Partnership and LLC Taxation – Spring 2012 – Brant Hellwig
PARTNERSHIP FORMATION: THE BASICS
1. Basic Statutory Scheme
Formation of a P’ship
· §721 – Nonrecognition
o Except in certain investment p’ships, both the p’ship and partners recognize no gain or loss on the transfer of property to the p’ship in exchange for a p’ship interest.
· §722 – Partners’ “Outside Basis”
o Basis of property contributed plus cash. Generally, may tack the holding period of contributed prop. to p’ship interest.
· §723 – Inside Basis
o P’ship takes transferred basis in contributed prop. Also able to tack.
· These nonrecognition statutes do not apply for services provided in exchange for a p’ship interest.
2. Common Issues on Formation
Contributions of Appreciated (or Depreciated) Property
· If a partner contributes property that has an inherent gain or loss at contribution, the gain or loss must be taken into account by the contributor.
Contribution of Depreciable Property
· Two issues – one for contributing partner and one for the p’ship.
o Contributing Partner – will the contribution trigger §1245 or 1250 recapture? May trigger recognition of gain in what might otherwise be expected to be a nonrecognition transaction.
o Partnership – How should cost recovery deductions be calculated? The P’ship succeeds to the contributing partner’s method of cost recovery.
Characterization of Gains and Loses From Disposition of Contributed Property
· §724 – Establishes 3 special characterization rules for gain or loss on contributed property.
o Unrealized Receivables – if contributed prop. is an Unrealized Rec. in the hands of the partner, any gain or loss on disposition is ordinary no matter how long it is held by the P’ship
o Inventory Items – if Inventory in hands of contributing partner, gain or loss w/in 5 years is Ordinary
o Capital Loss Prop – If contributed w/ BIL, loss on disposition w/in 5 years is capital to the extent of such BIL.
3. Liabilities – In General
o Increase in Partner’s share of liabilities is considered a deemed cash contribution
o Decrease in partner’s share of liabilities is considered a deemed cash distribution by the p’ship
· §733 – Basis for Nonliquidating Distribution.
o In a nonliquidating distribution from the p’ship to the partner, partner’s outside basis is reduced by $ Distributed and basis of distributed property.
· §731(a)(1) – If cash distributed exceeds basis, gain is recognized.
· Commissioner v. Tufts – relief of liabilities in a sale is considered amount received.
· Recourse vs. Nonrecourse
o Recourse liabilities are allocated to those partners who bear the “economic risk of loss” (i.e. who has ultimate responsibility if p’ship was worthless and liability became due). Generally, recourse liabilities are shred in accordance w/ how the partners share losses.
o Nonrecourse Liabilities, because theoretically no partner will ultimately be liable, Nonrecourse liab. are allocated same as profits. The theory is that payments will come from profits of the venture.
Contribution of Encumbered Property
· Simultaneously decreasing partner’s share of personal liabilities (Cash distribution) and an increase in share of P’ship liabilities. Only the net change is taken into account.
· Two Important Consequences
o Partner’s outside basis reflects his share of p’ship liabilities.
o Deemed cash distribution may trigger gain recognition.
Contributions of Accounts Receivable and Payable
· Accts. Rec. – consists of three steps
o § 723 – P’ship gets a transferred basis (typically zero)
o §724 – When income is received, it is characterized as Ordinary
o §704(c) – the income is allocated to the contributing partner.
· Accts. Payable – not considered P’ship liabilities for purposes of § 752.
o § 704(c)(3) – p’ship must allocate to the contributor the deduction for payables when paid. This prevents two unpleasant results:
§ Recognition of gain on contribution of certain ongoing business. (which would be recognized if this were considered a liability).
§ The equivalent of assigning deductions (income).
4. Organization and Syndication Expenses
· §709(b) – p’ship may elect to currently deduct the lesser of:
o the amount of org. expenses(not syndication expenses) or
o $5,000, reduced by amount which org. expenses exceed $50,000.
§ Org. expenses not deducted currently are amortized over 180 months.
· Syndication Expenses continue to be nondeductible, nonamortizable capital expenditures.
FORMATION OF A PARTNERSHIP
A) Contributions of Property
1. Introduction to Partnership Accounting
§704 – Partner’s Distributive Share
· 704(a) – Distributive share is determined by the Pship agreement.
o However, Pship agreement may be amended till filing deadline. Pships must follow separate acct rules in the regs b/c otherwise, could go back and amend Pship agreement after tax items for the year are determined and distrib. In a way that would be most beneficial to partners – i.e. it would lead to abuse.
· 704(b) – unless P’ship items are referenced in agreement, tax items are allocated based on each partner’s interest in the P’ship.
o Even if they are referenced, they must also have SUBSTANTIAL ECONOMIC EFFECT, otherwise they will be allocated based on each partner’s interest in the P’ship.
Substantial Economic Effect
· Two Prong Test
1. Does the special allocation have an Economic Effect? §1.704-1(b)(2)(ii)
2. Is the special allocation substantial
· Economic Effect
o Three Requirements (stated in §1.704-1(b)(2)(ii)(b)(1), (2), and (3))
1. Maintain Capital Accounts in accordance with §1.704-1(b)(2)(iv)
§ Increase by
· Cash contributions (including Pship liabs. ASSUMED by partner. But does not include increase of partner’s share of Pship liabilities)
· FMV of prop. contributed (net of liab.)
· Allocations of pship income and gain, including tax-exempt
§ Decreased by
· Cash Distributions (includes partner’s individual liabs ASSUMED by pship, but does not include decreases in share of pship liabs)
· FMV of prop distributed (net of liab)
· Allocations of expenditures
· Allocations of pship loss and deduction.
2. Liquidating Distributions must be made in accordance w/ positive Capital Accounts as determined after Cap. Acct. adjustments for the year have been taken into account, and
3. Requirement to Restore Negative Capital Accounts
o Pre-contribution gain must be allocated to the contributing partner.
o Only increases (decreases for loss) Partner’s outside basis b/c the increased value was already taken into account at the time of contribution for purposes of his Capital Account. (e.g. A contributes prop. w/ a basis of 20 and FMV of 40. If the prop is later sold for 60, the BIG of 20 (40-20) is allocated to A and increases his basis. It doesn’t affect his cap acct. because the initial contribution increased his cap acct by the FMV of the prop. contributed while his basis was only increased by the basis of the prop contributed).
· §1.704-1(b)(2)(iv)(f) – When certain events occur (as listed in this section – pg. 1358 of code and reg book) the Pship may increase or decrease capital counts of partners to reflect a revaluation of pship property on the pship’s books.
B) Treatment of Liabilities: The Basics
1) Impact of Liabilities on Outside Basis
§752 – Treatment of Certain Liabilities
· A partner’s share of recourse liab = portion for which he bears the Economic Risk of Loss.
o A limited partner’s share of recourse liab gen may not exceed the amount, which he is obligated to contribute to the Pship in the future.
· In the case of Nonrecourse liab, none of the partners has any personal liab. and such liab are generally allocated based on each partner’s share of Pship profits rather than losses.
· Partner’s share of Pship liab increases his outside basis but has no effect on his Book Value Capital Account.
· If his share of Pship liab is decreased (e.g. by admitting a new partner), his book capital account is decreased
· 1st must determine Recourse or Nonrecourse. Ask, “may any partner be called on to satisfy the debt out of his own pocket.”
o If so, Recourse à§1.752-2 determines his share
o If not, Nonrecourse à 1.752-3 determines his share (determined by % share of profit)
§1.752-2 – Partner’s Share of Recourse Liabilities
· 1.752-2(a) – share = amount partner or related person bears economic risk of loss.
· (b)(1) – Risk of loss = amount the partner is on the hook for if there is a Constructive Liquidation.
· (1) – Constructive Liquidation =
o (i) Pship liab become payable in full; (ii) all Pship assets FMV=zero, other than prop contrib. to secure a liab.; (iii) all prop dis
here is a substantial risk of forfeiture, you don’t receive interest till risk is gone. By that time you could have a capital account b/c of distributive share of profits. §83(b) can lock you in at zero.
PARTNERSHIP OPERATIONS: THE BASICS
A) Tax Consequences to the Partnership: Aggregate and Entity Principles
· Flexibility is the goal: the rules are designed to ensure that the tax consequences track the economics of whatever deals the partners strike.
· P’ship is treated as an entity whenever doing so facilitates computation of the partners’ shares of income and deduction. For these reasons, the P’ship must:
o Adopt a taxable year
o Choose a method of accounting, and
o Make certain elections just as if it were a taxpayer.
1. The Pship as an Entity
Revenue Ruling 68-79
· A Pship is treated as a separate taxable entity, therefore, the amount and character of tax items are determined at the Pship level
· As such, if X held a Pship interest for 2 months when the Pship decided to sell stock it has held for over a year, X would still get capital gain treatment b/c the character is determined at the Pship level.
· §724 – Keep in mind that gain or loss on the sale of some property contributed to the Pship retains the character it would have had if sold by the contributing partner.
o If property is contributed to the Pship by a partner and in the hands of such partner, the property was:
§ (a) an unrealized receivable, gain or loss is ordinary on disposition by Pship
§ (b)Inventory, gain or loss is ordinary if disposed of w/in 5 years
§ (c) a capital asset, any loss is treated as a loss from the sale of a capital asset if disposed of w/in 5 years to the extent that just before contribution, basis >FMV
Demirjian v. Commissioner
· Sale of an office building to govt in a forced sale. Π said gain was not recognizable yet b/c it was a §1033 involuntary conversion. §1033 says, “if you take proceeds from involuntary conversion and put into similar property, you can defer the gain if all proceeds are invested.” Additionally, the PSHIP must make the appropriate election under §1033.
· However, in this case, the partners split up the proceeds and each bought – in their individual capacity – their own replacement prop and INDIVIDUALLY elected §1033 nonrecognition.
· The Court held this election was not sufficient, that it should have been made at the PSHIP level.
o This is like an owner (in this case the Pship) getting proceeds from an involuntary conversion and someone else (the partners in their individual capacity) using the proceeds to purchase replacement property.
· Any election affecting the computation of taxable income derived from a Pship shall be made by the Pship.
2. Assignment of Income
Schneer v. Commissioner
· Lawyer joins new firm (Pship) that reqs. partners to contribute earnings to the Pship.
· Lawyer had earnings stemming from services performed for his old Firm and contributed to Pship under agreement.
o Commission maintains that this is Lucas v. Earl assignment of income and as such is taxable to the Lawyer.
o The court draws a distinction between income earned prior to joining the new Pship and income earned after joining the new Pship. Ct said if income is earned while he is a partner, and it is earned by a business related to the new Pship, it is income of the new Pship.
· ******Hellwig says the “related business” requirement is wrong. The determination should only be based on whether the income was earned prior to or after joining the new Pship.