General Rules: Check-the-Box System
· Separate Entities
o If an organization recognized as a separate entity for federal tax purposes is not a trust, it is a “business entity” under the regulations
o Certain business entities are automatically classified as corporations
o A noncorporate business entity (an “eligible entity”) with at least two members is classified as a partnership unless an election is made for the entity to be classified as an association
· Single-Owner Organizations
o A single-owner entity is disregarded for tax purposes and treated as an extension of its owner unless the entity elect to be classified as an association and thus taxed as a C corporation
· Publicly Traded Partnerships
§ Any partnership whose interests are
· Traded on an established securities market, or
· Readily tradable on a secondary market (or its substantial equivalent
o An interest is “readily tradable” if taking into account all of the facts and circumstances, the partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market
§ Provided for partnerships if 90 percent or more of their gross income consists of certain passive-type income items (e.g., interest, dividends, real property rents, gains from the sale of real property and income and gains from certain natural resources activities)
FORMATION OF A PARTNERSHIP
Contributions of Property
o Section 721(a) provides that not gain or loss shall be recognized to a partnership or to any of its partners on a contribution of property to the partnership in exchange for an interest in the partnership
· The term is broadly defined to embrace money, goodwill, and even intangible service-flavored assets such as accounts receivable, patents, unpatented technical know-how and favorable loan or lease commitments embodied in a letter of intent secured through the efforts of the contributing partner.
· Does not include services rendered to the partnership and a partner who receives a partnership interest in exchange for services generally realizes ordinary income under Section 61.
· Section 721 does not require the transferors of property to be in “control” of the partnership immediately after the exchange
§ Noncompensatory Option
· A noncompensatory option includes a call option or warrant to acquire a partnership interest, the conversion feature in a partnership debt instrument, and the conversion feature in a preferred equity interest in a partnership
· Under the regulations, Section 721 does not apply to the transfer of property to a partnership in exchange for a noncompensatory option, but it does apply to the exercise of that option
· Generally, an individual holding a noncompensatory option to acquire a partnership interest is not treated as a partner for purposes of allocating partnership income but if the option provides the holder with rights substantially similar to the rights afforded a partner, then the option holder is treated as a partner in allocating income
o Section 721(b) provides for recognition of gain when a partner transfers property to a partnership which would be treated as an investment company (within the meaning of Section 351) if the partnership were incorporated
· Basis and other Tax Attributes
o Property Contributed to the Partnership (Inside Basis)
§ Section 723 provides that the partner’s basis in the contributed property is transferred to the partnership
§ Section 1223(2) provides that the partner’s holding period in the property carries over to the partnership
§ Section 724 provides that, in certain situations, the partnership will recognize the same character of gain or loss that the contributing partner would have recognized on a sale of the property
§ Section 704(c)(1) generally prevents the precontribution gain or loss from being shifted to the other partners by requiring the partnership to allocated that gain or loss solely to the contributing partner when it subsequently disposes of the property or distributes it to another partner
o Partnership Interest Received by Partner (Outside Basis)
· Section 722 provides that a partner’s basis in his partnership interest is equal to the sum of the cash and adjusted basis of any property contributed to the partnership
§ Holding Period
· The partner’s holding period in the partnership interest is determined by Section 1223(1), which permits the partner to tack his holding period for the contributed property if that property was a capital or Section 1231 asset.
· To the extent the contributed property consists of cash or ordinary income assets, the holding period begins on the date of the exchange.
o For this purpose, recapture gain (e.g., under Section 1245) is treated as a separate asset which is not a capital or Section 1231 asset
· If the partner contributes a mix of assets, the holding period in the partnership interest is fragmented in proportion to the fair market value of the portion of the interest received for the property to which the holding period relates, divided by the fair market value of the entire interest.
· Operation of the Rules – Revenue Ruling 99-5
o A is single owner of LLC, which is disregarded as an entity separate from its owner
§ Situation 1
o B purchases 50% of A’s ownership interest in the LLC for $5,000.
o A does not contribute any portion of the $5,000 to the LLC
o A and B continue to operate the business of the LLC as co-owners of the LLC
o The LLC is converted to a partnership when the new member, B, purchases an interest in the disregarded ent
e partner’s distributive share of income for the partnership’s taxable year. An amount treated as an advance or drawing of money is taken into account at the end of the partnership taxable year.
§ Under Sections 731 and 733, a distribution of cash is considered a return of capital, which reduce the partner’s outside basis (but not below zero) by the amount of the distribution
§ If the amount of the liability exceeds the basis of the property contributed, Section 731(a) treats the excess of the constructive cash distribution over the outside basis as gain from the sale or exchange of the newly acquired partnership interest, which is treated as capital gain under Section 741.
§ The portion of debt from which the contributing partner is relieved is then allocated to the other partners, who are considered to have contributed cash to the partnership, and the outside basis of each is increased accordingly
o Nonrecourse Liabilities
§ The regulations allow the partners to specify their interests in partnership profits for purposes of allocating nonrecourse liabilities, and those interests will be respected if they a reasonably consistent with allocations of other significant items of partnership income or gain that are respected for tax purposes
§ The section 752 regulations provide that a partner who contributes property encumbered by nonrecourse debt is first allocated that portion of the liability equaling the gain that would be allocated to that partner under section 704(c) if the property were sold at the time of the contribution for an amount equal to the liability
§ The balance of the liability is allocated under the flexible general rule—that is, in accordance with the partners’ share of partnership profits
Contributions of Services
· Receipt of a Capital Interest for Services
o Capital Interest
§ An interest in both the future earnings and the underlying assets (i.e., the “capital”) of the partnership.
§ A partner who has a capital interest will be entitled to a share of the partnership’s net assets in the event the partner withdraws or the partnership is liquidated
o Consequences to Partner
§ A service partner who receives a capital interest realizes ordinary income in an amount equal to the value of the interest less the amount, if any, paid for the interest
§ The timing of the income is determined under Section 83