SMChap020

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 owner’s 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. The owners are then 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 flow-through 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 like a conglomeration of individual owners. Each partnership is viewed as an aggregation of the partners’ separate interests in the assets and liabilities of the partnership. For example, each partner, rather than the partnership, pays tax on their individual share of partnership income. The entity concept treats partnerships more like 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 rather than the individual partners. 4. [LO 2] What is a partnership interest, and what specific economic rights or entitlements are included with it? 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

20-1 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


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 don’t 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 partner’s partnership interest prior to the deemed distribution. This happens if the assumption of the partner’s liabilities is in excess of the partner’s basis of the contributed property. If the cash deemed to have received exceeds the tax basis immediately before the deemed distribution, 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 is 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 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 that have been allocated to the individual partners. 8. [LO 2] What is recourse and nonrecourse debt, and how is each generally allocated to partners? 20-2 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


Recourse debt is debt for which partners are considered to have an economic risk of loss. Partners are legally liable for recourse debt and must satisfy this type of debt 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 because nonrecourse debt is typically secured by real property. An example of nonrecourse debt is a mortgage on a building. In regards to a partnership’s 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 generally allocated to the partners according to their profit sharing ratios. Despite the partners not being legally liable for some debt, all debt is allocated to adjust the outside basis of the partners. 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. The partner’s tax basis in his or her partnership interest would be increased by the basis of the assets contributed. Next, the property’s debt is allocated to each partner according to who is ultimately responsible for it or by each partner’s profit-sharing ratio. The basis of the contributed assets plus the allocation of debt would represent the partner’s tax basis in the partnership immediately before the deemed distribution of cash as a result of the relief of debt attached to the contributed property. If the partner is not allocated enough debt, the partner’s 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 provides more tax-related information for each partner. For instance, each partner’s share of inside basis of the partnership’s assets can be calculated by adding the partner’s share of debt to her/his capital account. 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 partnership’s 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 profits 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 the interest is 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 profits 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 determined by taking the cost basis of the interest the partner purchased and adding to this basis any debt allocated to the partner’s interest. The holding period for this purchased interest will begin on the date that the partner purchased the partnership interest. 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 20-4 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


consist of many different partners ranging from two to hundreds. The hassle to obtain every partner’s 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 partnership’s year end but at the partner’s year end. Thus, the first year of the partnership will be reported by the partner on her/his return which includes the partnership’s year end. This allows the partner to defer the reporting of the first nine months of income or loss from the partnership into the succeeding tax year when the partner’s income tax return is filed. 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 each 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 partnership’s 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. If these two tests don’t apply, along with the exception to elect an alternative year end, then the least aggregate deferral test goes into effect. 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 partner’s months of deferral under the potential tax year and weighting it with the partner’s profit interest percentage. Then, each partner’s 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? Under the tax accounting rules, a partnership with a corporate partner must use the accrual method of accounting unless the following exception applies. A partnership with a corporate partner is eligible to use the cash method of accounting when the partnership has average gross receipts over the past three taxable years less than or equal to $5 million. 18. [LO 4] What is a partnership’s 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 partnership’s 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 partner’s current tax situation. The following is a partial list of items that are separately stated on a partnership return. 1. Short-term capital gains (losses) 2. Long-term capital gains (losses) 3. Section 1231 gains (losses) 4. Charitable contributions 5. Dividends 6. Interest income 7. Guaranteed payments 8. Net earnings (losses) from self-employment 9. Tax-exempt income 10. Net rental real estate income (loss) 11. Investment interest expense 12. Section 179 deductions



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 partnership’s 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 partner’s 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 partnership’s 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 partnership’s 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 partner’s 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 partner’s share of ordinary business income is treated as investment income and not subject to selfemployment 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. 23. [LO 4] What challenges do LLCs face when deciding whether to treat their members’ shares of ordinary business income as self-employment income? 20-7 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


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 selfemployment 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 LLC’s 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 selfemployment 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 built-in 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 partnership’s 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 an additional five months to file Form 1065. The extension must be filed on Form 7004.



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 partner’s share of items both separately-stated and non-separately stated. In addition, each partner’s 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 because certain situations require partners to actually know their tax basis. These situations occur when a partner sells her/his partnership interest or when a partner receives a distribution from the partnership. Tracking the tax basis in the partnership interest helps the partner determine the amount of gain or loss that must be reported on the partner’s tax return. 27. [LO 5] Why does a partner’s tax basis in her partnership need to be adjusted annually? A partner’s 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 partner’s basis in her partnership interest? The following items will increase a partner’s basis and must be adjusted for on an annual basis in the order given. 1. Actual and deemed cash contributions to the partnership 2. Partner’s share of ordinary business income 3. Partner’s share of separately-stated income/gain items and 4. Partner’s share of tax-exempt income 29. [LO 5] What items will decrease a partner’s basis in her partnership interest? The following items will decrease a partner’s 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 partner’s basis have been taken into effect.



1. 2. 3. 4.

Actual and deemed cash distributions from the partnership Partner’s share of non-deductible expenses (fines, penalties, etc.) Partner’s share of ordinary business losses and Partner’s share of separately-stated expenses/loss items

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) the tax basis limitation, (2) 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 partner’s 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 amount for the partner. The at-risk amount is generally the same as the partner’s tax basis, except that it excludes the partner’s share of nonrecourse debt. This limit still includes recourse debt and qualified nonrecourse debt. Finally, in the case of a passive participant in a partnership, losses cannot be taken if the loss exceeds the amount of passive income reported by the partner. Passive losses such as losses from rental activities or losses allocated to a limited partner 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 partner’s 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 partner’s 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 partner’s at-risk calculation. 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 partner’s 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 partner’s 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 partner’s 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 individual’s 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 individual’s participation is not less than any other individual’s participation in the activity. 20-11 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


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. 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).

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 Joseph’s tax basis in his partnership interest? b. What is Berry Hill’s basis in the equipment? a. $27,000. Joseph’s 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. Joseph’s holding period for his outside basis would depend upon the holding period of the assets contributed. If property contributed is a capital or Section 1231 asset, the holding period for that portion of the partnership interest includes the holding



period of the contributed property. Otherwise, the holding period of the partnership interest begins on the date it is received. b. $5,000. Berry Hill Partnership’s 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 Partnership’s 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 Lance’s tax basis in his LLC interest? b. What is Lance’s holding period in his interest? c. What is Cloud Peak’s basis in the contributed property? d. What is Cloud Peak’s holding period in the contributed property? a. $455,000. Lance’s 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, Lance’s profit sharing ratio is used to allocate a portion of the LLC debt to him. b. Three years. 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 Lance’s holding period in the contributed property. 39. [ LO 2] Laurel contributed equipment worth $200,000, purchased 10 months ago 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 Creek’s accounts payable, but she did not guarantee any portion of the $100,000 nonrecourse mortgage securing Sand Creek’s office building. Other than the accounts payable and mortgage, Sand Creek does not owe any debts to other creditors. 20-13 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


a. What is Laurel’s initial tax basis in her LLC interest? b. What is Laurel’s holding period in her interest? c. What is Sand Creek’s initial basis in the contributed property? d. What is Sand Creek’s holding period in the contributed property? a. $280,000. Laurel’s basis in her LLC interest is made up of the $250,000 basis in the equipment (no depreciation was taken on the equipment prior to the contribution because it was acquired and contributed within the same calendar year) Laurel contributed, her $15,000 share of accounts payable that she guaranteed, and her $15,000 share of the nonrecourse mortgage securing Sand Creek’s office building (15% x $100,000). Laurel’s profits sharing ratio is used to allocate a portion of the mortgage to her because it is nonrecourse debt. b. Laurel’s holding period begins the day the LLC interest is acquired because the asset she contributed is not a capital or Section 1231 asset. The equipment is not a Section 1231 asset because it was used in a trade or business for one year or less. c. $250,000. The LLC takes a carryover basis in the contributed property. d. Ten months. Laurel’s holding period is included in the LLC’s holding period regardless of the nature of the property Laurel contributed. 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: Cash Land Totals

Basis Fair Market Value $ 30,000 $ 30,000 100,000 120,000 $ 130,000 $ 150,000

Sally: Equipment used in a business Totals

200,000 $ 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 Harry’s tax basis in his partnership interest? e. What is Sally’s tax basis in her partnership interest? f. What is Evergreen’s tax basis in its assets? g. Following the format in Exhibit 20-2, 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. Harry’s basis in his partnership interest is simply the combined tax basis in the cash and land he contributed to the partnership. e. $200,000. Sally’s basis in her partnership interest equals $200,000 basis in the equipment she contributed. f. $330,000. The partnership’s 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 partnership’s 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 Cosmo’s 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.



Description (1) Basis in contributed Land (2) Nonrecourse mortgage in

Cosmo $90,000 $30,000

Explanation Nonrecourse

excess of basis in contributed

debt > basis is

land

allocated only

(3) Remaining nonrecourse

to Cosmo 25% x

$22,500

mortgage Basis immediately prior to

[120,000 - (2)] $142,500

debt relief (4) Relief from mortgage debt Cosmo’s initial tax basis in Y

($120,000) $22,500

Mountain

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

b. $22,500 as indicated in the table above. 42. [LO2] When High Horizon LLC was formed, Maude contributed the following assets in exchange for a 25 percent capital and profits interest in the LLC: Maude: Cash Land* Totals


*Nonrecourse debt secured by the land equals $160,000 James, Harold and Jenny each contributed $220,000 in cash for a 25% profits and capital interest. a. How much gain or loss will Maude and the other members recognize? b. What is Maude’s tax basis in her LLC interest? c. What tax basis do James, Harold, and Jenny have in their LLC interests? d. What is High Horizon’s tax basis in its assets?



e. Following the format in Exhibit 20-2, prepare a tax basis balance sheet for the High Horizon LLC showing the tax capital accounts for the members. a. $0. None of the members recognize gain because their debt relief was not in excess of their bases in their LLC interest prior to any debt relief. See table below: Description

Maude

Other

Explanation

Members (1) Basis in contributed Land (2) Cash contributed (3) Nonrecourse mortgage in

$100,000 $20,000 $60,000

$220,000 Nonrecourse


debt > basis is

land

allocated only


$25,000

mortgage Basis immediately prior to

$205,000

debt relief (5) Relief from mortgage debt Each member’s initial tax

$25,000

to Maude 25% x [160,000 - (3)]

($160,000) $45,000

basis in the LLC

$245,000

(1) + (2) + (3) + (4) + (5)

b. $45,000. See table in part a. above. c. $245,000 each. See table in part a. above. d. $780,000. High Horizon takes a $120,000 carryover basis in the assets Maude contributes and a $660,000 basis in the total cash the other three members contributed.



e. High Horizon’s tax basis balance sheet would appear as follows: High Horizons, LLC Tax Basis Balance Sheet Tax Basis Assets: Cash Land Totals Liabilities and Capital: Mortgage debt Capital-Maude Capital-James Capital-Harold Capital-Jenny Totals

$680,000 100,000 $780,000 $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: Cash Land* Totals


*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 Kevan’s tax basis in his LLC interest? c. What tax basis do Jerry and Dave have in their LLC interests?



d. What is Albee LLC’s tax basis in its assets? e. Following the format in Exhibit 20-2, prepare a tax basis balance sheet for the Albee LLC showing the tax capital accounts for the members. What is Kevan’s share of the LLC’s inside basis? f. If the lender holding the nonrecourse debt secured by Kevan’s 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 Kevan’s 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? a. $0. None of the members recognize gain because their debt relief was not in excess of their bases in their LLC interest prior to any debt relief. See table below: Description

Kevan

Other

Explanation

Members (1) Basis in contributed Land (2) Cash contributed (3) Nonrecourse mortgage in

$120,000 $15,000 $90,000

$245,000 Nonrecourse


debt > basis is

land

allocated only


$40,000

$40,000

mortgage

to Kevan 33.3% x [$210,000 (3)]

Basis immediately prior to debt relief (5) Relief from mortgage debt Each member’s initial tax

$265,000 ($210,000) $55,000

basis in the LLC

$285,000

(1) + (2) + (3) + (4)+ (5)

b. $55,000. See table in part a. above. 20-20 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


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. e. Albee, LLC’s 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

Kevan

Jerry

Dave

Explanatio n

(1) Basis in contributed Land (2) Cash contributed (3) Mortgage

$120,000 $15,000 $70,000

$245,000 $140,000

$245,000 $0

Guarantee

33.33% x $210,000 for Kevan and 66.67% x $210,000

(4) Basis immediately

$205,000

$385,000

$245,000

prior to debt relief (5) Relief from

($210,000)

$0

$0

mortgage debt (6) Gain Recognized

$5,000 (4)-

$0

$0

(5) $0

$385,000

$245,000

Each member’s initial tax basis in the LLC

for Jerry 1+2+3

(4)+(5) ( (4) + (5) + (6)

g. Kevan’s basis is $0, Jerry’s basis is $385,000, and Dave’s 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. 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 built-in 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 Investors LLC when it was worth $2,500,000, in exchange for a 10 percent capital and profits interest. South Peak’s strategy is to hold land for investment purposes only and then sell it later at a gain. a. If South Peak sells the property for $3,000,000 four years after Claude’s 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 Claude’s 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} a. Reggie sold his LLC interest, a capital asset, for $30,000 when he had a basis in the LLC interest of $20,000. Thus, he will recognize a $10,000 capital gain. The capital gain is treated as a long-term capital gain because he has held his LLC interest for more than twelve months. In this situation, the holding period of his LLC interest at the date he contributed property is irrelevant. b. Under Reg. §1.1223-3(b)(1), the holding period of Reggie’s LLC interest is based on the relative fair market value of the property he contributed. Since two-thirds of the value of the property he contributed was a capital asset held for three years, twothirds of his LLC interest is treated as being held for three years and the remaining one-third of his LLC interest has a holding period that begins on the date of contribution. Under Reg. §1.1223-3(c)(1), two-thirds or $6,667 of the resulting $10,000 capital gain from the sale will be treated as long-term capital gain and the remaining one-third or $3,333 will be treated as short-term capital gain. 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 Winterhaven’s 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 LLC’s 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 LLC’s debt. Because the LLC’s debt is a nonrecourse debt, it must



be allocated to her using Connie’s profits interest. Thus, her basis in the LLC equals $2,500 or 5 percent of the LLC’s $50,000 accounts payable. c. Connie reports $10,000 of ordinary income or 5 percent of the LLC’s 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 LLC’s 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. Kari’s 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. Consequently, the only tax consequences for the year are those relating to the admission of Kari to the partnership. a. Compute and characterize any gain or loss Kari may have to recognize as a result of her admission to the partnership. b. Compute Kari’s basis in her partnership interest. c. Prepare a balance sheet of the partnership immediately after Kari’s 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 partnership’s capital or $100 as ordinary income. b. Kari’s basis in her partnership interest will be equal to the amount of income she reports or $100.



c. Immediately after Kari’s admission into the partnership the partnership’s 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

704(b)/FMV $60 60 72 $192

60 180 60 300

46 46 100 $192

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. 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 Capital’s balance sheet on the day Dave received his capital interest appears below: Assets: Cash Investments Land Totals

Basis Fair Market Value $ 150,000 $ 150,000 200,000 700,000 150,000 250,000 $ 500,000 $1,100,000

Liabilities and capital: Nonrecourse Debt Lance* Robert* Totals

100,000 200,000 200,000 $ 500,000

100,000 500,000 500,000 $ 1,100,000

*Assume that Lance’s basis and Robert’s basis in their LLC interests equal their tax basis capital accounts plus their respective shares of nonrecourse debt. 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 member’s tax basis in his LLC interest immediately after Dave’s receipt of his interest. c. Prepare a balance sheet for Cirque Capital immediately after Dave’s 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 member’s tax basis in his LLC interest immediately after Dave’s 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: Description (1) Beginning

Dave $0

Lance $250,000

Robert $250,000

Explanation $200,000 tax basis capital

Basis in LLC

account + [.5 x $100,000

(2) Ordinary

nonrecourse debt] Liquidation Value of Capital

$100,000

Income

Interest (.1 x $1,000,000 fair

(3) Ordinary

($50,000)

($50,000)

Deduction (4) Increase in

Partners. (2) x .5 [$100,000 nonrecourse debt x

$10,000

Debt Allocation (5) Decrease in Debt Allocation (6) Ending

market value of LLC capital) Capital Shift from Non-Service

$110,000

(5,000)

(5,000)

$195,000

$195,000

10% profit sharing ratio] (4) x .5 (1) + (2) + (3) + (4) + (5)

Basis in LLC

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 member’s 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 Dave’s admission into the LLC, the LLC’s balance sheet will appear as follows: Cirque, LLC Balance Sheet Tax Basis Assets: Cash Land Inventory Totals Capital: Nonrecourse Debt Capital-Lance Capital-Robert Capital-Dave Totals

704(b/)FMV

$150,000 200,000 150,000 $500,000

$150,000 700,000 250,000 $1,100,000

$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: Description (1)

Dave $0

Lance $250,000

Robert $250,000

Beginning Basis in LLC (2) Ordinary

account + [.5 x $100,000 nonrecourse debt] Dave does not recognize any

$0

Income (3) Increase

Explanation $200,000 tax basis capital

income because he only receives a profits interest. [$100,000 nonrecourse debt

$10,000

in Debt

x 10% profit sharing ratio]

Allocation (4) Decrease

(5,000)

(5,000)

$245,000

$245,000

(3) x .5

in Debt Allocation (5) Ending

$10,000

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

Basis in LLC

Dave does not recognize any income because he only received a profits interest. e. As reflected in line (5) of the table above, Dave’s basis is $10,000, Lance’s basis is $245,000, and Robert’s 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, Ramon’s basis in Del Sol was $200,000 which included a $100,000 share of nonrecourse debt allocated to him. a. What is Garrett’s 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?



a. Garrett’s 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 % 33.33% 33.33% 33.34%

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%

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 5 percent or more 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 the year end of the principal partners or December 31. 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? Tall Tree 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 Tall Tree. Also, because all three principal partners in Tall Tree have different year ends, the principal partner test is not met. As a result, Tall Tree must decide which of three potential year ends, December 31, June 30, or October 31, will provide its members the least aggregate deferral. The table below illustrates the required computations: Possible Year Ends

Members

%

12/31 Year End

Tax

Months

Year

% x MD

6/30 Year End

10/31 Year End

Months

%x

Months

%x

Deferral*

Deferral*

MD

Deferral*

MD

0

(MD) 6

2.4

(MD) 2

.8

Eddie

40%

12/31

(MD) 0

Robinson Pitcher

25%

6/30

6

1.5

0

0

8

2

35%

10/31

10

3.5 5

4

1.4 3.8

0

0 2.8

Lenders Perry Homes Total Aggregate

Deferral *Months deferral equals number of months between proposed year end and member’s year end.

As the table above indicates, Tall Tree must use October 31 as its year end because it provides the least amount of aggregate deferral to the members.



55. [LO 3] Rock Creek LLC was recently formed with the following members: Name Mark Banks Highball PropertiesLLC Chavez BuildersInc.

Tax Year End December 31 March 31

Capital/Profits % 35% 25%

November 30

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

Members

Mark Banks Highball

%

12/31 Year End

Tax

Months

Year

Deferral*

35% 25%

12/31 3/31

(MD) 0 3

40%

11/30

11

% x MD

3/31 Year End

11/30 Year End

Months

%x

Months

%x

Deferral*

MD

Deferral*

MD

0 .75

(MD) 9 0

3.15 0

(MD) 1 4

.35 1

4.4

8

3.2

0

0

Properties, LLC Chavez Builders,Inc. Total

5.15

6.35

1.35

Aggregate Deferral *Months deferral equals number of members between proposed year end and partner’s 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.



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, 2002-1 CB 1037.} 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 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. 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 Creek’s ordinary business income (loss) for the year? Turtle Creek’s ordinary business income is calculated in the table below: Description Sales revenue Less: Cost of goods 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.



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 §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 Georgio’s separately stated items for the year? a. Georgio’s allocation of ordinary business income is reflected in the table below: Description

Total

20%

Amount

Allocated to Georgio

Sales revenue Less: Cost of goods sold Depreciation - MACRS Employee wages Guaranteed payments Ordinary Business Income

$70,000 (26,000) (3,000) (11,000) (3,000) $27,000

$5,400



b. Georgio’s separately stated items are calculated in the table below: Description

Total

20%

Amount

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 Georgio’s taxable income computation, they must be separately disclosed because they affect Georgio’s tax basis in his LLC interest. 60. [LO4] {Research} Richard Meyer and two friends from law school recently formed Meyer and Associates as a limited liability partnership (LLP). Income from the partnership will be split equally among the partners. The partnership will generate fee income primarily from representing clients in bankruptcy and foreclosure matters. While some attorney friends have suggested that the partners’ earnings will be self-employment income, other attorneys they know from their local bar association meetings claim just the opposite. After examining relevant authority, explain how you would advise Meyer and Associates on this matter. {Hint: See §1402(a)(13) and Renkemeyer, Campbell & Weaver LLP v. Commissioner, 136 T.C. 137 (2011)} Section 1402(a)(13) provides that a limited partner’s share of partnership ordinary business income is not self-employment income, but the Code does not specifically address the treatment of ordinary business income allocated to partners of limited liability partnerships or LLP’s. In attempting to address how the self-employment tax rules should apply to LLC members, partners in LLP’s, and other partners with limited liability (other than limited partners in a limited partnership), Prop. Reg. § 1.1402(a)2(h)(5) states that service partners in service partnerships such as law firms, accounting firms, etc. may not be treated as limited partners for self-employment tax purposes. Nonetheless, proposed regulations are not authoritative and taxpayers are not required to follow them. However, the Tax Court, in Renkemeyer, Campbell & Weaver LLP v. Commissioner, 136 TC 137(2011) decided to follow the approach in the proposed regulations and treat law partners in a law firm organized as an LLP as subject to the self-employment tax. Thus, to avoid controversy with the IRS, Richard and his partners should treat their earnings as self-employment income. However, if they are willing to litigate in a court other than the Tax Court (U.S. District Court or Federal Court of



Claims), they might consider taking a position that their earnings from the partnership are not self-employment income. 61. [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 Gary’s 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 Gary’s 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 Gary’s 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?



a. Gary’s ordinary business income, separately stated items, and self-employment income are calculated in the table below: Description Sales revenue Less: Cost of goods sold Depreciation - MACRS Employee wages Other expenses Guaranteed payments Ordinary Business Loss

Total

Allocated to Gary

Explanation

Amount $70,000 (38,000) (9,000) (14,000) (2,000) (13,000) ($6,000)

($2,700)

45% allocation to Gary

Separately Stated Items on Schedule K-1: Section 1231 gains

$8,000

$3,600

Cash charitable

($3,000)

($1,350)

contributions Guaranteed payment

$13,000

$13,000

Gary’s guaranteed

$900

payment 45% allocation to

$10,300

Gary ($2,700) ordinary

Municipal bond interest Self-employment income

$2,000 $7,000 [$13,000

45% allocation to Gary 45% allocation to Gary

business loss allocated

guaranteed

to Gary + $13,000

payment -

guaranteed payment

$6,000 ordinary loss]



b. If Gary is a limited partner, then his self-employment income would equal the $13,000 guaranteed payment he received. c. Under Proposed Reg. §1.1402(a)-2, Gary’s $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. 62. [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 §1245 recapture income Interest income Cost of goods sold Depreciation - MACRS Supplies expense Employee wages Investment interest expense Partner’s 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 Poki’s 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 preparer’s instructions at www.irs.gov.} Hoki Poki’s ordinary business income is computed as follows: Description (1)Sales revenue (2) Section 1245 recapture income (3)Cost of goods sold (4)Depreciation - MACRS (5)Supplies expense (6)Employee wages (7)Partner’s medical insurance premiums (8)Ordinary business income

Total Amount $70,000 8,000 (38,000) (9,000) (1,000) (14,000) (3,000) $13,000



Hoki Poki’s separately stated items are reflected in the table below: Separately Stated Items (1)$2,000 Rental real estate income (2)$2,000 Interest income (3)$1,000 Investment interest expense (4)$3,000 Medical insurance premiums or $3,000 Guaranteed Payments

$8,000 Self-Employment Income

Explanation See line 2 of Schedule K-1 See line 5 of Schedule K-1 See instructions for line 13 of Schedule K-1, Code H See instructions for line 13 of Schedule K-1, Code M (to provide partners with the information needed to compute the for AGI deduction for medical insurance) According to Rev. Rul. 91-26, partner’s medical insurance premiums paid by the partnership are treated as guaranteed payments by the partners. Line (8) from the table above (general partners treat ordinary business income as self-employment income) + (4) (guaranteed payments are always treated as selfemployment income) – line (2) from table above (Per §1402(a)(3)(C), gains from the sale of property are not included in selfemployment income)

63. [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 Rite’s self-employment earnings increase when the equipment was sold? {Hint: See §1402(a)(3).} Buy Rite’s 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 Rite’s 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.



64. [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 partnership’s annual income, Jhumpa and Stewart receive an annual guaranteed payment of $10,000 to compensate them for additional services they provide. Firewalker’s income statement for the current year reflects the following revenues and expenses: Sales revenue Interest income Long-term capital gains Cost of goods 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 Firewalker’s 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? a. The table below illustrates Firewalker’s ordinary business income and separately stated items. Note that the total self employment income for all partners consists of Firewalker’s $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 guaranteed payments made to Dave and Stewart.



b. Description Sales revenue Less: Cost of goods 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 Guaranteed Payments Self-employment income

Total $340,000

Jhumpa

Stewart

Kelly

(120,000) (75,000) (28,000) (4,500) (20,000) $92,500

$30,833

$30,833

$30,833

$3,300 $1,200 $20,000 $112,500

$1,100 $400 10,000 $40,833

$1,100 $400 10,000 $40,833

$1,100 $400 $30,833

c. The table above reflects the partner’s shares of ordinary business income and her/his separately stated items. Note that each partner’s self employment income consists of her/his individual shares of ordinary business income plus the guaranteed payment she/he received, if any.



d. The table below reflects the partner’s self-employment tax liability: Description (1)Self-employment

Stewart $40,833

Jhumpa $40,833

Kelly $30,833

income (2) Percentage of self

92.35%

92.35%

92.35%

tax (3) Earnings from self-

$37,709

$37,709

$28,474

employment (4) Self employment tax

15.3%

15.3%

15.3%

rate (5) Self-employment tax

$5,769

$5,769

$4,357

Explanation

employment income subject to self-employment (1) x (2)

(3) x (4)

liability

65. [LO 4] This year, Darrel’s distributive share from Alcove Partnership includes $6,000 of interest income, $3,000 of dividend income, and $70,000 ordinary business income. a. Assume that Darrel materially participates in the partnership. How much of his distributive share from Alcove Partnership is potentially subject to the Medicare contribution tax? b. Assume that Darrel does not materially participate in the partnership. How much of his distributive share from Alcove Partnership is potentially subject to the Medicare contribution tax? a. If Darrel materially participates in the business, the ordinary income is not passive to him and should not be subject to the Medicare contribution tax. The $6,000 of interest income and the $3,000 of dividend income are potentially subject to the Medicare contribution tax. b. If Darrel is not a material participant in the partnership, the $6,000 of interest income, the $3,000 of dividend income, and the $70,000 of ordinary business income are potentially subject to the Medicare contribution tax. 66. [LO 4] {Research} Lane and Cal each own 50 percent of the profits and capital of HighYield LLC. HighYield owns a portfolio of taxable bonds and municipal bonds, and each year the portfolio generates approximately $10,000 of taxable interest and $10,000 of



tax- exempt interest. Lane’s marginal tax rate is 35 percent while Cal’s 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 HighYield’s 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 HighYield’s special allocation, how will it likely reallocate the taxable and tax-exempt interest among the members? {Hint: See Reg. §1.704-1(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. 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. 67. [LO 5] Larry’s 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 Partner’s Share of Debt Partner’s Share of Income Ending Tax Basis

Total Amount $10,000 10,000 3,000 $23,000

68. [LO 5] Carmine was allocated the following items from the Piccolo LLC for last year: Ordinary business loss Nondeductible penalties Tax-exempt interest income 20-46 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


Short-term capital gain Cash distributions Rank these items in terms of the order they should be applied to adjust Carmine’s tax basis in Piccolo for the year (some items may be of equal rank). 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 Carmine’s 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) 69. [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 partnership’s annual income, Oscar and Felix receive annual guaranteed payments of $7,000 to compensate them for additional services they provide. Eastside’s income statement for the current year reflects the following revenues and expenses: Sales revenue Dividend income Short-term capital gains Cost of goods 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?



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)Partner’s share of ordinary business income

Oscar $80,000

Felix $80,000

Marv $80,000

$1,900 $933

$1,900 $933

$1,900 $933

$14,500

$14,500

$14,500

(5)Deemed distribution from debt repayment (6)Guaranteed payments received

($10,000)

($10,000)

($10,000)

0

0

$87,333

$87,333

(7)Ending tax basis

$87,333

Explanation

$5,700 x 33.33% $2,800 x 33.33% [$52,000 overall net income - ($5,700 Dividend Income + $2,800 Short-Term Capital Gains)] x 33.3% [$120,000 - $90,000] x 33.33% Partners don’t increase the basis of their partnership interests by the amount of guaranteed payments received (1)+(2)+(3)+(4)+(5)



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)Partner’s share of ordinary business income

Oscar $10,000

Felix $10,000

Marv $10,000

Explanation

$1,900 $933

$1,900 $933

$1,900 $933

$5,700 x 33.33% $2,800 x 33.33%

$14,500

$14,500

$14,500

(5)Deemed distribution from debt repayment (6)Guaranteed payments received

($40,000)

($40,000)

($40,000)

[$52,000 overall net income - ($5,700 Dividend Income + $2,800 Short-Term Capital Gains)] x 33.3% [$120,000 - $0] x 33.33%

0

0

(7)Gain recognized by partners (8)Ending tax basis

$12,667

$12,667

$12,667

0

0

0

Partners don’t increase the basis of their partnership interests by the amount of guaranteed payments received -[(5)+(1)+(2)+(3)+(4)] Generally (1)+(2)+(3)+(4)+(5) but may not go lower than zero



70. [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 partnership’s annual income, Pam and Sergei receive annual guaranteed payments of $20,000 to compensate them for additional services they provide. Oak Grove’s income statement for the current year reflects the following revenues and expenses: Sales revenue Dividend income §1231 losses Cost of goods sold Employee wages Depreciation expense Guaranteed payments Miscellaneous expenses Overall net income

$476,700 6,600 (3,800) (245,000) (92,000) (31,000) (40,000) (11,500) $ 60,000

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 Pam’s 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. Pam’s basis is $140,000, Sergei’s basis is $65,000, and Mercedes’s basis is $65,000 as computed in the table below: Description (1)Beginning tax basis (including partners’ share of debt) (2) Dividends income

(3)Partner’s share of ordinary

Pam $50,000

Sergei $50,000

Mercedes $50,000

$2,200

$2,200

$2,200

$19,067

$19,067

$19,067

$30,000

$15,000

$15,000

business income

(4) Debt increase (deemed cash contribution)

Explanation Given $6,600 x 33.33% (Pam’s profits interest doesn’t increase until the end of the year) [$60,000 overall net income - ($6,600 Dividend Income ($3,800) Section 1231 Losses)] x 33.3% Pam :[( $150,000 x 40%) – ($90,000 x 33.33%)] Other Partners: [($150,000 x 30%) –

(5) Pam’s new 6.67% capital

$40,000

($20,000)

($20,000)

interest

($90,000 x 33.33%)] Additional 6.67% capital interest to Pam is a guaranteed payment to Pam and a deduction allocated equally to other

(6) Cash guaranteed payments received

(7) Section 1231 losses (8)Ending tax basis

0

0

($1,267) $140,000

($1,267) $65,000

($1,267) $65,000

partners Partners don’t increase the basis of their partnership interests by the amount of cash guaranteed payments received ($3,800) x 33.33% Sum of (1) through (7)



b. Pam’s basis is $136,000, Sergei’s basis is $61,000, and Mercedes’ basis is $61,000 as computed in the table below: Description Ending tax basis given facts in part

Pam $140,000

Sergei $65,000

Mercedes $65,000

a. Campaign contribution

($4,000)

($4,000)

($4,000)

Explanation See solution to part a. above ($12,000) x 33.33% Non-deductible expenses must reduce a partner’s tax basis

New ending basis given facts in part

$136,000

$61,000

$61,000

b.

71. [LO 6] {Research} Laura Davis is a member in a limited liability company that has historically been profitable but is expecting to generate losses in the near future because of a weak local economy. In addition to the hours she works as an employee of a local business, she currently spends approximately 150 hours per year helping to manage the LLC. Other LLC members each work approximately 175 hours per year in the LLC, and the time Laura and other members spend managing the LLC has remained constant since she joined the company three years ago. Laura’s tax basis and amount at-risk are large compared to her share of projected losses; however, she is concerned that her ability to deduct her share of the projected losses will be limited by the passive activity loss rules. a. As an LLC member, will Laura’s share of losses be presumed to be passive as they are for limited partners? Why or why not? {Hint: See §469(h)(2) and Garnett v. Commissioner, 132 T.C. 368 (2009)} b. Assuming Laura’s losses are not presumed to be passive, is she devoting sufficient time to the LLC to be considered a material participant? Why or why not? c. What would you recommend to Laura to help her achieve a more favorable tax outcome? d. Section 469(h)(2) specifies that limited partners are presumed to be passive participants. However, Laura is not a limited partner; rather she is a member in an LLC. For a time, the IRS argued that LLC members should be treated as limited partners in this context because of their limited liability. Nonetheless, the Tax Court in Garnett v. Commissioner, 132 T.C. 368 (2009) and in subsequent memorandum decisions determined that §469(h)(2) does not always apply to LLC members. In response to the Garnett decision, the Treasury provided in Prop. Reg. § 1.469-



5(e)(3)(i) that LLC members will not automatically be treated as limited partners as long as they have management rights for some portion of the year. Thus, if Laura can satisfy any one of the seven tests for material participation in Reg. §1.4695T(a), she may treat her losses as active. e. In all likelihood, Laura is not spending enough time managing the LLC to be considered a material participant. Given the facts provided, the only test for material participation in Reg. §1.469-5T(a ) she might satisfy is the seventh test which provides that an individual must participate on a “regular, continuous, and substantial basis” during the year to be treated as a material participant. It is not clear that she would satisfy this subjective test given her current level of involvement. f. Laura should be advised to increase her time spent managing the LLC from 150 to 175 hours per year. If she does this, she will clearly satisfy the test for material participation found in Reg. §1.469-5T(a )(3) which provides that Laura will be a material participant if she works more than 100 hours during the year in the LLC and the number of hours she works is not less than the number of hours other individual LLC members spend managing the LLC during the year. 72. [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 $4,000 of recourse debt and $6,000 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. a. How much of Alfonso’s loss is limited by his tax basis? b. How much of Alfonso’s loss is limited by his at-risk amount? c. How much of Alfonso’s loss is limited by the passive activity loss rules? a. Because Alfonso’s 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 Alfonso’s tax basis, $6,000 is limited because Alfonso’s at-risk amount is only $24,000 ($30,000 regular tax basis less the $6,000 nonrecourse debt not allowed in calculating the at-risk amount). Thus, $24,000 of loss remains after the tax basis and at-risk limitations, and Alfonso has a $6,000 at-risk carryover. c. Because Alfonso doesn’t materially participate in the partnership, he may only deduct the $24,000 loss remaining after the tax basis and at-risk limitations to the extent he 20-53 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


has passive income from other sources. Thus, he may deduct $1,000 of the $24,000 loss currently and will have a $23,000 passive activity loss carryover. 73. [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).} a. According to Rev. Rul. 66-94, 1966-1 CB 166 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 Diego’s $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:

Section 1231 losses Short-term capital losses

(1) Original Loss $70,000 $30,000

(2) Amount Deducted Currently $14,000 ($20,000 x $70,000/$100,000) $6,000 ($20,000 x $30,000/$100,000)

(1) – (2) Loss Carryover $56,000 $24,000

b. As indicated in the table above, Juan Diego’s $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. 74. [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 Vista’s general debt obligations. By the end of the year, Farell’s share of Sierra Vista’s general debt obligations has 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. As a partner in the Riverwoods Partnership, he also has year 1 Schedule K-1 passive income of $5,000. 20-54 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


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 Farrell’s 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.



a. Farrell may only deduct $5,000 currently, and he will have a $10,000 loss suspended by the tax basis limitation, a $100,000 loss suspended by the at-risk limitation, and a $5,000 loss suspended under the passive activity limitation as illustrated in the table below: Description

Tax Basis Limitation

At-risk Limitation

(1) Beginning Tax basis and At-risk amount

$100,000

$10,000

(2) Increase in nonrecourse debt

$10,000

$0

(3) Tax basis and At-risk amount before ordinary business loss (4) Ordinary business loss (5) Loss clearing the Tax basis hurdle (6)Loss suspended by Tax basis hurdle (7) Loss clearing Tax basis hurdle (8) Loss clearing At-risk hurdle (9) Loss suspended by Atrisk hurdle (10) Passive activity loss (11) Passive income (12) Loss used to offset Passive income (13) Passive activity loss carryover

$110,000

$10,000

Passive Activity Limitation

Explanation General debt obligations of LLCs are treated as nonrecourse debt. Thus, Farrell’s beginning at-risk amount is $90,000 less than his beginning tax basis. Non recourse debt increases by $100,000 $90,000. Nonrecourse debt not included in atrisk amount. (1) + (2)

($120,000) ($110,000)

Loss limited to $110,000 tax basis

($10,000)

(4) - (5) ($110,000)

(5)

($10,000)

Loss limited to $10,000 at-risk amount (7) - (8)

($100,000) ($10,000) $5,000 ($5,000) ($5,000)

(8) Farrell is not a material participant From Riverwoods Partnership Loss only used to the extent of passive income (10) – (12)



b. Farrell may only deduct $10,000 currently, and he will have a $10,000 loss suspended by the tax basis limitation, and a $100,000 loss suspended by the at-risk limitation as illustrated in the table below: Description


At-risk Limitation

(1) Beginning tax basis and At risk amount

$100,000

$10,000


$10,000

$0

(3) Tax basis and At-risk amount before ordinary business loss (4) Ordinary business loss (5) Loss clearing the Tax basis hurdle (6)Loss suspended by Tax basis hurdle (7) Loss clearing Tax basis hurdle (8) Loss clearing At-risk hurdle (9) Loss suspended by Atrisk hurdle (10) Passive activity loss

$110,000

$10,000


Explanation General debt obligations of LLCs are treated as nonrecourse debt. Thus, Farrell’s beginning at-risk amount is $90,000 less than his beginning tax basis. Non recourse debt increases by $100,000 $90,000. Nonrecourse debt not included in atrisk amount. (1) + (2)

($120,000) ($110,000)


($10,000)

(4) – (5) ($110,000)

(5)

($10,000)


($100,000)

(11) Passive income (12) Loss used to offset Passive income (13) Passive activity loss carryover

($10,000)

(8) Farrell is not a material participant

$30,000

From Riverwoods Partnership Loss used to the extent of passive income

($10,000) $0

(10) – (12)



c. Farrell may only deduct $10,000 currently, and he will have a $10,000 loss suspended by the tax basis limitation, and a $100,000 loss suspended by the at-risk limitation as illustrated in the table below: Description

Tax Basis Limitation $100,000

At-risk Limitation $10,000


$10,000

$0

(3) Tax basis and At-risk amount before ordinary business loss

$110,000

$10,000

(4) Ordinary business loss (5) Loss Clearing the Tax basis hurdle (6) Loss suspended by Tax basis hurdle (7) Loss clearing Tax basis hurdle (8) Loss clearing At-risk hurdle and deducted on tax return

($120,000)


(9) Loss suspended by Atrisk hurdle

Explanation General debt obligations of LLCs are treated as nonrecourse debt. Thus, Farrell’s beginning at-risk amount is $90,000 less than his beginning tax basis. Nonrecourse debt increases by $100,000 - $90,000. Nonrecourse debt not included in at-risk amount. (1) + (2)

($110,000)


($10,000)

(4) - (5) ($110,000)

(5)

($10,000)

Loss limited to $10,000 at-risk amount on line (3). This amount is deducted on Farrell’s return because he is an active participant. (7) - (8)

($100,000)





75. [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 (including his share of Maverick’s debt) in his partnership interest. During the year, Maverick incurred a $30,000 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 $75,000. Jenkins is not involved in any other passive activities and this is the first year he has been allocated losses from Maverick. 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 $15,000 loss suspended by the tax basis limitation, a $10,000 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:



Description


At-risk Limitation


$50,000

$50,000


$10,000

$0

(3) Tax basis and At-risk amount before ordinary business loss (4) Ordinary business loss (5) Loss clearing the Tax basis hurdle (6)Loss suspended by Tax basis hurdle (7) Loss clearing Tax basis hurdle (8) Loss clearing At-risk hurdle (9) Loss suspended by Atrisk hurdle (10) Passive activity loss (11) Passive income (12) Loss used to offset Passive income (13) Passive activity loss carryover

$60,000

$50,000


Explanation General debt obligations of general partnerships are treated as recourse debt. Thus, Jenkins’ beginning atrisk amount is the same as his beginning tax basis. Nonrecourse debt generally not included in at-risk amount. (1) + (2)

($75,000) ($60,000)


($15,000)

(4) - (5) ($60,000)

(5)

($50,000)


($10,000) ($50,000) $0

(8)Jenkins is not a material participant Given

$0

Loss only used to the extent of passive income

($50,000)

(10) – (12)



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 $15,000 loss suspended by the tax basis limitation. In addition, Prop. Reg. §1.465-66(a) provides that Jenkins may utilize the $10,000 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. 76. [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 Lorinda’s 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 Lorinda’s debt, without the right to be reimbursed by Suki. If Steve follows his advisor’s recommendations, how much additional Lorinda loss can he deduct on his current tax return? How does Steve’s decision affect the amount of loss Suki can deduct on her current return and the amount and type of her suspended losses? 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 as illustrated in the table below:



Description



(2) Distribution (3) Tax basis and At-risk amount before ordinary business loss

($10,000) $160,000

($10,000) $10,000

(4) Ordinary business loss (5) Loss clearing the Tax basis hurdle

($200,000)

$400,000 x50%

($160,000)


(6)Loss suspended by Tax basis hurdle (7) Loss clearing Tax basis hurdle

($40,000)

(4) - (5)


Explanation General debt obligations of LLCs are treated as nonrecourse debt. Thus, Suki or Steve’s beginning at-risk amount is $150,000 less than their beginning tax basis. (1) + (2)

($160,000)

(5)

(8) Loss clearing At-risk hurdle and currently deductible

($10,000)


($150,000)

Loss limited to $10,000 at-risk amount on line (3). This amount is currently deductible because Steve and Suki are active participants in the activity. (7) - (8)





b. 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 have a $80,000 loss suspended by the at-risk limitation as illustrated in the table below: Description



(2) Increase in debt allocation

$50,000

$100,000

(3) Tax basis and At-risk amount before ordinary business loss (4) Ordinary business loss (5) Loss clearing the Tax basis hurdle (6)Loss suspended by Tax basis hurdle (7) Loss clearing Tax basis hurdle (8) Loss clearing At-risk hurdle and currently deductible

$220,000

$120,000



Explanation General debt obligations of LLCs are treated as nonrecourse debt. Thus, Steve’s beginning at-risk amount is $150,000 less than his beginning tax basis. [(100,000 + 50% x $200,000) - $150,000] for tax basis and [100,000 – 0] for at-risk amount because guaranteeing the debt makes it recourse debt (1) + (2)

($200,000) ($200,000)

Loss is less than tax basis limitation

$0

(4) - (5) ($200,000)

(5)

($120,000)

Loss is limited to at-risk amount on line (3). This amount is currently deductible because Steve is an active participant in the activity. (7) - (8)

($80,000)



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: Description (1) Beginning Tax basis and At-risk amount

(2) Distribution (3) Decrease in debt allocation (4) Tax basis and At-risk amount before ordinary business loss (5) Ordinary business loss (6) Loss clearing the Tax basis hurdle (6)Loss suspended 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



($10,000) ($50,000)

($10,000) $0

$110,000

$10,000

Explanation General debt obligations of LLCs are treated as nonrecourse debt. Thus, Suki’s beginning at-risk amount is $150,000 less than her beginning tax basis. [($200,000 x 50% ) – ($300,000 x 50%)] (1) + (2)+ (3)

($200,000) ($110,000)

Loss is limited to the tax basis

($90,000)

(5) - (6) ($110,000)

(6)

($10,000)

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)

($100,000)



77. [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. Alpine’s 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. Alpine’s ordinary business losses for the current year totaled $600,000 and neither member is involved in other activities that generate passive income. a. How much of each member’s loss is suspended because of the tax basis limitation? b. How much of each member’s loss is suspended because of the at-risk limitation? c. How much of each member’s 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


At-risk Limitation


$250,000

$250,000

(2) Ordinary business loss (3) Loss clearing the Tax basis hurdle (4) Loss suspended by Tax basis hurdle (5) Loss clearing Tax basis hurdle (6) Loss clearing At-risk hurdle

($300,000)



Explanation Because the LLC’s mortgage debt is qualified nonrecourse financing, it is included in both the tax basis and at-risk amount 50% x $600,000

($250,000)


($50,000)

(2) - (3) ($250,000)

(3)

($250,000)


$0





b. As indicated in the table above, none of the members’ loss allocation will be suspended because of the at-risk limitation. c. Each member’s $250,000 loss remaining after the tax basis and at-risk 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.

Comprehensive Problems 78. [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 §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 partner’s 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 partnership’s first year of operations. c. 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? 20-70 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


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

$23,333

Aaron

Deanne

Explanation

$110,000 $23,333

$110,000 $23,333

$0

$0

($70,000) $0

(4 )- [(1)+ (2)+ (3)] if positive,

(6) Partners’ initial tax

$23,333

basis

$133,333

$133,333

otherwise 0 (1) + (2) + (3)+ (4) + (5)

b. The partners’ shares of ordinary business loss and separately stated items are reflected in the table below:



Description (1) Partners’ (11) Mortgageinitial Tax basis (deemed reduction (2) Sales revenue cash distribution) Less: (12) Self-employment (3) Cost of goods Loss sold (13) Guaranteed (4) Operating Payment expenses Partners’ ending tax (5) Guaranteed basis payments (6) Ordinary

Total ($7,000)

Keon $23,333 ($2,333)

Aaron $133,333 ($2,333)

Deanne $133,333 ($2,333)

($4,333)

($4,334)

($1,333)

Explanation See problem ($7,000) x 33.33% a. above

$470,000 ($10,000) (410,000)

3,000

(70,000) (3,000)

Line 6 + 13

$17,767

127,767

127,767

(1) + (6)+ (7) through (11) [Sum of (2) through (5)] x 33.33%

($13,000)

($4,333)

($4,333)

($4,333)

$2,400

$800

$800

$800

gains (8) Section 1231

$2,400 x 33.33%

$900

$300

$300

$300

gains (9) Municipal bond

$900 x 33.33%

$300

$100

$100

$100

$300 x 33.33%

($300)

($100)

($100)

($100)

($300) x 33.33%

Business Loss Separately Stated Items on Schedule K-1: (7) Long-term capital

interest (10) Charitable contributions

c. Blue Bell Partnership’s page 1 and Schedule K to be included with Form 1065 and Deanne’s Schedule K-1 are shown below:









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. 79. [LO 4, 5, 6] The TimpRiders LP 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 §1231 gain

$650,000 $500,000 $160,000 $2,000 $2,000 $6,000

On the last day of the year, the partnership distributed $3,000 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. How much of their losses are currently not deductible by Lance and Francesca because of the tax basis limitation? c. To what extent does the passive activity loss limitation apply in restricting their deductible losses for the year? d. Using the information provided, prepare TimpRiders’ page 1 and Schedule K to be included with its Form 1065 for the current year. Also, prepare a Schedule K-1 for Lance and Francesca.



a. Lance has an ending basis of $5,000 and Francesca has an ending basis of $0 as illustrated in the table below: Description

Total

Lance

Francesc

(Limited

a

) $10,000

(General) $3,000

$3,000 $1,000

$3,000 $1,000

$6,000 x 50% $2,000 x 50%

interest (4) Basis Before

$14,000

$7,000

Distributions (5) Cash

Sum of lines (1) through (3)

($3,000)

($3,000)

distributions (6) Basis Before

$11,000

$4,000

(1) Partners’ initial

Explanation

Given

Tax basis Basis Increasing Items: (2) Section 1231 gain (3) Tax-exempt

$6,000 $2,000

Given (4) + (5)

Loss Allocations (7) Sales revenue Less: (8) Cost of goods

(500,000)

sold (9) Operating

(160,000)

expenses (10) Ordinary

($10,000)

($5,000)

($5,000)

business loss (11) Short-term

[Sum of (7) through (9)] x 50%

($2,000)

($1,000)

($1,000)

($2,000) x 50%

$5,000

$0

capital loss Partners’ ending tax

$650,000

basis

(6) + (10) + (11) or limited to a basis of zero. Thus, the tax basis limitation applies to Francesca.

b. As indicated in the table in part a., Lance's loss allocations are not limited by his tax basis; however, Francesca's has $2,000 of losses that are not deductible currently because of the tax basis limitation. c. Although Lance’s 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 20-77 © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.


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 don’t apply to Francesca because she works full time managing the partnership and would be classified as a material participant. d. TimpRiders LP’s page 1 and Schedule K to be included with Form 1065 and both partner’s Schedule K-1 are shown below:















80. [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 member’s interest immediately after the formation of the LLC. b. When does each member’s holding period for his or her LLC interests begin? c. What is Bar T’s tax basis and holding period in its land? d. What is Bar T’s required tax year-end? e. What overall methods of accounting were initially available to Bar T? f. List the separate items of partnership income, gains, losses, deductions and other items that will be included in each member’s Schedule K-1 for the first year of operations. Use the proposed self-employment tax regulations to determine each member’s selfemployment 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?



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. LeBron’s adjusted basis is $216,667, Dennis’ adjusted basis is $216,667, and Susan’s adjusted basis is $16,667 as calculated in the table below: Description (1) Basis in contributed land (2) Cash contributed (3) Debt allocated to

LeBron

Dennis

$200,000

Susan $50,000

Explanation

$50,000

Nonrecourse

$200,000

Susan only

debt > Susan’s tax basis in contributed

(4) Debt allocated to

$16,667

$16,667

$16,667

partners

property [$100,000 $50,000] x 33.33%

(5) Relief from nonrecourse mortgage (6) Gain recognized

($100,000) $0

$0

$0

(5 )- [(1)+ (2)+ (3)+ (4)] if positive,

(7) Partners’ initial tax

$216,667

basis

$216,667

$16,667

otherwise 0 (1) + (2) + (3) + (4) +(5)



b. The holding period for LeBron and Dennis begins when they receive their LLC interests because they only contributed cash. In contrast, Susan’s holding period includes the holding period for the land he contributed since Susan held the land as either a capital or Section 1231 asset. c.

Bar T receives a $50,000 tax basis in the land and will include Susan’s 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).



f. The member’s 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 of Bar T’s debt. Susan clearly has self-employment income under the proposed regulations because she works full time in the enterprise. Description (1) Members’ Initial Tax Basis (2) Dividends (3) Municipal bond interest (4) Deemed cash

Total

LeBron $216,667

Dennis $216,667

Susan $16,667

Explanation See part a. above

$1,200 $300

$400 $100

$400 $100

$400 $100

$1,200 x 33.33% $300 x 33.33%

$40,000

$20,000

$20,000

($3,000)

($1,000)

($1,000)

Accounts payable are only allocated to LeBron and Dennis because they guaranteed them

contribution from accounts payable (5) Cash distributions (6) Deemed cash

($1,000) ($9,000)

distribution to Susan for mortgage repayment

(7) Member’s Tax Basis Before Loss Allocation (8) Sales revenue Less: (9) Cost of goods sold (10) Operating expenses (11) Guaranteed payments (12) Ordinary Business Loss (13) Self-employment loss

$236,167

$236,167

$7,167

(380,000) (670,000) (10,000) ($440,000)

($146,667

($146,667

($146,667

($430,000)

) ($146,667

) ($146,667 )

) ($136,667

$89,500

$0

$620,000

) Members’ ending Tax

Because Susan was originally allocated the first $50,000 of the nonrecourse mortgage, the repayment goes to reduce her share of the debt. Sum of (1) through (6)

$89,500

basis

)

[Sum of (8) through (11)] x 33.33% Line (12) + $10,000 guaranteed payment for Susan only. (7)+ (12) but not less than zero. Susan must carry over $7,167 + ($146.667)



or ($139,500) of ordinary loss.

g. 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. h. 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). i. 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.


SMChap020

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