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Chapter C9

Partnership Formation and Operation

Discussion Problems

C9-1 Advantages of a partnership for Yong and Li include:1. The partnership itself is not subject to tax, thereby eliminating the problem of

double taxation that exists for C corporations. p. C9-4.2. Partners may divide the partnership's profit or loss among themselves without

regard to their proportionate capital interests. pp. C9-17 through C9-20.3. Partnerships are popular because of the relative simplicity and informality

inherent in creating and operating such entities. No legal agreement is required to form a partnership but a written agreement is advisable. p. C9-2.

4. Under the conduit principle of taxation, partnership losses and other items receiving special tax treatment flow through to the partners. p. C9-4.

C9-2 A corporation provides limited liability protection for the business owners while a general partnership does not. The purchase of the inn is likely to be financed with debt and additional debt is likely to be incurred during the renovations. The construction required during the renovation and the day-to-day operation of the inn provide significant exposure for liability from lawsuits. The partnership form would not protect the owners of the business from possibly losing their individual assets. pp. C9-2 and C9-3.

C9-3 Since Sam will be providing business advice, this partnership should be arranged as a general partnership. Both brothers will be actively managing the business and therefore limited liability protection would not be available to Sam if the partnership is created as a limited partnership with Sam as the limited partner. pp. C9-2 and C9-3.

C9-4 Whether Doug receives a profits interest or a capital and profits interest, he must report the value of the property he receives for services as ordinary income. The amount he reports as income is the initial basis for his partnership interest. While there is no theoretical difference in the receipt of a profits interest, practically it is seldom possible to value solely a profits interest. If the profits interests can not be valued, Doug recognizes no income and has a zero basis in his partnership interest. pp. C9-10 and C9-11.

C9-5 a. The existing partner could contribute the property tax-free to the partnership, but Sec. 704(c) makes it mandatory that the tax attributes from contributed property must be allocated to the partner that contributes the property. Under Sec. 704(c), the partners must specially allocate among themselves the income, gain, loss and deductions attributable to contributed property in a manner which reflects the difference between the property's FMV and its tax basis at the time of the contribution. In addition, the partnership will have the property with a carryover basis which is below its FMV. For depreciable assets, the partnership will get

C9-1

smaller depreciation deductions and the special allocation of depreciation among the partners may not totally compensate the other partners. pp. C9-5 through C9-12 and C9-18 through C9-20.

b. Sell or lease the property to the partnership, or sell the property to a third party who then contributes the property to the partnership. pp. C9-26 and C9-27.

c. Ordinary income recognition is required on a partner's sale of property to the partnership where the seller owns more than 50% of the capital or profits interests if the property is either depreciable, or is not a capital asset, in the hands of a partnership. If the partner leases property to a partnership, the partner retains the depreciation and other deductions with respect to the property. The leasing partner also avoids the depreciation recapture provisions. Rentals received from the partnership are taxed as ordinary income. A sale of the property to a third party is taxed as any other sale would be with no special tax consequences. pp. C9-26 and C9-27.

C9-6 a. The partner must recognize gain on the contribution of property and assumption of a liability if the amount of the liability assumed by the other partners exceeds the contributing partner's basis in the contributed property plus her share of existing partnership liabilities. pp. C9-5 through C9-7.

b. The basis in the partnership interest will be decreased by the amount of the liability assumed by the other partners. pp. C9-7 and C9-8.

C9-7 a, b, and d. p. C9-12.

C9-8 Partnership ordinary income, or Sec. 702(a)(8) income, is the total of partnership income and deduction items which do not have to be separately stated. This partnership has $100,000 of ordinary income. Partnership taxable income is the sum of all taxable items which are either separately stated or included in ordinary income. BW has taxable income of $150,000 ($100,000 ordinary income + $50,000 long-term capital gain). p. C9-17.

C9-9 b, c, d, e, and g. pp. C9-15 through C9-17.

C9-10 The partner's distributive share will equal the sum of his earnings for one-half of his beginning-of-the-year interest for the entire year and his earnings for the other one-half of his beginning-of-the-year interest for nine months (calculated on a daily basis). pp. C9-17 through C9-18.

C9-11 Yes. A limited partner's basis can be increased by recourse liabilities only to the extent the limited partner is liable to stand an economic loss. This would add to the limited partner's basis any amounts that he would be obligated to repay a general partner should the general partner have to pay the debt as well as any amounts of the debt which were guaranteed by the limited partner. pp. C9-20 through C9-24.

C9-2

C9-12 Qualified nonrecourse real estate financing is included in the at-risk basis of both general and limited partners. This financing meets the requirements for qualified nonrecourse real estate financing. pp. C9-24 and C9-25.C9-13 The Sec. 704(d) loss limitation rule is less restrictive than the at-risk rules. Section 704(d) limits the loss to the adjusted basis (before reduction by current year's losses) of a partner's interest in the partnership at the end of the partnership tax year in which the loss is incurred. The at-risk rules reduce this basis amount by any nonrecourse debt. pp. C9-23 through C9-25.

C9-14 As a limited partner in the JRS Partnership, Jeff is almost certainly subject to the passive loss limitation rules on losses from this partnership. Accordingly, income from a general partnership in which Jeff does materially participate (and thus earns active income) cannot be used to offset the passive losses. Losses from the JRS Partnership can only be used to offset passive income or can be claimed when Jeff sells the entire interest in the JRS Partnership or the partnership terminates. pp. C9-25 and C9-26.

C9-15 ABC Partnership will hold the land as inventory for resale to customers and not as a capital asset. Since Helen owns more than a 50% interest in the ABC Partnership, the sale of the land to the partnership will generate ordinary income instead of capital gain for Helen. If Helen instead contributes the land to the partnership, no gain will be recognized until the partnership sells the lots. Then, when each lot is sold, Helen will recognize the pre-contribution gain as well as her share of any post-contribution appreciation and all of the gain will be ordinary income taxable at a marginal rate(s) of up to 39.6%. In total, the ordinary income under this alternative will be the same as if Helen had sold the land to the partnership. A contribution will allow her to delay the gain recognition. Even better results occur if Helen can dispose of 5% or more of her partnership interest so then she owns, directly and indirectly, 50% or less of the ABC Partnership. If she owns 50% or less, she can recognize capital gain on the sale of the land to the partnership and use these gains to offset any capital losses she may have already recognized or that she may desire to recognize. The capital gains are taxed to most taxpayers at a maximum marginal tax rate of 20% or up to 19.6 percentage points below the rate applicable to ordinary income. Alternatively, she could sell the land to a third party who would then contribute the land to the ABC Partnership. Her gain on the sale of the land would then be capital gain, and the contributing partner would recognize no gain when the land was transferred to the partnership. pp. C9-26 and C9-27.

C9-16 A guaranteed amount is stated as a fixed dollar amount regardless of the partnership's income or loss. A guaranteed minimum can only be determined after the profitability of the partnership's operations has been determined. A guaranteed minimum may be paid partly out of the partner's distributive share and partly as a guaranteed payment which total to the amount of the guaranteed minimum. pp. C9-27 and C9-28.

C9-17 Regulation Sec. 1.707-1(c) provides that a partner reports guaranteed payments as ordinary income in the partner's tax year which includes the last day of the partnership's tax year in which the partnership deducted the payments under its method of accounting. A partner's

C9-3

distributive share of partnership items (determined under Sec. 702(a)) is reported in the tax year which includes the last day of the partnership's tax year. Thus, to report the two payments is the same to Tracy. pp. C9-27 and C9-28.

C9-18 The Sec. 704(e) rules apply only to a capital interest in a partnership, where capital is a material income producing factor, and where the family member is the true owner of the interest. If capital is a material income producing factor for the partnership, the family partnership rules apply. pp. C9-29 and C9-30.

C9-19 The distributive shares allocated to Andrew and Steve will be combined and then a reasonable salary for Andrew's personal services will be allocated to him. The remaining portion of the distributive share (after a reasonable salary to Andrew) will be allocated 30/50ths to Andrew and 20/50ths to Steve. pp. C9-29 and C9-30.

Issue Identification Questions

C9-20 · Does Bob recognize any gain on the formation? When will his precontribution gain be recognized?· What is Bob's basis and holding period for his partnership interest?

· Does Kate recognize any loss on the contribution of property in exchange for her partnership interest? When will her precontribution loss be recognized? What will the character of the loss be?· What is Kate's basis and holding period for the partnership interest she

received in exchange for property?· What basis and holding period does the partnership have in the property received?· What happens to the depreciation recapture for the building?· Did Kate receive any of her partnership interest for services?

· If so, what gain/loss/deductions must the partnership recognize?· What income must Kate recognize?

Bob must determine his basis in the partnership interest ($65,000 = $95,000 - $60,000 + $30,000 share of liabilities) and his holding period for his interest in the partnership (begins with his ownership of the office building). Since Bob recognizes no gain or loss, he does not have to be concerned with any recapture potential under Sec. 1250. Bob will have to recognize precontribution gain on the office building at a future date.

Kate must determine her basis in the partnership interest ($105,000 = $75,000 + $30,000 share of liabilities) and her holding period for her interest in the partnership (begins with her ownership of the land). Kate recognizes no loss at the time of the partnership formation. If the land was a capital asset to Kate and the land is sold by the partnership within five years of Kate's contribution, the loss will be a capital loss up to $25,000 and that capital loss will be allocated to Kate as a precontribution loss. After five years, the character of the loss will be determined by the character of the land to the partnership,

C9-4

but Kate will still have to report any precontribution loss which is recognized. Guaranteed payments will be reported as ordinary income.

The partnership must be concerned with the basis and holding period of the assets it receives (carryover for both basis and holding period). The partnership can deduct from ordinary income the guaranteed payments made to Kate.

There is an additional tax issue which must be addressed. Bob contributed property with a net value of $70,000 for a one-half interest in the partnership while Kate contributed property with a net value of only $50,000 for a one-half interest in the same partnership. The total partnership has a net value of $120,000 ($130,000 + $50,000 - $60,000 liability). There must be some explanation. One possibility is that Bob has made a $10,000 gift to Kate. If this is so, both partners bases must be adjusted to reflect the gift. Alternatively, the facts suggest that Kate may be receiving some of her partnership interest in exchange for her services in managing the business for the first year while receiving no guaranteed payment. If this is so, Kate must recognize ordinary income and increase her basis for the value of the partnership interest she received in exchange for services. If Kate is receiving some of her partnership interest for services, the partnership must recognize gain or loss in the partnership assets she is deemed to receive and must adjust the basis of the assets for her deemed recontribution. The partnership must also deduct the guaranteed payment. pp. C9-5 through C9-12.

C9-21 · What items qualify as organizational expenses, which are start-up expenses, and which can be expensed now?· Does the partnership want to amortize organizational expenses and/or

start-up expenses? If so, over what time period does the amortization occur?

· When does the partnership business begin?

The partnership must first characterize each expense as an organizational expense, a start-up expense (Chapter C3), another expense to be capitalized or as a current period expense. The costs of drawing up the partnership agreement and of establishing the accounting system are organizational expenses. The expenses of searching for a retail outlet is a start-up expense, and the expense of having an income statement prepared is a current period expense.

The partnership must then decide if it wants to amortize the organizational and start-up expenses. Usually a partnership would choose to amortize the expenses since the alternative is to let the expenses sit in an asset account until the partnership ceases to do business. If the partnership decides to amortize the expenses, the election under Sec. 195 and/or Sec. 709 must be made. Each of the accounts can be amortized over not less than 60 months, but most taxpayers see no reason to amortize over any period longer than the minimum.

C9-5

Another issue the partnership must face is when is the partnership is considered to begin business. Regulation Sec. 1.709-2(c) states that business begins when the partnership "starts the business operation for which it was organized." Amortization of both the organizational expenses and the start-up expense begins with the month in which business begins. p. C9-12.

C9-22 · Is the receipt of a profits interest in the ABC Partnership in exchange for Cara's services a taxable event?· If it is a taxable event, what is the amount of character of the income that

is recognized?· What is Cara's basis and holding period for her partnership interest?

The receipt of the partnership interest is not a taxable event. Under Rev. Proc. 93-27 (1993-2 C.B. 343), the receipt of a profits interest is taxable only under circumstances where the FMV of the interest can be readily determined. This situation does not fit into one of the three exceptions contained in the revenue procedure guidelines as being a taxable event. pp. C9-10 through C9-12.

C9-23 · What is George's basis in his partnership interest?· Does the repayment of the partnership liability cause an adjustment to

George's basis in his partnership interest?· Is the repayment of the nonrecourse liability a taxable event for George?

If so, what is the amount and character of the income reported?

Repayment of partnership liabilities are treated as distributions to the partners. A distribution made to a partner that is in excess of their basis for the partnership interest produces a taxable gain. The gain can be calculated as follows:

Basis at the beginning of the year $15,000 Plus: George's share of income

(0.20 x $20,000) 4,000 George's basis before the distribution $19,000 Minus: George's deemed distribution from

repayment of partnership liability (0.20 x $100,000) (20,000)

George's recognized gain $ 1,000

pp. C9-21 through C9-24.

C9-24 · What is Katie's deductible loss from her partnership investment?· What is Katie's Sec. 704(d) basis in her partnership interest?· What is Katie's at risk basis in her partnership interest?· Is the loss from the JKL Partnership a passive loss?

C9-6

· Does Katie have passive income from this investment or other investments? If so, can she deduct her losses? If not, do the losses carryover to later years?

As a limited partner, Katie is presumed not to materially participate in the partnership. Therefore, her loss can not be deducted because it is a loss from a passive activity unless she has passive income from other investments, or she terminates her interest in the limited partnership. If no such income exists, they carry over to later years. pp. C9-23 through C9-26.C9-25 · Do the family partnership rules apply when there is no family

relationship?· Does reasonable compensation need to be paid to Daniel for his services?· If so, what is reasonable compensation for Daniel's services?

· Does David need to be recognized as a partner in the CD Partnership?· If so, what is David's allocable share of the partnership income?· What is Daniel's allocable share of the partnership income?

The family partnership rules are written in terms of the donor-donee relationship. Accordingly, they apply in this situation. Both Daniel and David would be allocated a reasonable compensation amount. Then the remainder of the income originally allocated to Daniel and David would be reallocated to them based on their relative capital interests. pp. C9-29 and C9-30.

Problems

C9-26 a. Neither partner recognized gain nor loss (Sec. 721).

b. Suzanne Bob Basis of contributed property $59,000 $95,000Minus: Partnership assumption

of individual liabilities (80,000)a

Plus: Share of partnership liabilities 40,000 40,000Basis in partnership $99,000 $55,000

a Bob's basis can also be determined by reducing the basis of his contributed property by the liabilities assumed by the other partner ($95,000 - $40,000 = $55,000).

c. The partnership takes a carryover basis in each asset: inventory (securities), $14,000; land, $45,000; and building, $50,000.

d. Amount realized $20,000Minus: Adjusted basis ( 14,000)Realized gain $ 6,000

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Precontribution gain of $1,000 ($15,000 FMV at contribution - $14,000 basis) is allocated to Suzanne. The remaining $5,000 gain is shared equally by Bob and Suzanne. Suzanne reports $3,500 of gain and Bob reports $2,500 of gain. The gain is ordinary (and not capital) because the property was inventory to Suzanne and the partnership sold the inventory within five years of its contribution. pp. C9-5 through C9-10 and C9-20 through C9-21.

C9-27 a. Fred recognizes ordinary income (compensation) of $15,000. Ed recognizes $87,000 (calculated in part c below) of capital (Sec. 1231) gain. The other partners do not recognize any gain or income.

b. The partnership recognizes no gain, loss or income on the transfers.c. Al: $ 15,000 Cash contribution

19,500 Mortgage allocated to partner$ 34,500 Basis of partnership interest

Bob: $ -0- Accounts receivable basis to Bob 26,000 Mortgage allocated to partner$ 26,000 Basis of partnership interest

Clay: $ 13,000 Equipment basis to Clay 19,500 Mortgage allocated to partner$ 32,500 Basis of partnership interest

Dave: $ 50,000 Land basis to Dave 19,500 Mortgage allocated to partner$ 69,500 Basis of partnership interest

Ed: $ 15,000 Building basis to Ed

(130,000) Mortgage contributed to partnership 26,000 Mortgage allocated to partner($89,000) Tentative basis (and amount of gain recognized)$ -0- Actual basis (basis cannot be less than zero)

Fred: $ 15,000 Services contributed by Fred 19,500 Mortgage allocated to partner$ 34,500 Basis of partnership interest

d. Cash, $15,000; building, $15,000; accounts receivable, $-0-; organizational expenditures, $15,000; equipment, $13,000; and land, $50,000.

e. There is no depreciation recapture on the building since straight-line MACRS depreciation has been used. The depreciation recapture potential for the office equipment carries over to the partnership. It will be recognized when the partnership sells or exchanges the property in a taxable transaction.

f. If Fred's profits interest had an ascertainable value, the result is unchanged. If the profits interest has no ascertainable value at the time of the transaction, Fred recognizes no

C9-8

income and the partnership has no organizational expenditure for which an amortization deduction can be claimed.

g. Partnership: Amount realized $ 9,000 Minus: Adjusted basis ( 50,000) Recognized loss ($41,000)

Dave: Pre-contribution loss: Fair market value $15,000 Minus: Adjusted basis 50,000 Pre-contribution loss ($35,000)

Total loss $41,000 Minus: precontribution loss (35,000) Post-contribution loss $ 6,000

Pre-contribution loss $35,000 Plus: Share of post-contribution loss (0.15 x $6,000) 900 Dave's distributive share of loss $35,900

Other Partners: Post-contribution loss allocated to other partners ($6,000 - $900) $ 5,100

Note that each partner can claim his share of the $5,100 loss only when he has enough basis in his partnership interest. pp. C9-5 through C9-11, and C9-18 and C9-19.

C9-28 a. Julie and Kay recognize no income on the partnership formation. Susan recognizes ordinary income equal to the value of the partnership interest received, or $30,000.

b.

Julie Kay Susan

Basis of property contributedPlus: Share of liabilitiesMinus: Liabilities assumed by partnershipPlus: Income recognizedBasis in partnership interest

$ -0- 27,000

$27,000

$80,000 36,000

(90,000) $26,000

N/A$27,000

30,000 $57,000

c. Accounts receivable $ -0- Land 50,000 Building 30,000 Organizational expenditure 30,000

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d. All of Kay's precontribution loss is allocated to her and the remaining loss, if any, is shared ratably among the three partners.

Julie (30%)

Kay (40%) Susan (30%)

Total (100%)

Precontribution loss*Postcontribution loss**Total loss

$ 600 $ 600

$30,000 800

$30,800 $ 600 $ 600

$30,000 2,000

$32,000

*$50,000 basis - $20,000 FMV = $30,000 precontribution loss.**$20,000 FMV - $18,000 sales price = $2,000 postcontribution loss.

pp. C9-5 through C9-12, C9-18 and C9-19.

C9-29 a. Sean reports $75,000 of ordinary income and has a $75,000 basis in his partnership interest. The partnership deducts $75,000 as compensation. The partnership (and the remaining partners) must also recognize gains and losses as if 20% of each asset had been sold at its FMV to pay for Sean's services. The basis in each asset having a gain (or loss) related to it will be adjusted upward (or downward) by the amount of the gain (or loss) recognized.

b. Under the Sol Diamond case, if there is an ascertainable FMV for the interest, such value must be reported as income by Sean and is deductible by the XYZ Partnership. If there truly is no ascertainable FMV for the 20% interest, neither Sean nor the XYZ Partnership has any current tax consequences. See Rev. Proc. 93-27 where the IRS indicated that only in three specific instances will it tax a profits interest received for services. pp. C9-10 through C9-12.

C9-30 Marjorie: Income: $15,000 ($20,000 FMV of interest - $5,000 cash)Basis in partnership interest: $15,000 income recognized + $5,000 cash contributed + Marjorie's share of partnership liabilities (not given in problem).

Eldorado: Capitalizes the $15,000 as part of the capital raised by the partnership. This amount is a syndication fee and can not be deducted now nor amortized in the future as an organizational expenditure. The $5,000 cash contribution increases the partnership's assets. Marjorie's capital account includes $15,000 + $5,000, or $20,000.


C9-10

C9-31 a.

Possible Tax Year-ends

6/30 9/30 10/31

PartnerName

PartnershipInterest

TaxYear

MonthsDeferred Total

MonthsDeferred

Total

MonthsDeferred Total

BethCindyDelux

1/31/31/3

6/309/3010/31

034

.00 1.00 1.33 2.33

901

3.00 .00

.33 3.33

8 11

0

2.67 3.67 .00 6.34

The partnership must use a June 30 year-end, or with a Sec. 444 election, a tax year which ends on March 31, April 30, or May 31.

b. The natural business year which ends on January 31.c. The partnership would be required to use an October 31 year-end, or the tax year

of the majority partner. Alternatively, if IRS permission was received, a natural business year-end (January 31) could be used, or with a Sec. 444 election, a tax year which did not exceed a three-month deferral of income could be used. pp. C9-12 through C9-15.

C9-32 a. The tax year-end of majority partners Bipin and Damien is December 31, and this is the required year-end for the partnership.

b. Yes. Possible year-ends are those that allow for no more than a three-month deferral from the required December 31 year-end. These include September 30, October 31, and November 30. pp. C9-12 through C9-15.

C9-33 a. Separately stated items:Dividends $ 19,000* Municipal bonds interest 18,000 Corporate bond interest 29,000* Pre-contribution gain on land specially allocated to Karen 25,000** Sec. 1231 loss 28,000 Net long-term capital loss 4,000 Short-term capital losses 5,000 Charitable contributions 23,000 Investment interest expense 16,000* Guaranteed payment to Karen 37,000 Rehabilitation expenditure 164,000

*Items which must be separately stated so that investment interest limitation and portfolio income can be properly reported by the partners.

**The land was held by Karen as inventory and therefore will generate $40,000 of ordinary income if sold by the partnership within five years of the contribution. All pre-contribution gain ($25,000) must be allocated to Karen while the remaining $15,000 of post-contribution gain is shared by all of the partners in part b.

b. KLM's ordinary income:Operating profit (minus guaranteed payment [$120,000 - $37,000] $83,000 Post-contribution gain on land contributed by Karen 15,000 MACRS depreciation allowance (36,000) Ordinary income $62,000


C9-34

TransactionBook

Income

(a.)Taxable Income

(b.)Ordinary Income

(c.)Separately

Stated Items

INCOMEOperating ProfitRental incomeInterest municipal bondsInterest corporate bondsDividendGain on investment landLTCGSTCLSec. 1231 gainSec. 1251 gainEXPENSESDepreciationInterest:

MortgageMun. bond loan

Guaranteed paymentTOTAL

$ 94,000 30,000 15,000 3,000

20,000 60,000 10,000

( 7,000)9,000

44,000

( 39,000)

( 18,000)( 5,000)( 30,000)

$186,000

$ 94,000 31,000*

3,000 20,000 66,000b 10,000

( 7,000) 9,000

44,000

( 41,000)d

( 18,000)

-0- e $211,000

$ 94,000

44,000

( 29,000)

( 30,000)$ 79,000

$ 31,000 15,000 3,000

20,000 66,000c 10,000

( 7,000) 9,000

12,000

( 18,000) ( 5,000) 30,000

a Prepaid rental income is reported for tax purposes when it is received.b For financial accounting purposes, the basis of the land was $15,000 and gain of $60,000 was reported. The tax basis was $6,000 smaller so the tax gain would be $6,000 larger.

c The precontribution gain of $6,000 ($15,000 - $9,000) must be specially allocated to Jim while the postcontribution gain of $60,000 ($66,000 total gain - $6,000 precontribution gain) is allocated ratably to all three of the partners.d MACRS depreciation is used for tax purposes.e Note that the guaranteed payment has no net effect on taxable income. The guaranteed payment both reduces ordinary income and increases separately stated income items that are taxable.

Each partner will be notified of his share of low income housing expenditures qualifying for the credit.

pp. C9-15 through and C9-20.

C9-35 a.

Partner

Items Total Becky Chuck Dawn

Ordinary incomeLong-term capital gainShort-term capital lossCharitable contribution deduction

$120,000 18,000 6,000

20,000

$24,000 3,600 1,200 4,000

$36,000 5,400 1,800 6,000

$60,000 9,000 3,000

10,000

b.

Partnership Total %

Becky's Amount %

Chuck's Amount

1/1 through 6/30a

Ordinary income LTCG STCL Charitable contribution

7/1 through 12/31b

Ordinary income LTCG STCL Charitable contribution

$59,507 8,925 2,975 9,918

$60,493 9,074 3,025

10,082

20%20%20%20%

25%25%25%25%

$11,901 1,785

595 1,984

$15,123 2,269

756 2,521

30%30%30%30%

25%25%25%25%

$17,852 2,678

893 2,975

$15,123 2,269

756 2,521

a1/1 through 6/30 is 181 days in a non-leap year.b7/1 through 12/31 is 184 days in a non-leap year.

pp. C9-17 and C9-18.

C9-36 a.

Total Amy (25%) Brad (35%) Craig (40%)

Ordinary lossLTCGSec. 1231 gainSTCL

($120,000) 190,000 40,000

( 30,000)

($30,000) 47,500 10,000

( 7,500)

($42,000) 66,500 14,000

( 10,500)

($48,000) 76,000 16,000

( 12,000)

b.

Brad Craig

Partnership 35% 55% 40% 20%

Ordinary Loss1/1-6/30a

7/1-12/31b

LTCG1/1-6/307/1-12/31Sec. 12311/1-6/307/1-12/31STCL1/1-6/307/1-12/31

($59,507) ( 60,493)

94,219 95,781

19,836 20,164

( 14,877) ( 15,123)

($20,827)

32,977

6,943

( 5,207)

($33,271)

52,680

11,090

( 8,318)

($23,803)

32,688

7,934

( 5,951)

($12,099)

19,156

4,033

( 3,025)

a1/1 through 6/30 is 181 days in a non-leap year.b7/1 through 12/31 is 184 days in a non-leap year.

pp. C9-17 and C9-18.

C9-37 Patty:Ordinary income: $ 3,200 (0.40 x $8,000)Long-term capital gain:

Precontribution $ 6,000 ($10,000 - $4,000)Postcontribution 1,600 [0.40 x ($10,000 - $6,000)]

Total income/gain $10,800

Dave reports $4,800 ($8,000 x 0.60) of ordinary income and $2,400 ($4,000 x 0.60) of long-term capital gain.


C9-38 a. Yes. If any income is allocated in any way other than according to the partner's interest in the partnership, there is a special allocation. Neither the capital gain nor the ordinary income is allocated according to the partners' 50-50 interests. However, the special allocation

does not meet the test of having substantial economic effect, and will not be acceptable to the IRS.

b. The special allocation affects only the partners's tax consequences and not the economic consequences. Each partner's distributive share is still $100,000. Accordingly, the special allocation will not be accepted, and the income must be allocated according to the partners' 50-50 interest in the partnership. The partners must report the following:

Total Clark LoisCapital gain $ 60,000 $30,000 $30,000Ordinary income 140,000 70,000 70,000

pp. C9-19 and C9-20.

C9-39 a. The special allocation could have substantial economic effect in 1998 but not in 1999 or 2000 since Diane does not have to repay negative capital account balances.

b. The special allocation will have substantial economic effect in all three years.c. The special allocation will not have substantial economic effect in 1999 or 2000

since Diane will have a negative capital account balance in both years. The liability increases basis, but does not increase her capital account. pp. C9-19 and C9-20.

C9-40 a. Carryover basis of contributed property $14,000 Minus: Debt assumed by partners (0.80 x $10,000) ( 8,000) Partnership interest basis $ 6,000

b. Carryover basis from friend $34,000 Plus: Share of partnership liabilities 20,000 Partnership interest basis $54,000

c. The interest's FMV used in valuing the estate ($120,000) is Kelly's basis. pp. C9-20 through C9-24.

C9-41 a. The FMV of the partnership interest, or $25,000.b. Land basis $ 6,000

Car basis 15,000 Cash contributed 2,000 Recourse liabilities (0.40 x $100,000) 40,000 Basis in partnership interest $63,000


C9-42 a. Purchase price $ 50,000 Plus: Share of liabilities (0.40 x $200,000) 80,000

Taxable distributive share ($30,000 + $10,000 - $1,000) 39,000

Nontaxable distributive share ($8,000 - $2,000) 6,000 Minus: Change in liabilities (0.40 x $20,000) ( 8,000) Basis on December 31 $167,000

b. Purchase price $ 50,000 Plus: Share of liabilities (0.30 x $200,000) 60,000 Taxable distributive share 39,000 Nontaxable distributive share 6,000 Increase in nonrecourse liabilities (0.40 x $80,000) 32,000 Minus: Reduction in recourse liabilities (0.30 x $100,000) ( 30,000) Basis on December 31 $157,000

c. Purchase price $ 50,000 Plus: Taxable distributive share 39,000 Nontaxable distributive share 6,000 Increase in nonrecourse liabilities (0.40 x $80,000) 32,000 Basis on December 31 $127,000


C9-43 a.

Kerry City Corporation

January 1 basisShort-term capital gainNonrecourse liabilitySec. 704(d) basis before lossesAt-risk basis before losses

Distributive share of loss:Ordinary lossLong-term capital loss

Deductible loss

$300,000 150,000

50,000 $500,000 $450,000

$450,000 50,000

450,000

$300,000 150,000

50,000 $500,000

N/Aa

$450,000 50,000

500,000

aCity Corporation is not closely-held and is therefore exempt from the at-risk rules.b. The basis after the loss is zero for each partner.c. The nonrecourse liability is considered to be at-risk. Therefore, both partners can

deduct the full $500,000 loss and have a zero basis for their partnership interest after the year's operations. pp. C9-24 and C9-25.

C9-44

Gary (general partner-60%) Mary (general partner-40%)

Tax Basis At-Risk Basis Tax Basis At-Risk Basis

Beginning basisRecourse debtNonrecourse debt

Operating lossDeductible lossEnding basis

$ 60,000 18,000

60,000 $138,000 (120,000)

$ 18,000

$ 60,000 18,000

$ 78,000

( 78,000) $ -0-

$40,000 12,000

40,000 $92,000 (80,000)

$12,000

$ 40,000 12,000

$ 52,000

( 52,000) $ -0-

Gary recognizes a $78,000 loss and Mary recognizes a $52,000 loss both of which have been limited because of the at-risk rules.

pp. C9-24 and C9-25.

C9-45 a.

Eve Tom

Beginning basisPlus: Share of LTCGBasis before losses

Share of losses

Limitations on losses - Sec. 704(d) limitAt-risk limitPassive activity limit

Deductible loss

$46,000 8,000

$54,000

$56,000

$54,000 54,000

N/A

$54,000

$75,000 12,000 $87,000

$84,000

$87,000 87,000a 12,000b

$12,000

a Since the partnership has no nonrecourse liabilities, the at-risk basis equals the regular basis for both partners and the at-risk rules do not limit the losses they can deduct.

b Eve materially participates in the partnership business so the partnership's ordinary loss is an active loss for her. Tom is a limited partner and does not materially participate so his deduction for losses is limited to the passive income he earns from this (and all other) passive activities during this year. Since the problem states that he has no other income except his salary, Tom's losses can be deducted only to the extent of his share of the

income (long-term capital gain) from this partnership. [Note that these rules determine the amount of loss which Tom can deduct. The character (and the treatment of Tom's income on the tax return) remains $12,000 ordinary loss and $12,000 long-term capital gain.]

b. The additional $100,000 recourse debt would increase both the Sec. 705 basis and the at-risk basis for Eve. This would give her enough basis to deduct her full $56,000 distributive share of partnership losses. As a limited partner, Tom would have a basis increase only if he had some agreement to assume an economic risk of loss related to the recourse borrowings. Even if he had a basis increase (which is unlikely), Tom would not likely be able to deduct any additional loss since the passive activity loss rules still limit passive losses to passive income.


C9-46 a.

Kate Chad Stan

Basis before year-endPlus: Capital gainBasis before lossesAt-risk basis before losses

Distributive share of lossCharacter of lossDeductible loss

$100,000 20,000

$120,000 $ 70,000

$ 80,000 Active

$ 70,000

$100,000 20,000

$120,000 $ 70,000

$ 80,000 Passive

$ 20,000*

$ 50,000 10,000 $ 60,000 $ 35,000

$ 40,000 Passive

$ 10,000*

*The passive losses are deductible to the extent of passive income earned during the year. This assumes there is no passive income from other sources which can be offset by the passive loss and that the capital gains are not portfolio income.

b. Rental activities are passive activities so Kate and Chad are limited to a $25,000 loss deduction which may be reduced if Kate and Chad have AGIs in excess of $100,000. Stan does not actively participate in the rental activity so he has the same deductible loss as above. pp. C9-24 through C9-26.

C9-47 a. Amount realized $ 40,000 Minus: Adjusted basis ( 60,000) Realized loss ($20,000)

The loss cannot be recognized because Susan is deemed to own 100% of the partnership. The partnership has a cost basis of $40,000 in the securities.

b. Amount realized $ 40,000 Minus: Adjusted basis ( 50,000) Realized loss ($10,000)

The realized loss is fully recognized because Susan owns only 15% of the partnership.

c. Amount realized $ 40,000 Minus: Adjusted basis ( 30,000) Realized gain $ 10,000

The entire $10,000 is recognized as a capital gain, even though Susan owns, directly and indirectly, 65% of the partnership, because the property is a capital asset to the partnership.

pp. C9-26 and C9-27.

C9-48 a. Amount realized $ 30,000 Minus: Adjusted basis ( 40,000) Realized loss ($10,000)

The loss is fully recognized by Jack as a capital loss.b. Amount realized $ 30,000

Minus: Adjusted basis ( 44,000) Realized loss ($14,000)

Jack's loss is not recognized since he owns directly and indirectly more than 50% of the partnership.

c. Amount realized $ 30,000 Minus: Adjusted basis ( 20,000) Realized gain $ 10,000

The gain is recognized by Jack as a capital gain.d. The gain is recognized as ordinary income since Jack owns directly and indirectly

100% of the partnership and the land is ordinary income property to the partnership.

pp. C9-26 and C9-27.

C9-49 Maura

15%

35% Kara 45% (Maura's Mother)

20% 3% Lynn

Maura's interest in KTV is counted as indirectly owned by Kara. Therefore, KLM and KTV are partnerships in which the same persons own directly or indirectly more than 50% of the capital or profits interests.

a. Amount realized $50,000 Minus: Adjusted basis (80,000)

KLM

Realized loss $30,000 The loss is not recognized by the KTV Partnership.

b. Amount realized $50,000 Minus: Adjusted basis (23,000) Realized gain $27,000

The gain is recognized as a capital gain by the KTV Partnership.c. Amount realized $50,000

Minus: Adjusted basis (35,000) Realized gain $15,000

The gain is recognized as ordinary income by the KTV Partnership.

pp. C9-26 and C9-27.

C9-50

SDPartnership

Allocation to Partner:Scott Bob

Ordinary incomeMinus: Guaranteed paymentPartnership ordinary incomeCapital gain

$23,000 (10,000) $13,000 $14,000

$5,000 OI $6,500 OI

$7,000 LTCG

$5,000 OI $6,500 OI

$7,000 LTCG

OI = Ordinary income LTCG = long-term capital gain.

pp. C9-27 and C9-28.

C9-51 a.

ABPartnership

Allocation to Partner:Allen Bob

Guaranteed paymentOrdinary incomeTotal received

$ 90,000 70,000a

$160,000 $35,000 $35,000

$ 90,000 35,000

$125,000

b.

ABPartnership


Ordinary income before guaranteed paymentMinus: Adjustment for guaranteed payment*Income allocation

*Guaranteed minimumMinus: Bob's distributive shareGuaranteed payment

$160,000

-0- $160,000

$ 90,000 ( 80,000) $ 10,000

$80,000

(10,000) $70,000

$ 80,000

10,000 $ 90,000

c.

ABPartnership


LTCGGuaranteed paymentMinus: Ordinary loss allocatedb

Total received

$140,000 80,000

( 80,000) $140,000

$70,000

(40,000) $30,000

$ 70,000 80,000

( 40,000) $110,000

a$160,000 - $90,000 = $70,000b-0- ordinary income before guaranteed payment - $80,000 guaranteed payment = ($80,000) ordinary loss.

pp. C9-27 and C9-28.

C9-52 a.

PS

Partnership

Allocation to Partner: Pam Susan

LTCGGuaranteed paymentMinus: Ordinary loss allocatedTotal received

$ 10,000 40,000

(40,000)a

$ 10,000

$ 3,000 40,000

(12,000) $31,000

$ 7,000

( 28,000) ($21,000)

a$-0- - $40,000 = ($40,000) ordinary loss.

b.

PS

Partnership


Guaranteed paymentOrdinary income allocatedSec. 1231 gainTotal received

$ 35,000 35,000b

60,000 $130,000

$35,000 7,000

12,000 $54,000

$28,000 48,000 $76,000

b$70,000 - $35,000 = $35,000 ordinary income.

c. Ordinary income before guaranteed payment $120,000 Times: Pam's distributive share of partnership income x 0.40 Pam's distributive share $48,000 Plus: Pam's guaranteed payment ($60,000 - $48,000) 12,000 Pam's total payment (guaranteed minimum) $60,000

PS

Partnership


Guaranteed paymentOrdinary income allocatedTotal received

$ 12,000 108,000c $120,000

$12,000 48,000 $60,000

$60,000 $60,000

c$120,000 - $12,000 = $108,000

pp. C9-27 and C9-28.

C9-53 Assuming Son passes the tests for ownership of the partnership interest, Son is a partner since capital is a material income producing factor. Allocation of the income would occur as follows:

Dad (0.70 x $100,000) $ 70,000 Fred (0.10 x $100,000) 10,000 Son (0.20 x $100,000) 20,000 Total distributive share $100,000


C9-54 Partnership income before guaranteed payment $160,000 Minus: Reasonable compensation for Steve ( 70,000) Partnership ordinary income $ 90,000

Distributive shares: Steve (60%) $ 54,000 Tracy (20%) 18,000 Vicki (20%) 18,000 Total $ 90,000

In addition to his distributive share, Steve would receive $70,000 of ordinary income from the guaranteed payment, or $124,000.


Tax Form/Return Preparation Problem

C9-55 (See Instructor's Guide)

Case Study Problems



Tax Research Problems




Documents

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