognize a loss. 731(a)(2). y A s loss is amt of cash distributed + basis she takes in A/R, which is 20 + 0 = 20. A s basis is 50. Thus 20 50 = (30) loss. y Loss is capital. Flush language 731(a).

61

Liquidating Distribution: Treatment of Cash Payment to Retiring Ptr o In General (these are from class notes, note for the sake of reliability)  Ptr is receiving cash distribution or cash equivalent and retiring, thus he is liquidating his interest and gets cash instead of P-ship assets so he no longer has a share in the P-ship s prop  P-ship either paying Ptr cash to reflect: x Income stream if he w/h stayed in the P-ship; OR o If pmt classified as Ptr s share of income  Ptr includes cash pmt as OI  P-ship gets deduction for that pmt x P-ship is buying the Ptr s share of goodwill o Pmt can t be classified as goodwill unless: 736(b)(3)  Retiring Ptr that s liquidating his interest is a general Ptr; AND  P-ship is a service P-ship w/ continuing operations o If pmt classified as goodwill:  Ptr recognized capital G on the income  P-ship gets NO deduction Statute, 736  736(a) Payments considered as Distributive Share or Guaranteed Pmt Pmts made in liquidation of a retiring Ptr s interest are considered: x 736(a)(1) As a distributive share if amt of pmt is determined w/ regard to the P-ship s income x 736(a)(2) A guaranteed payment under 707(c) if the amt of pmt is NOT determined w/ regard to the Pship s income  736(b)(1) Payment for Interest in P-ship (general rule) - Pmts made in liquidation of a Ptr s interest are determined to be made in exchange for the Ptr s interest in the P-ship s prop, and thus the pmt is a distribution by the P-ship and not a distributive share or guaranteed pmt under subsection (a)  736(b)(2) Payment for Interest in P-ship (special rule) Pmts in exchange for P-ship prop do NOT include amts paid for: x Unrealized Receivables of the P-ship x Goodwill of the P-ship (unless PA provides for liquidation pmt for goodwill) How the Statute Operates  736(b) is the general rule. x To the extent a liquidating payment is made to a retiring Ptr in exchange for his P-ship interest in P-ship property, the payment is considered a distribution by the P-ship & NOT a pmt described in 736(a) x NOTE: 736(b) applies to all P-ships that are NOT service P-ships  736(a) is the exception. x 3 requirements to fall into exception. When pmts are made: o (1) To a retiring general Ptr o (2) Of a service P-ship o (3) For unrealized receivables under 751(c) or the P-ship s goodwill x Then the pmts are treated/characterized under 736(a) o 736(a)(1): If the pmt is made w/ regard to the P-ship s income Distributive Share o 736(a)(2): If the pmt is made w/out regard to the P-ship s income Guaranteed Pmt

62

EXAMPLE: 736(b) Payments:  ABC is = capital P-ship; A retires. P-ship agrees to pay 4 pmts on Jan. 1. of 96, 97, 98, 99 in amts of 100, 100, 100, &70. A is fully liabile on his 1/3 share of P-ship s liabilities until last pmt rec d. At time of agreement, ABC s BS: Asset Cash Acct Rec Building Land Goodwill Total Book 150 300 240 60 0 750 FMV 150 300 330 420 300 1,500 A s share Bk 50 100 80 20 250 Liabilities Mortgage Subtotal Capital A B C Subtotal Total Book 390 390 Book 120 120 120 360 750 FMV 390 390 FMV 370 370 370 1110 1500 A s Share 130

120

250

x x x

A s outside basis is 250 (A s capital a/c + share of liabilities) Because this is a capital P-ship; pmts are governed by 736(b) & distribution rules. A s total cash distribution is going to be 500: o 370 per agreement above o 130 upon last pmt when A s share of liabilities is reduced to zero

Tax Consequences of distributions: x Jan 1, 1996: Cash distribution of 100, A s outside basis is 250. Cash not in excess of basis, thus no G recognition. 731(a). x Jan 1, 1997: A s outside basis reduced to 150 from prev. distribution. 733. Cash distribution of 100. Cash not in excess of outside basis, thus no G recognition. 731(a). x Jan 1, 1998: A s outside basis reduced to 50 from prev. distribution. 733. Cash distribution of 100. Cash in excess of outside basis by 50 (100 50). Thus, G recognized on 50 excess. 731(a). o If 754 election in place, P-ship will have positive adjustment of 50. 734. x Jan 1, 1999: A receives total of 200 distribution. (70 actual cash, 130 constructive cash from reduction in liabilities. 752(b).). A s basis is reduced to zero from prev. distribution. 733. Thus, entire distribution is in excess of A s outside basis so entire 200 is G. 731(a). o If 754 election in place, P-ship will have positive adjustment of 200. 734.

736(a) Payments  In General x Pmts that are guaranteed pmts are ordinary income to Ptr and are deductible to the P-ship. Reg. 1.7361(a)(4) x Pmts toward goodwill are also deductible by the P-ship x Note that recapture of 1245 is NOT an unrealized receivable for purposes of 736. Flush language 751(c).

63

EXAMPLE: 736(a) Payments:  ABC is = service P-ship; A is general Ptr and retires. PA has no provision in its PA for goodwill. P-ship agrees to pay 1 lump sum distribution to A of 370 for complete liquidation of his interest. At time of agreement, ABC s BS: Asset Cash Acct Rec Equipment Building Land Goodwill Total Book 375 0 75 240 60 0 750 FMV 375 300 75 330 120 300 1500 A s share Bk 125 0 25 80 20 0 250 Liabilities Mortgage Subtotal Capital A B C Subtotal Total Book 390 390 Book 120 120 120 360 750 FMV 390 390 FMV 370 370 370 1110 1500 A s Share 130

120

250

x x x

A s outside basis is 250 (A s capital a/c + share of liabilities) Because this is a service P-ship & a general Ptr is retiring, 736(a) will govern part of this pmt since the pmt will essentially reflect pmt for unrealized receivables and goodwill. 736(a), 736(b)(3). A s total cash distribution is going to be 500: o 370 per agreement above o 130 for reduction of A s share of liabilities. 752(b).

Tax Consequences of Distributions: x A s share of goodwill and a/r are 100 each, thus 200 of the pmt is going to be treated under 736(a), while remaining 300 distribution is treated under 736(b). x Because the pmt attributable to goodwill and a/r are based on FMV and not the income of the P-ship, the pmts are guaranteed pmts. 736(a)(2). Thus, 200 is OI to A and P-ship gets to deduct 200 as an expense. 162(a). o Note: Benefit to Ptrs They get the immediate deduction passed trhough to them for the goodwill rather than if they purchased it where they w/h to amortize it over 15 years as generally required for goodwill. x The 300 remaining balance is a distribution under 736(b). 751(b) does not need to be considered b/c the A/R were taken care of by 736(a). x The distribution is cash of 300, A s basis is 250. Thus, there is an excess 50 cash distribution and must recognize capital G on that 50. 731(a)(1). o If P-ship has 754 election in effect, it w/h a positive adjustment of 50. 734.

64

OPTIONAL 734 ADJUSTMENT WITH RESPECT TO DISTRIBUTIONS (CH. 7, 8) In General Concept o Liquidating distributions can create disparities btw inside & outside basis  Disparities eliminated or reduced by 734(b) Provides election to make basis adjustment to those P-ships w/ 754 election in effect If election made, 755 provides manner of application Adjustment trigged when a distributee Ptr receives more (or less if liquidating distribution) than her share of inside basis in the P-ship prop

o o

734 | Optional Adjustment to Basis of Undistributed P-ship Property o 734(a) General Rule: Basis of P-ship prop s/n/b adjusted as a result of a distribution unless:  754 election is in place; or  Substantial basis reduction

Determining Amt of Adjustment - 734(b): Cash Distributions o o If distributee Ptr recognized G on distribution Adjustment increases basis in P-ship assets by amt of that G Adjustment decreases basis of P-ship assets by amt of that L

If distributee Ptr recognized L on liquidating distribution

Distributions of Property o If distributee takes basis in distributed prop that is lower than what the basis was to the P-ship of remaining P-ship prop by the difference in the 2 bases Adjustment increases basis

If, from a liquidating distribution, distributee takes basis in distributed prop that is higher than the basis was to the P-ship Adjustment decreases basis of remaining P-ship prop by difference in the 2 bases

65

S-CORPS
S-Corp Status Requirements 1361(a), (b) o o 100 SH or less Majority of SH are individuals (there are exceptions)  Must be US citizen or non-resident alien  Estates  Most trusts  Charitable organizations  An entity by itself can be a SH  H&W count as one SH  1 family counts as 1 SH Only 1 class of stock  Can have voting and non-voting Organization made proper S-Corp election

Who can t be an S-Corp SH? - 1361(a), (b) o C Corps o Any person not an individual o P-ships o LLS (except single member LLCs) o Nonresident aliens o Some trusts

66

S-Corps, in general Treatment of S-Corps as Subsidiaries 1361(b)(3) o o Tax nothing, just like single member LLCs & grantor trusts; thus they are not treated as a separate Corp Qualified Subchapter S subsidiary  100% of subsidiary s stock held by sole parent S-Corp  S-Corp elects to treat the cop as a qualified subchapter S subsidiary

Termination of S-Corp Election o 1362(d)(1): An S-Corp. can revoke its status.  1361(d)(1)(B): SH representing over one half of the shares (voting or nonvoting) must consent to the revocation.  1361(d)(1)(C): A revocation made within the first two and a half months of a year may be applied retroactively. Otherwise, it shall apply on the 1st day of the next taxable year. 1362(d)(2): An S-Corp. loses its status when it ceases to qualify as a small business corp.  1362(d)(2)(B): Termination by cessation takes effect on the day of cessation.  1362(e) provides for two short tax years.  The entity cannot automatically switch off a calendar year tax year. 1362(g): If an election terminates, no new election may be made for five tax years unless the IRS consents to an earlier reelection. 1362(f): The IRS may ignore inadvertent terminations (other than by revocation). NOTE: An S-Corp can t get consent to terminate its status, all it needs to do is just transfer shares of stock to an ineligible SH (i.e. a nonresident alien or a Corporate SH)

o o

67

S-Corp Tax Consequences Basic Tax Regime of S-Corp o P-ship type Tax Treatment  Single SH level tax  Corp s IDGLC pass through to SH Corp type Tax Treatment  Character of tax items determined at Corp level  Basis/Distribution rules designed to assure SH receives previously taxed income without paying add l tax on transactions such as: x Distributions of appreciated prop x Stock redemptions x Liquidations x Transactions occurring when the S-Corp was formerly a C-Corp Where Subchapter S does not control, look to Subchapter C.  S-Corps form, merge, and liquidate like C-Corps.  The differences are in a narrow field of operations.  Even there, the most interesting aspects are in the transition between C and S. Where Subchapter S is simpler than a P-ship, it is at a disadvantage to the taxpayer.  Except for the lack of provisions analogous to 704(c)(1)(B) and reverse 704(c). S-Corps can use the tax-free reorg provisions of Subchapter C, while a P-ship cannot.  Thus, if forming a new enterprise with goal of selling out tax-free to an acquiring Corp can start as an S-Corp to set the stage for the hoped-for future tax-free disposition under the subchapter C reorg provisions.

68

Corporate Tax vs. P-ship Tax Regimes o Corporate Formation  351(a): No G/L will be recognized if property transferred to a Corp by one or more persons solely in exchange for stock the Corp, and the contribution SH gain control after exchange. x Control = 80% or more x If a 25% shareholder makes a subsequent transfer and no other shareholder did, she must recognize gain/loss Comparison x P-ship: Generally free movement of assets in & out of P-ship at any time w/out G recognition x Corp: Free movement of assets in and out of Corp without G recognition only if the transferor(s) has control of the Corp. x S-Corp: Gain is always recognized on transfers out except for cash.

Liabilities  357(a): Assumption of Debt is Not Treated as Money or Other Property. x But, 357(b): If the debt is recently acquired for a purpose of avoiding tax, it can be treated as money. x 351(b): If the amount of debt exceeds the shareholder s basis, the debt is non-qualified consideration and is treated as cash received from the Corp to the extent the shareholder gets something back besides shares. Comparison x P-ship: Assumption of debt is not necessarily a recognition of gain, and assumption of debt is treated as contribution of cash to P-ship 752(a). x 752(b) treats decreases of debt as cash distribution

Basis  358: Basis to Distributee of Corporate Stock x Exchange: Property with a basis of $30 and value of $100 traded for $80 of stock and $20 of something else. Gain of $20 would be recognized (something else not qualified property for exchange) causing the stock to take a basis of $50 in the hands of the new shareholder. x Comparison o Somewhat like 707(a)(2)(B) regarding boot o Possible calculation is 727 + 707/705 + 733 362: Basis to Corp: Generally, value to the contributing shareholder plus any gain recognized by the contributing shareholder in the course of the contribution

Corporate Operations  1(h)(11) Changes tax dividends as if net capital gains. x The tax on net capital gains currently ranges from 5%-28%. x The tax on ordinary income currently ranges from 10%-35%. The tax on Corps does not include S-Corps. x 11 provides a maximum rate of 35% for S-Corps. Historically, Corp earns another $100 $35 tax x $65 distributed to shareholders and taxed at 35% -> $25 tax x Net $40 to shareholders Now, x

$65 distributed to shareholders and taxed at 15% $10 tax 69

x 

Net $55 to shareholders

With an S election, shareholders taxed 35% $35 tax x Net $65 to shareholders x S-Corp is less attractive than before. Distributions to Another Non-S-Corp. x Deductible by recipient to a certain percentage o At most $30 of $100 dividends would be taxed

Complete Liquidation  336: Full Recognition: Generally G/L recognized to Corp as if such property were sold at fair market value. x Some losses disallowed on sales of depreciated property to related persons. x Gain is not recognized if distributed to a parent Corp. x Other loss exceptions. Comparison: 731(b): No gain or loss to P-ship upon distribution of property to Ptrs

 o

Conversion    P-ship can convert to a Corp without recognition of gain. A Corp cannot convert to a P-ship without recognizing gain or loss. It is a fully taxable transaction. Check-the-Box Rules: Election from C to S can cause treatment as if liquidation. x Gain and loss are calculated on each asset as if sold at fair market value. x Gain and loss are calculated for the owners as if their interest were sold and contributed back.

70

Taxation of S-Corp Operations: S-Corps that Never were C-Corps o Taxation, Calendar year    o 1363(a) (like 701): No tax is imposed on respective entities. 1363(b) (like 703(a), (b)): Provide entity-level determinations and entity-level elections 1378: S-Corp must use the calendar year (owners must be individuals)

Flow Through of Income    1366(a), (b), (c) (like 702(a), (b), (c)): Income passes through with the appropriate character. 1366(a): Each shareholder is taxed on her pro-rata share of the Corp s tax items. 1366(b): Character: Determined as if realized directly from the source x Corp passes gain and loss through to shareholders. 1366(d)(1) (like 704(d)) Loss Limitation: Aggregate losses passed through to a SH cannot exceed the SH s adjusted (stock) basis in the Corp. x 1366(d)(2): Losses that cannot be taken can be carried forward. They do not expire. x 469 PAL rules and 465 At-Risk rules apply to shareholders of S-Corps. 1366(a) (like 706(a)) provides that S-Corp activity is included in the tax year of the owners that includes the end of the Corp s tax year. x 1366(b): Separately state the items of income so that the shareholders may treat them with the same character. 1377(a)(1): Pro-rate tax items for the year for joining shareholders. x No ability to do actual allocation like 706(d)(1). 1377(a)(1): Pro-rate tax items for the year for reduction in holdings (i.e. redemption of SH stock)

 o Basis     o

1367(a) (like 705(a), 732(a)(1)) 1367(a)(1): Allocations of income increase adjusted basis. 1367(a)(2): Distributions and allocations of loss reduce adjusted basis. No possibility of a 754 election

Distributions  1368(b): If no AE (accum. earnings): x Cash distributions first reduce adjusted basis x Excess cash distribution over AB = G recognition o Similar to 731(a) P-ship cash distributions, & 731(b); S-Corp does not recognize gain. x 1368(d) increases stock basis for income during the year prior to determining the tax consequences of distributions. EXAMPLE: Property with a basis of $30 is sold for $100 and the money distributed. There are two equal shareholders.  Shareholder A has a basis in the Corp of $50. Her basis increases by the $70/2=$35 gain from the sale to $85. The distribution of $50 then decreases her basis by $50 to $35. 71

 x 

Shareholder B has a basis in the Corp of $0 and a suspended loss of $20. Her basis increases by the $70/2=$35 gain from the sale to $15. The distribution of $50 then decreases her basis to $0 with a capital gain of $35 recognized. CAPITAL G RECOGNIZED UPON LIQUIDATION.

1368(d): When S-Corp has loss for tax yr, distributions during year taken into account before loss limit.

Types of Distributions x 301 Distributions: Corp distributes its stock to its SH, 1368(b) x 317(b) Stock Redemptions: any purchase by a Corp of its own stock x Distributions in complete liquidation of the Corp treated as if SH sold their stock back to Corp There are no S-Corp rules for the Distribution of Property. x 311(a): General rule: No loss recognition on property. x 311(b): G recognition req d on distribution of appreciated prop; treat as if sold on date of distribution. x 366: Generally triggers gain and loss in the case of liquidating distributions Comparison x 731(b): Distribution of non-cash property has no immediate tax consequences to the P-ship x 731(a): Distribution of non-cash property usually has no tax consequences to the Ptr

Debt   Debt does not affect the bases of the shareholders. 1366(d) Thus, Corporate losses flow through but frequently suspend. The losses will be freed as debt is paid off.

72

Shifting from a C-Corp to an S-Corp o Accumulated Earnings & Profits  1368(c) Permits the Corp distribute S earnings before old C earnings. x 1368(e)(1): A Corporate account called the accumulated adjustments account ( AAA ) tracks post-S election income. This income is taxed only to the shareholders. o Post-S election income does not effect the Corp historic earnings. x Distributions come first from the accumulated adjustments account (S earnings). EXAMPLE: $500 earnings/profits before the S election. Post-election, there is another $100 earnings (goes to AAA). The Corp makes a $150 distribution. x The first $100 comes from the AAA and is not taxable to the Corp. x The $50 comes from the historical earnings/profits account. This is treated as a dividend. EXAMPLE: $100 earnings/profits after the S election is on tax-exempt bonds that would have passed through. x 1368(e)(1)(A): Tax-exempt income does not increase the AAA. o Tax-exempt income still passes through tax free. o Tax-exempt income still increases shareholder bases in stock. x Thus, the $150 is drawn from the historical earnings/profits account.  o A Corp can elect to distribute historical earnings/profits first.

Built-in Gains  1374(a) Taxes built-in gain at the Corporate rate level if gain is recognized during the recognition period. The tax is imposed on the Corp. 1374(b): The net recognized built-in gain is taxed at the highest rate specified in 11(b). x This is the highest Corporate rate of 35%. 1374(d)(8): If there is a merger of an S and a C-Corp, the S takes over C s assets with historical bases. 1366(f)(2): The tax imposed shall be treated as a loss.

  o NOL 

1371(b): A net operating loss c/f from a C year cannot be used in an S year there is no entity tax to use the C entity s loss against. 1734(b)(2): Any NOL c/f allowed as a deduction against net recognized built-in gain. Treated as income.

73

Shifting from an S-Corp to a C-Corp o Revoking S-Corp Status  o See Termination of S-Corp status above.

Allocation of Income   1362(e)(2): Allocate income and expenses pro rata between the two short years. Divide proportionately by the number of days between each, e.g., 100/365 and 265/365.

Other considerations  Why switch mid-year? x NOL to expire. But, the short S year might age the NOL to zero. x For sale of an S-Corp in the middle of a year when the buyers want to purchase a C-Corp. 1371(e) Gives the former S-Corp time after it loses S status to make tax-free 1368(b) distributions of earnings that were earned while the Corp was an S-Corp and, thus, were already taxed to the shareholders. x 1368(b): If no accumulated earnings, cash distributions first reduce adjusted basis before triggering gain. x 1377(b): The post-termination transition period is typical a year, but may be 120 days. Otherwise, as a C-Corp, distributions would be ordinary income dividends under 301, to the extent of C undistributed earnings.

74