tax class notes
1. Balance Sheet
- Inside Basis (Tax)
- Basis of assets of PS for tax purposes
- Based on basis in hands of contributing P (723)
- Book Value (Book)
- Determined by PS with great latitude
- Starting point is FMV of the contributed assets
- Outside Basis (Tax Capital Acct)
- Basis of partners of their interest in the PS
- Represents the amount the P may withdraw without additional tax/gain (731, 741)
- Determines carryover basis of property distributed to partners (732), in which case outside basis deemed to wipe to 0 (704d)
- Cannot be negative. Stops at 0, excess results in capital gain (731). Any negative outside basis represents contribution needed from P.
- Determines amount of distributive share of PS loss that P can deduct at end of PS tax year in which loss is incurred. If limited, a proportionate share of each class is suspended (704d). Suspended losses carry forward indefinitely.
- Starting point is P's adjusted basis in contributed property (722/723/742)
- Calculated in 705(a) and (b) (direct method and indirect method)
- Direct 705(a): Adjusted by contributions and distributions: Increased by distributive share of income on last day of PS year, decreased by distributions, and finally decreased by distributive share of operating loss. Not adjusted for capital expenditures, which are just a change in form of assets.
- Increased by adjusted basis of property contributed, net of liabilities
- Indiredt 705(b): Calculate outside basis based on inside basis.
- Liabilities reflected in outside basis (752)
- When PS borrows money, PS liability matched by PS asset (the cash borrowed). Similar with pay-off of liability.
- When a P's share of PS liability increases/decreases, 752 treats increase in liability as deemed contribution of cash to PS, and decrease in liability as deemed cash distribution.
- Inside basis should be equal to outside basis. Exceptions for:
- Acquisition by other than contribution, i.e. by sale or exchange at FMV. Outside basis calculated under 742, partnership's basis unadjusted under 743, unless election made under 754
- G/L on distribution: Outside basis increased/decreased in amount of G/L without increase/decrease of total partnership inside basis.
- Distribution rules: Distribution resulting gain an increase/decrease in basis of PS assets, i.e. decrease in total basis of distributed assets under distribution limitation rules. See 732.
- 754 election to readjust inside to equal outside.
- Capital Account (Book)
- Capital Account, indicates P's relative economic interest and rights in the PS
- If negative, partners should have obligation to contribute to PS
- Credited with FMV of property contributed less any liabilities secured by the property
- Property transferred to PS without recognition of G/L. No tax upon contribution - 721a, even if in exchange for PS share.
- Basis carries over to PS.
- Contribution of encumbered property may trigger recognition of gain if 752 treats PS as assuming the contributing P's liabilities.
- Measure of whether gain/loss is recognized
- No gain or loss (tax) to P or PS upon distribution (731), unless exceptions apply (i.e. distribution in excess of basis)
2. Disposition: gain or loss on disposition (741)
- Measure of basis of distributed property
- Partners get carryover basis in distributed assets (732)
- Reduce outside basis by amount of basis of distribution (733)
- Reduce capital account by FMV of distribution (704)
3. Allocation of liquidating distribution: First to money, then unrealized receivables and inventory, the other property (732, 733). Loss recognized only if property distributed is cash, AR, and inventory. Amount of loss is unallocated/unrecovered basis (731). Basis of distributed property is adjusted basis of P's interest in PS, reduced by cash distributed in same transaction (732).
- Monthly distributions are treated as a loan against distributive share of income; gain not taken into account until end of year. 731.
- Loss Limitations
- Measure of amount of partner's allocable share of PS losses that can be used by partner to offset non PS income (704(d)).
- Partner's distributive share of PS loss is allowed only to the extent of adjusted basis of P's interest at the end of the PS year (determined by outside basis)
- Partnerships don't borrow money, partners do. 752
- Increases in partner's share of PS debt considered contribution of money (752); Decreases treated as distribution of money (752)
- On contribution of property subject to liability, outside basis increased by basis of contributed property, net of liability.
iv. Net to zero (for $1 of basis from debt, must have $1 of deemed distribution that will result in net basis impact of 0). (731(a), 733, 752(b))
- Reduction of partnership debt treated as a distribution of MONEY made on last day of PS year (752b). If deemed distribution exceeds basis = capital gain = phantom income (income without receiving cash).
- Generally, only general partners are liable for recourse debt, not limited partners. Debt doesn't increase outside basis of limited partners, because only the GP has economic risk of loss.
- Partner's outside basis increases by amount of recourse loan taken by partnership. 752a - debt incurred by the PS is considered a contribution of money by the partner to the partnership and increases the outside basis of the partners
- Partnership debt is recourse to extent partner bears economic risk of loss (752). i.e. if partner is bound to make payment if partnership liquidates. Economic risk of loss is determined through a constructive liquidation - all assets are worthless, and all partnership debt becomes immediately due and payable, to be paid by partners according to partnership agreement, assets sold for FMV, all items allocated. Capital accounts will likely be negative, that indicates how much each partner has economic risk of loss for.
- Recourse debt generally divided between the partners, regardless of who contributes the underlying property to the partnership. Debt reduces outside basis (i.e. if 50/50 partners, outside basis of each partner reduced by 50% of the debt); capital account reduced by all of the debt attached to underlying contributed asset.
- Assumption of liability by partnership results in decrease in basis to partner contributing underlying asset, but partner assumes economic risk for recourse debt so basis increased back up again by his % share. Recourse debt is a deemed cash contribution by the partner.
5. Flow-Through of Income
- Each partner takes into account separately his distributive share of partnership income (702). Distributive share determined by PS/ agreement (704), unless allocations in agreement doesn't have substantial economic effect.
- Partner's outside basis increased by distributive share of taxable income of PS (705). Includes separately stated items and bottom line income (702).
- Partner's outside basis [and capital account] decreased (but not below zero) by partnership distributions (733), and share of partnership loss and expenditures which are neither deductible or chargeable to a capital acct (705a)
- Sale by partnership of asset at gain is allocated first to contributing partner (704)
- Character of gain as capital or ordinary determined in the hands of the partnership - i.e., holding period determined by time held by the partnership. 724(c)
- Partner's distributive share of loss is deductible only to extent of P's outside basis at the end of the PS year in which the loss is incurred. Any nondeductible portion is carried forward indefinitely, and deductible if sufficient basis is restored (704d).
- Character of limited loss is pro rated by item / total loss x limited loss deduction
- Capital account also reduced, can reduce below zero.
- Nondeductible fines should be applied first so the fines aren't converted to tax loss
- Organization and syndication expenses are not deductible nor capitalizable. Each capital account is decreased by these amounts. Org. costs are amortized under 709b, 704-1. Org/Syn expenses increases inside basis; only org. increase book value (not syn. expenses because 704-1 says capital accounts are reduced by syn expenses). On liquidation of PS, the capital account has been already reduced by the syn expenses, which means the cap account is lower than the outside basis by that amount, resulting in a loss. So the partners recognize the "deduction" through that loss.
6. Allocations - 704b
- Validity determined annually (1.704-1b2i)
- P's distributive share determined by PS agreements (704a).
- Allocations per PS agreements must have economic effect (1.704-1b2iib)
- Rules (1.704-1) provide an elective safe harbor for allocations (if you meet these rules, you have substantial economic effect):
- P's capital accounts must be determined and maintained in accordance with 1.704-1b2iv, i.e., increased for contributions and book income/gain, decreased by distributions, etc.
- Upon liquidation of PS, liquidating distributions must be made in accordance with positive capital account balances;
- If deficit in capital account following liquidation, P is unconditionally obligated to restore deficit balance. [most PS's fail to meet this requirement]
- Economic effect must be substantial (1.704-1b2iib) - will affect the ultimate dollar amounts to be received by the P's from the PS, independent of tax consequences
- If PS agreement doesn't meet this test, under 1.704-1b2, allocations deemed to have economic effect at the end of the PS year if a liquidation of PS would produce the same economic results to the P's as the above rules.
- But if allocation in agreement does not have substantial economic effect, or if no allocation provided in the agreement, then P's distributive share is determined in accordance with P's interest in PS
- P's interest in PS is default standard under 704b, follows a cash-in-cash-out method, and is based on (1.704-1b3ii):
- relative contributions
- interest of P's in economic profits and losses
- interest of P's in cash flow and other non-liquidating distributions
- rights to distributions of capital upon liquidation.
- Loss gets allocated to the person who would have a loss upon liquidation.
- Allocations of built-in gain or loss under 704c:
- Built in gain = higher book value over inside basis.
- When property with FMV that differs from basis is contributed to PS, goal is to ensure that P who contributed the property receives benefits/burdens of built-in gain or loss on it and does not unreasonably shift burden to other P's.
- Built-in gain or loss is allocated to contributing P, not in accordance with allocations in PS agreement. Upon sale of property, tax gain allocated to contributing P up to amount of built-in gain. Excess allocated among P's in accordance with profit interests. Applies anytime there is built-in gain or loss, regardless of substantial economic effect test.
- Any allocated gain also increases P's outside basis
- Determine tax amount of item such as gain or depreciation
- Determine book amount of same item
- Allocate book amount of item among P's based on PS agreement
- Allocate tax amount of item to non-contributing P's up to amount of book allocation
- Allocate any excess tax amount to contributing P
i. For depreciable property, book depreciation allocated between P's in accordance with deduction or loss-sharing percentage.
ii. Tax depreciation contributed to noncontributing partner equal to book depreciation previously allocated, excess to contributing partner.
iii. If ceiling rule (amount of income/gain/loss/deduction allocated to the P's for tax purposes is limited to amount taken to account by PS) applies:
7. Nonrecourse Liabilities and Deductions (752-1)
- Both GP and LP share nonrecourse liabilities as they share PS profits.
- 752b treats decrease in P's individual liabilities by reason of PS assumption as a deemed distribution of cash from PS to P. 752a - increase in P's share of PS liabilities treated as deemed contribution of cash by P to PS. 733 says that deemed cash distribution from net relief of liabilities reduces contributor's outside basis in PS interest, but not below 0. If deemed distribution exceeds outside basis, contributor recognizes gain under 731a1 and 741.
- Assumption of P liability by PS decreases P's individual liabilities, but increases P's share of PS liabilities. Net decrease is treated as a deemed cash distribution (752). Under 733, deemed distribution reduces P's basis in PS interest. Balance in excess of 0 basis triggers capital gain under 731a and 741. Alternatives: Contribute property with higher basis, or remain personally liable to creditor.
- PS debt is nonrecourse if no P bears economic risk of loss for the liability
- Losses and deductions attributable to PS nonrecourse liabilities are nonrecourse deductions
- Nonrecorse deductions equals net increase in PS minimum gain (704-2c)
- PS minimum gain = gain PS would realize if it disposed of property subject to liability for no consideration other than full satisfaction of the liability (704-2d)
- Allocation (three part formula):
- Minimum Gain: Difference between the amount of a non-recourse debt and the book value of the encumbered property, allocated to the partner to whom the related non-recourse deductions were allocated (704b)
- Minimum gain chargeback allocates gain to the partner to whom non-recourse deductions were properly allocated. Allocates sufficient gain to partner to bring capital accounts back up to zero.
- 704c gain: Difference between (excess of) the amount of the non-recourse debt and the tax (inside) basis of the property, allocated to the partner who contributed the property
- Excess minimum gain: Allocated to the partner to whom the partnership expects the nonrecourse deductions will be properly allocated (generally allocated in accordance with PIP). P who receives nonrecourse deduction will receive matching allocation of income/gain when PS disposes of the property or repays the nonrecourse liability.
8. Sale or Exchange of PS Interest
- Generally, capital gain or loss equal to difference between amount realized and outside basis; amount realized includes P's share of PS liabilities.
- Gain on sale of PS is divided into two categories:
- Section 751 "collectibles" assets (unrealized receivables or inventory items): 28% tax
ii. Section 1250 Capital Gain: 25% tax
- Capital assets producing long term capital gain or loss: 15% tax
- Adjusted basis is determined as of date of sale or exchange (705)
- Income for year
- Interim closing of books; or
- Pro rata based on full year financials, determined under any reasonable method.
- Basis is cost plus debt assumed (742)
- Buyer takes seller's capital account (704)
9. Terminations, Divisions, Mergers
- Under 708a, PS continues until termination occurs. Under 708b, termination only occurs if:
- No part of the PS business continues to be conducted in a PS form; or
- Upon sale or exchange of 50% or more (aggregated) of the total interests in PS capital and profits within 12 month period.
- State law dissolution is not a termination
- Uniform Partnership Act secs. 601 and 801 provide circumstances under which PS may be dissolved and business must be wound up.
- CA PS Act Sec. 15031 and 15032 defines dissolution
d. Even if PS is dissolved, under 708 the PS continues until it is terminated. PS terminated only if no party of any business, financial operation, or venture continues to be carried out. (708b1A)
i. Terminated if sale or exchange of 50% or more of total interests in PS profit and capital within 12 month period (708b1B)
- If PS is terminated by sale or exchange, PS deemed to contribute all assets and liabilities to new PS in exchange for interest in new PS, and then terminated PS distributes interest in new PS to purchasing partner and other remaining P's in liquidation of old PS. (708). New PS inside basis equal to purchasing and continuing P's aggregate outside basis.
- When PS sells all assets, gain is allocated among partners, which increases their outside basis
- RR 99-6: For tax purposes to buying partner, PS is deemed to make a liquidating distribution of all assets to the partners. Basis carries over. Holding period begins day after sale, 735b (carryover holding period) doesn't apply.
- Basis of property PS distributes in liquidation of PS equals partner's basis in PS interest (732b)
- 731a1: No G/L on distribution
- 735b: P's holding period in assets includes PS's holding period
10. Hot Assets (751)
- 741: General rule is that taxpayer has gain on sale or exchange of PS interest equal to difference between amount realized and outside basis. Gain generally capital, subject to 751.
- 751 prevents conversion of ordinary income into capital gain
- 751a: Sales and Exchanges of PS interest
- Ordinary income recognized based on hypothetical sale to P of section 751 "hot" assets (unrealized receivables, depreciation recapture from 1245 and 1250 property, and inventory)
- Inventory items if substantially appreciated in value, if exceeds 120 percent of basis of all inventory items, including receivables attributable to inventory.
- Allocation of 751 items will generally be respected if at arm's length.
- Depreciation recapture: The amount by which the lesser of the recomputed basis of the property or the amount realized exceeds the adjusted basis of the property.
- Income/loss = same as if PS sold all property in fully taxable transaction for cash at FMV. Any gain or loss attributable to hot assets is ordinary gain or loss.
- Must file statement with return indicating date of sale, amount of 751 property gain/loss, any additional gain/loss (capital)
- 751b: Disproportionate Dispositions - focus on exchange table
- Applies when P is distributed more or less than P's share of ordinary income assets of PS.
- Classify assets as 751b or other
- Determine value of P's pre- and post-distribution interests in each asset
- Determine PS exchange table
- Determine which assets involved in 751b exchange
- Determine basis of assets
- Determine consequences of 751b exchange
- Treatment of portion of distribution not included in 751b exchange: Pretend that PS makes current distribution of assets to that P and then P exchanges those assets with the PS for the assets he or she got too much of. Gain or loss recognized on that deemed exchange, possibly by both P and PS.
- Ensures partners are allocated proper share of ordinary income
11. Rebalancing Basis: 754 Election
- Purpose: Prevents misallocation of income, gain, loss, or deduction. Maintains equality between inside and outside basis.
- Tax planning: Can increase / decrease basis of PS assets; can only revoke with consent of commissioner.
- 743: Allows for basis adjustment in PS property if 754 election made
- Determine total cash to PS from disposition by PS of all PS assets, immediately after the transfer of the PS interest, for cash equal to FMV of the assets
- Reduce that amount by PS debt to determine cash available to P's
- Determine transferee's % interest in PS capital (sum of transferee's interest as P in PS previously taxed capital, plus share of PS liabilities)
- Cash x % = T's interest in PS capital, = T' cash from hypothetical transaction
- Add tax loss or subtract tax gain from hypothetical transaction to determine T's share of previously taxed capital
- Add T's share of PS debt equals T's share of adjusted basis of the assets of the PS
- Take T's basis in purchased PS interest less T's share of adjusted basis of the assets of the PS to determine his adjustment amount
- Basis allocation (755) must be done on an asset-by-asset basis, first by class of asset (capital, 1231(b), all other ordinary income) then by individual asset. The effect of 734b is to reallocate basis among the capital assets, while leaving the basis of ordinary assets unchanged.
12. Partner-Partnership Transactions
- P acting as partner compensated as P = Subchapter K applies, taxed as P
- P acting as third party and compensated as third party = Taxed as third party for purchases/sale/lease of property with PS, lend/borrow money from PS
- P acting as P but compensated as TP (i.e. for services rendered or otherwise determined without regard to PS income) = Guaranteed payments, authorized 707c
- Purported partner = Taxed as third party
- Receipt of partnership interest for services rendered by P taxed at FMV as ordinary income under 61. Treated as receiving interest if entitiled to receive PS assets upon liquidation, vs. just right to receive future PS profits
- P's subject to business risk, TP's not
- P status suggests that payment is fee or return for property
- Allocation/distr. close in time to P services
- Facts and circumstances - P became P just to obtain tax benefit, treatment not available if same circumstances as TP
- Value of services in relation to fee
- Guaranteed Payments - 706a
- Ok: Law firm contingent fees, broadway play producers
- Income to recipient, deductible by PS
- No impact on P's capital account or basis
13. Payments to Retiring Partners (736)
- If primarily capital as material income producing factor, see 736b
- Depreciation recapture
- Even if capital is not material income producing factor, PS property includes goodwill provided for in PS agreement
- Taxed as distribution (731)
- Disproportionate under 751b?
- Dist. of money in excess of adj. basis is capital gain
- No deduction to PS
- If capital NOT material income producing factor, 746a applies
- Goodwill provided for in PS agreement is stated goodwill, taxed under 736b. Other goodwill and unrealized receivables taxed under 736a.
- Ordinary income to recipient and deductible by remaining P's
- Balance of transaction taxed under 736b
14. Limited Liability Companies (7701)
- LLP - For accountants, lawyers, architects
- Not liable for debts of PS, therefore debt is non-recourse, and allocations do not have substantial economic effect
- See 1.704-2(e) for provisions providing for allocations despite no substantial economic effect