Tax Chapter 20 No Homework-Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships
Chapter 20 Forming and Operating Partnerships SOLUTIONS MANUAL Discussion Questions

1. [LO 1] What is a flow-through entity, and what effect does this designation have on how business entities and their owners are taxed? Flow-through entities are entities that are not taxed on the entity level; rather, these entities are taxed on the owners level. These types of entities conduct a regular business; however, the income earned and deductions allowed are passed to the owners of these flow-through entities, and the owners are taxed on the amount allocated to them. Thus, flow-through entities provide a way for income and deductions to be taxed only once instead of twice. 2. [LO 1] What types of business entities are taxed as flow-through entities? The two main business entities that are taxed as flow-through entities are partnerships and S corporations. Partnerships are taxed under Subchapter K and consist of general partnerships, limited partnerships, and limited liability companies (LLC). S corporations are taxed under Subchapter S. Both these types of business entities are treated as flowthrough entities and are taxed accordingly. 3. [LO 1] Compare and contrast the aggregate and entity concepts for taxing partnerships and their partners. The aggregate concept treats partnerships more align with an individual. Each partnership is viewed as an aggregation of each partners separate interest in the assets and liabilities of the partnership. For example, each partner is proportioned and taxed on a certain amount of income the partnership creates. The partnership, as a whole, is never taxed. The entity concept treats partnerships more align with a corporation. Each partnership is an entity separate from its partners. For example, the partnership decides on which tax method to use and which tax elections to make, not the partners individually. 4. [LO 2] What is a partnership interest, and what specific economic rights or entitlements are included with it?
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A partnership interest is an equity interest in a partnership. This interest is created through a transfer or sale of cash, property, or services in exchange for an equity interest in the partnership. A partnership interest gives each partner certain rights or entitlements. The two main economic rights are a capital interest and profit interest in the partnership. A capital interest is the right for a partner to receive a share of the partnership assets during liquidation. A profit interest is the right or obligation for a partner to receive a share of the future income or losses of the partnership. 5. [LO 2] What is the rationale for requiring partners to defer most gains and all losses when they contribute property to a partnership? The rationale for requiring partners to defer most gains and losses when contributing property to a partnership is twofold. First, the IRS desires that entrepreneurs have a way to start their own business without having to pay any taxes upfront. Second, the partners are considered still owning the property they have contributed to the partnership. While they dont own the property outright, each partner has a small percentage of the property contributed in her/his partnership interest she/he exchanged for. This second reasoning helps further support the idea that partnerships follow the aggregate concept. 6. [LO 2] Under what circumstances is it possible for partners to recognize gain when contributing property to partnerships? Partners have the potential of recognizing gain on the contribution of property when the property contributed is secured by debt. In determining whether gain must be recognized, the partner must assess the cash deemed to have received from the partnership distribution compared with the tax basis of the partners partnership interest prior to the deemed distribution. If the cash deemed to have received exceeds the tax basis, then a gain must be recognized. This circumstance occurs due to the negative basis created for the partner, which is not allowed under partnership tax law. 7. [LO 2] What are inside basis and outside basis, and why are they relevant for taxing partnerships and partners? An inside basis, in relation to partnerships, is the basis the partnership takes in the assets that the partnership holds. An outside basis, in relation to partnerships, is the tax basis each partner has in the partnership. The inside basis is necessary to compute the gain/loss recognized on all property sold by the partnership. The outside basis is necessary to compute the gain/loss recognized on the partnership interest when sold. For tax purposes, the inside basis is similar to the basis the partner had in
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the property prior to contribution. On the other hand, the outside basis corresponds not only to the contributed property, but also to the debt and income/losses of the partnership.
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8. [LO 2] What is recourse and nonrecourse debt, and how is each generally allocated to partners? Recourse debt is debt for which partners are considered to have an economic risk of loss. This type of debt partners are legally liable for and must satisfy personally if the partnership cannot. An example of recourse debt is accounts payable. Nonrecourse debt is debt for which no partners are considered to have an economic risk of loss in. This is a debt for which partners are not legally liable for. An example of nonrecourse debt is a mortgage. In regards to a partnerships debt, recourse debt is allocated to those partners that have the ultimate responsibility of paying the debt. The debt is allocated to the partners that have an economic risk of loss. On the other hand, nonrecourse debt is allocated to all the partners according to the profit sharing ratios. Despite the partners not being legally liable for this debt, the debt is allocated proportionately to adjust the outside basis of each partner. 9. [LO 2] How does the amount of debt allocated to a partner affect the amount of gain a partner recognizes when contributing property secured by debt? A partner that contributes property secured by debt is not only contributing the property to the partnership but also the debt. In calculating the outside basis of the partner, the partner must take her/his tax basis in the property and decrease her/his basis by the amount of the propertys debt. Next, the propertys debt is allocated to each partner according to who is ultimately responsible for it or by each partners profit-sharing ratio. If the partner is not allocated enough debt, the partners outside basis will become negative and a gain must be recognized. Thus, a partner can only avoid gain by obtaining enough of the partnership debt to keep her/his basis at least above zero. 10. [LO 2] What is a tax-basis capital account, and what type of tax-related information does it provide? A tax-basis capital account is an equity account that is created for each partner of the partnership. This account is measured using the tax accounting rules. The account reflects tax basis of any capital contributions (i.e., property and cash), capital distributions, and future earnings and losses allocated to that partner. Additionally, a tax-basis capital account can provide more tax-related information for each partner. For instance, each partners share of inside basis of the partnerships assets can be calculated by adding the partners share of debt to her/his capital account. Furthermore, if a partner acquires her/his interests by con-
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tributing property tax-free, then the partners outside basis will be equal to that partners share of partnership inside basis.
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11. [LO 2] Distinguish between a capital interest and a profits interest, and explain how partners and partnerships treat when exchanging them for services provided. A partnership interest can be broken down into two distinct rights: (1) capital interest and (2) profits interest. To become a partner in a partnership, you will receive at least one of these rights. A capital interest is the right to receive a share of the partnership assets at liquidation. A profits interest is the right to share in the future earnings and losses of the partnership. While these rights are given to most partners that contribute cash or property, special rules exist when these rights are given to partners in exchange for services. When a partner receives a capital interest in exchange for services rendered to the partnership, the partner must treat the liquidation value of the capital interest as ordinary income. Further, the tax basis for the partner will be equivalent to the amount of ordinary income recognized. The holding period for this tax basis will begin on the date the capital interest is received. From the partnerships perspective, the partnership can deduct or capitalize the value of the capital interest depending upon the type of services rendered. This is determined on a fact and circumstance basis. Additionally, the amount deducted by the partnership is allocated to the non-service partners as consideration for effectively transferring a portion of their capital interest to the service partner. When a partner receives a profit interest in exchange for services rendered to the partnership, the partner has no immediate tax impact because they have no liquidation value at the time they are received. Thus, the non-service partners will not receive any deductions for the additional partner to the partnership. As the partnership makes future profits and losses, the service partner will be allocated her/his portion of these losses according to the profit sharing ratios. The debt allocated to non-service partners must also be redistributed with the additional service partner receiving her/his portion of debt. Therefore, the tax basis of a service partner with only a profit interest will either be zero or the portion of debt the partner is allocated. 12. [LO 2] How do partners who purchase a partnership interest determine the tax basis and holding period of their partnership interests? When a partner purchases a partnership interest, the initial tax basis for the partner is a determined by taking the cost basis of the interest the partner purchased and adding to this basis any debt allocated to the partners interest. The holding period for this purchased interest will begin on the date that the partner purchased the partnership interest.
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13. [LO 3] Why do you think partnerships, rather than the individual partners, are responsible for making most of the tax elections related to the operation of the partnership? The responsibility for the partnership, not the partners, to make the majority of tax elections regarding the operation of the partnership is twofold. First, partnerships can consist of many different partners ranging from two to hundreds. The hassle to obtain every partners approval on what elections to make would be very time consuming. The costs would more than likely outweigh the benefits in performing this function. Second, in many partnerships only a few partners are actively involved in the management of the partnership. The limited partners have ownership to obtain a tax advantage on their own personal returns. Thus, the entity concept would appear more reasonable when dealing with the actual operations of the partnership. 14. [LO 3] If a partner with a taxable year-end of December 31 is in a partnership with a March 31 taxable year-end, how many months of deferral will the partner receive? Why? A partner with a calendar year end will receive nine months of deferral in her/his partnership interest that has a March 31 year end. A partner must report the income or loss of the partnership not at the partners year end but at the partnerships year end. Thus, the first year of the partnership will be reported by the partner on her/his second return which includes the partnerships year end. 15. [LO 3] In what situation will there be a common year-end for the principal partners when there is no majority interest taxable year? The principal partner test states that the required tax year is the taxable year all the principal partners have in common. A principal partner is a partner that owns at least 5 percent interest in the partnership profits and capital. For the principal partner test to pass and not the majority interest test, the partnership must consists of numerous partners that (1) own less than 5 percent profit and capital interest and (2) have a variety of fiscal year ends. For example, if four partners with a calendar year end owned 10 percent and 20 additional partners with differing fiscal year ends owned less than 5 percent, then the majority test would not pass, but the principal partners test would. 16. [LO 3] Explain the least aggregate deferral test for determining a partnerships year end and discuss when it applies. The least aggregate deferral test is the last resort test that a partnership must follow when figuring out the partnership year end. The first test is the majority interest test. The second test is the principal partners test.
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If these two tests dont apply, along with the exception to elect an alternative year end, then the least aggregate deferral test goes into effect.
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The least aggregate deferral test selects the tax year which provides the partner group as a whole the smallest amount of aggregate tax deferral. This is calculated by taking each partners months of deferral under the potential tax year and weighting it with the partners profit interest percentage. Then, each partners weighted totals are summed up to come up with an aggregate deferral number. The potential tax year that produces the smallest aggregate deferral must be the one chosen by the partnership. 17. [LO 3] When are partnerships eligible to use the cash method of accounting? A partnership is eligible to use the cash method of accounting unless the partnership has average gross receipts over the past three taxable years greater than $5 million and has a corporate partner. Under the tax accounting laws, a partnership must use the accrual method of accounting with a corporate partner, unless the above exception applies. 18. [LO 4] What is a partnerships ordinary business income (loss) and how is it calculated? Through the course of business, partnerships create income or losses. Some of these items are considered to affect a specific partner or groups of partners differently. Thus, these separately-stated items must be reported on a partner-by-partner basis. Then, after adjusting the partnerships business income (loss) for these separately-stated items, the partnership reports the remaining amount of business income (loss) to ordinary business income (loss). The total amount will be allocated to each partner according to the special allocation rules agreed upon or else based upon the profit sharing ratios of the partnership. 19. [LO 4] What are some common separately stated items, and why must they be separately stated to the partners? Separately-stated items must be taken out of ordinary income (loss) because these items either (1) relate only to a specific partner in the partnership or (2) the item is taxed differently for each partner depending upon the entity of the partner and the partners current tax situation. The following is a list of items that are considered to be separately stated on a partnership return. 1. 2. 3. 4. 5. 6. 7. 8. Short-term capital gains (losses) Long-term capital gains (losses) Section 1231 gains (losses) Charitable contributions Dividends Interest income Guaranteed payments Net earnings (losses) from self-employment
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9. Tax-exempt income 10. Net rental real estate income (loss) 11. Investment interest expense 12. Section 179 deductions
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20. [LO 4] Is the character of partnership income/gains and expenses/losses determined at the partnership or partner level? Why? In keeping with the entity concept, the character of all income/gains and expenses/losses is determined at the partnership level. Despite the chance that specific items would change character depending upon the partner who holds them, the IRS has decided to unify the character of all items by looking at the character from the partnerships perspective. Thus, partnerships are required to file a 1065 return along with all partners K-1s to help audit the amounts and character that show up on the individual partners return. 21. [LO 4] What are guaranteed payments and how do partnerships and partners treat them for income and self-employment tax purposes? Guaranteed payments are similar to cash salary payments for services provided. The idea behind a guaranteed payment is for a partner to receive a fixed amount of income no matter the profit (loss) for the partnerships taxable year. Thus, on the partnership level, they are treated like a salary payment to an unrelated party. The partnership deducts the guaranteed payment in computing the partnerships ordinary business income (loss). On the partner level, the partner that receives a guaranteed payment must account for the guaranteed payment as a separately-stated item that is taxed as ordinary income. Further, the partner must include the amount of the guaranteed payment in computing self-employment income for tax purposes. This amount is included no matter if the partner is a general partner, limited partner, or LLC member. 22. [LO 4] How do general and limited partners treat their share of ordinary business income for self-employment tax purposes? In determining how different partners treat their share of ordinary business income, the IRS assesses the involvement the partner has in the partnership. General partners are considered to be actively involved in the management of the partnership. Thus, the general partners share of ordinary business income is treated as trade or business income and is subject to self-employment tax. Conversely, limited partners are generally not actively involved with managing the partnership. The limited partners share of ordinary business income is treated as investment income and not subject to self-employment tax. Both types of partners must treat guaranteed payments as income relating to self-employment; however, the ordinary business income depends on the type of partner.
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23. [LO 4] What challenges do LLCs face when deciding whether to treat their members shares of ordinary business income as self-employment income?
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Due to the lack of authoritative ruling that exists for LLCs, members must decide on their own whether to include ordinary business income as self-employment income or not. A proposed regulation gave us clarity on this matter; however, the regulation was withdrawn. Members of an LLC should still review this proposed regulation to understand the stance the IRS is trying to take and whether they will take an aggressive or conservative stance for their specific situation. The proposed regulation helped clarify that if an LLC member is involved in the operations of the LLC, the member should treat the ordinary business income as self-employment income. The regulation listed the following three criteria that would demonstrate active involvement in the LLC: (1) personally liable for the debt of the LLC as an LLC member, (2) authority to contract on behalf of the LLC, or (3) participate in more than 500 hours in the LLCs trade or business during the taxable year. If any one of these requirements is met, then the LLC member would be more associated as a general partner and should more than likely account for the ordinary business income as self-employment income. 24. [LO 4] How much flexibility do partnerships have in allocating partnership items to partners? Partnerships have a great deal of flexibility in determining how to allocate partnership items to partners, both separately-stated and non-separately stated items. The determining factors must be (1) the partners agree upon the allocations and (2) the allocations have substantial economic effect. The second factor is put into place to make sure the allocations are being accomplished for a business objective and not just to reduce or avoid taxes. While both of these items need to be met for a special allocation of a partnership item, certain items have mandatory allocations to specific partners. For example, contributed property builtin gain (loss) must be allocated to the partner who contributed the property when the property is sold. Any additional gain (loss) will be allocated according to the partnership agreement. Overall, if the partnership has no mandatory allocations or does not specify and meet the requirements for special allocations, the partnership will allocate according to the capital or profit interest. 25. [LO4] What are the basic tax-filing requirements imposed on partnerships? While a partnership does not pay taxes, the IRS still requires all partnerships to file an information return to the IRS Form 1065 (U.S. Return of Partnership Income). This form must be filed by the 15th day of the 4th month of the partnerships year end. For calendar year end partnerships, the form must be filed by April 15th. An extension is available to file by the due date of the original return and provides the partnership
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an additional five months to file Form 1065. The extension must be filed on Form 7004.
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The tax return that must be filed by all partnerships consists of a detailed calculation of the partnerships ordinary business income (loss) on page 1 of Form 1065. On page 3 of Form 1065, Schedule K must be filled out which lists the ordinary business income (loss) along with any separately-stated items. This schedule is an aggregate of each partners share of items both separately-stated and non-separately stated. In addition, each partners proportion of the above items is reported on a Schedule K-1. A Schedule K-1 for every partner must be filed with Form 1065, and each individual partner will receive her/his own Schedule K-1 from the partnership. 26. [LO 5] In what situations do partners need to know the tax basis in their partnership interests? Partners should always keep track of the tax basis in their partnership interest; however, certain situations require partners to actually know their tax basis. These situations include when a partner sells her/his partnership interest or when a partner receives a distribution from the partnership. The main reasoning is to help the partner figure out the amount of gain which s/he most report on her/his current tax return. 27. [LO 5] Why does a partners tax basis in her partnership need to be adjusted annually? A partners tax basis needs to be adjusted annually for the following three reasons. First, a partner does not want to double count any income/gain from the partnership when she/he sells her/his partnership interest or receive a distribution from the partnership. Second, the IRS does not want partners to double count any expenses/losses from the partnership in a similar situation from above. Last, partners want to make sure they adjust for tax-exempt income and non-deductible expenses, so these items will not ultimately be taxed or deducted at the time of selling a partnership interest or receiving a distribution from the partnership. 28. [LO 5] What items will increase a partners basis in her partnership interest? The following items will increase a partners basis and must be adjusted for on an annual basis in the order given. 1. Actual and deemed cash contributions to the partnership 2. Partners share of ordinary business income 3. Partners share of separately-stated income/gain items and 4. Partners share of tax-exempt income 29. [LO 5] What items will decrease a partners basis in her partnership interest?
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The following items will decrease a partners basis and must be adjusted for on an annual basis in the order given. These items will be adjusted after all the increases to a partners basis have been taken into effect. 1. Actual and deemed cash distributions from the partnership 2. Partners share of non-deductible expenses (fines, penalties, etc.) 3. Partners share of ordinary business losses and 4. Partners share of separately-stated expenses/loss items
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30. [LO 6] What hurdles (or limitations) must partners overcome before they can ultimately deduct partnership losses on their tax returns? While a partnership can create an ordinary business loss, the individual partners potentially will not be able to deduct the entire amount in the year of the loss. The partner must overcome three loss limitation rules before the deduction is available. If the loss does not pass any of the limitations, then the loss is suspended indefinitely under that specific hurdle. The three loss limitations are (1) assessing the tax basis of the partner, (2) evaluating the at-risk loss limitation, and (3) the passive activity loss limitation. First, a partner is not able to take any losses that exceed the tax basis of the partner, the partners outside basis. This limitation prevents partners from taking losses beyond their investment or basis in their partnership interests. Second, a partner cannot take any losses that exceed the at-risk limit for the partner. The at-risk limit is generally the same as the partners tax basis, except for the share of nonrecourse debt attributable to the partner. This limit still includes recourse debt and qualified nonrecourse debt. Finally, losses cannot be taken if the loss exceeds the amount of passive income reported by the partner. Passive losses, losses from rental activities or limited partnerships, can only be offset with passive gains. 31. [LO 6] What happens to partnership losses allocated to partners in excess of the tax basis in their partnership interests? Losses that are allocated to partners that exceed the partners tax basis cannot be used during the current taxable year. The excess loss will be suspended and carried forward indefinitely until the partner has sufficient basis to utilize the losses. A partner would be able to increase her/his tax basis by (1) making a capital contribution, (2) guaranteeing more partnership debt, or (3) helping the partnership become more profitable. Once the partners tax basis is positive, the losses previously suspended can be used. 32. [LO 6] In what sense is the at-risk loss limitation rule more restrictive than the tax basis loss limitation rule? While the at-risk loss limitation and tax basis loss limitation are basically the same, one difference exists between the two different hurdles a partner must overcome when faced with losses. The at-risk loss limitation only accounts for those items that the partner is at risk for. The major item that is not included under the at-risk calculation but is included in the tax basis is nonrecourse debt. As a note, qualified nonrecourse debt is still considered to be part of the partners at-risk calculation.
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33. [LO 6] How do partners measure the amount they have at risk in the partnership? A partner will measure her/his partnership at-risk amount by looking at what items affect the partners economic risk of loss. In most cases, items included in the at-risk amount would include cash contributed, tax basis of property contributed, recourse debt, qualified nonrecourse debt, and any other adjustments to the partners tax basis excluding nonrecourse debt. Nonrecourse debt is considered a part of the tax basis but not a part of the at-risk basis since the partner does not have an economic risk of loss for this type of debt. 34. [LO 6] In what order are the loss limitation rules applied to limit partners losses from partnerships? The order of the hurdles a partner must pass for the loss limitation rules are (1) tax basis loss limitation, (2) at-risk loss limitation, and (3) passive activity loss limitation. As the losses exceed the limitation in each hurdle, the suspended losses will be carried forward indefinitely within each group until enough basis or income is generated to cover these losses. Once the loss has passed all three limitations, the partner can use the loss as a deduction on her/his own personal return. 35. [LO 6] How do partners determine whether they are passive participants in partnerships when applying the passive activity loss limitation rules? According to the Code, a partner is considered to be a passive participant if the activity conducted is a trade or business and the partner does not materially participate in the activity. The IRS has made it clear that those participants in rental activities and limited partners within a partnership are automatically considered to be passive participants. Further, regulations help clarify whether a partner would be considered a material participant. If the partner meets any of the conditions below, then the partner would be a material participant and the activity would not be considered a passive activity to the partner. 1. The individual participates in the activity more than 500 hours during the year. 2. The individuals activity constitutes substantially all of the participation in such activity by individuals. 3. The individual participates more than 100 hours during the year and the individuals participation is not less than any other individuals participation in the activity.
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4. The activity qualifies as a significant participation activity (individual participates for more than 100 hours during the year) and the aggregate of all other significant participation activities is greater than 500 hours for the year.
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5. The individual materially participated in the activity for any 5 of the preceding 10 taxable years. 6. The activity involves personal services in health, law, accounting, architecture, and so on, and the individual materially participated for any three preceding years. 7. Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year. 36. [LO 6] Under what circumstances can partners with passive losses from partnerships deduct their passive losses? A partner may deduct the passive losses she/he has generated from a partnership under three circumstances. First, a passive loss is not deductible until the taxpayer generates current year passive income in the activity producing the loss. Second, a passive loss is not deductible until the taxpayer generates current year passive income from another passive activity the taxpayer is involved with. Last, a passive loss will not be deductible unless the taxpayer sells the activity that has produced the passive loss. In this case, the taxpayer will report a gain or loss on the sale and can use the passive loss to offset this or any other source of income ( i.e., active income, portfolio income, or other passive income).
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Problems
37. [LO 2] Joseph contributed $22,000 in cash and equipment with a tax basis of $5,000 and a fair market value of $11,000 to Berry Hill Partnership in exchange for a partnership interest. a. What is Josephs tax basis in his partnership interest? b. What is Berry Hills basis in the equipment? a. $27,000. Josephs tax basis is considered to be his outside basis in the partnership. The tax basis includes the $22,000 in cash and his original basis in the equipment, $5,000. Josephs holding period for his outside basis would depend upon the holding period of the assets contributed. All capital or Section 1231 assets tacks onto the partnership interest. All other property has a holding period from the date the partnership interest is acquired. b. $5,000. Berry Hill Partnerships basis in the equipment is a carryover basis from the partner who contributed the equipment. The basis in the equipment plus the basis in the cash will give us Berry Hill Partnerships inside basis. The holding period for the equipment carries over to the Berry Hill Partnership from Joseph. 38. [ LO 2] Lance contributed investment property worth $500,000, purchased three years ago for $200,000 cash, to Cloud Peak LLC in exchange for an 85 percent profits and capital interest in the LLC. Cloud Peak owes $300,000 to its suppliers but has no other debts. a. What is Lances tax basis in his LLC interest? b. What is Lances holding period in his interest? c. What is Cloud Peaks basis in the contributed property? d. What is Cloud Peaks holding period in the contributed property? a. $455,000. Lances basis in his LLC interest is made up of the $200,000 basis of the investment property he transferred to the LLC and his $255,000 share of the LLC debt (85% x $300,000). Because LLC general debt obligations are treated as nonrecourse debt, Lances profit sharing ratio is used to allocate a portion of the LLC debt to him.
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b. Three years.
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Because Lance contributed a capital asset, the holding period of the contributed assets tacks onto his partnership interest. c. $200,000. The LLC takes a carryover basis in the contributed property. d. Three years. The LLC inherits Lances holding period in the contributed property. 39. [ LO 2] Laurel contributed equipment worth $200,000, purchased 10 months ago (acquired on January 31st) for $250,000 cash and used in her sole proprietorship, to Sand Creek LLC in exchange for a 15 percent profits and capital interest in the LLC. Laurel agreed to guarantee all $15,000 of Sand Creeks accounts payable but she did not guarantee any portion of the $100,000 nonrecourse mortgage securing Sand Creeks office building. Other than the accounts payable and mortgage, Sand Creek does not owe any debts to other creditors. a. What is Laurels initial tax basis in her LLC interest? b. What is Laurels holding period in her interest? c. What is Sand Creeks initial basis in the contributed property? d. What is Sand Creeks holding period in the contributed property?
40. [LO 2] {Planning}Harry and Sally formed the Evergreen partnership by contributing the following assets in exchange for a 50 percent capital and profits interest in the partnership: Harry: Basis Fair Market Value Cash $ 30,000 $ 30,000 Land 100,000 120,000 Totals $ 130,000 $ 150,000 Sally: Equipment used in a business 200,000 Totals $ 200,000 $ 150,000 150,000
a. How much gain or loss will Harry recognize on the contribution? b. How much gain or loss will Sally recognize on the contribution? c. How could the transaction be structured a different way to get a better result for Sally? d. What is Harrys tax basis in his partnership interest?
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e. What is Sallys tax basis in her partnership interest? f. What is Evergreens tax basis in its assets? g. Prepare a tax basis balance sheet for the Evergreen partnership showing the tax capital accounts for the partners. a. $0. Generally, partners recognize gain on property contributed to a partnership only when the cash they are deemed to receive from debt relief exceeds their basis in the partnership prior to the deemed distribution. Harry did not have any debt relief. b. $0. Partners may never recognize loss when property is contributed to a partnership even when they are relieved of debt. c. Sally should consider selling the property to the partnership rather than contributing it. By selling the property, she could recognize the $50,000 built-in loss on the equipment. d. $130,000. Harrys basis in his partnership interest is simply the combined tax basis in the cash and land he contributed to the partnership.
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e. $200,000. Sallys basis in her partnership interest equals $200,000 basis in the equipment she contributed. f. $330,000. The partnerships basis in its assets equals the sum of the partners bases in the cash ($30,000), in the land ($100,000), and in the equipment ($200,000). g. The partnerships tax basis balance sheet would appear as follows: Evergreen Partnership Tax Basis Balance Sheet Tax Basis Assets: Cash Equipment Land Totals Capital: Capital-Harry Capital-Sally Totals $30,000 200,000 100,000 $330,000 130,000 200,000 $330,000
41. [LO 2] Cosmo contributed land with a fair market value of $400,000 and a tax basis of $90,000 to the Y Mountain partnership in exchange for a 25 percent profits and capital interest in the partnership. The land is secured by $120,000 of nonrecourse debt. Other than this nonrecourse debt, Y Mountain partnership does not have any debt. a. How much gain will Cosmo recognize from the contribution? b. What is Cosmos tax basis in his partnership interest? a. $0. As reflected in the table below, Cosmo does not recognize any gain because the $120,000 of cash he is deemed to receive from debt relief does not exceed his basis in Y Mountain prior to this deemed distribution.
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Description (1) Basis in contributed Land (2) Nonrecourse mortgage in excess of basis in contributed land (3) Remaining nonrecourse mortgage (4) Relief from mortgage debt Cosmos initial tax basis in Y Mountain
Cosmo Explanation $90,000 $30,000Nonrecourse debt > basis is allocated only to Cosmo $22,50025% x [120,000 - (2)] ($120,000) $22,500(1) + (2) + (3) + (4)
b. $22,500 as indicated in the table above. 42. [LO2] Maude, James, Harold and Jenny formed the High Horizon LLC by contributing the following assets in exchange for 25 percent capital and profits interests in the LLC: Maude:Basis Fair Market Value Cash $ 20,000 $ 20,000 Land* 100,000 200,000 Totals $ 120,000 $ 220,000 *Nonrecourse debt secured by the land equals $160,000 James, Harold and Jenny each contributed $220,000 in cash. a. How much gain or loss will Maude and the other members recognize? b. What is Maudes tax basis in her LLC interest? c. What tax basis do James, Harold, and Jenny have in their LLC interests? d. What is High Horizons tax basis in its assets? e. Prepare a tax basis balance sheet for the High Horizon LLC showing the tax capital accounts for the members. a.$0.
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None of the partners recognize gain because their debt relief was not in excess of their bases in their partnership interest prior to any debt relief. See table below:
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Description (1) Basis in contributed Land (2) Cash contributed (3) Nonrecourse mortgage in excess of basis in contributed land (4) Remaining nonrecourse mortgage (5) Relief from mortgage debt Each members initial tax basis in the LLC b.$45,000. See table in part a. above. c. $245,000 each. See table in part a. above.
Maude $100,000
Other Members
Explanation
$20,000 $220,000 $60,000 Nonrecourse debt > basis is allocated only $25,000 ($160,000) $45,000 $245,000 (1) + (2) + (3) + (4) + (5) $25,000 to Maude 25% x [160,000 - (3)]
d. $780,000. High Horizon takes a $120,000 carryover basis in the assets Maude contributes and a $660,000 in the total cash the other three members contributed. e. High Horizons tax basis balance sheet would appear as follows: High Horizons, LLC Tax Basis Balance Sheet Tax Basis Assets: Cash Land Totals $680,000 100,000 780,000
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Liabilities and Capital: Mortgage debt Capital-Maude Capital-James Capital-Harold Capital-Jenny Totals
160,000 (40,000) 220,000 220,000 220,000 780,000
Note that the members tax capital accounts are equal to their bases in the LLC interests less their individual shares of LLC debt. 43. [LO2] Kevan, Jerry, and Dave formed Albee LLC. Jerry and Dave each contributed $245,000 in cash. Kevan contributed the following assets: Kevan: Basis Fair Market Value Cash $ 15,000 $ 15,000 Land* 120,000 230,000 Totals $ 135,000 $ 245,000 *Nonrecourse debt secured by the land equals $210,000 Each member received a one-third capital and profits interest in the LLC. a. How much gain or loss will Jerry, Dave and Kevan recognize on the contributions? b. What is Kevans tax basis in his LLC interest? c. What tax basis do Jerry and Dave have in their LLC interests? d. What is Albee LLCs tax basis in its assets? e. Prepare a tax basis balance sheet for the Albee LLC showing the tax capital accounts for the members. What is Kevans share of the LLCs inside basis? f. If the lender holding the nonrecourse debt secured by Kevans land required Kevan to guarantee 33.33 percent of the debt and Jerry to guarantee the remaining 66.67 percent of the debt when Albee LLC was formed, how much gain or loss will Kevan recognize? g. If the lender holding the nonrecourse debt secured by Kevans land required Kevan to guarantee 33.33 percent of the debt and Jerry to guarantee the remaining 66.67 percent of the debt when Albee LLC was formed, what are the members tax bases in their LLC interests?
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a. $0. None of the partners recognize gain because their debt relief was not in excess of their bases in their partnership interest prior to any debt relief. See table below: Description (1) Basis in contributed Land (2) Cash contributed (3) Nonrecourse mortgage in excess of basis in contributed land (4) Remaining nonrecourse mortgage (5) Relief from mortgage debt Each members initial tax basis in the LLC b.$55,000. See table in part a. above. c. $285,000 each. See table in part a. above. d. $625,000. Albee, LLC takes a $135,000 carryover basis in the assets Kevan contributes and a $490,000 in the total cash the other two members contributed. ($210,000) $55,000 $285,000 (1) + (2) + (3) + (4)+ (5) $40,000 $40,000 Kevan $120,000 $15,000 $245,000 $90,000 Nonrecourse debt > basis is allocated only to Kevan 33.3% x [$210,000 (3)] Other Members Explanation
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e. Albee, LLCs tax basis balance sheet would appear as follows: Albee , LLC Tax Basis Balance Sheet Tax Basis Assets: Cash Land Totals Liabilities and Capital: Mortgage debt Capital-Kevan Capital-Jerry Capital-Dave Totals $505,000 120,000 625,000 210,000 (75,000) 245,000 245,000 625,000
Note that the members tax capital accounts are equal to their bases in the LLC interests less their individual shares of LLC debt. f. $5,000. See table below: Description (1) Basis in contributed Land (2) Cash contributed (3) Mortgage Guarantee Kevan $120,000 $15,000 $70,000 Jerry Dave Explanation
$245,000 $140,000
$245,000 $033.33% x $210,000 for Kevan and 66.67% x $210,000 for Jerry
(4) Relief from mortgage debt
($210,000)
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(5) Gain Recognized Each members initial tax basis in the LLC
$5,000 $0
$0 $385,000
$0[(1)+ (2)+ (3) + (4)] $245,000(1) + (2) + (3)+ (4) + (5)
g. Kevans basis is $0, Jerrys basis is $385,000, and Daves basis is $245,000. See the table in part f. above. 44. [LO2] {Research} Jim has decided to contribute some equipment he previously used in his sole proprietorship in exchange for a 10 percent profits and capital interest in Fast Choppers LLC. Jim originally paid $200,000 cash for the equipment. Since then, the tax basis in the equipment has been reduced to $100,000 because of tax depreciation, and the fair market value of the equipment is now $150,000. a. Must Jim recognize any of the potential 1245 recapture when he contributes the machinery to Fast Choppers? {Hint: See 1245(b)(3).} b. What cost recovery method will Fast Choppers use to depreciate the machinery? {Hint: See 168(i)(7).} c. If Fast Choppers were to immediately sell the equipment Jim contributed for $150,000, how much gain would Jim recognize and what is its character? {Hint: See 1245 and 704(c).} a. According to Section 1245(b)(3), recapture potential on property contributed to a partnership is only recognized to the extent any gain is recognized from the contribution of property. Because Jim was not relieved of any debt in the transaction, he will not recognize gain from the contribution under Section 721. Therefore, Jim does not recognize any of the Section 1245 recapture potential on the equipment at the time of contribution. b. According to Section 168(i)(7), a transferee partnership will step into the shoes of the transferor partner for purposes of depreciating contributed equipment. In this situation, Fast Choppers will continue to depreciate the equipment using the same method instituted by Jim over the remaining useful life of the equipment. In other words, the annual depreciation calculation will proceed as if the property were still held by Jim.
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c. Under Section 704(c), all $50,000 of gain recognized from the sale of the equipment would be allocated to Jim because this gain was builtin at the time the equipment was contributed. Moreover, the Section 1245 recapture potential remains with the equipment after the contribution; as a result, all $50,000 of gain recognized (the lesser of the $50,000 gain recognized or the $100,000 depreciation taken) must be characterized as Section 1245 recapture income. 45. [LO2] {Research} Ansel purchased raw land three years ago for $200,000 to hold as an investment. After watching the value of the land drop to $150,000, he decided to contribute it to Mountainside Developers LLC in exchange for a 5 percent capital and profits interest. Mountainside plans to develop the property and will treat it as inventory, like all of the other real estate it holds. a. If Mountainside sells the property for $150,000 after holding it for one year, how much gain or loss does it recognize and what is the character of its gain or loss? {Hint: See 724.} b. If Mountainside sells the property for $125,000 after holding it for two years, how much gain or loss does it recognize and what is the character of the gain or loss? c. If Mountainside sells the property for $150,000 after holding it six years, how much gain or loss is recognized and what is the character of the gain or loss? a. According to Section 724(c), recognized losses on assets that were capital assets in the hands of contributing partners are treated as capital losses up to the amount of loss built into the assets at the time they were contributed if they are sold within a five year period beginning on the date of contribution. Thus, Mountainside Developers will recognize a $50,000 loss characterized as a capital rather than an ordinary loss. b. In this instance, Mountainside Developers will recognize a $75,000 loss from the sale of the land. The built-in loss at the time the land was contributed or $50,000 will be characterized as a capital loss, and the remaining $25,000 loss will be characterized as an ordinary loss per Section 724(c). c. Because Mountainside Developers held the land as inventory for more than five years, it will recognize a $50,000 ordinary loss per Section 724(c). 46. [LO2] {Research} Claude purchased raw land three years ago for $1,500,000 to develop into lots and sell to individuals planning to build their dream homes. Claude intended to treat this property as inventory, like his other development properties. Before completing the development of the property, however, he decided to contribute it to South Peak In-
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vestors LLC when it was worth $2,500,000, in exchange for a 10 percent capital and profits interest. South Peaks strategy is to hold land for investment purposes only and then sell it later at a gain.
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a. If South Peak sells the property for $3,000,000 four years after Claudes contribution, how much gain or loss is recognized and what is its character? {Hint: See 724.} b. If South Peak sells the property for $3,000,000 five and one-half years after Claudes contribution, how much gain or loss is recognized and what is its character? a. Under Section 724(b), any gain or loss on contributed property that was treated as inventory by the contributing partner and sold by the partnership during the five year period beginning on the date of contribution is treated as ordinary gain or loss. Thus, the entire $1,500,000 gain from the sale of the land will be treated as ordinary gain. b. Section 724(b) only applies if contributed property is sold during the five year period beginning on the date of contribution. Because South Peak sold the land after the expiration of this time period and held the land as investment property, it should recognize $1,500,000 of capital gain. 47. [LO2] {Research} Reggie contributed $10,000 in cash and a capital asset he had held for three years with a fair market value of $20,000 and tax basis of $10,000 for a 5 percent capital and profits interest in Green Valley LLC. a. If Reggie sells his LLC interest thirteen months later for $30,000 when the tax basis in his partnership interest is still $20,000, how much gain does he report and what is its character? b. If Reggie sells his LLC interest two months later for $30,000 when the tax basis in his partnership interest is still $20,000, how much gain does he report and what is its character? {Hint: See Reg. 1.1223-3}
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48. [LO2] Connie recently provided legal services to the Winterhaven LLC and received a 5 percent interest in the LLC as compensation. Winterhaven currently has $50,000 of accounts payable and no other debt. The current fair market value of Winterhavens capital is $200,000. a. If Connie receives a 5 percent capital interest only, how much income must she report and what is her tax basis in the LLC interest? b. If Connie receives a 5 percent profits interest only, how much income must she report and what is her tax basis in the LLC interest? c. If Connie receives a 5 percent capital and profits interest, how much income must she report and what is her tax basis in the LLC interest? a. Connie reports $10,000 of ordinary income or 5 percent of the LLCs capital of $200,000. Her basis in the LLC interest is also $10,000. b. Connie will not report any income but will have a basis in the LLC interest equal to her share of the LLCs debt. Because the LLCs debt is a nonrecourse debt, it must be allocated to her using Connies profits interest. Thus, her basis in the LLC equals $2,500 or 5 percent of the LLCs $50,000 accounts payable. c. Connie reports $10,000 of ordinary income or 5 percent of the LLCs capital of $200,000. Her basis in the LLC is $12,500 consisting of the $10,000 of income she recognizes for the receipt of her capital interest and her $2,500 share of the LLCs nonrecourse accounts payable. 49. [LO2] Mary and Scott formed a partnership that maintains its records on a calendar-year basis. The balance sheet of the MS Partnership at year-end is as follows: Cash Land Inventory Mary Scott Basis $ 60 60 72 $192 $ 96 96 $192 Fair Market Value $ 60 180 60 $300 $150 150 $300
At the end of the current year, Kari will receive a one-third capital interest only in exchange for services rendered. Karis interest will not be subject to a substantial risk of forfeiture and the costs for the type of services she provided are typically not capitalized by the partnership. For the current year, the income and expenses from operations are equal.
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Consequently, the only tax consequences for the year are those relating to the admission of Kari to the partnership.
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a. Compute and characterize any gain or loss Kari may have to recognize as a result of her admission to the partnership. b. Compute Karis basis in her partnership interest. c. Prepare a balance sheet of the partnership immediately after Karis admission showing the partners tax capital accounts and capital accounts stated at fair market value. d. Calculate how much gain or loss Kari would have to recognize if, instead of a capital interest, she only received a profits interest. a. Kari will recognize one-third of the fair market value of the partnerships capital or $100 as ordinary income. b. Karis basis in her partnership interest will be equal to the amount of income she reports or $100. c. Immediately after Karis admission into the partnership the partnerships balance sheet will appear as follows:
MS Partnership Balance Sheet Tax Basis Assets: Cash Land Inventory Totals Capital: Capital-Mary Capital-Scott Capital-Kari Totals $60 60 72 $192 46 46 100 $192 704(b)/FMV 60 180 60 300 100 100 100 $300
Essentially, the tax capital and 704(b) capital accounts for both Scott and Mary are reduced by their $50 share of the $100 compensation expense the partnership will deduct for the capital interest Kari receives.
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d. If Kari only receives a profits interest, she will not recognize any income until she receives a profits allocation from the partnership. 50. [LO2] Dave LaCroix recently received a 10 percent capital and profits interest in Cirque Capital LLC in exchange for consulting services he provided. If Cirque Capital had paid an outsider to provide the advice, it would have deducted the payment as compensation expense. Cirque Capitals balance sheet on the day Dave received his capital interest appears below: Assets: Basis Cash $ 150,000 $ 150,000 Investments 200,000 700,000 Land 150,000 250,000 Totals $ 500,000 $1,100,000 Fair Market Value
Liabilities and capital: Nonrecourse Debt 100,000 100,000 Lance* 200,000 500,000 Robert* 200,000 500,000 Totals $ 500,000 $ 1,100,000 *Assume that Lances basis and Roberts basis in their LLC interests equal their tax basis capital accounts. a. Compute and characterize any gain or loss Dave may have to recognize as a result of his admission to Cirque Capital. b. Compute each members tax basis in his LLC interest immediately after Daves receipt of his interest. c. Prepare a balance sheet for Cirque Capital immediately after Daves admission showing the members tax capital accounts and their capital accounts stated at fair market value. d. Compute and characterize any gain or loss Dave may have to recognize as a result of his admission to Cirque Capital if he receives only a profits interest. e. Compute each members tax basis in his LLC interest immediately after Daves receipt of his interest if Dave only receives a profits interest. a. The tax consequences of giving Dave both a 10 percent capital and profits interest are summarized in the following table:
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Description (1) Beginning Basis in LLC
Dave Lance $0 $250,000
Robert Explanation $250,000$200,000 tax basis capital account + [.5 x $100,000 nonrecourse debt] Liquidation Value of Capital Interest (.1 x $1,000,000 fair market value of LLC capital) ($50,000)Capital Shift from Non-Service Partners. (2) x .5 [$100,000 nonrecourse debt x 10% profit sharing ratio] (5,000)
(2) Ordinary In- $100,000 come (3) Ordinary Deduction (4) Increase in Debt Allocation (5) Decrease in (5,000) $10,000 ($50,000)
(4) x .5
Debt Allocation (6) Ending Ba- $110,000 $195,000 sis in LLC
$195,000 (1) + (2) + (3) + (4) + (5)
As indicated in line (2) of the table above, Dave recognizes $100,000 of ordinary income. b. As indicated in line (6) of the table above, the members tax bases in the LLC interests immediately after Dave is admitted are as follows: $110,000 for Dave and $195,000 for Lance and Robert. c. Immediately after Daves admission into the LLC, the LLCs balance sheet will appear as follows:
Cirque, LLC Balance Sheet Tax Basis Assets: Cash Land Inventory Totals $150,000 200,000 150,000 $500,000 704(b/)FMV $150,000 700,000 250,000 $1,100,000
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Capital: Nonrecourse Debt Capital-Lance Capital-Robert Capital-Dave Totals
$100,000 150,000 150,000 100,000 $500,000
100,000 450,000 450,000 100,000 $1,100,000
d. The tax consequences of giving Dave only a 10 percent profits interest are summarized in the following table:
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Description (1) Beginning Basis in LLC (2) Ordinary Income
Dave Lance $0 $250,000
Robert Explanation $250,000$200,000 tax basis capital account + [.5 x $100,000 nonrecourse debt] Dave does not recognize any income because he only receives a profits interest. [$100,000 nonrecourse debt x 10% profit sharing ratio] (5,000)
$0
(3) Increase in Debt Allocation (4) Decrease in Debt Allocation (5) Ending Basis in LLC
$10,000
(5,000)
(3) x .5
$10,000 $245,000
$245,000
(1) + (2) + (3) + (4)
Dave does not recognize any income because he only received a profits interest. e. As reflected in line (5) of the table above, Daves basis is $10,000, Lances basis is $245,000, and Roberts basis is $245,000. 51. [LO 2] Last December 31, Ramon sold the 10 percent interest in the Del Sol Partnership that he had held for two years to Garrett for $400,000. Prior to selling his interest, Ramons basis in Del Sol was $200,000 which included a $100,000 share of nonrecourse debt allocated to him. a. What is Garretts tax basis in his partnership interest? b. If Garrett sells his partnership interests three months after receiving it and recognizes a gain, what is the character of his gain?
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a. Garretts basis in his partnership interest is equal to the $400,000 amount he paid for it plus his $100,000 share of partnership debt or $500,000. b. Because Garrett purchased his partnership interest, his holding period for the interest begins on the date the interest was purchased. As a result, he only has a three month holding period before the partnership interest is sold. This means his capital gain from the sale of his partnership interest will be short-term capital gain. 52. [LO 3] Broken Rock LLC was recently formed with the following members:
Name George Allen Elanax Corp. Ray Kirk Tax Year End December 31 June 30 December 31 Capital/Profits % 33.3% 33.3% 33.3%
What is the required taxable year-end for Broken Rock LLC? George Allen and Ray Kirk together own more than 50 percent of the profits and capital of Broken Rock. Because both George and Ray have a December 31 year end, December 31 is majority interest taxable year and is also the required year end for Broken Rock. 53. [LO 3] Granite Slab LLC was recently formed with the following members:
Name Nelson Black Brittany Jones Lone Pine, LLC Red Spot, Inc. Pale Rock, Inc. Thunder Ridge, LLC Alpensee, LLC Lakewood, Inc. Streamside, LLC Burnt Fork, Inc. Snowy Ridge, LP Whitewater, LP Straw Hat, LLC Wildfire, Inc. Tax Year End December 31 December 31 June 30 October 31 September 30 July 31 March 31 June 30 October 31 October 31 June 30 October 31 January 31 September 30 Capital/Profits % 22.0% 24.0% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5%
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What is the required taxable year-end for Granite Slab LLC? Because none of the partners with the same year end together own more than 50 percent of the capital and profits of Granite Slab, there is no majority interest taxable year. However, Nelson Black and Brittany Jones are principal partners because they individually own more than 5 percent of the profits and capital of Granite Slab. Moreover, they both have a December 31 year end. Therefore, the required year end of the partnership is year end of the principal partners or December 31.
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54. [LO 3] Tall Tree LLC was recently formed with the following members:
Name Eddie Robinson Pitcher Lenders, LLC Perry Homes, Inc. Tax Year End December 31 June 30 October 31 Capital/Profits % 40% 25% 35%
What is the required taxable year-end for Tall Tree LLC? 55. [LO 3] Rock Creek LLC was recently formed with the following members:
Name Mark Banks Highball Properties, LLC Chavez Builders, Inc. Tax Year End December 31 March 31 November 30 Capital/Profits % 35% 25% 40%
What is the required taxable year-end for Rock Creek LLC? Rock Creek does not have a majority interest taxable year because no partner or group of partners with the same year end owns more than 50 percent of the profits and capital interests in Rock Creek. Also, because all three principal partners in Rock Creek have different year ends, the principal partner test is not met. As a result, Rock Creek must decide which of three potential year ends, December 31, March 31, or November 30, will provide its members the least aggregate deferral. The table below illustrates the required computations:
Possible Year Ends 12/31 Year End 3/31 Year End 11/30 Year End
Members
Tax Year
Months Deferral* (MD) 0 3 11
% x MD
Months % x MD Deferral* (MD) 9 0 8
Months Deferral* (MD) 1 4 0
%x MD .35 1 0 1.35
Mark Banks 35% Highball Prop- 25% erties, LLC Chavez Builders,Inc. Total Aggregate Deferral 40%
12/31 3/31 11/30
0 .75 4.4 5.15
3.15 0 3.2 6.35
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*Months deferral equals number of members between proposed year end and partners year end.
As the table above indicates, Rock Creek must use November 30 as its year end because it provides the least amount of aggregate deferral to the members.
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56. [LO 3]{Research} Ryan, Dahir, and Bill have operated Broken Feather LLC for the last four years using a calendar year-end. Each has a one-third interest. Since they began operating, their busy season has run from June through August, with 35 percent of their gross receipts coming in July and August. The members would like to change their tax year-end and have asked you to address the following questions: a. Can they change to an August 31 year-end and, if so, how do they make the change? {Hint: See Rev. Proc. 2002-38.} b. Can they change to a September 30 year-end and, if so, how do they make the change? {Hint: See 444.} a. If Broken Feather can establish that 25 percent of its gross receipts for the current twelve month period ending on August 31 fell within the months of July and August, and it can establish the same thing for the two preceding years ending on August 31, then Broken Feather can change its year end to August 31 under Rev. Proc. 2002-38. b. Under Section 444, Broken Feather can elect to have its year end fall up to three months ahead of its normal required calendar year end. Thus, it may elect to have a September 30, October 31, or November 30 year end under Section 444. However, if it makes the Section 444 election, it must calculate and deposit a Section 7519 payment with the IRS to offset the deferral benefit the partners receive by having the year end fall before December 31. 57. [LO 3] {Research}Ashlee, Hiroki, Kate, and Albee LLC each own a 25 percent interest in Tally Industries LLC, which generates annual gross receipts of over $10 million. Ashlee, Hiroki, and Kate manage the business, but Albee LLC is a nonmanaging member. Although Tally Industries has historically been profitable, for the last three years losses have been allocated to the members. Given these facts, the members want to know whether Tally Industries can use the cash method of accounting. Why or why not? {Hint: See 448(b) (3)} Generally, partnerships without corporate partners may use the cash method of accounting. However, partnerships that are tax shelters may not use the cash method of accounting. According to Section 448(b)(3), partnerships defined as tax shelters are ineligible to use the cash method. Section 461(i)(3)(B) includes syndicates among the other categories of tax shelters. Section 1256(e)(3)(B) defines a syndicate as any partnership that allocates more than 35 percent of its losses to either limited partners or limited entrepreneurs. In addition to limited partnerships, this provision likely also applies to LLCs because Section 464(e)(2) defines a limited entrepreneur as any person, including LLC members, other than a limited partner, who does not actively participate in the management of the enterprise. In summary, if more than 35 percent of losses in a given year are allocated to either limited partners or
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to LLC members not actively participating in the management of an LLC, the limited partnership or LLC will be not be permitted to use the cash method. Because of these restrictions, a significant number of limited partnerships and LLCs that would otherwise qualify are denied the use of the cash method.
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Because only 25 percent of Tally Industries loss for the year is allocated to a member that does not actively participate in management and it does not have a corporate member, Tally will be able to use the cash method. 58. [LO 4] Turtle Creek Partnership had the following revenues, expenses, gains, losses, and distributions: Sales revenue Long-term capital gains Cost of goods sold Depreciation - MACRS Amortization of organization costs Guaranteed payments to partners for general management Cash distributions to partners $40,000 $2,000 ($13,000) ($3,000) ($1,000) ($10,000) ($2,000)
Given these items, what is Turtle Creeks ordinary business income (loss) for the year? Turtle Creeks ordinary business income is calculated in the table below:
Description Sales revenue Less: Cost of good sold Depreciation - MACRS Amortization of organization costs Guaranteed payments Ordinary Business Income Separately Stated Items on Schedule K-1: Long-term capital gains Guaranteed payments Cash distributions Amount $40,000 (13,000) (3,000) (1,000) (10,000) $13,000 $2,000 $10,000 $2,000
Note that guaranteed payments must be separately disclosed to the partners that receive them, and cash distributions must be separately disclosed so that partners can reduce the tax basis of their partnership interests by the amount of the distributions.
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59. [LO 4] Georgio owns a 20 percent profits and capital interest in Rain Tree LLC. For the current year, Rain Tree had the following revenues, expenses, gains, and losses: Sales revenue Gain on sale of land (1231) Cost of goods sold Depreciation - MACRS Section 179 deduction* Employee wages Fines and penalties Municipal bond interest Short-term capital gains Guaranteed payment to Sandra $70,000 $11,000 ($26,000) ($3,000) ($10,000) ($11,000) ($3,000) $6,000 $4,000 ($3,000)
*Assume the 179 property placed in service limitation does not apply. a. How much ordinary business income (loss) is allocated to Georgio for the year? b. What are Georgios separately stated items for the year? a. Georgios allocation of ordinary business income is reflected in the table below:
Description
Total Amount 20% Allocated to Georgio
Sales revenue Less: Cost of good sold Depreciation - MACRS Employee wages Guaranteed payments Ordinary Business Income
$70,000 (26,000) (3,000) (11,000) (3,000) $27,000
$5,400
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b. Georgios separately stated items are calculated in the table below:
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Description
Total Amount 20% Allocated to Georgio
Separately Stated Items on Schedule K-1: Section 1231 gains Section 179 deduction Short-term capital gains Municipal bond interest* Fines and penalties*
$11,000 (10,000) 4,000 6,000 (3,000)
$2,200 (2,000) 800 1,200 (600)
*Although these amounts are not included in Georgios taxable income computation, they must be separately disclosed because they affect Georgios tax basis in his LLC interest. 60. [LO 4] The partnership agreement of the G&P general partnership states that Gary will receive a guaranteed payment of $13,000, and that Gary and Prudence will share the remaining profits or losses in a 45/55 ratio. For year 1, the G&P partnership reports the following results: Sales revenue Gain on sale of land ( 1231) Cost of goods sold Depreciation - MACRS Employee wages Cash charitable contributions Municipal bond interest Other expenses $70,000 $8,000 ($38,000) ($9,000) ($14,000) ($3,000) $2,000 ($2,000)
a. Compute Garys share of ordinary income (loss) and separately stated items to be reported on his year 1 Schedule K-1, including his self-employment income (loss). b. Compute Garys share of self-employment income (loss) to be reported on his year 1 Schedule K-1, assuming G&P is a limited partnership and Gary is a limited partner. c. What do you believe Garys share of self-employment income (loss) to be reported on his year 1 Schedule K-1 should be, assuming G&P is an LLC and Gary spends 2,000 hours per year working there full time?
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Garys ordinary business income, separately stated items, and self-emDescription Total Amount Allocated to Gary Explanation Sales revenue $70,000 Less: Cost of good sold (38,000) Depreciation - MACRS (9,000) Employee wages (14,000) Other expenses (2,000) Guaranteed payments (13,000) Ordinary Business Loss ($6,000) ($2,700) 45% allocation to Gary Separately Stated Items on Schedule K-1: Section 1231 gains Cash charitable contributions Guaranteed payment Municipal bond interest Self-employment income $8,000 ($3,000) $13,000 $2,000 $7,000 [$13,000 guaranteed payment $6,000 ordinary loss] $3,600 45% allocation to Gary ($1,350) 45% allocation to Gary $13,000 Garys guaranteed payment $900 45% allocation to Gary $10,300 ($2,700) ordinary business loss allocated to Gary + $13,000 guaranteed payment
ployment income are calculated in the table below:
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a. If Gary is a limited partner, then his self-employment income would equal the $13,000 guaranteed payment he received. b. Under Proposed Reg. 1.1402(a)-2, Garys $2,700 share of ordinary business loss will reduce his $13,000 guaranteed payment leaving him with $10,300 of self-employment income (because he spent more than 500 hours working in the trade or business of the LLC). In this instance, the proposed regulations provide Gary with a favorable interpretation of the law. 61. [LO 4] {Research} Hoki Poki, a cash-method general partnership, recorded the following items for its current tax year: Rental real estate income Sales revenue Section 1245 recapture income Interest income Cost of goods sold Depreciation - MACRS Supplies expense Employee wages Investment interest expense Partners medical insurance premiums paid by Hoki Poki $2,000 $70,000 $8,000 $2,000 ($38,000) ($9,000) ($1,000) ($14,000) ($1,000) ($3,000)
As part of preparing Hoki Pokis current year return, identify the items that should be included in computing its ordinary business income (loss) and those that should be separately stated. {Hint: See Schedule K-1 and related preparers instructions at www.irs.gov.}
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62. [LO 4] {Research} On the last day of its current tax year, Buy Rite LLC received $300,000 when it sold a machine it had purchased for $200,000 three years ago to use in its business. At the time of the sale, the basis in the equipment had been reduced to $100,000 due to tax depreciation taken. How much did Buy Rites self-employment earnings increase when the equipment was sold? {Hint: See 1402(a)(3).} Buy Rites self-employment income does not increase due to the sale of the equipment. According to 1402(a)(3)(C), gains from the sale of equipment are not included in Buy Rites self-employment income. Thus, Buy Rite must insure that the $100,000 of ordinary Section 1245 recapture is subtracted from its ordinary business income or loss when calculating its self-employment income. Because the remaining $100,000 of Section 1231 gain is separately stated, it is not included in ordinary business income or loss and therefore will not be included in self-employment income. 63. [LO 4] Jhumpa, Stewart, and Kelly are all one-third partners in the capital and profits of Firewalker general partnership. In addition to their normal share of the partnerships annual income, Jhumpa and Stewart receive an annual guaranteed payment of $10,000 to compensate them for additional services they provide. Firewalkers income statement for the current year reflects the following revenues and expenses:
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Sales revenue Interest income Long-term capital gains Cost of good sold Employee wages Depreciation expense Guaranteed payments Miscellaneous expenses Overall net income
$340,000 3,300 1,200 (120,000) (75,000) (28,000) (20,000) (4,500) $97,000
a. Given Firewalkers operating results, how much ordinary business income (loss) and what separately stated items [including the partners self-employment earnings (loss)] will it report on its return for the year? b. How will it allocate these amounts to its partners? c. How much self-employment tax will each partner pay assuming none have any other source of income or loss?
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The table below illustrates Firewalkers ordinary business income and separately stated items. Note that the total self employment income for all partners consists of Firewalkers $92,500 ordinary business income (because ordinary business income from a general partnership is always treated as self-employment income by the partners) plus the $20,000 in
Description Sales revenue Less: Cost of good sold Employee wages Depreciation expense Misc. expenses Guaranteed payments Ordinary Business Income Separately Stated Items on Schedule K-1: Interest income Long-term capital gains Self-employment income Total Jhumpa $340,000 (120,000) (75,000) (28,000) (4,500) (20,000) $92,500 $30,833 $30,833 $30,833 Stewart Kelly
$3,300 $1,100 $1,200 $400 $112,500 $40,833
$1,100 $400 $40,833
$1,100 $400 $30,833
guaranteed payments made to Dave and Stewart.
a. The table above reflects the partners shares of ordinary business income and her/his separately stated items. Note that each partners self employment income consists of her/his individual shares of ordi-
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nary business income plus the guaranteed payment she/he received, if any.
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b. The table below reflects the partners self-employment tax liability:

Description Stewart (1)Self-employment in- $40,833 come (2) Percentage of self employment income subject to self-employment tax (3) Earnings from selfemployment (4) Self employment tax rate (7) Self-employment tax liability $37,709 15.3% $5,769 $37,709 15.3% $5,769 $28,474 15.3% $4,357 (3) x (4) (1) x (2) 92.35% Jhumpa $40,833 92.35% Kelly $30,833 92.35% Explanation
64. [LO 4] {Research} Lane and Cal each own 50 percent of the profits and capital of HighYield LLC. HighYield owns a portfolio of taxable and municipal bonds, and each year the portfolio generates approximately $10,000 of taxable interest and $10,000 of tax- exempt interest. Lanes marginal tax rate is 35 percent while Cals marginal tax rate is 15 percent. To take advantage of the difference in their marginal tax rates, Lane and Cal want to modify their operating agreement to specially allocate all of the taxable interest to Cal and all of the tax-exempt interest to Lane. Until now, Lane and Cal had been allocated 50 percent of each type of interest income. a. Is HighYields proposed special allocation acceptable under current tax rules? Why or why not? {Hint: See Reg. 1.704-1(b)(2)(iii)(b) and 1.704-1(b)(5) Example (5).} b. If the IRS ultimately disagrees with HighYields special allocation, how will it likely reallocate the taxable and tax-exempt interest among the members? {Hint: See Reg. 1.7041(b)(5) Example (5)(ii).} a. According to IRC 704 partnership allocations will be respected by the IRS unless they do not have substantial economic effect. The facts provided are almost identical to the general scenario described in Reg. 1.704-1(b)(2)(iii)(b) and to the detailed facts described in 1.704-1(b)(5) Example (5) given that the special allocation to Lane and Cal simply changes the character of the income allocated to Lane and Cal but not the amount. Thus, this allocation is not appropriate because it is not substantial.
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b. As described in Reg. 1.704-1(b)(5) Example (5)(ii), the IRS will likely assert that 50 percent of both the taxable and tax-exempt bond interest should be allocated to Lane and Cal. 65. [LO 5] Larrys tax basis in his partnership interest at the beginning of the year was $10,000. If his share of the partnership debt increased by $10,000 during the year and his share of partnership income for the year is $3,000, what is his tax basis in his partnership interest at the end of the year? $23,000 as computed in the table below:
Description Beginning Tax Basis Increase in Partners Share of Debt Partners Share of Income Ending Tax Basis Total Amount $10,000 10,000 3,000 $23,000
66. [LO 5] Carmine was allocated the following items from the Piccolo LLC for last year: Ordinary business loss Nondeductible penalties Tax-exempt interest income Short-term capital gain Cash distributions Rank these items in terms of the order they should be applied to adjust Carmines tax basis in Piccolo for the year. Items that increase basis are applied first, then distributions, and then items that reduce basis. Thus, the items above should be applied in the following order to adjust Carmines tax basis: Tax Exempt Income and Short Term Capital Gain (basis increasing items come first) Cash Distribution (distributions come after basis increasing items) Ordinary Business Loss and Non-Deductible Penalties (basis reducing items come last) 67. [LO 5] Oscar, Felix, and Marv are all one-third partners in the capital and profits of Eastside general partnership. In addition to their normal share of the partnerships annual income, Oscar and Felix receive annual guaranteed payments of $7,000 to compensate them for additional services they provide. Eastsides income statement for the current year reflects the following revenues and expenses:
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Sales revenue Dividend income Short-term capital gains Cost of good sold Employee wages Depreciation expense Guaranteed payments Miscellaneous expenses Overall net income
$ 420,000 5,700 2,800 (210,000) (115,000) (28,000) (14,000) (9,500) $ 52,000
In addition, Eastside owed creditors $120,000 at the beginning of the year but managed to pay down its debts to $90,000 by the end of the year. All partnership debt is allocated equally among the partners. Finally, Oscar, Felix and Marv had a tax basis of $80,000 in their interests at the beginning of the year. a. What tax basis do the partners have in their partnership interests at the end of the year? b. Assume the partners began the year with a tax basis of $10,000 and all the debt was paid off on the last day of the year. How much gain will the partners recognize when the debt is paid off? What tax basis do the partners have in their partnership interests at the end of the year?
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a. All of the partners have an ending tax basis of $87,333 as calculated in the table below:
Description (1)Beginning tax basis (including partners share of debt) (2)Dividend income (3)Short-term capital gains (4)Partners share of ordinary business income Oscar $80,000 Felix $80,000 Marv $80,000 Explanation
$1,900 $933 $14,500
$1,900 $933 $14,500
$1,900 $933
$5,700 x 33.33% $2,800 x 33.33%
(5)Deemed distribution from debt repayment (6)Guaranteed payments received
($10,000) 0
$14,500[$52,000 overall net income - ($5,700 Dividend Income + $2,800 Short-Term Capital Gains)] x 33.3% ($10,000) ($10,000) [$120,000 $90,000] x 33.33% 0 Partners dont increase the basis of their partnership interests by the amount of guaranteed payments received $87,333 (1)+(2)+(3)+(4)+(5 )
(7)Ending tax basis
$87,333
$87,333
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b. Each partner recognizes gain of $12,667 and has an ending basis of zero as calculated in the table below:
Description (1)Beginning tax Basis (including partners share of debt) (2)Dividend income (3)Short-term capital gains (4)Partners share of ordinary business income Oscar $10,000 Felix $10,000 Marv $10,000 Explanation
$1,900 $933 $14,500
$1,900 $933 $14,500
$1,900 $933
$5,700 x 33.33% $2,800 x 33.33%
(5)Deemed distribution from debt repayment (6)Guaranteed payments received
($40,000) 0
$14,500 [$52,000 overall net income - ($5,700 Dividend Income + $2,800 Short-Term Capital Gains)] x 33.3% ($40,000) ($40,000) [$120,000 - $0] x 33.33% 0 Partners dont increase the basis of their partnership interests by the amount of guaranteed payments received $12,667 [(5)+(1)+(2)+(3)+(4) ] 0 Generally (1)+(2)+(3)+(4)+(5) but may not go lower than zero
(7)Gain recognized by partners (8)Ending tax basis
$12,667 0
$12,667 0
68. [LO 5] Pam, Sergei, and Mercedes are all one-third partners in the capital and profits of Oak Grove General Partnership. Partnership debt is allocated among the partners in accordance with their capital and profits interests. In addition to their normal share of the partnerships annual income, Pam and Sergei receive annual guaranteed payments of $20,000 to compensate them for additional services they provide. Oak Groves income statement for the current year reflects the following revenues and expenses: Sales revenue Dividend income Section 1231 losses Cost of good sold Employee wages
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$476,700 6,600 (3,800) (245,000) (92,000)
Depreciation expense Guaranteed payments Miscellaneous expenses Overall net income
(31,000) (40,000) (11,500) $ 60,000
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In addition, Oak Grove owed creditors $90,000 at the beginning and $150,000 at the end of the year, and Pam, Sergei and Mercedes had a tax basis of $50,000 in their interests at the beginning of the year. Also, Sergei and Mercedes agreed to increase Pams capital and profits interest from 33.3 percent to 40 percent at the end of the tax year in exchange for additional services she provided to the partnership. The liquidation value of the additional capital interest Pam received at the end of the tax year is $40,000. a. What tax basis do the partners have in their partnership interests at the end of the year? b. If, in addition to the expenses listed above, the partnership donated $12,000 to a political campaign, what tax basis do the partners have in their partnership interests at the end of the year assuming the liquidation value of the additional capital interest Pam receives at the end of the year remains at $40,000? a. Pams basis is $140,000, Sergeis basis is $65,000, and Mercedess basis is $65,000 as computed in the table below:
Description (1)Beginning tax basis (including partners share of debt) (2) Dividends income $2,200 $2,200 $2,200 $6,600 x 33.33% (Pams profits interest doesnt increase until the end of the year) $19,067 [$60,000 overall net income ($6,600 Dividend Income - ($3,800) Section 1231 Losses)] x 33.3% $15,000 Pam :[( $150,000 x 40%) ($90,000 x 33.33%)] Other Partners: [($150,000 x 30%) ($90,000 x 33.33%)] Pam Sergei Mercedes $50,000 $50,000 $50,000 Explanation Given
(3)Partners share of ordinary business income
$19,067
$19,067
(4) Debt increase (deemed cash contribution)
$30,000
$15,000
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(5) Pams new 6.67% capital interest
$40,000 ($20,000) ($20,000) Additional 6.67% capital interest to Pam is a guaranteed payment to Pam and a deduction allocated equally to other partners 0 0 Partners dont increase the basis of their partnership interests by the amount of cash guaranteed payments received ($1,267)($1,267) ($1,267) ($3,800) x 33.33% $140,000 $65,000 $65,000Sum of (1) through (7)
(6) Cash guaranteed payments received
(7) Section 1231 losses (8)Ending tax basis
b. Pams basis is $136,000, Sergeis basis is $61,000, and Mercedes basis is $61,000 as computed in the table below:
Description Ending tax basis given facts in part a. Campaign contribution Pam $140,000 ($4,000) Sergei Mercedes Explanation $65,000 $65,000See solution to part a. above ($4,000) ($4,000)($12,000) x 33.33% Non-deductible expenses must reduce a partners tax basis New ending basis given facts $136,000 $61,000 in part b. $61,000
69. [LO 6] Alfonso began the year with a tax basis in his partnership interest of $30,000. His share of partnership debt at the beginning and end of the year consists of $5,000 of recourse debt and $5,000 of nonrecourse debt. During the year, he was allocated $40,000 of partnership ordinary business loss. Alfonso does not materially participate in this partnership and he has $1,000 of passive income from other sources.
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a. How much of Alfonsos loss is limited by his tax basis? b. How much of Alfonsos loss is limited by his at-risk amount? c. How much of Alfonsos loss is limited by the passive activity loss rules? a. Because Alfonsos basis before the loss allocation is $30,000, $10,000 of his $40,000 loss allocation is limited by his tax basis and will carryover to the following year. b. Of the $30,000 loss not already limited by Alfonsos tax basis, $5,000 is limited because Alfonsos at-risk amount is only $25,000 ($30,000 regular tax basis less the $5,000 nonrecourse debt not allowed in calculating the at-risk amount). Thus, $25,000 of loss remains after the tax basis and at-risk limitations and Alfonso has a $5,000 at-risk carryover. c. Because Alfonso doesnt materially participate in the partnership, he may only deduct the $25,000 loss remaining after the tax basis and at-risk limitations to the extent he has passive income from other sources. Thus, he may deduct $1,000 of the $25,000 loss currently and will have a $24,000 passive activity loss carryover. 70. [LO 5, 6] {Research} Juan Diego began the year with a tax basis in his partnership interest of $50,000. During the year, he was allocated $20,000 of partnership ordinary business income, $70,000 of 1231 losses, $30,000 of short-term capital losses, and received a cash distribution of $50,000. a. What items related to these allocations does Juan Diego actually report on his tax return for the year? {Hint: See Reg. 1.704-1(d)(2) and Rev. Rul. 66-94.} b. If any deductions or losses are limited, what are the carryover amounts and what is their character? {Hint: See Reg. 1.704-1(d).}
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a. According to Rev. Rul. 66-94, Juan Diego should increase his basis first by his $20,000 share of ordinary business income and then reduce it by his $50,000 cash distribution. At this point, his remaining basis of $20,000 will be reduced to zero by the $70,000 Section 1231 losses and $30,000 short-term capital losses allocated to him. Reg. 1.704-1(d)(2) describes how Juan Diegos $20,000 tax basis before considering the loss allocations should be allocated to the two types of losses. The table below illustrates the required calculations:
(1) Original (2) Amount Deducted Loss Currently $70,000 $14,000 ($20,000 x $70,000/$100,000) $30,000 $6,000 ($20,000 x $30,000/$100,000) (1) (2) Loss Carryover $56,000 $24,000
Section 1231 losses Short-term capital losses
b. As indicated in the table above, Juan Diegos $80,000 loss carryover (due to his $20,000 tax basis limitation) will be characterized as a $56,000 Section 1231 loss and a $24,000 short-term capital loss. 71. [LO 6] Farell is a member of Sierra Vista LLC. Although Sierra Vista is involved in a number of different business ventures, it is not currently involved in real estate either as an investor or as a developer. On January 1, year 1, Farell has a $100,000 tax basis in his LLC interest that includes his $90,000 share of Sierra Vistas general debt obligations. By the end of the year, Sierra Vistas general debt obligations have increased to $100,000. Because of the time he spends in other endeavors, Farell does not materially participate in Sierra Vista. His share of the Sierra Vista losses for year 1 is $120,000 and, as a partner in the Riverwoods Partnership, he has year 1 Schedule K-1 passive income of $5,000. a. Determine how much of the Sierra Vista loss Farell will currently be able to deduct on his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations. b. Assuming Farrells Riverwoods K-1 indicates passive income of $30,000, determine how much of the Sierra Vista loss he will ultimately be able to deduct on his tax return for year 1 and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations. c. Assuming Farrell is deemed to be an active participant in Sierra Vista, determine how much of the Sierra Vista loss he will ultimately be able to deduct on his tax return for year 1 and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations.
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a.
72. [LO 6] {Research} Jenkins has a one-third capital and profits interest in the Maverick General Partnership. On January 1, year 1, Maverick has $120,000 of general debt obligations and Jenkins has a $50,000 tax basis in his partnership interest. During the year, Maverick incurred a $30,000 in nonrecourse debt that is not secured by real estate. Because Maverick is a rental real estate partnership, Jenkins is deemed to be a passive participant in Maverick. His share of the Maverick losses for year 1 is $105,000. Jenkins is not involved in any other passive activities and this is the first year he has been allocated losses from Maverick.
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a. Determine how much of the Maverick loss Jenkins will currently be able to deduct on his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations. b. If Jenkins sells his interest on January 1, year 2, what happens to his suspended losses from year 1? {Hint: See Sennett v. Commissioner 80 TC 825 (1983) and Prop. Reg. 1.465-66(a).} a. Jenkins may not deduct any losses currently, and he will have a $25,000 loss suspended by the tax basis limitation, a $30,000 loss suspended by the at-risk limitation, and a $50,000 loss suspended by the passive activity loss limitation as illustrated in the table below:
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Tax Basis At-risk Limita- Passive ActiviExplanation Limitation tion ty Limitation (1) Beginning $50,000 $50,000 General debt obligaTax basis and Attions of general partrisk amount nerships are treated as recourse debt. Thus, Jenkins beginning at-risk amount is the same as his beginning tax basis. (2) Increase in $30,000 $0 Nonrecourse debt nonrecourse generally not includdebt ed in at-risk amount. (3) Tax basis and $80,000 $50,000 (1) + (2) At-risk amount before ordinary business loss (4) Ordinary ($105,000) business loss (5) Loss clearing ($80,000) Loss limited to the Tax basis $80,000 tax basis hurdle (6)Loss suspend- ($25,000) (4) - (5) ed by Tax basis hurdle (7) Loss clearing ($80,000) (5) Tax basis hurdle (8) Loss clearing ($50,000) Loss limited to At-risk hurdle $50,000 at-risk amount (9) Loss sus($30,000) (7) - (8) pended by Atrisk hurdle (10) Passive ac($50,000) (8)Jenkins is not a tivity loss material participant (11) Passive in$0 Given come (12) Loss used to $0 Loss only used to the offset Passive inextent of passive income come (13) Passive ac($50,000) (10) (12) tivity loss carryover
Description
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b. According to Sennett v. Commissioner 80 TC 825 (1983), a partner with losses suspended by the tax basis limitation disappear when the partnership interest is sold. Thus, Jenkins will lose the $25,000 loss suspended by the tax basis limitation. In addition, Prop. Reg. 1.46566(a) provides that Jenkins may utilize the $30,000 loss suspended by the at-risk limitation to offset any gain he would otherwise report from the disposition of his partnership interest. Finally, Jenkins may deduct the $50,000 passive activity loss carryover in the year of disposition. 73. [LO 6] {Planning} Suki and Steve own 50 percent capital and profits interests in Lorinda LLC. Lorinda operates the local minor league baseball team and owns the stadium where the team plays. Although the debt incurred to build the stadium was paid off several years ago, Lorinda owes its general creditors $300,000 (at the beginning and end of the year) that is not secured by firm property or guaranteed by any of the members. At the beginning of the current year Suki and Steve had a tax basis of $170,000 in their LLC interests including their share of debt owed to the general creditors. Shortly before the end of the year they each received a $10,000 cash distribution, even though Lorindas ordinary business loss for the year was $400,000. Because of the time commitment to operate a baseball team, both Suki and Steve spent more than 1,500 hours during the year operating Lorinda. a. Determine how much of the Lorinda loss Suki and Steve will each be able to deduct on their current tax returns, and list their losses suspended by the tax basis, at-risk, and passive activity loss limitations. b. Assume that sometime before receiving the $10,000 cash distribution, Steve is advised by his tax advisor that his marginal tax rate will be abnormally high during the current year because of an unexpected windfall. To help Steve utilize more of the losses allocated from Lorinda in the current year, his advisor recommends refusing the cash distribution and personally guaranteeing $100,000 of Lorindas debt, without the right to be reimbursed by Suki. If Steve follows his advisors recommendations, how much additional Lorinda loss can he deduct on his current tax return? How does Steves decision affect the amount of loss Suki can deduct on her current return and the amount and type of her suspended losses?
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a. The members (either Steve or Suki) may deduct $10,000 in losses currently, and they will have a $40,000 loss suspended by the tax basis limitation, and a $150,000 loss suspended by the at-risk limitation
Tax Basis At-risk LimitaExplanation Limitation tion (1) Beginning $170,000 $20,000 General debt obligations of LLCs Tax basis and Atare treated as nonrecourse debt. risk amount Thus, Suki or Steves beginning at-risk amount is $150,000 less than their beginning tax basis. (2) Distribution ($10,000) ($10,000) (3) Tax basis and $160,000 $10,000 (1) + (2) At-risk amount before ordinary business loss Description
(4) Ordinary ($200,000) business loss (5) Loss clearing ($160,000) the Tax basis hurdle (6)Loss suspend- ($40,000) ed by Tax basis hurdle (7) Loss clearing Tax basis hurdle (8) Loss clearing At-risk hurdle and currently deductible (9) Loss suspended by Atrisk hurdle
$400,000 x50% Loss limited to $160,000 tax basis
(4) - (5) ($160,000) ($10,000) (5)
Loss limited to $10,000 at-risk amount on line (3). This amount is currently deductible because Steve is an active participant in the activity. ($150,000) (7) - (8)
as illustrated in the table below:
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Under these facts, Steve may deduct $120,000 in losses currently (a $110,000 increase over the loss he could deduct in part a.), and will
Tax Basis At-risk LimitaExplanation Limitation tion (1) Beginning $170,000 $20,000 General debt obligations Tax basis and Atof LLCs are treated as risk amount nonrecourse debt. Thus, Steves beginning at-risk amount is $150,000 less than his beginning tax basis. (2) Increase in $50,000 $100,000 [(100,000 + 50% x debt allocation $200,000) - $150,000] for tax basis and [100,000 0] for at-risk amount because guaranteeing the debt makes it recourse debt (3) Tax basis and $220,000 $120,000 (1) + (2) At-risk amount before ordinary business loss (4) Ordinary ($200,000) business loss (5) Loss clearing ($200,000) Loss is less than tax basis the Tax basis limitation hurdle (6)Loss suspend$0 (4) - (5) ed by Tax basis hurdle (7) Loss clearing ($200,000) (5) Tax basis hurdle (8) Loss clearing ($120,000) Loss is limited to at-risk At-risk hurdle amount on line (3). This and currently deamount is currently deductible ductible because Steve is an active participant in the activity. (9) Loss sus($80,000) (7) - (8) pended by Atrisk hurdle Description
have a $80,000 loss suspended by the at-risk limitation as illustrated in the table below:
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Suki may deduct $10,000 in losses currently (the same amount of loss as in part a.), and she will have a $90,000 loss suspended by the tax basis limitation and a $100,000 loss suspended by the at-risk limitation as illustrated in the table below:
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Tax Basis At-risk LimitaExplanation Limitation tion (1) Beginning $170,000 $20,000 General debt obligations Tax basis and Atof LLCs are treated as risk amount nonrecourse debt. Thus, Sukis beginning at-risk amount is $150,000 less than her beginning tax basis. (2) Distribution ($10,000) ($10,000) (3) Decrease in ($50,000) $0 [($200,000 x 50% ) debt allocation ($300,000 x 50%)] (4) Tax basis and $110,000 $10,000 (1) + (2)+ (3) At-risk amount before ordinary business loss (5) Ordinary ($200,000) business loss (6) Loss clearing ($110,000) Loss is limited to the tax the Tax basis basis hurdle (6)Loss suspend- ($90,000) ed by Tax basis hurdle (7) Loss clearing Tax basis hurdle (8) Loss clearing At-risk hurdle and currently deductible (9) Loss suspended by Atrisk hurdle (5) - (6) ($110,000) ($10,000) (6) Loss is limited to at-risk amount on line (4). This amount is currently deductible because Suki is an active participant in the activity. (7) - (8)
Description
($100,000)
74. [LO 6]{Research} Ray and Chuck own 50 percent capital and profits interests in Alpine Properties LLC. Alpine builds and manages rental real estate, and Ray and Chuck each work full time (over 1000 hours per year) managing Alpine. Alpines debt (both at the beginning and end of the year) consists of $1,500,000 in nonrecourse mortgages obtained from an unrelated bank and secured by various rental properties. At the beginning of the current year, Ray and Chuck each had a tax basis of $250,000 in his LLC interest including his share of the nonrecourse mortgage debt. Alpines ordinary business losses for the current year totaled $600,000 and neither member is involved in other activities that generate passive income.
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a. How much of each members loss is suspended because of the tax basis limitation? b. How much of each members loss is suspended because of the at-risk limitation? c. How much of each members loss is suspended because of the passive activity loss limitation? {Hint: See 469(b)(7).} a. Each member will have $50,000 of loss suspended because of the tax basis limitation as reflected in the table below:
Description (1) Beginning Tax basis and Atrisk amount
Tax Basis At-risk Limita- Passive ActiviLimitation tion ty Limitation $250,000 $250,000
Explanation Because the LLCs mortgage debt is qualified nonrecourse financing, it is included in both the tax basis and at-risk amount 50% x $600,000 Loss limited to $250,000 tax basis (2) - (3) (3) Loss limited to $250,000 at-risk amount (7) - (8)
(2) Ordinary ($300,000) business loss (3) Loss clearing ($250,000) the Tax basis hurdle (4) Loss sus($50,000) pended by Tax basis hurdle (5) Loss clearing ($250,000) Tax basis hurdle (6) Loss clearing ($250,000) At-risk hurdle (7) Loss suspended by Atrisk hurdle $0
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b. As indicated in the table above, none of the members loss allocation will be suspended because of the at-risk limitation. c. Each members $250,000 loss remaining after the tax basis and atrisk limitations (see table in part a.) is deductible currently. Although rental real estate ventures are generally treated as passive activities under 469(c)(2), 469(b)(7) provides an exception for taxpayers that work more than half of the time in real property trades or businesses and work more than 750 hours in real property trades or businesses in a given year. Given the facts in this problem, both members will be treated as active participants and will therefore be able to immediately deduct $250,000.
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Comprehensive Problems
75. [LO 2, 4, 5] Aaron, Deanne, and Keon formed the Blue Bell General Partnership at the beginning of the current year. Aaron and Deanne each contributed $110,000 and Keon transferred an acre of undeveloped land to the partnership. The land had a tax basis of $70,000 and was appraised at $180,000. The land was also encumbered with a $70,000 nonrecourse mortgage for which no one was personally liable. All three partners agreed to split profits and losses equally. At the end of the first year Blue Bell made a $7,000 principal payment on the mortgage. For the first year of operations, the partnership records disclosed the following information: Sales revenue $470,000 Cost of goods sold $410,000 Operating expenses $70,000 Long-term capital gains $2,400 Section 1231 gains $900 Charitable contributions $300 Municipal bond interest $300 Salary paid as a guaranteed payment to Deanne (not included in expenses) $3,000 a. Compute the adjusted basis of each partners interest in the partnership immediately after the formation of the partnership. b. List the separate items of partnership income, gains, losses, and deductions that the partners must show on their individual income tax returns that include the results of the partnerships first year of operations. c. (Optional) Using the information generated in answering parts a. and b., prepare Blue Bells page 1 and Schedule K to be included with its Form 1065 for its first year of operations along with Schedule K-1 for Deanne. d. What are the partners adjusted bases in their partnership interests at the end of the first year of operations?
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a. This initial adjusted basis for Keon is $23,333, for Aaron is $133,333, and for Deanne is $133,333 as shown in the calculations with table below:
Description (1) Basis in contributed land (2) Cash contributed (3) Debt allocated to partners (4) Relief from nonrecourse mortgage (5) Gain recognized Keon $70,000 Aaron Deanne Explanation
$23,333 ($70,000) $0
$110,000 $23,333
$110,000 $23,333
$0
$0(4 )- [(1)+ (2)+ (3)] if positive, otherwise 0 $133,333(1) + (2) + (3)+ (4) + (5)
(6) Partners initial tax basis
$23,333
$133,333
b. The partners shares of ordinary business loss and separately stated items are reflected in the table below:
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Description (1) Partners initial Tax basis (2) Sales revenue Less: (3) Cost of goods sold (4) Operating expenses (5) Guaranteed payments (6) Ordinary Business Loss Separately Stated Items on Schedule K-1: (7) Long-term capital gains (8) Section 1231 gains (9) Municipal bond interest (10) Charitable contributions (11) Mortgage reduction (deemed cash distribution)
Total
Keon Aaron Deanne Explanation $23,333 $133,333 $133,333See problem a. above
$470,000 (410,000) (70,000) (3,000) ($13,000) ($4,333) ($4,333) ($4,333)[Sum of (2) through (5)] x 33.33%
$2,400 $900 $300 ($300)
$800 $300 $100 ($100)
$800 $300 $100 ($100) ($2,333)
$800$2,400 x 33.33% $300$900 x 33.33% $100$300 x 33.33% ($100)($300) x 33.33% ($2,333)($7,000) x 33.33%
($7,000) ($2,333)
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(12) Self-employment Loss
($10,000) ($4,333)
($4,334)
($1,333)Line 6 + $3,000 guaranteed payment to Deanne 127,767(1) + (6)+ (7) through (11)
Partners ending tax basis
$17,767
127,767
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c. Blue Bell Partnerships page 1 and Schedule K to be included with Form 1065 and Deannes Schedule K-1 are shown below:
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d. Keon has an ending basis of $17,767, Aaron has an ending basis of $127,767 and Deanne has an ending basis of $127,767. These amounts are calculated in the table included with the solution to part b. above. 76. [LO 4, 5, 6] The TimpRiders Limited Partnership has operated a motorcycle dealership for a number of years. Lance is the limited partner, Francesca is the general partner, and they share capital and profits equally. Francesca works full-time managing the partnership. Both the partnership and the partners report on a calendar-year basis. At the start of the current year, Lance and Francesca had bases of $10,000 and $3,000 respectively, and the partnership did not carry any debt. During the current year, the partnership reported the following results from operations: Net sales Cost of goods sold Operating expenses Short-term capital loss Tax-exempt interest Section 1231 gain $650,000 $500,000 $160,000 $2,000 $2,000 $6,000
On the last day of the year, the partnership distributed $3000 each to Lance and Francesca. a. What outside basis do Lance and Francesca have in their partnership interests at the end of the year? b. To what extent does the tax basis limitation apply in restricting the partners deductible losses for the year? c. To what extent does the passive activity loss limitation apply in restricting their deductible losses for the year? Lance has an ending basis of $5,000 and Francesca has an ending basis of $0 as illustrated in the table below:
Description (1) Partners initial Tax basis Basis Increasing Items: (2) Section 1231 gain
Total
Lance
Francesca
Explanation
(Limited) (General) $10,000 $3,000Given
$6,000
$3,000
$3,000$6,000 x 50%
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(3) Tax-exempt interest (4) Basis Before Distributions (5) Cash distributions (6) Basis Before Loss Allocations (7) Sales revenue Less: (8) Cost of good sold (9) Operating expenses (10) Ordinary business loss (11) Short-term capital loss Partners ending tax basis
$2,000
$1,000 $14,000 ($3,000) $11,000
$1,000$2,000 x 50% $7,000Sum of lines (1) through (3) ($3,000)Given $4,000(4) + (5)
$650,000 (500,000) (160,000) ($10,000) ($5,000) ($2,000) ($1,000) $5,000 ($5,000)[Sum of (7) through (9)] x 50% ($1,000)($2,000) x 50% $0(6) + (10) + (11) or limited to a basis of zero. Thus, the tax basis limitation applies to Francesca.
a. As indicated in the table in part a., Lances loss allocations are not limited by his tax basis; however, Francescas total losses are limited to $4,000his tax basis prior to his loss allocations. b. Although Lances loss allocations are not limited because of his tax basis, his share of the ordinary business loss is classified as a passive activity loss because he is a limited partner. Thus, he must carryover his $5,000 ordinary business loss as a passive activity loss until he either receives passive income or he sells his partnership income. His $1,000 short-term capital loss is not limited because it is a portfolio rather than a passive loss. The passive activity loss rules dont apply to Francesca because he works full time managing the partnership and would be classified as a material participant.
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77. [LO 2, 4, 5] LeBron, Dennis, and Susan formed the Bar T LLC at the beginning of the current year. LeBron and Dennis each contributed $200,000 and Susan transferred several acres of agricultural land she had purchased two years earlier to the LLC. The land had a tax basis of $50,000 and was appraised at $300,000. The land was also encumbered with a $100,000 nonrecourse mortgage (i.e., qualified nonrecourse financing) for which no one was personally liable. The members plan to use the land and cash to begin a cattle-feeding operation. Susan will work full-time operating the business, but LeBron and Dennis will devote less than two days per year to the operation. All three members agree to split profits and losses equally. At the end of the first year, Bar T had accumulated $40,000 of accounts payable jointly guaranteed by LeBron and Dennis and had made a $9,000 principal payment on the mortgage. None of the members have passive income from other sources. For the first year of operations, the partnership records disclosed the following information: Sales revenue Cost of goods sold Operating expenses Dividends Municipal bond interest Salary paid as a guaranteed payment to Susan (not included in expenses) Cash distributions split equally among the members at year-end $620,000 $380,000 $670,000 $1,200 $300 $10,000 $3,000
a. Compute the adjusted basis of each members interest immediately after the formation of the LLC. b. When does each members holding period for his or her LLC interests begin? c. What is Bar Ts tax basis and holding period in its land? d. What is Bar Ts required tax year-end? e. What overall methods of accounting are available to Bar T? f. List the separate items of partnership income, gains, losses, deductions and other items that will be included in each members Schedule K-1 for the first year of operations. Use the proposed self-employment tax regulations to determine each members self-employment income or loss. g. What are the members adjusted bases in their LLC interests at the end of the first year of operations? h. What are the members at-risk amounts in their LLC interests at the end of the first year of operations?
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i. How much loss from Bar T, if any, will the members be able to deduct on their individual returns from the first year of operations? a. LeBrons adjusted basis is $216,667, Dennis adjusted basis is $216,667, and Susans adjusted basis is $16,667 as calculated in the table below:
Description (1) Basis in contributed land (2) Cash contributed (3) Debt allocated to susan only LeBron Dennis Susan Explanation $50,000
$200,000
$200,000 $50,000Nonrecourse debt > Susans tax basis in contributed property $16,667[$100,000 $50,000] x 33.33% ($100,000)
(4) Debt allocated to partners (5) Relief from nonrecourse mortgage (6) Gain recognized
$16,667
$16,667
$0
$0
$0(5 )- [(1)+ (2)+ (3)+ (4)] if positive, otherwise 0 $16,667(1) + (2) + (3) + (4) +(5)
(7) Partners initial tax basis
$216,667
$216,667
b. The holding period for LeBron and Dennis begins when they receive their LLC interests because they only contribute cash. In contrast, Susans holding period includes the holding period for the land he
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contributed since Susan held the land as either a capital or Section 1231 asset.
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c. Bar T receives a $50,000 tax basis in the land and will include Susans holding period as part of its holding period. d. Bar T must adopt a calendar year end because all of its members have calendar year ends. e. Bar T may adopt either the cash or accrual method of accounting. It may generally use the cash method because it does not have a corporate member. However, it must use the accrual method in accounting for its inventory related transactions (i.e., the hybrid method). The members separately stated items are listed on lines (2), (3), (11), and (13) in the table below. Note that LeBron and Dennis have self-employment income under the proposed regulations because they are responsible for some
Description (1) Members Initial Tax Basis (2) Dividends (3) Municipal bond interest (4) Deemed cash contribution from accounts payable (5) Cash distributions ($3,000) ($1,000) ($1,000) Total LeBron Dennis $216,667 $216,667 $400 $100 $20,000 $400 $100 $20,000 Susan Explanation $16,667See part a. above $400$1,200 x 33.33% $100$300 x 33.33% Accounts payable are only allocated to LeBron and Dennis because they guaranteed them ($1,000)
$1,200 $300 $40,000
of Bar Ts debt. Susan clearly has self-employment income under the proposed regulations because he works full time in the enterprise.
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(6) Deemed cash distribution to Susan for mortgage repayment
(7) Members Tax Basis Before Loss Allocation (8) Sales revenue Less: (9) Cost of good sold (10) Operating expenses (11) Guaranteed payments (12) Ordinary Business Loss (13) Self-employment loss $620,000 (380,000) (670,000) (10,000)
$236,167 $236,167
($9,000)Because Susan was originally allocated the first $50,000 of the nonrecourse mortgage, the repayment goes to reduce her share of the debt. $7,167Sum of (1) through (6)
($440,000) ($146,667 ($146,667 ($146,667[Sum of (8) through (11)] x ) ) ) 33.33% ($430,000) ($146,667 ($146,667 ($136,667Line (12) + ) ) )$10,000 guaranteed payment to Susan $0(7)+ (12) but not less than zero. Susan must carry over $7,167 + ($146.667) or ($139,500) of ordinary loss.
Members ending Tax basis
$89,500
$89,500
f. As indicated in the table in part f. above, the ending basis for LeBron is $89,500, the ending basis for Dennis is $89,500, and the ending basis for Susan is $0.
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g. Generally, the members at-risk amounts will be less than the amount of their tax bases to the extent they are allocated nonrecourse debt that is not qualified nonrecourse financing. In this case, the members at-risk amounts are the same as their tax bases in part g. because the nonrecourse mortgage is qualified nonrecourse financing and the accounts payable are treated as recourse debt (i.e., they are guaranteed by LeBron and Dennis). h. As indicated in the table in part f. above, the $146,667 loss allocated to LeBron and Dennis is not limited by their tax bases. However, given the facts provided, they cannot deduct their losses currently and each has a $146,667 passive activity loss carryforward because they are not material participants in the enterprise. As for Susan, her $146,667 loss is initially limited to her $7,167 tax basis leaving her with a $139,500 loss carryforward. However, because she is a material participant in Bar T, she may deduct the $7,167 currently.
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Tax Chapter 20 No Homework-Forming and Operating Partnerships

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Tax Chapter 20 No Homework-Forming and Operating Partnerships

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Chapter 20 - Forming and Operating Partnerships

Chapter 20 Forming and Operating Partnerships SOLUTIONS MANUAL Discussion Questions

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

160,000 (40,000) 220,000 220,000 220,000 780,000

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

(4) Relief from mortgage debt

Chapter 20 - Forming and Operating Partnerships

$0[(1)+ (2)+ (3) + (4)] $245,000(1) + (2) + (3)+ (4) + (5)

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Description (1) Beginning Basis in LLC

Dave Lance $0 $250,000

Debt Allocation (6) Ending Ba- $110,000 $195,000 sis in LLC

$195,000 (1) + (2) + (3) + (4) + (5)

Chapter 20 - Forming and Operating Partnerships

Capital: Nonrecourse Debt Capital-Lance Capital-Robert Capital-Dave Totals

$100,000 150,000 150,000 100,000 $500,000

100,000 450,000 450,000 100,000 $1,100,000

Chapter 20 - Forming and Operating Partnerships

Description (1) Beginning Basis in LLC (2) Ordinary Income

Dave Lance $0 $250,000

(1) + (2) + (3) + (4)

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Chapter 20 - Forming and Operating Partnerships

Months Deferral* (MD) 0 3 11

Months % x MD Deferral* (MD) 9 0 8

Months Deferral* (MD) 1 4 0