Tax Allocation in Partnerships and LLCs Minimizing Tax Impact Through - - PowerPoint PPT Presentation

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Tax Allocation in Partnerships and LLCs

Minimizing Tax Impact Through Strategic Allocation of Income, Gains, Losses and Liabilities

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1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Saba Ashraf Partner McKenna Long & Aldridge Atlanta Saba Ashraf, Partner, McKenna Long & Aldridge, Atlanta Jed A. Roher, Attorney, Godfrey & Kahn, Madison, Wis. Lynn Fowler, Partner, Kilpatrick Townsend & Stockton, Atlanta

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Tax Allocation in Partnerships Tax Allocation in Partnerships and LLCs

Saba Ashraf McKenna Long & Aldridge LLP McKenna Long & Aldridge LLP Atlanta, Georgia sashraf@mckennalong.com

February 6, 2013

Basic Concept 1: Difference Between LLC Unit/Interest & Sh f St k f C ti & Share of Stock of Corporation

Each share of a corporation within a particular class entitles its owner to a horizontal slice of: – (i) the corporation’s current value (the “capital interest”); and – (ii) the corporation’s future value – which includes (a) future appreciation b d th d t f th i iti f th i t t d (b) f t i (th beyond the date of the acquisition of the interest, and (b) future income (the “profits interest”)

A share, when 100 are outstanding entitles an owner of 1 share to: 1. 1/100 of the future income (i.e. dividends) of the corporation; 2. 1/100 of the current value of the ( corporation (if corporation were sold now, such owner would get 1/100th of value) 3. 1/100 of the future value or d l d f h proceeds on liquidation of the corporation

6

Basic Concept 1: Difference Between LLC Unit/Interest & St k f C ti & Stock of Corporation

• A unit or interest in an LLC does not entitle its owner to a

horizontal slice of everything. horizontal slice of everything.

• An LLC Operating Agreement is basically a contract between

the members as to how they are going to share all these things (income of the business, current value and future value).

• If you provide for a unit mechanism in your Operating

Agreement, that doesn’t mean that your unit is entitling its holder to a pro rata portion of these things. You have to think about how these things are to be shared among the members about how these things are to be shared among the members, and you have to build your operating agreement to reflect this

• sharing. It won’t happen simply by virtue of owning a unit if

you don’t explicitly provide what your unit entitles your holder to.

• You can set up a unit mechanism and give each unit a horizontal

slice of all these things, but they don’t have to.

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Basic Concept 2: Distributions Versus Allocations p

• Separate Distribution and Allocation Sections. An LLC

Operating Agreement generally has on the one hand a Operating Agreement generally has, on the one hand, a “Distributions” section, and on the other hand the “Allocations” section.

• Distributions Section. The distribution section sets forth

the timing and order in which the “distributable cash” of the LLC will be distributed to the members (also called ( the “Waterfall”). This reflects the economic sharing the members have agreed to. All ti S ti Th ll ti ti t f th

• Allocations Section. The allocations section sets forth

how the book items of income, gain, loss, deduction (which includes the taxable income and loss) of the LLC will be shared among the members of the LLC.

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Basic Concept 2: Distributions Versus Allocations p

• Allocations. Members can decide how they will share

the items of taxable income or loss of the LLC.

– Members have a good bit of control over how to share. – People/companies generally are very excited upon People/companies generally are very excited upon learning that the taxable income and losses of LLCs may be shared among its members in accordance with their agreement – and have immediate visions of having all the taxable income allocated to members that can bear it (i.e. tax exempt members or members that have unused losses), and having all the tax losses go to them. However as you might guess this is not so easy In order However, as you might guess, this is not so easy. In order to be respected by the IRS, the allocations the members agree to must have “substantial economic effect.”

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Example of Distributions Section Example of Distributions Section

Distributions. 4.1.1 Net Cash Flow. Except as otherwise provided in this Agreement, in the discretion of the Managers Net Cash Flow shall be distributed annually or at such other times as determined by the be distributed annually, or at such other times as determined by the Managers, to the Members in the following order and priority: (a) First 100% to Investor until the cumulative (a) First, 100% to Investor until the cumulative distributions under this Section 4.1.1(a) equal Investor's initial Capital Contribution. (b) Second, twenty percent (20%) to Developer and eighty percent (80%) to Investor.

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Example of Allocations Section Example of Allocations Section

Profits and Losses. Except as otherwise provided in Section 4.2.2, any Profits or Losses of the Company for any Allocation Year shall be allocated among the Members in the following order and priority. (a) Profits. (i) First, Profits shall be allocated one hundred percent (100%) to Investor in an amount equal to the excess, if any, of the cumulative Losses allocated to Investor pursuant to S ti 4 2 1(b)(ii) f ll i All ti Y th l ti P fit ll t d t t thi S ti Section 4.2.1(b)(ii) for all prior Allocation Years over the cumulative Profits allocated pursuant to this Section 4.2.1(a)(i) for all prior Allocation Years. (ii) Second, after giving effect to the allocations made pursuant to Section 4.2.1(a)(i), Profits shall be allocated twenty percent (20%) to Developer and eighty percent (80%) to Investor. (b) Losses. (i) First, Losses shall be allocated twenty percent (20%) to Developer and eighty percent (80%) to Investor in an amount equal to the excess, if any, of the cumulative Profits allocated pursuant to 4.2.1(a)(ii) for all prior Allocation Years over the cumulative Losses allocated pursuant to this Section 4.2.1(b)(i) for all prior Allocation Years. (ii) Second, after giving effect to the allocations made pursuant to Section 4.2.1(b)(i), Losses shall be allocated one hundred percent (100%) to Investor.

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Substantial Economic Effect

• SEE generally requires that the income and

l b ll t d t th b th t losses be allocated to the members that actually bear the economic impact of the losses losses.

• Super Simple Example: A& B form LLC, A

contributing $0 and B contributing $100 contributing $0, and B contributing $100. A B A B $0 $100

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Allocation Provisions – Substantial Economic Effect

• LLC has $100 of taxable LLC decides to hang on to the

cash, but it still has to allocate all the taxable income to the members. It has to allocate it to somebody. So, the LLC allocates it all to B. If that happens, then, pp generally, for that allocation to have SEE, B has to actually get that $100 at some point. You can’t allocate $100 of taxable income to B and then give that cash to g A instead.

• Similarly, if the LLC loses the $100 of money that B

contributed you have to allocate that $100 loss to B contributed, you have to allocate that $100 loss to B. You can’t allocate the $100 loss to A, and then have B be the one that is actually out of pocket $100.

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Substantial Economic Effect ‐ Requirements

Key Requirements of SSE. (Again, these are based on the theory that the real economics should determine the tax consequences.):

1. Capital Account be kept for each member. A Capital Account is analogous to a person’s bank account balance At any point in time the balance shows you how much A Capital Account is analogous to a person s bank account balance. At any point in time, the balance shows you how much the bank has to give you if you decide to close down your account with the bank. One of the key premises that the partnership tax regulations are based on is that the Capital Account balance effectively represents the value of a member’s interest in the LLC. 2. The Capital Account balance must be increased or decreased in accordance with certain rules. You bank account balance is (i) increased by the amount of money you deposited, (ii) increased by the interest you earn on the deposit, (iii) decreased by withdrawals you make. Analogously, a Capital Account balance of a member is:

‐increased by contributions of money or other property i d b i ll ti t th b ‐increased by income allocations to the members ‐decreased by loss allocations ‐decreased by distributions to the member

3. On liquidation, the amount a member gets is equal to his/her Capital Account balance. Using the bank account balance as an analogy, when you close an account, you get what is equal to your bank account

• balance. Similarly, an LLC has to distribute an amount equal to the bank account balance when a member leaves the LLC.

This has to be the rule in order for the rules described above for computing the Capital Account balance to have any

• meaning. It wouldn’t make sense that you had all these rules for computing your bank account or Capital Account balance, if
• n closing an account or on liquidation, the LLC/bank had to give you an amount completely unrelated to your balance.

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Substantial Economic Effect – Simple Examples

• Ex. 1 – A & B form an LLC; each contributes $100.

The operating agreement (“OA”) says profits and losses will be allocated 60% to A and 40% and losses will be allocated 60% to A and 40% to B. It also says CA will be kept for A and B and they will be increased by income allocation, contributions made and decreased by distributions and losses allocated + it says

A B

by distributions and losses allocated + it says

• n liquidation A and B will get their “capital

account balance.”

$100 $100

Operating Agreement says:

• Profits and Losses to be allocated 60% to A and 40% to B
• Capital accounts to be kept for A and B that are increased by

income allocation, contributions, and decreased by distributions and losses allocated.

• On liquidation A and B will get their capital account balances

returned to them.

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Substantial Economic Effect – Simple Examples

• So, the LLC has $200 of taxable income. Under OA, $120 (60%)of

thi i ll t d t A (b i i A’ C it l A t b l t this is allocated to A (bringing A’s Capital Account balance to $220),and $80 is allocated to B (bringing his CA to $180). Suppose at the end of the year, the LLC sells all its assets and liquidates. It has $400 of assets, so A gets $220 and B gets $180 $ , g $ g $

A B Beginning Capital Account $100 $100 $200 taxable income $120 (60%) $80 (40%) Capital Account at Year End $220 $180

• Because CA are properly kept and liquidating distributions are in

accordance with CA balances, this LLC’s allocations will be respected by the IRS.

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Substantial Economic Effect – Simple Examples

• Ex. 2 – Same as before, except that when the nontax lawyer looked

at the section of the Operating Agreement that says how distributions will be made on liquidation the lawyer thought – distributions will be made on liquidation, the lawyer thought

“no way am I going to say liquidations will be made in accordance with capital account balances when neither I nor my client really understand what that’ll

• mean. I can’t take the chance that my clients gets out of the deal anything

different from what they expect to get out. I don’t have the time or the patience to go talk to our tax person.”

So, he changes the Operating Agreement to say that on liquidation A will receive 60% of the proceeds, and B will be entitled to receive 40% of the proceeds 40% of the proceeds.

• So, now if the LLC liquidates when it has $400 of assets, everyone

ignores Capital Account balances, and A gets $240 on liquidation (60% of $400) and B gets $160 (40% of 400).

• Because the allocated income provided for in the Operating

Agreement does not match the economic gain that would be realized by each member on liquidation, the contractually agreed upon allocations do not have SEE and will not be respected upon allocations do not have SEE and will not be respected.

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Substantial Economic Effect – Simple Examples

• Ex. 3 – A&B form an LLC and contribute $100 each; they decide that on ultimate

liquidation, A will receive 60% of the proceeds and B will receive 40% of the proceeds. p A B

Operating Agreement says: ‐share distributions 60/40 / ‐but liquidating distributions made in accordance with positive capital account balances.

$100 $100

• The nontax lawyers uses the form used for the LLC in Ex. 2 as a starting point for
• drafting. If you’ll recall, that didn’t have liquidation in accordance with Capital

d a t g. you eca , t at d d t a e qu dat o acco da ce t Cap ta Account balances. They give it to their tax lawyer to review. The tax lawyer and the nontax lawyer do not coordinate or communicate with each other at all as to what the business deal is. The tax lawyer “fixes” the OA to provide for liquidation in accordance with capital account balances (because s/he wants the OA to have ll ti th t th IRS ill t) B t ith t li i it th t l allocations that the IRS will respect). But now, without realizing it, the tax lawyer has completely altered the business deal of the parties.

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Substantial Economic Effect – “Substantiality” Substantial Economic Effect Substantiality

• The “substantiality” aspect of SEE comes up a bit less
• frequently. This test is more subjective.
• In general, for an allocation to be substantial, there must be

reasonable possibility that the allocation will affect substantially the dollar amounts received by the partners independent of tax considerations.

• An example of a potential substantiality problem is when a

partnership contains both a tax‐exempt partner and a taxable partner and the partnership specially allocates disproportionate taxable income to the tax‐exempt partner d th ll t di ti t t t i t and then allocates disproportionate tax‐exempt income to the taxable partner to have the 2 special allocations generally offset economically but lower the overall taxes paid by the partner in the aggregate paid by the partner in the aggregate.

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Getting Distribution/Allocation Provisions Right

• 2 Goals: (1) Get economic/business deal right, and (2)

Ensure that allocations have SEE, so that no risk of IRS Ensure that allocations have SEE, so that no risk of IRS setting them aside. The Distribution provisions and the Allocation provisions of the OA have to work together to get these right to get these right.

• The Distribution provisions set out what the parties

economically get from the LLC. They are the most important The Allocation provisions allocate the

• important. The Allocation provisions allocate the

income and loss to members. But since allocations also affect capital accounts, they can indirectly affect the business deal of the parties particularly true the business deal of the parties – particularly true where you are liquidating in accordance with capital account balances.

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Allocation Provisions – Ways They Can Be Wrong

With that it is important to understand that there are 2 ways in which allocations may be wrong. 1. If they don’t have SEE, the IRS can come along and reallocate them “in y g accordance with the partner’s interest in the partnership.”

– In a simple case, such as one where the current and liquidating distributions are supposed to be shared by everyone pro‐rata, it is pretty easy to figure out what “in accordance with the partner’s interest in the partnership” means. – However, where the distribution scheme is more complicated, it is pretty hard to figure it out: Example: A & B form an LLC. A contributes $100, and B contributes $20. Economic deal between the parties is: 1. First, A gets his capital back, with a 5% rate of return 2. Then B gets his capital back 3. The next $100 of distributions is shared 75% by B and 25% by A; 4 The next $250 of distributions is shared 50% by A and B 4. The next $250 of distributions is shared 50% by A and B 5. Any additional distributions are shared 67% by A and 33% by B If the allocations in the operating agreement do not have SEE, it may not be possible to predict with any degree of confidence who will be taxed on the LLC’s income This could result in some very unpleasant surprises to the members

• income. This could result in some very unpleasant surprises to the members,

who entered into the deal believing that each member would be taxed in accordance with the allocations set forth in the operating agreement.

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Allocation Provisions – Ways They Can Be Wrong

• The IRS cannot invalidate provisions that call

The IRS cannot invalidate provisions that call for contributions or distributions; these provisions are matters of agreement among provisions are matters of agreement among the parties.

• What the IRS can do is invalidate allocations
• What the IRS can do is invalidate allocations,

reallocate, and assess interest and penalties.

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Allocation Provisions – Ways They Can Be Wrong

• 2. The second way that the allocation provisions can be “wrong” is by not

properly reflecting the economic deal of the members.

• A common example In an effort to comply with the SEE regulations the
• A common example: In an effort to comply with the SEE regulations, the
• perating agreement contains provisions under which (1) all income or loss

allocated to a member is reflected in a member’s capital account, and (2) upon liquidation of the LLC, the members will be entitled to distributions in proportion to their positive capital account balances proportion to their positive capital account balances.

• This means the effect of income allocations is not merely on the amount of

tax that each members will be required to pay, but also on the number of real dollars that the member will get when the LLC ultimately liquidates.

• So if the allocations are “wrong” (not because they fail to comply with the

SEE rules, but because they don’t properly reflect the economic deal) the effect can be that the actual cash received by each member, regardless of tax consequences, may not be in accordance with the intention of the q , y parties.

23

Drafting Allocation/Distribution Provisions Drafting Allocation/Distribution Provisions There are many ways to draft an allocation There are many ways to draft an allocation

• provision. Very broadly, they can be placed in 2

categories: categories: 1 L d h

• 1. Layered approach
• 2. Targeted/Forced approach

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2 Allocation Provision Approaches 2 Allocation Provision Approaches

1 Layered Approach

• 1. Layered Approach

The tax lawyer carefully goes through the

• rdering rules in the Distribution Section (the
• rdering rules in the Distribution Section (the

“Waterfall”) and thinks through how allocations should be made so as to (i) not alter the should be made so as to (i) not alter the business deal of the members, and (ii) so that the regulations have SEE the regulations have SEE.

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1st Approach: Layered Allocation 1 Approach: Layered Allocation

Simple Example: A & B form an LLC. A puts in $100, and B puts in $50. Distributions: Distributions of available cash shall be made each year at he discretion of the Manager and shall be in the following order of priority: (i) First to A until the Unpaid Preferred Amount has been reduced to zero; (i) First, to A, until the Unpaid Preferred Amount has been reduced to zero; (ii) Then to return A’s capital contributions; and (iii) Then to return B’s capital contribution; and (iv) Thereafter, equally to A and B. ( ) , q y Allocations: ‐Profits shall be allocated each year as follows: (i) First, if A’s capital account balance is less than the Unpaid Preferred Amount to A, until A’s Unpaid Preferred Amount has been reduced to zero; and (ii) Thereafter equally to A & B (ii) Thereafter, equally to A & B.

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1st Approach: Layered Allocation 1 Approach: Layered Allocation

• Pros:

– There is a greater emphasis placed on making sure the Capital Account balances get to the right place, which necessarily means there is a greater emphasis on making sure the client him/herself has thought through precisely what their business deal is. Once you start to ask business people some questions about their business deal, you often realize they haven’t fully thought it through.

• Cons:

Time consuming – Time consuming. – You will actually have to talk with tax lawyers. – Hard to explain to your client. – Even with all the discussion there can be no guarantee that the Even with all the discussion, there can be no guarantee that the allocations are correct. – The consequence of an error is that the business deal itself might be

• changed. So, there is a lot riding on making sure these are correct.

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2nd Approach: Targeted/Forced Allocations

• Generally, this type of allocation provision says

something along the lines of “profits and losses will be allocated in such a way so as to cause each member’s capital account balance to be equal to the amount that p q the member is entitled to receive if the LLC were to liquidate at the end of the year.”

• In other words, the distributions should be very clear.

If they are clear, then the LLC will allocate the income/losses to the members to force each member’s income/losses to the members to force each member s Capital Account balance to equal precisely what the member is supposed to receive on liquidation.

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2nd Approach: Targeted/Forced Allocation

• Increasingly Popular.
• There are many different ways to draft such a provision.
• One example:

Net Profits and Net Losses for the year shall be allocated among the partners in a manner such that, to the extent possible, the capital account balance of each partner at the end of such year shall be equal to the excess of: p y q (1)The amount that would be distributed to such partner if (a) the company were to sell the assets of the company for their Gross Asset Values, (b) all Company liabilities were settled in cash according to their terms (limited, with respect to each nonrecourse liability, to the book values of the assets securing such liability) and (c) the net proceeds thereof were distributed securing such liability), and (c) the net proceeds thereof were distributed in full pursuant to the distribution provisions, over (2)The sum of (a) the amount, if any, without duplication, that such Partner would be obligated to contribute to the capital of the Company, (b) such Partner’s share of Partnership Minimum Gain determined pursuant to p p

• Treas. Reg. Section 1.704‐2(g) and (c) such Partner’s share of Partner

Nonrecourse Debt Minimum Gain determined pursuant to Treas. Reg. Section 1.704‐2(i)(5), all computed as of the date of the hypothetical sale described in (1) above.

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2nd Approach: Targeted/Forced Allocation pp g

Way this practically works: (1) Each member’s Capital Account is adjusted based on the year’s contributions, distributions and book‐ups (i.e. everything other than the income/loss tax allocations). (2) Everyone pretends the LLC sells all its assets for cash at the end of the year at their fair market value, and that it took the proceeds and will distribute to the members pursuant to the waterfall. (3) The income/loss the LLC has is allocated among the members so that each member’s balance equals the q amount the member would be entitled to receive as described in Step (2).

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2nd Approach: Targeted/Forced Allocations

Ex: A and B form an LLC. A contributes $90. B contributes $10. Distributions: Cash is paid first to return contributed capital + a 10% annual preferred return, and then is paid 80/20 to A and B respectively. The LLC earns $20 of income in year 1. A B

Operating Agreement Distrib tions Operating Agreement Distributions

• 1. First to return contributed capital+

preferred return of 10% 2 Then 80/20 to A and B

• 2. Then 80/20 to A and B.

$90 $10

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2nd Approach: Targeted/Forced Allocations

Step 1: Our example is really simple and we’re pretending there were no

• ther contributions/distributions. So, A’s capital account is $90 and B’s is $10

Step 2: All the LLC’s assets at the end of the year are worth $120 ($100 contributions + $20 income). If the LLC liquidated at the end of the year, then under our distribution waterfall, A and B would get $107 and $13 respectively: respectively:

A B Total Return of capital $90 $10 $100 Preferred returns $9 $1 $10 Residual return $8 $2 $10 Total Distribution if LLC sold all assets and liquidated $107 $13 $120

Step 3: Allocate income to that A’s capital account balance equals $107.

For A to get from $90 (beginning capital account) to $107 (ending capital ‐For A: to get from $90 (beginning capital account) to $107 (ending capital account), we have to add $17 to it. A gets allocated $17 of the taxable income. ‐For B: to get from $10 to $13, we allocate $3 of taxable income to him or her.

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2nd Approach: Targeted/Forced Allocation 2 Approach: Targeted/Forced Allocation

Pros:

• 1. Can’t alter the business arrangement. There is

economic certainty.

• 2. You technically have SEE because liquidating

distributions equal the amount of the capital account balance. balance.

• Some people take position that it is unclear whether

targeted/forced allocations have SEE because technically you are still liquidating in accordance with distributions scheme. However, most take the view that where the capital account balance must equal that amount to be received in the waterfall, it doesn’t matter that the liquidation section doesn’t precisely say “liquidate in accordance with capital account balances ” say liquidate in accordance with capital account balances.

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2nd Approach: Targeted/Forced Allocation 2 Approach: Targeted/Forced Allocation

Cons: 1. They are the easy way out, so often no one (including the tax lawyers and the members of the LLC) stops to think through how income/losses will really be allocated. 2 The work and the risk is shifted from the lawyer during the 2. The work and the risk is shifted from the lawyer during the drafting of the OA to the accountant who will prepare the K‐1s. (In all honesty, even in perfectly drafted allocation provisions, there are usually situations that come up that the accountant has to think through that the drafters didn’t anticipate or address.) 3. Practically, there is really no telling how the person actually doing the allocations is doing them and whether s/he really understands how the targeted allocation provision works (Same is true how the targeted allocation provision works. (Same is true, however, for layered allocations.)

34

Allocations with Respect to Built‐In Gain or Loss Property

• If a member contributes assets with built‐in

a e be co t butes assets t bu t appreciation or depreciation, special rules require that the built‐in tax gain or loss (when it is ll d b h ) b ll d eventually recognized by the LLC) be allocated back to the contributing partner. A i k i i d th t thi l l t t th

• Again, keep in mind that this only relates to the

allocations of gain and loss. The distributions of the proceeds from the sale of the property can be the proceeds from the sale of the property can be shared by the members in whatever manner they choose.

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Allocations with Respect to Built‐in ( ) Gain or Loss Property ‐ Section 704(c)

A B $100 h Property with value of $100 d b i f $20 cash $100 and basis of $20 When the partnership eventually sells the property, the $80 of taxable gain must b ll d B U lik i h i B ’ i h j be allocated to B. Unlike with a corporation, B can’t escape taxation on that just by contributing it to the LLC. If the property is sold for more than $100, then while the first $80 of gain must be allocated to B, the remainder of the economic gain (i.e., the post contribution gain) can be allocated in accordance with the

36

g ( , p g ) parties’ agreement.

Allocations with Respect to Built‐in ( ) Gain or Loss Property ‐ Section 704(c)

• Another way to look at this is that the tax‐basis
• t e

ay to oo at t s s t at t e ta bas s shortfall (i.e., to the extent that the tax basis is less than the value upon contribution) must be b b h b h b borne by the contributing partner. The tax basis shortfall can be borne by the contributing partner either by having (i) the taxable gain on the sale either by having (i) the taxable gain on the sale being allocated to the contributing partner, (ii) the tax depreciation deductions being allocated p g away from the contributing partner to the non‐ contributing partner.

37

Nonrecourse Deductions & Minimum Gain Chargeback P i i Provisions

• A special set of rules govern allocation of partnership

deductions funded by nonrecourse debt Without the deductions funded by nonrecourse debt. Without the special rule, these allocations could not have SEE because no members bears the economic burden of the losses associated with these since the lender is really the one associated with these since the lender is really the one whose capital is at stake (and not a member’s).

• Example:
• A and B each contribute $100 to a LLC.

A and B each contribute $100 to a LLC.

• LLC borrows $800 on a nonrecourse basis to buy a building for $1

million.

• Once the building was depreciated from $1000 to $800, A’s and B’s

capital accounts would be zero capital accounts would be zero.

• Any further allocations of depreciation would drive their capital

accounts impermissibly negative but for the special nonrecourse deduction rules.

38

Nonrecourse Deductions & Minimum Gain Chargeback P i i Provisions

• To address this situation, the regulations create the concept called

“ t hi i i i ” t t k d d ti h “partnership minimum gain” to track deductions where a non‐ partner lender is at risk for a partnership liability. Minimum gain is the amount by which the nonrecourse debt exceeds the basis in the property secured by the debt. (The debt will probably not start out p p y y ( p y as exceeding basis, but will get to that point when depreciation deductions are taken on the property, and eventually, the basis is below the debt encumbering the property.) The concept is that a nonrecourse deduction can be allocated to a partner to cause its nonrecourse deduction can be allocated to a partner to cause its capital account to be negative, even without a partner obligation to restore such negative capital account.

• The IRS allows this so long as there is a “minimum gain chargeback.”

g g g The idea is that when the property secured by the nonrecourse debt is disposed of, an amount of gain equal to the nonrecourse debt minus the basis will be “charged back” to those members that took the nonrecourse deductions So the IRS is protected overall took the nonrecourse deductions. So, the IRS is protected overall.

39

Nonrecourse Deductions & Minimum Gain Chargeback P i i Provisions

Example: p

• A and B each contribute $50k to an LLC
• LLC borrows an additional $900k on a non‐recourse basis to acquire a

$1 million building. g

• Over the years, A and B take depreciation deductions of $500k ($250k

each). Their capital accounts are decreased from $50k to negative $200.

• Of the $500k in deductions ($250k each), the first $100k ($50k each)

are attributed to A’s and B’s contributed capital. The remaining $200k each of deductions is attributed to the nonrecourse debt.

• It is okay to allocate these deductions to A and B so long as the $400k
• f partnership minimum gain ($900k liability less $500k basis) is
• f partnership minimum gain ($900k liability less $500k basis) is

allocated also to A and B.

• The minimum gain will be triggered on the sale by the LLC of the

building or if the lender forgives the loan. building or if the lender forgives the loan.

40

Nonrecourse Deductions & Minimum Gain Chargeback P i i Provisions

• Only the first $50 of the depreciation

deductions can have substantial economic

A B Initial Capital 50 50

effect, since neither of the parties contributed money greater than that.

• However, since the partnership agreement

contains a minimum gain chargeback

p Nonrecourse Deductions (250) (250) Net Capital (200) (200)

contains a minimum gain chargeback provision, this means the partnership will keep track of its minimum gain ($900 nonrecourse debt less $500 book basis will mean $400 of minimum gain). And when

Net Capital (200) (200)

mean $400 of minimum gain). And when the partnership minimum gain of $400 is recognized, each of A and B has agreed to recognize their share of $200 each. This minimum gain will support their negative minimum gain will support their negative capital account of $200, and prevent them from having Adjusted Capital Account Deficits.

41

Nonrecourse Deductions & Minimum Gain Chargeback P i i Provisions

If the partnership sells or otherwise disposes of If the partnership sells or otherwise disposes of the building, or if the creditor of the nonrecourse loan forgives all or a portion of the nonrecourse loan forgives all or a portion of the loan – the minimum gain will be recognized and the chargeback will kick in the chargeback will kick in.

42

Nonrecourse Deductions & Minimum Gain Chargeback P i i Provisions

• The regulations create a parallel concept for

g p p nonrecourse debt loaned or guaranteed by a partner (i.e., “partner nonrecourse debt”) except that those deductions and the related chargeback that those deductions and the related chargeback must be allocated to the lender/guarantor partner because that partner is indirectly at risk d t l b i th l d / t I th t due to also being the lender/guarantor. In that case, the regulations use the terms “partner minimum gain” and “partner minimum gain g p g chargeback” to have similar meanings to “partnership minimum gain” and “partnership minimum gain chargeback ” minimum gain chargeback.

43

Capital Shifts p

• Why is it important? The IRS has historically successfully asserted

th t “ hift” i it l t d t bl t f that a “shift” in capital among partners produces a taxable event for the receiving partner (and in some cases, for the transferring partners too). See Lehman v. Commissioner, 19 T.C. 659.

• What is it? Capital shifts can take many forms but a capital shift

What is it? Capital shifts can take many forms, but a capital shift generally occurs when a member with a capital interest agrees to forgo part or all of its right to proceeds on liquidation of the LLC.

• As earlier discussed, one of the key concepts underlying partnership

taxation is that the capital account balance represents what each partner is entitled to receive on the liquidation of a partnership, and thus, the capital account balance must represent the value of the partnership interest the value of the partnership interest.

44

Capital shift – simplest example Capital shift simplest example

• A and B form a partnership. A contributes $0 and B contributes $100. The
• perating agreement says split the proceeds 50/50 on liquidation.
• There is a capital shift of $50 from B to A. This shift is immediate because

the operating agreement says that on an immediate liquidation, A and B would share equally. (In other words, it isn’t as if a hurdle has to be reached before this shift kicks in.)

A On liquidation: A B

$100

On liquidation: A gets $50 B gets $50

45

Capital Shift – Targeted/Forced Allocation With Preferred Return

Ex: A & B form an LLC. A puts in $100, and B puts in $50. Distributions: (i) Fi A il A f d ($10 f 1)

A B

(i) First, to A, until A gets preferred return ($10 for year 1); (ii) Then to return A’s capital contributions; and (iii) Then to return B’s capital contribution; and (iv) Thereafter, equally to A and B.

$100 $50

The LLC earns $7 for year 1. If the LLC allocated in accordance with a layered approach, allocations would go y pp , g something like this (1st to A in an amount equal to A’s preferred return; then, equally to A & B):

A B Total l $ $ $ Beginning Capital Account $100 $50 $150 Allocation of income $7 $0 $7 Ending Capital Account $107 $50 $157

So, on liquidation, this is the amount A and B would get.

46

Capital Shift – Targeted/Forced Allocation With Preferred Return

If on the other hand, there was a targeted allocation provision: Step 1: Starting capital account balances: A=$100 and B = $50 Step 2: Distributions on hypothetical liquidation ‐ LLC has total of $157: Step 2: Distributions on hypothetical liquidation LLC has total of $157:

A B Total

Preferred Return $10 ‐ $10 Return of A’s Capital $100 ‐ $100 Residual Returns B’s Capital $47 $47 Total to be Distributed $110 $47 $147

So, on liquidation, this is the amount A and B would get. $3 of B’s capital got shifted to A. $3 of B s capital got shifted to A.

47

Capital Shift – Targeted/Forced Allocation With Preferred Return

• So, the key difference is that in the case where there is not enough

money to satisfy the preferred return priority, some of the capital will shift from B to A. What the parties probably really intended was that A gets a preferred return only if there is enough money in the LLC to satisfy h f d f h l b f d the preferred return after the capital contributions of A and B are

• satisfied. The potential taxable income occurs when the shift occurs. So,

if for years, there was enough to give the preferred return, and only at a certain point there was insufficient income then that is when the capital certain point there was insufficient income, then that is when the capital shifted, and that is when the taxable income event would occur.

• The allocation is technically correct. But the distributions may not be

what the parties intended what the parties intended.

• Maybe one way around this is to specify that the preferred return is to be

paid to the extent there were sufficient net profits.

48

Capital Shift – When Service Providers l Receives a Capital Interest

• Another typical example: LLC with A and B as members wants to give C, an

l i t t i th LLC employee, an interest in the LLC.

• Suppose A and B formed it on 1/1/12 by contributing $10 each.
• On 1/1/13, the LLC is worth $150, and they want to bring in C, and give him a “1/3

interest.” At this point, the capital acccounts of A and B should reflect a booked up p , p p balance of $75 each. If C gets a right to 1/3 or $50 upon entering, then $50 of capital shifted from A and B to C. A B ‐C’s interest would have been tax‐free if it had C s interest would have been tax free if it had been a “profits interest” instead of this. ‐How do get it to be a profits interest? ‐Say distribution/liquidation section id th t ft fi t $10 i t d t provides that after first $10 is returned to each of A and B, then everything is shared?

49

Capital Shift – Forfeit Interest on l l ll Failure to Meet Capital Call

Th b f thi LLC h d th t A

• The members of this LLC have agreed that

there will be regular capital calls; and that upon the failure of a member to meet a capital call, the member will forfeit a portion A p , p

• f his interest, and it will revert to the other

members.

• Example: A has contributed $1,000. The LLC

is worth $100 000 There is a capital call that is worth $100,000. There is a capital call that A fails to meet. Let’s assume A’s capital account balance at that time is $1,000. Under the terms of the operating agreement, A is to forfeit all of this (typically, it’ll probably be a portion). Upon the forfeiture, $1,000 of capital has shifted from A to the other members members.

50

Capital shift – Common examples Capital shift Common examples

• When a service provider receives anything other than a

p y g pure profits interest in an LLC.

• When a non‐compensatory option is exercise to

i i t t i LLC acquire an interest in an LLC.

• When a preferred interest in an LLC “converts” to a

common interest in an LLC at a point in time when the common interest in an LLC at a point in time when the common was already entitled to some value.

• When someone a member forfeits his/her/its interest

/ (perhaps because s/he or it couldn’t meet a capital call) and their capital shifts to the account of other members.

51

members.

Tax Consequences of Capital Shift

• In the context of compensatory capital shifts,

it is pretty clear that the IRS will tax the it is pretty clear that the IRS will tax the capital shift to the recipient.

• In the case of the exercise of non‐

t e case o t e e e c se o

• compensatory options, the IRS has issued

proposed regulations that take the position there is no capital shift or resulting income.

• Outside these 2 contexts, however, there is

relatively little law on the tax consequences

• f capital shifts.

52

Tax Consequences of Capital Shift

Based on the limited case‐law, the partnership tax regulations and the commentary, below is a summary of the approaches that may be taken: 1. There is current taxable income to the remaining partners in the amount of the capital that g p p has shifted from the defaulting partners to them. 2. There is current taxable income to the remaining partners; however, the value of the current income should equal the fair market value of the forfeited interest of the defaulting partners; this may not necessarily be equal to the capital being shifted. Perhaps minority discounts and lack of marketability would make this lower lack of marketability would make this lower. 3. Instead of accounting for the capital shift by reporting current income to the remaining partners, the partnership should do "catch‐up" allocations of future losses of the partnership (gross, not net) to the defaulting partners and income to the remaining partners until such time as enough income has been allocated to the remaining partners. This approach seems like a reasonable one; though there isn't certainty that the IRS would agree with it like a reasonable one; though there isn t certainty that the IRS would agree with it. 4. Finally, some take the position that the IRS would be wrong in asserting that there should be current taxable income. Though not all the commentators supporting this view are able to clearly articulate the rationale for this, it appears to be based on either a “bargain purchase” theory, or along the lines of: When a partnership redeems the interest of a partner for less th hi it l t b l th i 't id d t b it l hift t bl i than his capital account balance, there isn't considered to be a capital shift or taxable income to the remaining partner. It should be noted that this position carries a good bit of risk with it, and it is not at all clear that the IRS would agree with this.

53

Additional Authorities/Sources

• Jonathan R. Flora, Venture Capital, Meet Capital Shift, The M&A Tax Report,

February 2008.

• Kevin Thomason, The Myth of the Capital Shift, Journal of Passthrough

Entities, September‐October 2002.

• Robert P. Rothman, Translating Corporate Concepts into LLCs, 61 The Tax

Lawyer 161 (2007).

• Linda Z. Swartz, A Layman’s Guide to LLC Incentive Compensation, PLI’s Tax

planning for domestic & foreign partnerships, LLCs, joint ventures & other strategic alliances, 2007.

• Steven R. Schneider & Brian J. O’Connor, Partnership and LLC Agreements –

Learning to Read and Write Again, Tax Notes, December 21, 2009.

• William G. Cavanagh, Targeted Allocations Hit the Spot, Tax Notes, October

4, 2010.

• L. Andrew Immerman, Is There Any Such Thing as an LLC Unit?, Journal of

54

y g Business Entities, July/August 2009.

Tax Allocations in Partnerships and LLCs Partnerships and LLCs

Strafford Publications February 6, 2013

JED A ROHER JED A. ROHER One East Main Street Suite 500 Madison, WI 53701 Madison, WI 53701 jroher@gklaw.com

Agenda Agenda

II. Allocation of Contributed Property II. Allocation of Contributed Property III. Allocation of Liabilities IV. Distribution Rules IV. Distribution Rules

56

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Capital accounts are economic / book concepts

Capital accounts are economic / book concepts

• So, capital accounts are increased by fair market

value of contributed property

• And fair market value of property is reflected on

the partnership’s books

• But, basis is a tax concept
• So, contributor’s basis in partnership interest

d i d f b i i t derived from basis in property

• And partnership takes a basis in contributed

property equal to contributor’s basis

57

property equal to contributor s basis

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Can create book / tax disparities

Can create book / tax disparities

• A contributes property with a basis of $5,000,

FMV of $25,000; B contributes $75,000 cash , ; ,

• Assume 5-year, straight line depreciation

A (25 Units) B (75 Units) Total

Tax Book Tax Book Tax Book

Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000

58

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• The Code’s answer: § 704(c)(1)(A)

§ ( )( )( )

• “income, gain, loss, and deduction with respect

to property contributed to the partnership by a partner shall be shared among the partners so as partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its f i k t l t th ti f th t ib ti ” fair market value at the time of the contribution”

• “The purpose of section 704(c) is to prevent the

shifting of tax consequences among partners shifting of tax consequences among partners with respect to precontribution gain or loss.”

• Treas. Reg. § 1.704-3(a)(1)

59

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Goal is to bring book and tax into harmony

Goal is to bring book and tax into harmony “using a reasonable method that is consistent with the purpose of section 704(c)”. Treas. Reg. § 1.704-3(a)(1).

• 704(c) allocation rules apply on a property-by-

C ff property basis. Can choose different methods for different properties. Treas. Reg. § 1.704- 3(a)(2) 3(a)(2).

• Subject to an anti-abuse rule if allocations

aimed at reducing aggregate tax liability

60

aimed at reducing aggregate tax liability

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Regulations detail three methods:

Regulations detail three methods:

• traditional (Treas. Reg. § 1.704-3(b));
• traditional with curative allocations (Treas. Reg. §

( g § 1.704-3(c));

• remedial ((Treas. Reg. § 1.704-3(d))

61

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Traditional method:

Traditional method:

• Tax allocations follow book allocations
• But total income, gain, loss or deduction

, g , allocated to the partners in a taxable year with respect to a property cannot exceed the total t hi i i l d d ti ith partnership income, gain, loss or deduction with respect to that property in that year

• This is the “ceiling rule”

This is the ceiling rule

62

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Traditional method:

A (25 Units) B (75 Units) Total

Tax Book Tax Book Tax Book

Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Y1 Depreciation (1 250) (1 000) (3 750) (1 000) (5 000) Y1 Depreciation (1,250) (1,000) (3,750) (1,000) (5,000) Capital Accounts After Y1 5,000 23,750 74,000 71,250 79,000 95,000

63

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Traditional method with curative allocations:

Traditional method with curative allocations:

• Goal is to correct distortions caused by ceiling

rule

• Tax allocations follow book allocations, but

partnership can use tax allocations from other t t iti t ff t f ili l property to mitigate effect of ceiling rule

• Tax allocations from other property must be

expected to have same effect on partners’ tax expected to have same effect on partners tax liability as tax item limited by ceiling rule

64

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Traditional method with curative allocations:

A (25 Units) B (75 Units) Total

Tax Book Tax Book Tax Book

Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Y1 Depreciation (A asset) (1 250) (1 000) (3 750) (1 000) (5 000) Y1 Depreciation (A asset) (1,250) (1,000) (3,750) (1,000) (5,000) Y1 Depreciation (bought asset) (1,000) (3,750) (14,000) (11,250) (15,000) (15,000) Capital Accounts After Y1 4 000 20 000 60 000 60 000 64 000 80 000 Capital Accounts After Y1 4,000 20,000 60,000 60,000 64,000 80,000

65

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Remedial method:

Remedial method:

• Goal is to eliminate distortions caused by ceiling

rule

• Partnership creates phantom tax items to

allocate among the partners

66

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Remedial method:

A (25 Units) B (75 Units) Total

Tax Book Tax Book Tax Book

Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Y1 Depreciation (1 250) (1 000) (3 750) (1 000) (5 000) Y1 Depreciation (1,250) (1,000) (3,750) (1,000) (5,000) Y1 Remedial Allocations 2,750 (2,750) Capital Accounts After Y1 7,750 23,750 71,250 71,250 79,000 95,000

67

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• We have been talking about “operating”

We have been talking about operating allocations with respect to property

• On the sale of property, the basic rule is that

p p y, built-in gain or loss remaining in property on sale is allocated to contributing partner

68

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Sale of property:

p p y

A (25 Units) B (75 Units) Total

Tax Book Tax Book Tax Book

Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Sale for $25,000 20,000 20,000 Capital Accounts After Sale 25,000 25,000 75,000 75,000 100,000 100,000

69

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Sale of property after 1 year:

p p y y

A (25 Units) B (75 Units) Total

Tax Book Tax Book Tax Book

Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Y1 Depreciation (1,250) (1,000) (3,750) (1,000) (5,000) Capital Accounts After Y1 5,000 23,750 74,000 71,250 79,000 95,000 Sale for $20 000 16 000 16 000 Sale for $20,000 16,000 16,000 Capital Accounts After Sale 21,000 23,750 74,000 71,250 95,000 95,000

70

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• Sale of property after 1 year:

p p y y

A (25 Units) B (75 Units) Total

Tax Book Tax Book Tax Book

Capital Contribution 5,000 25,000 75,000 75,000 80,000 100,000 Y1 Depreciation (1,250) (1,000) (3,750) (1,000) (5,000) Capital Accounts After Y1 5,000 23,750 74,000 71,250 79,000 95,000 Sale for $25 000 16 000 16 000 Sale for $25,000 16,000 16,000 1,250 1,250 3,750 3,750 5,000 5,000 Capital Accounts After Sale 22,250 25,000 77,750 75,000 100,000 100,000

71

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• “Mixing Bowl” rules: Section 704(c)(1)(B) /

Mixing Bowl rules: Section 704(c)(1)(B) /

• Treas. Reg. § 1.704-4
• If property contributed by 1 partner is distributed

p p y y p to a different partner within 7 years of contribution, built-in gain or loss is allocated to contributing partner

72

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• 3. Allocation of

Partner 1 Partner 2

• 3. Allocation of

built-in gain to Partner 1

• 1. Contribution of

appreciated property

• 2. Distribution of

t /i 7 property w/in 7 years

704(c)(1)(B)

73

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• “Reverse” Mixing Bowl rules: Section 737(a) /

Reverse Mixing Bowl rules: Section 737(a) /

• Treas. Reg. § 1.704-4
• If partner contributes property with built-in gain,

p p p y g , and receives a distribution of other property within 7 years of contribution, contributing f ( ) f partner recognizes lesser of (i) excess of value

• f distributed property over partner’s outside

basis or (ii) amount that would have been basis, or (ii) amount that would have been recognized by partner under the mixing bowl rules w/r/t all property contributed by partner

74

rules w/r/t all property contributed by partner

Allocations: Contributed Property

• cat o s Co t buted
• pe ty

Partner 1

• 3. Allocation of

built in gain in

• 1. Contribution of

appreciated property

• 2. Distribution of
• ther property

w/in 7 years built-in gain in properties contributed by Partner 1 to Partner 1 property

737(a)

75

Allocations: Contributed Property

• cat o s Co t buted
• pe ty
• And watch out for the “disguised sale” rules of

And watch out for the disguised sale rules of 707(a)(2)(B)!

• If:
• direct or indirect transfer of money or other

property by a partner to a partnership,

• related direct or indirect transfer of money or
• ther property by partnership to contributing

partner or another partner and partner or another partner, and

• transfers properly characterized as a sale,
• Then transaction treated as sale of property

76

• Then transaction treated as sale of property

Agenda Agenda

II. Allocation of Contributed Property II. Allocation of Contributed Property III. Allocation of Liabilities IV. Distribution Rules IV. Distribution Rules

77

Allocation of Liabilities Allocation of Liabilities

• Increase in share of partner’s liabilities treated

Increase in share of partner s liabilities treated as a contribution of money by the partner to the partnership.

• Decrease in share of partner’s liabilities treated

as a distribution of money by the partnership to the partner.

• Any decrease in partner’s liabilities as a result of

a sale or exchange of the partner’s interest in the a sale or exchange of the partner s interest in the partnership treated as an amount realized under § 1001.

78

§

Allocation of Liabilities Allocation of Liabilities

• Two types of liabilities:

Two types of liabilities:

• Recourse: liabilities for which a partner bears the

“economic risk of loss” under Treas. Reg. § 1.752-2

• Nonrecourse: liabilities for which no partner

b th “ i i k f l ” bears the “economic risk of loss”

79

Allocation of Liabilities Allocation of Liabilities

• “Economic risk of loss”:

Economic risk of loss :

• Driven by obligation of a partner to make a

payment to any person if the partnership constructively liquidates

• Paying partner must not have any right of

i b t f th t reimbursement from any other partner

• Obligation can be derived from contractual
• bligations outside of partnership (guarantees
• bligations outside of partnership (guarantees,

etc.) or from partnership agreement (capital contribution obligation, DRO)

80

contribution obligation, DRO)

Allocation of Liabilities Allocation of Liabilities

• Recourse liabilities are allocated among the

Recourse liabilities are allocated among the partners that bear the economic risk of loss for those liabilities, to extent of economic risk.

• Nonrecourse liabilities are allocated among all
• f the partners. Each partner is allocated:
• Partner’s share of partnership minimum gain, +
• Partner’s share of 704(c) gain for property

bj t t li biliti subject to nonrecourse liabilities, +

• Partner’s allocable share of any remaining

nonrecourse liabilities based on share of profits

81

nonrecourse liabilities, based on share of profits

Agenda Agenda

II. Allocation of Contributed Property II. Allocation of Contributed Property III. Allocation of Liabilities IV. Distribution Rules IV. Distribution Rules

82

Distribution Rules Distribution Rules

• Distributions by a partnership to a partner

Distributions by a partnership to a partner generally trigger gain only if any money distributed exceeds the partner’s adjusted basis in the partner’s interest in the partnership. § 737(a)(1) f

• Any gain on distribution is treated as gain from

the sale or exchange of the distributee partner’s partnership interest partnership interest

83

Distribution Rules Distribution Rules

• First, partner’s basis in partnership interest is

First, partner s basis in partnership interest is reduced (but not below zero) by amount of cash distributed.

• If basis is insufficient to soak up cash, gain to

extent of excess

• Second, partner’s remaining basis becomes the

basis of any non-cash property distributed to the partner the partner

84

Distribution Rules Distribution Rules

• If more than one property / type of property is

If more than one property / type of property is distributed, remaining basis goes:

• first to any distributed unrealized receivables and

y inventory items, to the extent of the partnership’s basis in those items; d t th t di t ib t d (fi t t

• second to any other property distributed (first to

depreciated property, then to all property in proportion to inside basis) proportion to inside basis)

85

Distribution Rules Distribution Rules

• If distribution operates to increase or decrease

p a partner’s share of partnership hot assets (unrealized receivables or substantially appreciated inventory) in exchange for a appreciated inventory) in exchange for a decrease or increase in the partner’s share of

• ther partnership property, distribution is treated

as a sale or exchange. § 751(b).

• Trap for the unwary: admission of new partner

reduces existing partners’ share of nonrecourse reduces existing partners share of nonrecourse liabilities; deemed cash distribution / reduction in hot assets; 751(b) applies. Rev. Rul. 84-102.

86

Lynn E Fowler l k d k Kilpatrick, Townsend & Stockton LLP

1100 Peachtree Street, Suite 2800 Atlanta, Georgia 30309

V ADJUSTMENTS TO BASIS OF

404.815.6653 Lfowler@kilpatricktownsend.com

• V. ADJUSTMENTS TO BASIS OF

PARTNERSHIP/LLC ASSETS

Base Case

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 1200 2400 A Capital 900 1300 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

P allocates profits and losses 1/3 to each of A, B and C

88

A Transfers of Partnership

• A. Transfers of Partnership

Interests

89

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 1200 2400 A Capital 900 1300 Blackacre 1200 2400 A Capital 900 1300 B Capital 900 1300 C Capital 900 1300 C C p 900 300 Total 3300 4500 Total 3300 4500

A sells his interest to D for $1300 Partnership has made no Section 754 election

90

Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets

IRC §743- Special rules where section 754 election or substantial built-in loss.

(a) General rule. The basis of partnership property shall not be adjusted as the result of a ( ) p p p p y j transfer of an interest in a partnership by sale or exchange or on the death of a partner unless the election provided by section 754 (relating to optional adjustment to basis of partnership property) is in effect with respect to such partnership or unless the partnership has a substantial built-in loss immediately after such transfer. the partnership has a substantial built in loss immediately after such transfer.

91

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 1200 2400 A Capital 900 1300 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

What happens if P sells Blackacre for $1200? P recognizes $1200 gain D taxable on $400 gain allocated to D Good result for D?

92

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 1200 2400 A Capital 900 1300 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

A sells his interest to D for $1300 Partnership makes Section 754 election

93

Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets

IRC §743- Special rules where section 754 election or substantial built-in loss.

(b) Adjustment to basis of partnership property. In the case of a transfer of an interest ( ) j p p p p y in a partnership by sale or exchange or upon the death of a partner, a partnership with respect to which the election provided in section 754 is in effect or which has a substantial built-in loss immediately after such transfer shall— (1) i th dj t d b i f th t hi t b th f th ― (1) increase the adjusted basis of the partnership property by the excess of the basis to the transferee partner of his interest in the partnership over his proportionate share of the adjusted basis of the partnership property, or ― (2) decrease the adjusted basis of the partnership property by the excess of ( ) j p p p p y y the transferee partner's proportionate share of the adjusted basis of the partnership property over the basis of his interest in the partnership.

94

Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets

Treas Reg §743-1 - Optional adjustment to basis of

• Treas. Reg. §743-1 - Optional adjustment to basis of

partnership property.

(1) Generally. A transferee's share of the adjusted basis to the partnership of partnership propert is eq al to the s m of the transferee's interest as a partnership property is equal to the sum of the transferee's interest as a partner in the partnership's previously taxed capital, plus the transferee's share of partnership liabilities. Generally, a transferee's interest as a partner in the partnership's previously taxed capital is equal to—

― (i) The amount of cash that the transferee would receive on a liquidation of the partnership following the hypothetical transaction, as defined in paragraph (d)(2) of this section (to the extent attributable to the acquired partnership interest); increased by by ― (ii) The amount of tax loss (including any remedial allocations under §1.704-3(d)), that would be allocated to the transferee from the hypothetical transaction (to the extent attributable to the acquired partnership interest); and decreased by ― (iii) The amount of tax gain (including any remedial allocations under §1.704-3(d)), that would be allocated to the transferee from the hypothetical transaction (to the extent attributable to the acquired partnership interest). 95

Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets

D’s basis in partnership interest = $1500

Cash purchase price for interest = $1300 Plus D’s share of partnership liabilities = $200 p p

96

Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets

D’s previously taxed capital = $900

Amount distributed on hypothetical sale = $1300 Plus loss allocated to D on hypothetical sale = $0 yp Minus gain allocated on hypothetical sale = ($400) 2400 FMV 1200 A/B 1200 A/B 1200 Gain x 1/3 = $400

Plus share of liabilities

$200

P’s share of partnership basis

$1100

P s share of partnership basis

$1100

97

Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets

• Section 743(b) Basis Adjustment = $400

D’s basis in partnership interest = $1500 Minus D’s share of partnership basis = $1100 p p

98

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 1600 2400 D Capital 1300 1300 B Capital 900 1300 C Capital 900 1300 Total 3700 4500 Total 3700 4500

What happens if P sells Blackacre for $2400? P recognizes $800 gain No gain allocable to D Good result for D?

99

B Distributions of Partnership

• B. Distributions of Partnership

Property p y

100

Redemption of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 1200 2400 A Capital 900 1300 Blackacre 1200 2400 A Capital 900 1300 B Capital 900 1300 C Capital 900 1300 C C p 900 300 Total 3300 4500 Total 3300 4500

Partnership distributes $1300 to A in redemption of interest Partnership has made no Section 754 election

101

Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets

IRC §734-Adjustment to basis of undistributed partnership property where section 754 election or substantial basis reduction.

(a) General rule. The basis of partnership property shall not be adjusted as the result of a distribution of property to a partner unless the election, provided in section 754 (relating to optional adjustment to basis of partnership property), is in effect with respect to such partnership or unless there is a substantial basis reduction with respect to such distribution.

102

Redemption of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 800 800 Liabilities 600 600 Blackacre 1200 2400 A Capital B Capital 700 1300 C Capital 700 1300 Total 2000 3200 Total 2000 4500

What happens if P sells Blackacre for $1200? P recognizes $1200 gain B and C each taxable on $600 gain allocated to them Good result for B and C?

103

Redemption of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 1200 2400 A Capital 900 1300 Blackacre 1200 2400 A Capital 900 1300 B Capital 900 1300 C Capital 900 1300 C C p 900 300 Total 3300 4500 Total 3300 4500

Partnership distributes $1300 to A in redemption of interest Partnership makes Section 754 election

104

Effect of Distribution on Basis of Partnership Assets

IRC §734-Adjustment to basis of undistributed partnership property where section 754 election or substantial basis reduction.

(a) General rule. The basis of partnership property shall not be adjusted as the result of a distribution of property to a partner unless the election, provided in section 754 (relating to optional adjustment to basis of partnership property), is in effect with respect to such partnership or unless there is a substantial basis reduction with respect to such distribution.

105

Effect of Distribution on Basis of Partnership

IRC §734-Adjustment to basis of undistributed partnership property where section 754 election or substantial basis

Assets

property where section 754 election or substantial basis reduction.

(b) Method of adjustment. In the case of a distribution of property to a partner by a partnership with respect to which the election provided in section 754 is in effect or with respect to which there is a substantial basis reduction the partnership shall with respect to which there is a substantial basis reduction, the partnership shall—

(1) increase the adjusted basis of partnership property by— (A) the amount of any gain recognized to the distributee partner with respect to such distribution under section 731(a)(1), and ( )( ), (B) in the case of distributed property to which section 732(a)(2) or (b) applies, the excess

• f the adjusted basis of the distributed property to the partnership immediately before

the distribution (as adjusted by section 732(d) ) over the basis of the distributed property to the distributee, as determined under section 732, or

Paragraph (1)(B) shall not apply to any distributed property which is an interest in another partnership with respect to which the election provided in section 754 is not in effect.

106

Effect of Distribution on Basis of Partnership Assets

IRC §734-Adjustment to basis of undistributed partnership property where section 754 election or substantial basis d ti

Effect of Distribution on Basis of Partnership Assets

reduction.

(b) Method of adjustment. In the case of a distribution of property to a partner by a partnership with respect to which the election provided in section 754 is in effect or partnership with respect to which the election provided in section 754 is in effect or with respect to which there is a substantial basis reduction, the partnership shall—

(2) decrease the adjusted basis of partnership property by— (A) the amount of any loss recognized to the distributee partner with respect to such distribution under section 731(a)(2), and (B) in the case of distributed property to which section 732(b) applies, the excess of the basis of the distributed property to the distributee as determined under section 732 basis of the distributed property to the distributee, as determined under section 732,

• ver the adjusted basis of the distributed property to the partnership immediately before

such distribution (as adjusted by section 732(d)). 107

Effect of Purchase on Basis of Partnership Effect of Purchase on Basis of Partnership Assets

D’s gain recognized on distribution = $400

Cash distribution = $1300 Plus reduction of A’s share of partnership liabilities = $200 p p Total cash distribution = $1500 A’s adjusted basis of partnership interest = $1100 As adjusted basis of partnership interest = $1100 Gain = $400

108

Redemption of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 800 800 Liabilities 600 600 Blackacre 1600 2400 A Capital B Capital 900 1300 C Capital 900 1300 Total 2400 3200 Total 2400 4500

What happens if P sells Blackacre for $1200? P recognizes $800 gain B and C each taxable on $400 gain allocated to them Good result for B and C?

109

C Allocation of Basis Adjustments

• C. Allocation of Basis Adjustments

among Partnership Properties g p p

110

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 900 1200 A Capital 900 1300 Whiteacre 300 1200 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

A sells his interest to D for $1300 Partnership makes Section 754 election 743(b) adjustment = $400 How to allocate basis adjustment between Blackacre and Whiteacre

111

Allocation of Basis Adjustment Allocation of Basis Adjustment

IRC §755-Rules for allocation of basis.

(a) General rule. Any increase or decrease in the adjusted basis of partnership property under section 734(b) (relating to the optional adjustment to the basis of undistributed partnership property) or section 743(b) (relating to the optional adjustment to the basis of partnership property in the case of to the optional adjustment to the basis of partnership property in the case of a transfer of an interest in a partnership) shall, except as provided in subsection (b), be allocated— (1) i hi h h th ff t f d i th diff b t (1) in a manner which has the effect of reducing the difference between the fair market value and the adjusted basis of partnership properties, or (2) in any other manner permitted by regulations prescribed by the ( ) y p y g p y Secretary.

112

Allocation of Basis Adjustment Allocation of Basis Adjustment

IRC §755-Rules for allocation of basis.

(b) Special rule. In applying the allocation rules provided in subsection (a), increases or decreases in the adjusted basis of partnership property arising from a distribution of, or a transfer of an interest attributable to, property consisting of— (1) capital assets and property described in section 1231(b), or (2) any other property of the partnership, shall be allocated to partnership property of a like character except that the b i f h t hi t h ll t b d d b l basis of any such partnership property shall not be reduced below zero.

113

Allocation of §743(b) Adjustments

Rules for allocating basis adjustments among multiple assets (Treas.

• Reg. §§1.755-1(a); 1.755-1(b))
• Determine the character of partnership assets.

— capital assets and §1231(b) property. —

• rdinary income property
• rdinary income property.
• Determine the amount of gain or loss that the partnership would

recognize on a hypothetical sale of all properties for fair market value

• Basis adjustment allocated to ordinary income property to the extent of

transferee’s ordinary income or loss recognized on sale

• Remainder of basis adjustment allocated to capital gain property

114

Allocation of 743(b) Adjustments – cont.

Allocation of basis adjustments within a class (Treas. Reg. §1.755- 1(b)):

• Basis increases allocated to properties with unrealized gain in proportion to

Basis increases allocated to properties with unrealized gain in proportion to amount of gain allocated to transferee on hypothetical sale of property.

• Basis decreases allocated to properties with unrealized loss in proportion to

amount of loss allocated to transferee on hypothetical sale of property. amount of loss allocated to transferee on hypothetical sale of property.

115

Allocation of §734(b) Adjustments

Rules for allocating basis adjustments among multiple assets (Treas.

• Reg. §§1.755-1(a); 1.755-1(c))
• Determine the value of each of the partnership’s assets.
• Determine the character of any assets distributed.

— Basis adjustments arising from distributions of capital gain property Basis adjustments arising from distributions of capital gain property are generally allocated to capital assets and §1231(b) property. — Basis adjustments arising from distributions of ordinary income property are generally allocated to ordinary income property property are generally allocated to ordinary income property.

• The basis adjustment allocated to each class is allocated among the

items within each class.

116

Allocation of 734(b) Adjustments – cont.

Allocation of basis adjustments within a class (Treas. Reg. §1.755- 1(c)):

• Basis adjustment resulting from the recognition of gain or loss from the

Basis adjustment resulting from the recognition of gain or loss from the distribution must be allocated to the partnership’s capital gain property.

• Basis increases due to “lost basis” are allocated first to properties with

unrealized appreciation up to and in proportion with their respective unrealized appreciation up to and in proportion with their respective unrealized appreciation. Any excess is allocated among all properties in the class in proportion to FMV.

• Basis decreases due to “acquired basis” are allocated first to properties with

Basis decreases due to acquired basis are allocated first to properties with unrealized depreciation up to and in proportion with their respective amounts of unrealized depreciation. Any excess is allocated among all the properties within the class in proportion to their adjusted bases (after taking into account the first allocation).

117

Allocation of 734(b) Adjustments – cont.

Special Rules:

• If a decrease in basis is required and the basis adjustment exceeds the

remaining basis in the assets in a class, the assets are reduced to zero, remaining basis in the assets in a class, the assets are reduced to zero, but not below zero.

• When an increase or decrease in the basis of undistributed property

cannot be made because the partnership owns no property of the cannot be made because the partnership owns no property of the character required to be adjusted, the adjustment is made when the partnership acquires property of a like character to which an adjustment can be made. can be made.

118

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 900 1200 D Capital 900 1300 Whiteacre 300 1200 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

743(b) adjustment = $400 Hypothetical gain to D on sale of Blackacre = $300 Hypothetical gain to D on sale of Whiteacre = $100

119

Lynn E Fowler Kilpatrick, Townsend & Stockton LLP 1100 Peachtree Street Suite 2800

VI SALE OF INTEREST IN

1100 Peachtree Street, Suite 2800 Atlanta, Georgia 30309

• VI. SALE OF INTEREST IN

PARTNERSHIP/LLC

120

A Tax Consequences Associated

• A. Tax Consequences Associated

with Sale

121

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 900 1200 A Capital 900 1300 Whiteacre 300 1200 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

A sells his interest to D for $1300 Consequences to A

122

Tax Consequences to Seller

Consequences to A

Amount realized? Adjusted Basis? Gain/Loss realized? Character of gain/loss?

123

Tax Consequences to Seller

Amount Realized = $1500, sum of

Purchase price received from purchaser ($1300), plus Seller’s share of liabilities ($200) See I.R.C. §752(d)

Adjusted Basis = $1100, sum of tax capital plus partner’s share of j , p p p liabilities

See I.R.C. §752(a)

124

Tax Consequences to Seller

Character of Gain-§741

In the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized except as otherwise provided in section 751 (relating to unrealized receivables and inventory items).

125

B Hot Assets and Section 751(a)

• B. Hot Assets and Section 751(a)

Property p y

126

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 900 1200 A Capital 900 1300 Whiteacre 300 1200 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

A sells his interest to D for $1300 Blackacre held for sale to customers in the ordinary course of P’s business

127

Hot Assets

IRC §751

( ) S l h f i t t i t hi Th t f (a) Sale or exchange of interest in partnership. The amount of any money, or the fair market value of any property, received by a transferor partner in exchange for all or a part of his interest in the partnership attributable to— (1) unrealized receivables of the partnership, or (2) inventory items of the partnership (2) inventory items of the partnership, shall be considered as an amount realized from the sale or exchange of property other than a capital asset.

128

Hot Assets

IRC §751

( ) U li d i bl F f thi b h t th t (c) Unrealized receivables. For purposes of this subchapter, the term “unrealized receivables” includes, to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for— ( ) p y (1) goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset or exchange of property other than a capital asset, or (2) services rendered, or to be rendered.

129

Hot Assets

IRC §751

(c) Unrealized receivables (cont’d) F

f thi ti d ti

(c) Unrealized receivables. (cont d) For purposes of this section and, sections

731, 732, and 741 (but not for purposes of section 736), such term also includes mining property (as defined in section 617(f)(2)), stock in a DISC (as described in section 992(a)), section 1245 property (as defined in section 1245(a)(3)), stock in t i f i ti ( d ib d i ti 1248) ti 1250 t ( certain foreign corporations (as described in section 1248), section 1250 property (as defined in section 1250(c)), farm land (as defined in section 1252(a)), franchises, trademarks, or trade names (referred to in section 1253(a)), and an oil, gas, or geothermal property (described in section 1254) but only to the extent of the amount hich

• ld be treated as gain to

hich section 617(d)(1) 995(c) 1245(a) 1248(a) which would be treated as gain to which section 617(d)(1), 995(c), 1245(a), 1248(a), 1250(a), 1252(a), 1253(a) or 1254(a) would apply if (at the time of the transaction described in this section or section 731, 732, or 741, as the case may be) such property had been sold by the partnership at its fair market value. For purposes of this section and sections 731 732 and 741 (but not for purposes of section 736) such section and, sections 731, 732, and 741 (but not for purposes of section 736), such term also includes any market discount bond (as defined in section 1278) and any short-term obligation (as defined in section 1283) but only to the extent of the amount which would be treated as ordinary income if (at the time of the transaction described in this section or section 731 732 or 741 as the case may be) such property had in this section or section 731, 732, or 741, as the case may be) such property had been sold by the partnership.

130

Hot Assets

IRC §751

(d) Inventory items. For purposes of this subchapter, the term “inventory items” means— (1) property of the partnership of the kind described in section 1221(a)(1), (2) any other property of the partnership which on sale or exchange by (2) any other property of the partnership which, on sale or exchange by the partnership, would be considered property other than a capital asset and other than property described in section 1231, and (3) th t h ld b th t hi hi h if h ld b th (3) any other property held by the partnership which, if held by the selling or distributee partner, would be considered property of the type described in paragraph (1) or (2).

131

Hot Assets

Operation of Section 751(a)

• 1. Determine gain realized on sale of partnership interest
• 2. Determine amount of ordinary income that would be allocated to
• 2. Determine amount of ordinary income that would be allocated to

seller if partnership sold its assets for fair market value-that is amount of IRC §751(a) gain taxable as ordinary income

• 3. Remainder of gain is capital gain under IRC §741

132

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 900 1200 A Capital 900 1300 Whiteacre 300 1200 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

A sells his interest to D for $1300 Blackacre held for sale to customers in the ordinary course of P’s business $100 of gain ordinary income under §751(a); remainder gain is capital

133

C Collectibles Gain and

• C. Collectibles Gain and

Unrecaptured Section 1250 p Gain

134

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 900 1200 A Capital 900 1300 Whiteacre 300 1200 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

A sells his interest to D for $1300 Blackacre held for sale to customers in the ordinary course of P’s business Whiteacre basis reduced by $300 depreciation

135

Collectibles Gain, Etc.

IRC §1(h)(11)-Maximum tax rate

(C) 15 t f th dj t d t it l i ( if l t bl i ) i f (C) 15 percent of the adjusted net capital gain (or, if less, taxable income) in excess of the amount on which a tax is determined under subparagraph (B); (D) 25 percent of the excess (if any) of— (i) the unrecaptured section 1250 gain (or, if less, the net capital gain (determined without regard to paragraph (11))), over (ii) th (if ) f (ii) the excess (if any) of— (I) the sum of the amount on which tax is determined under subparagraph (A) plus the net capital gain, over (II) taxable income; and (E) 28 percent of the amount of taxable income in excess of the sum of the amounts hi h t i d t i d d th di b h f thi

• n which tax is determined under the preceding subparagraphs of this

paragraph.

136

Collectibles Gain, Etc.

• Treas. Reg. §1.1(h)-1(b)-Look-through capital gain

Look-through capital gain is the share of collectibles gain allocable to an interest in a partnership, S corporation, or trust, plus the share of section 1250 capital gain allocable to an interest in a partnership determined under paragraphs (b)(2) and (3) of this partnership, determined under paragraphs (b)(2) and (3) of this section. .

137

Collectibles Gain, Etc.

Operation of Look-Through Capital Gains

• 1. Determine amount of capital gain realized on sale of partnership

interest-$300 2 D t i t f ll tibl i d 1250 t i

• 2. Determine amount of collectibles gain and 1250 recapture gain

allocated to selling partner if partnership had sold assets for FMV 3 Remainder of gain is long term capital gain under IRC §741

• 3. Remainder of gain is long-term capital gain under IRC §741

138

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 900 1200 A Capital 900 1300 Whiteacre 300 1200 B Capital 900 1300 C Capital 900 1300

$ $

Total 3300 4500 Total 3300 4500

A sells his interest to D for $1300; total gain = $400 Blackacre held for sale to customers in the ordinary course of P’s business so $100 of gain is ordinary under IRC §751(a); rest is capital gain Whiteacre basis reduced by $300 depreciation Whiteacre basis reduced by $300 depreciation Total capital gain = $300, but $100 would be 1250 recapture and thus 25% capital gain

139

D Installment Sales

• D. Installment Sales

140

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 900 1200 A Capital 900 1300 Whiteacre 300 1200 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

A sells his interest to D for note in face amount of $1300 Blackacre held for sale to customers in the ordinary course of P’s business Can A report gain on installment method?

141

Use of Installment Method

Use of Installment Method

• Generally partnership interest is property-Code section 453 applies

to deferred payment sales of property H i t ll t th d t il bl f l f i t

• However, installment method not available for sales of inventory

property like Blackacre

• Does A have to look through to partnership assets to determine
• Does A have to look through to partnership assets to determine

eligibility for installment reporting?

142

E Termination of Partnership

• E. Termination of Partnership

143

D’s Purchase of A’s Interest

ASSETS LIABILITIES/ CAPITAL

TAX/BOOK FMV TAX/BOOK FMV

Cash 2100 2100 Liabilities 600 600 Blackacre 900 1200 A Capital 900 1300 Whiteacre 300 1200 B Capital 900 1300 C Capital 900 1300 Total 3300 4500 Total 3300 4500

A and B transfer their interests to D

144

Partnership Termination

IRC §708

(a) General rule. For purposes of this subchapter, an existing partnership shall be considered as continuing if it is not terminated. (b) Termination. (1) General rule. For purposes of subsection (a), a partnership shall be considered as terminated only if— (A) no part of any business financial operation or venture of the (A) no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership, or (B) within a 12-month period there is a sale or exchange of 50 percent or f th t t l i t t i t hi it l d fit more of the total interest in partnership capital and profits.

145

Partnership Termination

Impact of Partnership Termination

• Old partnership deemed to contribute assets subject to liabilities to new

partnership and distribute partnership interests in new partnership to partners

• Old partnership should not recognize gain or loss on deemed
• contribution. I.R.C. §721.
• Neither old partnership nor partners should recognize gain or loss
• n distribution of partnership interests

I R C §731

• n distribution of partnership interests. I.R.C. §731.

146

Partnership Termination

Impact of Partnership Termination

• Partnership tax year terminates as of close of date of termination.
• Partnership should file two tax returns-one through period of

termination and one from next day forward

• Elections of old partnership not applicable to new partnership.
• Consider partnership termination to nullify 754 election.
• But 743 basis adjustments carry forward to new partnership
• But 743 basis adjustments carry forward to new partnership
• Partnership depreciable property begins new depreciation period. I.R.C.

§168(i)(7).

147