Partnership Taxation: An Application Approach (2d … Partnership Taxation 2e...$12,000 and fair market value of $5,000. The property has a life of 10 years, with 7.5 years remaining

Partnership Taxation:

An Application Approach (2d Ed.)

Update

Spring – 2015

Joni Larson

Copyright © Joni Larson. All rights reserved.

Chapter 5. Receipt of Partnership Interest for Services

The Services has issued proposed regulations addresing the treatment of providing

services in exchange for a capital interest or for a profits interests. The proposed

regulations as summarized below.

Services in exchange for a capital interest. Because services are not considered

property for purposes of the non-recognition provision,1 a transaction in which a partner

receives a capital interest in a partnership in exchange for services does not come within

the non-recognition provision. However, there has been disagreement over whether a

capital interest received by the service partner is property for purposes of Section 83. If

applicable, Section 83 determines when property received for services must be included

in income.2 When property is transferred in connection with services, the person who

performs the services includes the fair market value of the property (less any amount paid

for the property) in income in the year the property becomes transferable or not subject to

a substantial risk of forfeiture.3 “Property” is defined as “real and personal property other

than either money or an unfunded and unsecured promise to pay money or property in the

future.”4

Under proposed regulations, when the interest is a substantially vested interest,

the service partner must include the liquidation value of the capital interest (less any

amount paid for the interest) in income upon receipt.5 The partner’s capital account

includes the amount included as compensation under Section 83(a).6 In addition, the

transfer of a capital interest to a service partner is not a taxable event to the partnership.7

Under Section 83, the partnership is entitled to a deduction equal to the amount included

as compensation by the service partner.8 Under a safe harbor provision, the deduction is

allowed based on the partnership’s method of accounting.9

Services in exchange for a profits interest. Regulations under Section 721 provide

that the transfer of a partnership interest in connection with the performance of services is

1 Treas. Reg. § 1.721-1(b).

2 Code Sec. 83(a).

3 Id.

4 Treas. Reg. § 1.83-3(e).

5 Sec. 5.01, Notice 2005-43.

6 Prop. Reg. § 1.704-1(b)(2)(iv)(b)(l). The proposed regulation applies to compensatory partnership

interests and defines a compensatory partnership interest as an interest in the transferring partnership that is

transferred in connection with the performance of services for that partnership. Prop. Reg. § 1.721-1(b)(3). 7 Prop. Reg. § 1.721-1(b)(2)(i). The proposed regulations provide that capital accounts be booked to fair

market value just prior to the transaction. Prop. Reg. § 1.704-1(b)(2)(iv)(f)(5)(iii). 8 Code Sec. 83(a), (h). To be deductible, the amount otherwise must meet the requirements of Section 162.

9 Sec. 5.02, Notice 2005-43. The proposed regulations provide the transfer of the partnership capital interest

in exchange for services rendered to the partnership is treated as a guaranteed payment. Prop. Reg. § 1.721-

1(b)(4)(i). As a guaranteed payment, the partner must include the amount in income in the year in which

the partnership takes the deduction. Under Section 83(h), the partnership would take the deduction in the

taxable year in which or with which ends the taxable year in which the partner included the amount in

income. If there is an inconsistency between the timing rules of Section 707(c) and those of Section 83,

those of Section 83 take precedence. Prop. Reg. § 1.707-1(c).


a transfer of property governed by Section 83.10

Moreover, proposed regulations under

Section 83 provide that property includes a partnership interest (making no distinction

between a capital interest and a profits interest).11

The proposed regulations and Notice

2005-43, which includes a proposed Revenue Procedure,12

also provide a safe harbor

under which the value of the partnership interest is equal to the liquidation value of the

interest.13

Because a profits interest partner has no interest in the underlying assets, the

profits interest generally will have no value. Thus, the partner has no income upon receipt

of the interest and the partnership is not entitled to a deduction.14

10

Prop. Reg. § 1.721-1(b)(1). 11

Prop. Reg. § 1.83-3(e). 12

Notice 2005-43, 2005-1 C.B. 1221. If the Revenue Procedure contained in this notice becomes final, it

will obsolete Rev. Proc. 93-27 and Rev. Proc. 2001-43. 13

Prop. Reg. § 1.83-3(l)(1), Sec. 4.02, Notice 2005-43, 2005-1 C.B. 1221. The partnership and all its

partners must elect the safe harbor. In addition, certain requirements must be met. See Prop. Reg. § 1.83-

3(1); Sec. 3.03, Notice 2005-43. 14

Code Sec. 83(a), (h).


Chapter 7. Non-Recourse Liabilities

In this chapter, allocation of non-recourse debt is made under the “third tier” of

allocations. In general, such an allocation is based on how the partners share profits.

Proposed regulations would alter this third tier allocation, often referred to as the

allocation of excess non-recourse deductions.

Under the proposed regulations, issued January 30, 2014, the partnership agreement may

specify the partners’ interest in partnership profits for purposes of allocating excess

nonrecourse liabilities, provided the interests specified are in accordance with the

partners’ liquidation value percentages.15

In general, a partner’s liquidation value

percentage is the ratio of the liquidation value of the partner’s interest in the partnership,

divided by the aggregate liquidation value of all the partners’ interest in the partnership.16

15

Prop. Reg. § 1.752-3(a)(3). 16

Id.


Chapter 15. Allocation of Recourse Deductions

Replace Problem 1(b)(3)(a), (b), and (c) (page 165) with the following:

(3) The partnership makes no distribution to Ben in the third year. In its third year, the

partnership has $20,000 of income, $20,000 of expenses, and $50,000 of depreciation

from the building.

(a) What is the impact of the allocation of deprecation on capital accounts in year

three?

(b) Alternatively, in the third year Ben contributed a promissory note for $75,000

to the partnership. What is the impact on the allocation of depreciation on capital

accounts?

(c) Alternatively, the partnership distributed $30,000 to Ben at the beginning of

year three. What is the impact of the distribution and the allocation of

depreciation and other partnership items on capital accounts?


Chapter 17. Allocations of Depreciation from Property Contributed to the

Partnership by a Partner

Treasury has issued proposed regulations to address Section 704(c)(1)(C). Under the

proposed regulations, if a partner contributes property with a built in loss to a partnership,

the built in loss is taken into account only in determining the amount of items allocated to

the contributing partner.17

For purposes of determining allocations to the non-

contributing partners, the initial basis of the built in loss property is equal to its fair

market value at the time of contribution.18

The contributing partner has a “basis

adjustment” amount equal to the amount of built in loss.19

The basis adjustment amount

is subsequently adjusted for the recovery of the basis adjustment. This adjustment

impacts only the contributing partner.20

Thus, for purposes of calculating income,

deduction, gain, and loss, the contributing partner will have a special basis for the

property. However, the basis adjustment does not impact the partnership’s computation

under Section 703.21

The adjustments to the contributing partner’s distributive shares do

not affect the partner’s capital account.22

If the contributed built in loss property is depreciable, the basis adjustment amount is

recovered through depreciation and included with the contributing partner’s other

depreciation for the year. The basis of the basis adjustment amount is reduced to reflect

the depreciation recovery.23

Example. Alex contributes depreciable property with an adjusted basis of

$12,000 and fair market value of $5,000. The property has a life of 10

years, with 7.5 years remaining at the time of contribution, and is

recovered using the straightline method, half-year convention. Ben

contributes $5,000.

Because the property is contributed with a built in loss, Alex’s basis

adjustment amount is $7,000 (amount of the built in loss). The partnership

takes a $5,000 basis in the property (basis equal to fair market value). The

partnership is entitled to $667 of depreciation each year ($5,000, divided

by 7.5 years remaining), which is allocated between Alex and Ben. Alex

also is entitled to $933 of depreciation with respect to his basis adjustment

amount ($7,000 basis adjustment amount, divided by 7.5 remaining

years).24

17

Prop. Reg. § 1.704-3(f)(1)(i). 18

Prop. Reg. § 1.704-3(f)(1)(ii). 19

Prop. Reg. § 1.704-3(f)(2)(iii). 20

Prop. Reg. § 1.704-3(f)(3)(ii)(A). 21

Id. 22

Prop. Reg. § 1.704-3(f)(3)(ii)(B). 23

Prop. Reg. § 1.704-3(f)(3)(ii)(D)(1). 24

Prop. Reg. § 1.704-3(f)(3)(ii)(D)(2).


Chapter 18. Allocations Related to the Sale of Contributed Property



















The contributing partner’s gain or loss from the sale of the contributed built in loss

property is equal to the contributing partner’s share of the partnership’s gain or loss from

the sale of the property, less the basis adjustment.31

25

Prop. Reg. § 1.704-3(f)(1)(i). 26

Prop. Reg. § 1.704-3(f)(1)(ii). 27

Prop. Reg. § 1.704-3(f)(2)(iii). 28

Prop. Reg. § 1.704-3(f)(3)(ii)(A). 29

Id. 30

Prop. Reg. § 1.704-3(f)(3)(ii)(B). 31

Prop. Reg. § 1.704-3(f)(3)(ii)(C).


Chapter 20. Non-Recourse Liabilities

On pages 240-242, there is a discussion of third tier allocations. Proposed regulations,

issued January 30, 2014, would alter the allocation of excess non-recourse deductions.

Under the proposed regulations, the partnership agreement may specify the partners’

interest in partnership profits for purposes of allocating excess nonrecourse liabilities,

provided the interests specified are in accordance with the partners’ liquidation value

percentages.32

In general, a partner’s liquidation value percentage is the ratio of the

liquidation value of the partner’s interest in the partnership, divided by the aggregate

liquidation value of all the partners’ interest in the partnership.33

32

Prop. Reg. § 1.752-3(a)(3). 33

Id.


Chapter 21. Tax Consequences to Transferring Partner

The tax rates applicable to long-term capital gains have changed. Accordingly, replace

Section 2. c Preferential Capital Gain Rates (pages 256-57) with the following.

The tax rate applicable to net long-term capital gains depends on the nature of the

asset sold and the taxpayer’s tax bracket. The rate will be one of the following:

28 percent;

25 percent;

20 percent

15 percent

0 percent; or

The tax rate applied to the taxpayer’s ordinary income.

If the taxpayer is in a tax bracket higher than 28 percent and the item sold is either

“collectibles” or “Section 1202 gain,” the maximum tax rate will be 28 percent. If the

taxpayer would otherwise be in a lower tax bracket, the taxpayer’s lower rate will

apply.34

Collectibles gain is gain from the sale or exchange of any rug, antique, metal,

gem, stamp, coin, or other collectible that has been held as a capital asset for more than

one year.35

“Section 1202” gain generally is 50 percent of the gain from the sale or

exchange of certain stock described in Section 1202.36

If the taxpayer is in a tax bracket higher than 28 percent and the item sold is either

“collectibles” or “Section 1202 gain,” the maximum tax rate will be 28 percent. If the

taxpayer would otherwise be in a lower tax bracket, the taxpayer’s lower rate will

apply.37

Example. Jamaal, who was in the 35 percent tax bracket, sold an antique

rug he had purchased three years earlier for investment purposes. He

recognized a long-term capital gain of $30,000. Because the gain was

from a collectible and Jamaal would otherwise have been in a higher tax

bracket, the gain from the rug will be taxed at the 28 percent rate. His

remaining income will be taxed at the 35 percent rate.

Alternatively, assume Jamaal had been in the 15 percent tax bracket when

he sold the antique rug. He still recognized a long-term capital gain of

$30,000. Because he was not in a tax bracket higher than 28 percent, the

gain will be taxed at the 15 percent rate, the same as his other income.

34

Section 1(h)(1)(E). 35

Section 1(h)(5)(A). 36

Section 1(h)(7). 37

Section 1(h)(1)(E).


In general, unrecaptured Section 1250 gain is long-term capital gain attributable

to depreciation allowed with respect to real estate held for more than one year.38

If the

gain is “unrecaptured Section 1250 gain,” it is taxed at a maximum rate of 25 percent.39

Example. Brian sold a building that he had used in his business for two

years for $100,000. At the time of the sale, the adjusted basis in the

building was $75,000 and he had claimed $25,000 of depreciation; he

recognized $25,000 of gain. Because the gain from the sale was

attributable to the depreciation taken by Brian prior to sale, the gain is

characterized as unrecaptured Section 1250 gain and is taxed at a rate not

higher than 25 percent.

Adjusted net capital gain is the gain remaining after considering the previous two

categories of gain, i.e., the net capital gain reduced by the amount of gain from

collectibles, Section 1202 gain, and unrecaptured Section 1250 gain.40

Adjusted net

capital gain is taxed at a maximum rate of 20 percent. If the gain otherwise would have

been taxed at the 10 or 15 percent marginal rate, it will be taxed at zero percent; if the

gain otherwise would have been taxed at the 25, 28, 33, or 35 percent marginal rate, it

will be taxed at 15 percent; if the gain otherwise would have been taxed at the 39.6

percent marginal rate, it will be taxed at 20 percent.41

Example. Erik is in the 35 percent tax bracket. He sold stock in GainCo

and recognized a long-term capital gain of $20,000. Erik sold no other

assets during the year. Because he had no collectibles, Section 1202, or

unrecaptured Section 1250 gain, the adjusted net capital gain is $20,000. It

will be taxed at the 15 percent rate. All other income will be taxed at the

35 percent rate. Alternatively, if Erik had been in the 10 percent tax

bracket, the $20,000 of gain would not be subject to tax.

__________________________________________________________________












38

Section 1(h)(6). 39

Section 1(h)(1)(D). 40

Section 1(h)(3). 41

Section 1(h)(1)(B), (C). 42

Prop. Reg. § 1.704-3(f)(1)(i). 43

Prop. Reg. § 1.704-3(f)(1)(ii). 44

Prop. Reg. § 1.704-3(f)(2)(iii).









In general, if the partner who contributed the built in loss property transfers the

partnership interest, the portion of the basis adjustment amount is eliminated. The

transferee partner is not treated as the contributing partner was with respect to the

interest. The transferor partner continues to have any remaining basis adjustment

amount.48

Example. Andy contributed land with a basis of $11,000 and fair market

value of $5,000. Bob and Cindy each contributed $5,000. Because Andy’s

property was contributed with a built in loss, Andy’s basis adjustment is

$6,000 (amount of the built in loss). The partnership takes a $5,000 basis

in the property (basis equal to fair market value). In the third year, when

the fair market value of the land is still $5,000, Andy sells his interest to

David for $5,000. Andy has a loss from the sale equal to the excess of his

outside basis, $11,000, over the amount realized, $5,000. David does not

succeed to any of the basis adjustment amount; it is eliminated upon

sale.49

45

Prop. Reg. § 1.704-3(f)(3)(ii)(A). 46

Prop. Reg. § 1.704-3(f)(3)(ii)(A). 47

Prop. Reg. § 1.704-3(f)(3)(ii)(B). 48

Prop. Reg. § 1.704-3(f)(3)(iii)(A). 49

Prop. Reg. § 1.704-3(f)(3)(iii)(C), Example 1.


Chapter 23. Non-Liquidating Distributions



















If a partnership distributes property to a partner and the partner has a basis adjustment

amount for the property, the basis adjustment amount is taken into consideration under

Section 732.56

Example. Beth contributed Blackacre with a basis of $15,000 and fair

market value of $10,000 and Whiteacre with a basis of $5,000 and fair

market value of $20,000. Carl contributed $30,000. Because Blackacre is

contributed with a built in loss, Beth’s basis adjustment amount is $5,000

(amount of the built in loss). The partnership takes a $10,000 basis in

Blackacre (basis equal to fair market value).

In Year 3, the partnership distributes Blackacre to Beth. At the time of the

distribution, the fair market value of Blackacre is $12,000 and Beth’s basis

in her partnership interest is still $20,000. For purposes of Section

732(a)(1), the basis of Blackacre immediately before the distribution is

$15,000, the partnership’s $10,000 basis, increased by Beth’s $5,000 basis

adjustment amount. Thus, upon distribution her basis in Blackacre is

$15,000.57

50

Prop. Reg. § 1.704-3(f)(1)(i). 51

Prop. Reg. § 1.704-3(f)(1)(ii). 52

Prop. Reg. § 1.704-3(f)(2)(iii). 53

Prop. Reg. § 1.704-3(f)(3)(ii)(A). 54

Id. 55

Prop. Reg. § 1.704-3(f)(3)(ii)(B). 56

Prop. Reg. § 1.704-3(f)(3)(v)(A). 57

Prop. Reg. § 1.704-3(f)(3)(v)(D), Example 1.


Chapter 25. Disproportionate Distributions

Page 329, Step Seven. In the first sentence, change “accounts receivable” to “inventory.”

________________________________________________________________________

The IRS has published proposed regulations under Section 751(b) on how a partner

should measure its interest in a partnership's unrealized receivables and inventory items

and on the tax consequences of a distribution that causes a reduction in that interest. The

regulations would allow use of the hypothetical sale approach only to determine whether

there is a hot asset shift, but then allow use of any reasonable method to determine the

amount of gain triggered. The regulations would affect partners in partnerships that own

unrealized receivables and inventory items and that make a distribution to one or more

partners.

The proposed regulations follow many of the principles of Notice 2006-14, first

describing the rules for determining partners' interests in Section 751 property. They then

outline a test to determine whether Section 751(b) applies to a partnership distribution

and provide an antiabuse rule that may apply when the test would not otherwise be

satisfied. Further, the regulations explain the tax consequences of a distribution covered

by Section 751(b) and describe miscellaneous issues, including a clarification to the

scope of Reg. § 1.751-1(a).

The regulations adopt the hypothetical sale approach as the method by which the partners

must measure their respective interests in Section 751 property for determining whether a

distribution reduces a partner's interest in the partnership's Section 751 property. Because

the hypothetical sale approach relies on the principles of Section 704(c) to preserve a

partner's share of the unrealized gain and loss in the partnership's Section 751 property,

the regulations make several changes to the regulations on Section 704(c) and

revaluations.

The IRS determined that a deemed gain approach produces an appropriate outcome in the

greatest number of circumstances and that the hot asset sale approach also produced an

appropriate outcome in most circumstances. However, no one approach produced an

appropriate outcome in all circumstances. Therefore, the proposed regulations would

withdraw the asset exchange approach of the current regulations but would not require

the use of a particular approach for determining the tax consequences of a Section 751(b)

distribution. Instead, the regulations provide that, if under the hypothetical sale approach

a distribution reduces a partner's interest in the partnership's Section 751 property, giving

rise to a Section 751(b) amount, the partnership must use a reasonable approach that is

consistent with the purpose of Section 751(b) to determine the tax consequences of the

reduction. Except in limited situations, a partnership will be required to continue using

the same approach, once chosen, including after a termination of the partnership.


Chapter 26. Mixing Bowl Transaction—Distribution of Previously Contributed

Property

In problem 1 (page 338), in addition to determining the tax consequences to the

partnership and Jeb, determine the tax consequences to Kayla.

___________________________________________________________________



















If the partnership distributes the property with the built in loss to the contributing partner,

the basis adjustment amount is taken into account under Section 732.64

If a partnership

distributes the property with the built in loss to a partner other than the contributing

partner, the distribute partner does not take the basis adjustment amount into

consideration. If Section 704(c)(1)(B) applies to treat the partner who contributed the

built in loss property as recognizing a loss on the sale of the property, the basis

adjustment amount is taken into consideration in determining the amount of the loss.65



market value of $20,000. Carl contributed $30,000. Because Blackacre is



Blackacre (basis equal to fair market value).

In Year 10, the partnership distributes Blackacre to Carl. Carl does not

take any portion of Beth’s basis adjustment amount into account. For

58

Prop. Reg. § 1.704-3(f)(1)(i). 59

Prop. Reg. § 1.704-3(f)(1)(ii). 60

Prop. Reg. § 1.704-3(f)(2)(iii). 61

Prop. Reg. § 1.704-3(f)(3)(ii)(A). 62

Id. 63

Prop. Reg. § 1.704-3(f)(3)(ii)(B). 64

Prop. Reg. § 1.704-3(f)(3)(v)(A). 65

Prop. Reg. § 1.704-3(f)(3)(v)(B).


purposes of Section 732(a)(1), the basis of Blackacre immediately before

the distribution is $10,000 (the partnership’s $10,000 basis). Thus, upon

distribution his basis in Blackacre is $10,000. Beth’s basis adjustment in

Blackacre is reallocated to Whiteacre.66

66



Chapter 28. Liquidating Distributions



















If a partner who had contributed property with a built in loss receives a liquidating

distribution of property (irrespective of whether he has a basis adjustment amount in the

property), the adjusted basis of the distributed property immediately before the

distribution includes the basis adjustment amount for the property in which the partner

relinquishes an interest.73

For purposes of determining the partner’s basis in the

distributed property, the partnership reallocates any basis adjustment amount from built

in loss property retained by the partnership to distributed properties of like character as

provided under Reg. § 1.755-1(c)(i), after applying Sections 704(c)(1)(B) and 737. If the

built in loss property is retained by the partnership and no property of a like character is

distributed, the basis adjustment amount is not reallocated to the distributed property for

purposes of Section 732, and Reg. § 1.734-2(c)(2) applies for any basis adjustment

amount not fully utilized by the partner.74



market value of $20,000. (Both Blackacre and Whiteacre are capital

assets.) Carl and Dennis each contributed $30,000. Because Blackacre is



Blackacre (basis equal to fair market value). The partnership makes a

Section 754 election.

67

Prop. Reg. § 1.704-3(f)(1)(i). 68

Prop. Reg. § 1.704-3(f)(1)(ii). 69

Prop. Reg. § 1.704-3(f)(2)(iii). 70

Prop. Reg. § 1.704-3(f)(3)(ii)(A). 71

Id. 72

Prop. Reg. § 1.704-3(f)(3)(ii)(B). 73

Prop. Reg. § 1.704-3(f)(3)(v)(C). 74

Id.


In Year 10, the partnership distributes Whiteacre and $10,000 to Beth in

complete liquidation of her interest. At the time of distribution, the fair

market value of Whiteacre is still $20,000, and Beth, Carl, and Dennis’s

basis are unchanged. For purposes of Section 732(a)(1), the basis of

Whiteacre immediately before the distribution is $10,000 (the

partnership’s $5,000 basis, plus Beth’s $5,000 basis adjustment amount).

Thus, upon distribution Beth’s basis in Whiteacre is $10,000. No

adjustment is required to be made under Section 73475

75



Chapter 29. Transaction in Capacity Other Than as Partner

In problem 2(c) (page 387), replace “distributed” with “allocated”.


Documents

Partnership Taxation: An Application Approach (2d … Partnership Taxation 2e...$12,000 and fair market value of $5,000. The property has a life of 10 years, with 7.5 years remaining