This Document Contains Chapters 19 to 21 Chapter 19 Corporate Formation, Reorganization, and Liquidation Learning Objectives 19-1. Review the taxation of property dispositions. 19-2. Recognize the tax consequences to the parties to a tax-deferred corporate formation. 19-3. Identify the different forms of taxable and tax-deferred acquisitions. 19-4. Determine the tax consequences to the parties to a corporate acquisition. 19-5. Calculate the tax consequences that apply to the parties to a complete liquidation of a corporation. Teaching Suggestions This chapter is one of the most challenging chapters in the textbook because it integrates the life cycle of a closely held company in one chapter. Most other texts discuss these topics in three chapters. You can decide that you only want to cover formation and liquidation. In the formations portion of the chapter, it may be important to help students understand why we have §351 and related provisions. These provisions are similar to other types of tax-deferred transactions (e.g., like-kind exchanges). You may also want to point out how §351 is different from §721. That is, for shareholders to qualify for tax deferral on the contribution of contributed property to corporations, shareholders transferring property must in the aggregate own 80 percent of the corporation after the transaction. Leaving out the reorganization section of the chapter will not diminish the continuity of the story line. The reorganization section is fun to teach if you can bring in some real-world acquisitions, such as Google’s acquisition of YouTube. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 LO4 LO5 Research Planning Tax forms DQ19-1 20 min. Medium X DQ19-2 20 min. Medium X DQ19-3 15 min. Medium X DQ19-4 20 min. Medium X DQ19-5 20 min. Medium X DQ19-6 20 min. Medium X DQ19-7 20 min. Medium X DQ19-8 20 min. Medium X DQ19-9 20 min. Medium X DQ19-10 20 min. Medium X DQ19-11 20 min. Medium X DQ19-12 10 min. Medium X DQ19-13 10 min. Medium X DQ19-14 10 min. Medium X DQ19-15 10 min. Medium X DQ19-16 10 min. Medium X DQ19-17 25 min. Hard X DQ19-18 25 min. Hard X DQ19-19 25 min. Hard X DQ19-20 20 min. Hard X DQ19-21 20 min. Hard X DQ19-22 20 min. Hard X DQ19-23 20 min. Hard X DQ19-24 20 min. Hard X DQ19-25 20 min. Hard X DQ19-26 20 min. Hard X DQ19-27 20 min. Hard X DQ19-28 25 min. Hard X DQ19-29 25 min. Hard X DQ19-30 25 min. Hard X DQ19-31 20 min. Medium X DQ19-32 20 min. Medium X DQ19-33 25 min. Medium X DQ19-34 25 min. Medium X DQ19-35 20 min. Hard X DQ19-36 25 min. Hard X P19-37 20 min. Medium X P19-38 20 min. Medium X X P19-39 20 min. Medium X P19-40 30 min. Medium X P19-41 30 min. Medium X X P19-42 30 min. Medium X X X P19-43 30 min. Medium X P19-44 20 min. Hard X X P19-45 5 min. Medium X P19-46 5min. Medium X P19-47 5 min. Medium X P19-48 5 min. Easy X P19-49 10 min. Medium X P19-50 5 min. Medium X P19-51 15 min. Medium X P19-52 10 min. Medium X P19-53 20 min. Medium X P19-54 10 min. Medium X P19-55 20 min. Medium X P19-56 20 min. Medium X P19-57 30 min. Hard X P19-58 20 min. Hard X P19-59 30 min. Hard X P19-60 20 min. Medium X P19-61 20 min. Medium X P19-62 30 min. Medium X P19-63 30 min. Medium X P19-64 25 min. Medium X P19-65 30 min. Hard X CP19-66 45 min. Medium CP19-67 60 min. Hard CP19-68 60 min. Hard CP19-69 60 min. Hard X X Lecture Notes 1) Review of the Taxation of Property Dispositions a) Gain or loss is realized when a person engages in a transaction (an exchange of property rights with another person). b) Gain or loss realized is computed by subtracting the transferor’s tax-adjusted basis in the property exchanged from the amount realized in the exchange. c) Gain or loss realized is recognized (included in the computation of taxable income) unless exempted or deferred by a provision of the tax laws. d) Refer to Exhibit 19-1 for Computing Gain or Loss Realized in a Property Transaction. e) Refer to Exhibit 19-2 for Computing the Amount Realized in a Property Transaction. f) Refer to Exhibit 19-3 for Computing a Property’s Adjusted Tax Basis in a Property Transaction. 2) Tax-Deferred Transfers of Property to a Corporation a) Tax deferral only applies to transfers of property to a corporation. b) Gain deferred decreases the shareholder’s tax basis in the stock to an amount equal to the stock’s fair market value less the gain deferred. c) Loss deferred increases the shareholder’s tax basis in the stock to an amount equal to the stock’s fair market value plus the loss deferred. d) The shareholder’s tax basis in the stock received reflects the deferred gain or loss. e) The persons transferring property to a corporation must receive solely stock in the corporation in return. f) The persons transferring property to a corporation must collectively control the corporation after the transaction. g) Transactions subject to tax deferral i) For shareholders to receive tax deferral in a transfer of property to a corporation, either at formation or later, the transferors must meet the requirements of IRC §351. ii) Meeting the Section 351 tax deferral requirements (1) Section 351 applies only to the transfer of property to the corporation. (a) Property includes money, tangible assets, and intangible assets (for example, company name, patents, customer lists, trademarks, and logos). (b) Services are excluded from the definition of property (that is, a person who receives stock in return for services generally has compensation equal to the fair market value of the stock received). (2) The property transferred to the corporation must be exchanged for stock of the corporation. (a) To receive tax deferral on the transfer, the transferor cannot receive something other than qualifying stock from the corporation in return for the property transferred that is referred to as boot. (b) The receipt of boot will cause the transferor to recognize gain, but not loss, realized on the exchange. (c) The type of stock a shareholder can receive in a §351 exchange is quite flexible and includes voting or nonvoting and common or preferred stock. (d) Stock for purposes of §351 does not include stock warrants, rights, or options. (e) Property transferred in exchange for debt of the corporation is not eligible for deferral under §351. (3) The transferor(s) of property to the corporation must be in control of the corporation, in the aggregate, immediately after the transfer. (a) Control is defined as ownership of 80 percent or more of the corporation’s voting stock and 80 percent or more of each class of nonvoting stock. (b) Whether the control test is met is based on the collective ownership of the shareholders transferring property to the corporation immediately after the transfer. (c) Voting power generally is defined as the ability of the shareholders to elect members of the corporation’s board of directors. iii) Tax consequences to shareholders (1) The tax basis of stock received in a tax-deferred §351 exchange equals the tax basis of the property transferred less any liabilities assumed by the corporation. (2) Most practitioners refer to the stock as having a substituted basis (that is, the basis of the property transferred is substituted for the basis of the property received). (3) Refer to Exhibit 19-4 for Computing the Tax Basis of Stock Received in a Tax-Deferred Section 351 Transaction. iv) Tax consequences when a shareholder receives boot (1) A shareholder who receives property other than stock (boot) in the transferee corporation recognizes gain (but not loss) in an amount not to exceed the lesser of gain realized or the fair market value of the boot received. (2) The amount of gain recognized when boot is received in a §351 transaction must be allocated to the property exchanged on a pro rata basis using the relative fair market values of the properties. (3) The character of gain recognized (capital gain, §1231 gain, ordinary income) is determined by the type of property to which the boot is allocated. (4) Refer to Exhibit 19-5 for Computing the Tax Basis of Stock in a Section 351 Transaction When Boot Is Received. v) Assumption of shareholder liabilities by the corporation (1) When an unincorporated business is incorporated, or an existing corporation creates a subsidiary, the newly created corporation frequently assumes the outstanding liabilities of the business. (2) An important tax issue is whether the assumption of these liabilities by the newly created corporation constitutes boot received by the shareholder transferring the liabilities to the corporation. (3) Under the general rule, the corporation’s assumption of a shareholder’s liability attached to property transferred is not treated as boot received by the shareholder. (4) Tax-avoidance transactions (a) The “avoidance” motive may be present where shareholders leverage their appreciated assets prior to the transfer and have the corporation assume the liabilities. (b) The “no business purpose” motive can be present when shareholders have the corporation assume the shareholders’ personal liabilities. (5) Liabilities in excess of basis (a) If the liabilities assumed by the corporation exceed the aggregate tax basis of the properties transferred by the shareholder, the shareholder recognizes gain to the extent of the excess liabilities. (6) Tax consequences to the transferee corporation (a) The corporation receiving property in exchange for its stock in a §351 transaction does not recognize (excludes) gain or loss realized on the transfer. (b) The tax basis of property received by the corporation equals the property’s tax basis in the transferor’s hands. (c) Most practitioners refer to the transferred property as having a carryover basis. (d) To the extent the shareholder’s tax basis carries over to the corporation and the property is §1231 property or a capital asset, the shareholder’s holding period also carries over. (e) This could be important in determining if subsequent gain or loss recognized on the disposition of the property qualifies as a §1231 gain or loss or a long-term capital gain or loss. (f) Refer to Exhibit 19-6 for Computing the Tax Basis of Each Asset Received by the Corporation in a Section 351 Transaction. (7) Other issues related to incorporating an ongoing business (a) Depreciable assets transferred to a corporation (i) To the extent a property’s tax-adjusted basis carries over from the shareholder, the corporation steps into the shoes of the shareholder and continues to depreciate the carryover basis portion of the property’s tax basis using the shareholder’s depreciation schedule. (ii) Practitioners often advise against transferring appreciated property (especially real estate) into a closely held corporation. (iii) By transferring the property into the corporation, the shareholder creates two assets with the same built-in gain as the original. (b) Contributions to capital (i) It is not a taxable event to the shareholder because the shareholder does not receive any additional consideration in return for the transfer. (ii) A shareholder making a capital contribution gets to increase the tax basis in her existing stock in an amount equal to the tax basis of the property contributed. (c) Section 1244 stock (i) For individuals, long-term capital gains are taxed at a maximum tax rate of 20 percent. Losses can only offset capital gains plus $3,000 of ordinary income per year. (ii) It allows a shareholder to treat a loss on the sale or exchange of stock that qualifies as §1244 stock as an ordinary loss. (iii) It applies only to individual shareholders who are the original recipients of the stock. (iv) The maximum amount of loss that can be treated as an ordinary loss under §1244 is $50,000 per year ($100,000 in the case of married, filing jointly shareholders). (v) For shareholders to qualify for this tax benefit, the corporation from which the stock was received must have been a “small business corporation” when the stock was issued. (vi) The IRC defines a small business corporation as one in which the aggregate amount of money and other property received in return for the stock or as a contribution to capital did not exceed $1 million. (vii) There is an additional requirement that for the five taxable years prior to the year in which the stock was sold, the corporation must have derived more than 50 percent of its aggregate gross receipts from an active trade or business. (viii) It provides a tax benefit to entrepreneurs who create a risky start-up company that ultimately fails rather than succeeds. 3) Taxable and Tax-Deferred Corporate Acquisitions a) Motivation for business acquisitions i) The decision to acquire an existing business can be motivated by many factors like: (1) Desire to diversify. (2) Acquire a source of raw materials (vertical integration). (3) Expand into new product or geographic markets. (4) Acquire specific assets or technologies. (5) Provide improved distribution channels. b) The acquisition tax model i) The acquiring corporation can acquire the target corporation through either a stock or an asset acquisition. ii) The acquisition can be structured as either taxable or tax-deferred. iii) Taxable asset acquisitions allow the acquiring corporation to step up the tax basis of the assets acquired to fair value. iv) In stock acquisitions and tax-deferred asset acquisitions, the tax basis of the target corporation’s assets remains at the carryover basis (generally, cost less any depreciation). v) Refer to Exhibit 19-7 for Types of Corporate Acquisitions. 4) Tax Consequences to a Corporate Acquisition a) Taxable acquisitions i) Cash purchases of stock are the most common form of acquisition of publicly held corporations. ii) Using cash to acquire another company has several nontax advantages; most notably, the acquiring corporation does not “acquire” the target corporation’s shareholders in the transaction and does not increase the denominator in its calculation of earnings per share. iii) There are disadvantages to using cash, particularly if the acquiring corporation incurs additional debt to fund the purchase. b) Tax-deferred acquisitions i) The tax law allows taxpayers to organize a corporation in a tax-deferred manner under §351. The tax law also allows taxpayers to reorganize their corporate structure in a tax-deferred manner. ii) For tax purposes, reorganizations encompass acquisitions and dispositions of corporate assets (including the stock of subsidiaries) and a corporation’s restructuring of its capital structure, place of incorporation, or company name. iii) The IRC allows for tax deferral to the corporation(s) involved in the reorganization and the shareholders provided the transaction meets one of seven statutory definitions and satisfies the judicial principles that underlie the reorganization statutes. iv) Tax deferral in corporate reorganizations is predicated on the seller’s receiving a continuing ownership interest in the assets transferred through the receipt of equity in the acquiring corporation. c) Judicial principles that underlie all tax-deferred reorganizations i) Continuity of interest (COI) (1) Tax deferral in reorganization is based on the presumption that the shareholders of the acquired (target) corporation retain a continuing ownership (equity) interest in the target corporation’s assets or historic business through ownership of stock in the acquiring corporation. ii) Continuity of business enterprise (COBE) (1) For a transaction to qualify as a tax-deferred reorganization, the acquiring corporation must continue the target corporation’s historic business or continue to use a significant portion of the target corporation’s historic business assets. iii) Business purpose test (1) To meet the business purpose test, the acquiring corporation must be able to show a significant non tax avoidance purpose for engaging in the transaction. d) Type A asset acquisitions i) Type A reorganizations [as described in §368(a) (1) (A)] are statutory mergers or consolidations. ii) Refer to Exhibit 19-8 for the Form of a Type A Merger. iii) Forward triangular Type A merger (1) Must meet requirements to be a straight Type A merger. (2) The target corporation merges into an 80-percent-or-more owned acquisition subsidiary of the acquiring corporation. (3) The acquisition subsidiary must acquire “substantially all” of the target corporation’s properties in the exchange. (4) Refer to Exhibit 19-9 for the Form of a Type A Forward Triangular Merger. iv) Reverse triangular Type A merger (1) Must meet requirements to be a straight Type A merger. (2) The acquisition subsidiary merges into the target corporation. (3) The target corporation must hold “substantially all” of the acquisition subsidiary’s properties and its own properties after the exchange. (4) The acquisition subsidiary must receive in the exchange 80 percent or more of the target corporation’s stock in exchange for voting stock of the acquiring corporation. (5) Refer to Exhibit 19-10 for the Form of a Type A Reverse Triangular Merger. e) Type B stock-for-stock reorganizations i) The acquiring corporation must exchange solely voting stock for stock of the target corporation. ii) The acquiring corporation must control (own 80 percent or more of) the target corporation after the transaction. iii) The target corporation shareholders take a substituted tax basis in the acquiring corporation stock received in the exchange. iv) The acquiring corporation takes a carryover tax basis in the target corporation stock received in the exchange. v) Refer to Exhibit 19-11 for the Form of a Type B Reorganization. vi) Refer to Exhibit 19-12 for Summary of Tax-Deferred Corporate Reorganizations. 5) Complete Liquidation of a Corporation a) Tax consequences to the shareholders in a complete liquidation i) The tax consequences to the shareholders in a complete liquidation depend on the shareholder’s identity and ownership percentage in the corporation. ii) All noncorporate shareholders receiving liquidating distributions have a taxable transaction. iii) The shareholders treat the property received as in “full payment in exchange for the stock” transferred. iv) The shareholder computes capital gain or loss by subtracting the stock’s tax basis from the money and fair market value of property received in return. v) If a shareholder assumes the corporation’s liabilities on property received as a liquidating distribution, the amount realized in the computation of gain or loss is reduced by the amount of the liabilities assumed. vi) The shareholder’s tax basis in the property received equals the property’s fair market value. vii) Corporations that own 80 percent or more of the liquidating corporation’s stock do not recognize gain or loss in a complete liquidation of the corporation. viii) Work through Example 19-28. b) Tax consequences to the liquidating corporation in a complete liquidation i) Taxable liquidating distributions (1) The liquidating corporation recognizes all gains and certain losses on taxable distributions of property to shareholders. (2) The liquidating corporation does not recognize loss if the property is distributed to a related party and either the distribution is non–pro rata, or the asset distributed is disqualified property. (3) A related person generally is defined as a shareholder who owns more than 50 percent of the stock of the liquidating corporation. (4) Disqualified property is property acquired within five years of the date of distribution in a tax-deferred §351 transaction or as a nontaxable contribution to capital. (5) A second loss disallowance rule applies to built-in loss that arises with respect to property acquired in a §351 transaction or as a contribution to capital. (6) A loss on the complete liquidation of such property is not recognized if the property distributed was acquired in a §351 transaction or as a contribution to capital, and a principal purpose of the contribution was to recognize a loss by the liquidating corporation. (7) The rule prevents a built-in loss existing at the time of the distribution from being recognized by treating the basis of the property distributed as being its fair market value at the time it was contributed to the corporation. (8) This prohibited tax-avoidance purpose is presumed if the property transfer occurs within two years of the liquidation. (9) This presumption can be overcome if the corporation can show that there was a corporate business purpose for contributing the property to the corporation. (10) This provision is designed as an anti-stuffing provision to prevent shareholders from contributing property with built-in losses to a corporation shortly before a liquidation to offset gain property distributed in the liquidation. (11) Work through Example 19-31. ii) Nontaxable liquidating distributions (1) The liquidating corporation does not recognize gain or loss on distributions of property to an 80 percent corporate shareholder. (2) If any one of the shareholders receives tax deferral in the liquidation, the liquidating corporation cannot recognize any loss, even on distributions to shareholders who receive taxable distributions. (3) Work through Example 19-32. (4) Liquidation-related expenses, including the cost of preparing and affecting a plan of complete liquidation, are deductible by the liquidating corporation on its final Form 1120. (5) Deferred or capitalized expenditures such as organizational expenditures also are deductible on the final tax return. 6) Conclusion 7) Summary 8) Key Terms Class Activities 1. Suggested class activities ○ Elimination: Develop several multiple-choice questions (A, B, C answers) or draw questions from the test bank relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C). Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing. ○ Comprehensive problems: Have students work in groups (two to four students) to complete one of the three comprehensive problems. The comprehensive problems are quite difficult and team learning will be beneficial in solving them. Make yourself available to students to answer questions but try to get them to work together to resolve their questions. You could choose one question (what is taxable income? or what are taxes payable or taxes due?) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest. ○ Real-world examples: ○ There are many interesting recent mergers you can discuss in class. Google’s $1.65 billion acquisition of YouTube in a reverse triangular merger always gets students’ attention (especially since the company was only 18 months old when it was acquired!). ○ It is difficult to find real-world examples for incorporations and liquidations. Working the problems is probably the best way to approach the topic. 2. Ethics discussion From page 19-6: Discussion points: • Michelle is attempting to avoid the control requirement under Section 351. If she gives half of the stock to her son immediately after forming the corporation, the step transaction doctrine would suggest that she would not qualify for Section 351 deferral. • Michelle should consider allowing Lance to apply compensation generated from his services to the corporation toward purchasing stock. Of course, the compensation would need to be reasonable in amount. From page 19-13: Discussion points: • Lisa would have a hard time arguing that assumption of debt on a personal asset is related to the business purpose of the exchange (rather than for compensating the shareholder). • If Lisa used her house as collateral for the business loan, then she could argue that the objective of the loan was related to how the proceeds were used (rather than the collateral for the loan). • If there is a tax-avoidance motive, the debt relief would be boot to Lisa and would likely trigger gains to her. • What factors would you consider to determine whether this is tax avoidance? Chapter 20 Forming and Operating Partnerships Learning Objectives 20-1. Describe tax flow-through entities and determine whether they are taxed as partnerships or S corporations. 20-2. Resolve tax issues applicable to partnership formations and other acquisitions of partnership interests, including gain recognition to partners and tax basis for partners and partnerships. 20-3. Determine the appropriate accounting periods and methods for partnerships. 20-4. Calculate and characterize a partnership’s ordinary business income or loss and its separately stated items and demonstrate how to report these items to partners. 20-5. Explain the importance of a partner’s tax basis in her partnership interest and the adjustments that affect it. 20-6. Apply the tax-basis, at-risk, passive activity loss, and excess business loss limits to losses from partnerships. Teaching Suggestions This chapter provides an overview of partnership formations and operations. In the formations area, the chapter focuses on the tax consequences to partners and partnerships when partners contribute either property or services in exchange for a partnership interest. As part of this analysis, the chapter discusses general principles regarding partnership debt allocation. In the operations area, the chapter covers separately stated items and tax reporting, self-employment issues affecting partners, partner basis adjustments, and limitations on tax losses from partnerships. The chapter is written in such a way that instructors who prefer to cover only formations or only operations can do so. We recommend one of two possible approaches when covering this chapter. First, you might consider discussing the Entities Overview chapter first as a general introduction to the taxation of flow-through entities, and then follow it with a discussion of this chapter and possibly the chapter that follows on S corporations. Alternatively, you might begin a module on flow-through entities with this chapter, followed by the next chapter on S corporations, and ending with the Entities Overview chapter to highlight important differences between partnerships and S corporations. Of all the topics included in the chapter, students tend to have the most difficulty with partnership debt allocation and the tax basis, the at-risk, and the passive activity loss limitations. These areas are likely to require more time in the classroom relative to other topics in the chapter. Two comprehensive partnership tax return problems are included in Appendix C for those instructors that want to emphasize the tax compliance requirements of operating a partnership. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 LO4 LO5 LO6 Research Planning Tax Forms DQ20-1 15 min. Easy X DQ20-2 15 min. Easy X DQ20-3 15 min. Easy X DQ20-4 20 min. Medium X DQ20-5 20 min. Medium X DQ20-6 20 min. Medium X DQ20-7 20 min. Medium X DQ20-8 20 min. Medium X DQ20-9 20 min. Medium X DQ20-10 20 min. Medium X DQ20-11 20 min. Medium X DQ20-12 10 min. Medium X DQ20-13 10 min. Medium X DQ20-14 10 min. Medium X DQ20-15 10 min. Medium X DQ20-16 10 min. Medium X DQ20-17 25 min. Hard X DQ20-18 25 min. Hard X DQ20-19 25 min. Hard X DQ20-20 20 min. Hard X DQ20-21 20 min. Hard X DQ20-22 20 min. Hard X DQ20-23 20 min. Hard X DQ20-24 20 min. Hard X DQ20-25 20 min. Hard X DQ20-26 20 min. Hard X DQ20-27 20 min. Hard X DQ20-28 25 min. Hard X DQ20-29 25 min. Hard X DQ20-30 20 min. Hard X DQ20-31 20 min. Hard X DQ20-32 20 min. Hard X DQ20-33 20 min. Hard X DQ20-34 20 min. Hard X DQ20-35 25 min. Hard X DQ20-36 25 min. Hard X P20-37 15 min. Easy X P20-38 15 min. Easy X P20-39 15 min. Medium X P20-40 20 min. Medium X X P20-41 20 min. Easy X P20-42 20 min. Medium X P20-43 30 min. Medium X P20-44 20 min. Medium X X P20-45 25 min. Medium X X P20-46 30 min. Medium X X P20-47 20 min. Medium X X P20-48 20 min. Medium X P20-49 25 min. Medium X P20-50 30 min. Medium X P20-51 20 min. Medium X P20-52 15 min. Medium X P20-53 20 min. Medium X P20-54 20 min. Medium X P20-55 20 min. Medium X P20-56 15 min. Medium X X P20-57 20 min. Medium X X P20-58 15 min. Medium X P20-59 20 min. Medium X P20-60 20 min. Medium X X P20-61 20 min. Medium X P20-62 30 min. Hard X X P20-63 20 min. Medium X X P20-64 20 min. Medium X P20-65 15 min. Easy X P20-66 20 min Medium X P20-67 20 min. Easy X X P20-68 15 min. Easy X P20-69 20 min. Easy X P20-70 30 min. Medium X P20-71 30 min. Medium X P20-72 30 min. Medium X X P20-73 20 min. Medium X P20-74 20 min. Medium X P20-75 20 min. Medium X X X P20-76 20 min. Medium X P20-77 30 min. Hard X X P20-78 30 min. Hard X X P20-79 30 min. Medium X X CP20-80 60 min. Hard X CP20-81 45 min. Hard X CP20-82 60 min. Hard Lecture Notes 1) Flow-Through Entities Overview a) Income earned by flow-through entities is usually not taxed at the entity level. b) The owners of flow-through entities are taxed on the share of entity-level income allocated to them. c) Income from flow-through entities is taxed only once—when it “flows through” to owners of these entities. d) Aggregate and entity concepts i) An entity approach treats tax partnerships as entities separate from their partners. ii) An aggregate approach treats tax partnerships as an aggregation of the partners’ separate interests in the assets and liabilities of the partnership. 2) Partnership Formations and Acquisitions of Partnership Interests a) Acquiring partnership interests when partnerships are formed i) Partnership interests represent the bundle of economic rights granted to partners under the partnership agreement. ii) These rights include the right to receive a share of the partnership assets if the partnership were to liquidate, called a capital interest, and the right or obligation to receive a share of future profits or future losses, called a profits interest. iii) The distinction between capital and profits interests is important because the tax rules for partnerships are sometimes applied to them differently. iv) Contributions of property (1) Gains and losses from the exchange of contributed property for partnership interests are either fully or partially deferred for tax purposes depending on the specifics of the transaction. (2) The tax rules in this area allow entrepreneurs to organize their businesses without having to pay taxes. (3) The tax rules follow the aggregate theory of partnership taxation because they recognize that partners contributing property to a partnership still own the contributed property, albeit a smaller percentage, since other partners will also indirectly own the contributed property through their partnership interests. (a) Gain and loss recognition (i) Partners don’t generally recognize gain or loss when they contribute property to partnerships. (ii) The general rule facilitates contributions of property with built-in gains (fair market value is greater than tax basis) but discourages contributions of property with built-in losses (fair market value is less than tax basis). (iii) Work through Example 20-1. (b) Partner’s initial tax basis (i) Initial tax basis for partners contributing property = basis of contributed property − debt securing contributed property + partnership debt allocated to contributing partner + gain recognized. (ii) A partner’s tax basis in his/her partnership interest is his/her outside basis, and the partnership’s basis in its assets is its inside basis. (iii) Partners will simply have a basis in their partnership interest equivalent to the tax basis of the property and cash they contributed, which ensures that realized gains and losses on contributed property are merely deferred until either the contributing partner sells her partnership interest or the partnership sells the contributed property. (iv) Recourse debt 1. Recourse debts are those for which partners have economic risks of loss—that is, they may have to legally satisfy the debt with their own funds. 2. Example: the unsecured debts of general partnerships, such as payables, are recourse debt because general partners are legally responsible for the debts of the partnership. (v) Nonrecourse debts 1. Nonrecourse debts don’t provide creditors the same level of legal recourse against partners. 2. Example: mortgages are typically secured by real property and only give lenders the right to obtain the secured property in the event the partnership defaults on the debt. 3. Because partners are responsible for paying nonrecourse debts only to the extent the partnership generates sufficient profits, such debts are generally allocated according to partners’ profit-sharing ratios. (vi) The fundamental difference between the two types of debt lies in the legal responsibility partners assume for ultimately paying the debt. (vii) Refer to Exhibit 20-1 for Basic Rules for Allocating Partnership Debt to Partners. (viii) Work through Example 20-3. (ix) If the debt securing the contributed property is nonrecourse debt, the amount of the debt in excess of the basis of the contributed property is allocated solely to the contributing partner, and the remaining debt is allocated to all partners according to their profit-sharing ratios. (x) Work through Examples 20-4 and 20-5 (4) Partner’s holding period in partnership interest (a) Contributing partner’s holding period in a partnership interest depends on the type of property contributed. (b) As partnership interest is a capital asset, its holding period determines whether gains or losses from the disposition of the partnership interest are short-term or long-term capital gains or losses. (c) Work through Example 20-6. (5) Partnership’s tax basis and holding period in contributed property (a) Contributing partner’s tax basis and holding period in contributed property carries over to the partnership. (b) Measuring both the partner’s outside basis and the partnership’s inside basis must be consistent with the entity theory of partnership taxation. (c) Partnerships generally take a basis in the property equal to the contributing partner’s basis in the property at the time of the contribution. (d) Whether gains or losses on dispositions of contributed property are capital or ordinary usually depends on the manner in which the partnership uses contributed property. (e) A new partnership would prepare its initial balance sheet using the tax basis for its assets. It would also create a tax capital account for each new partner, reflecting the tax basis of any property contributed and cash contributions. (f) A partnership’s tax basis balance sheet can provide useful tax-related information. (g) Partners set up §704(b) capital accounts in much the same way as tax capital accounts, except that §704(b) capital accounts reflect the fair market value rather than the tax basis of contributed assets. §704(b) capital accounts can be adjusted so they continue to reflect the fair market value of partners’ capital interests as accurately as possible and are a better measure of the true value of partner’s capital interests. (h) Work through Example 20-7. (i) Refer to Exhibit 20-2 for Color Comfort Sheets LLC. v) Contribution of services (1) Capital interests (a) The service partner’s tax basis in the capital interest he/she receives will equal the amount of ordinary income he recognizes, and his holding period will begin on the date he receives the capital interest. (b) The partnership either deducts or capitalizes the value of the capital interest, depending on the nature of the services the partner provides. (c) When the partnership deducts the value of capital interests used to compensate partners for services provided, it allocates the deduction only to the nonservice partners because they have effectively transferred a portion of their partnership capital to the service partner. (d) Work through Example 20-8. (2) Profits interests (a) Service partners receiving profits interests do not report ordinary income. (b) The only economic benefit they provide is the right to share in the future profits of the partnership. (c) They have no liquidation value at the time they are received. (d) Nonservice partners generally prefer to compensate service partners with profits interests because they don’t have to forgo their current share of capital in the partnership and don’t have to give up anything if the partnership is ultimately unprofitable. (e) As there is no immediate liquidation value associated with a profits interest, the service partner will not recognize income and the nonservice partners will not receive deductions. (f) Work through Examples 20-9 and 20-10. (3) Organizational, start-up, and syndication costs b) Acquisitions of partnership interests i) Refer to Exhibit 20-3 for Summary of Partner’s Outside Basis and Holding Period by Acquisition Method. ii) Work through Example 20-11. 3) Partnership Accounting: Tax Elections, Accounting Periods, and Accounting Methods a) Tax elections i) The partnership tax rules rely on the entity theory of partnership taxation and make the partnership responsible for tax elections. ii) The partnership makes other tax elections by filing a request with the IRS, such as Form 3115 to change an accounting method. iii) Work through Example 20-12. b) Accounting periods i) Required year-ends (1) Results in tax deferral for some or all of the partners. (2) Refer to Exhibit 20-4 for Partner Defers 11 Months of Income for One Year. (3) The government’s desire to reduce the aggregate tax deferral of partners provides the underlying rationale behind the rules requiring certain partnership taxable year-ends. (4) The majority interest taxable year is the taxable year of one or more partners who together own more than 50 percent of the capital and profits interests in the partnership. (5) Under the principal partners test, the required tax year is the taxable year the principal partners all have in common and principal partners are those have 5 percent or more interest in the partnership profits and capital. (6) The tax year with the least aggregate deferral is the one among the tax years of the partners that provides the partner group as a whole with the smallest amount of aggregate tax deferral. (7) Work through Example 20-13. c) Accounting methods i) Partnerships may not use the cash method under certain conditions as it facilitates the deferral of income and acceleration of deductions. If partnerships’ average annual gross receipts for the three prior taxable years are less than $26 million, partnerships with C corporation partners may use the cash method if they otherwise qualify. ii) Work through Example 20-14. 4) Reporting the Results of Partnership Operations a) Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities. b) Ordinary business income (loss) and separately stated items i) Partnerships file annual information returns reporting their ordinary business income (loss) and separately stated items. ii) Ordinary business income (loss) = Partnership overall income or loss exclusive of separately stated items. iii) Separately stated items change partners’ tax liabilities according to each partner’s unique situation. iv) Refer to Exhibit 20-6 for Common Separately Stated Items. v) Work through Examples 20-15 and 20-16. vi) Guaranteed payments (1) Guaranteed payments are separately stated items, are treated as ordinary income by partners receiving them, and are either capitalized or expensed by partnerships. (2) Guaranteed payments for services are always treated as self-employment income. (3) Refer to Exhibit 20-7 for Color Comfort Sheets LLC. (4) Work through Example 20-17. vii) Self-employment tax (1) Shares of ordinary business income (loss) are always treated as self-employment income (loss) by general partners and never treated as self-employment (loss) by limited partners. (2) Shares of ordinary business income (loss) may or may not be treated by LLC members as self-employment income (loss), depending on the extent of their involvement with the LLC. (3) Work through Examples 20-18 and 20-19. c) Limitation on Business Interest Expense i) A partnership’s deduction for business interest is limited to its business interest income plus 30 percent of its adjusted taxable income for the year. ii) Any disallowed business interest expense is allocated to the partners, reducing their basis in their partnership interests. iii) Partners carry forward their share of disallowed business interest expense until the partnership has excess business interest expense limitation to allocate to the partners. iv) The limitation on the deduction for business interest only applies to partnerships with average annual gross receipts for the prior three years greater than $26 million (indexed for inflation). d) Deduction for Qualified Business Income (QBI) i) Noncorporate partners may generally deduct 20 percent of the qualified business income allocated to them. ii) Qualified business income does not include a partnership’s income from specified service trade or businesses, and investment income such as capital gains, dividends, and investment interest income. iii) Qualified business income does not include partners’ guaranteed payments. iv) Partnerships must disclose, for each qualified trade or business, any information the partners require in order to calculate any limitation on QBI deduction. e) Net investment income tax i) A partner’s share of gross income from interest, dividends, annuities, royalties, or rents is included in the partner’s net investment income when calculating the net investment income tax. ii) A partner’s share of business income from a trade or business that is a passive activity and net gain from the sale of property other than property used in an active trade or business is also included in the partner’s net investment income. f) Allocating partners’ shares of income and loss i) Tremendous flexibility in allocating overall profit and loss as well as specific items of profit and loss to partners, as long as partners agree to the allocations and they have “substantial economic effect.” ii) Tax regulations presume the partners’ interests to be equal on a per capita basis but allow consideration for other factors reflecting the partners’ economic arrangement, such as their capital contributions, distribution rights, and interests in economic profits and losses. iii) Partnership allocations inconsistent with partners’ capital interests or overall profit-and-loss-sharing ratios are called special allocations. g) Work through Example 20-20. h) Partnership compliance issues i) Refer to Exhibit 20-8 (PART I) for Page 1 Form 1065. ii) Refer to Exhibit 20-8 (PART II) for Page 3 Form 1065. iii) Refer to Exhibit 20-8 (PART III) for 2019 Schedule K-1 for Sarah Walker (on 2018 forms) CCS Operates as an LLC. 5) Partner’s Adjusted Tax Basis in Partnership Interest a) A partner will increase the tax basis in her partnership interest for: i) Contributions ii) Share of ordinary business income iii) Separately stated income/gain items iv) Tax-exempt income b) A partner will decrease the tax basis in his/her partnership interest for: i) Cash distributions ii) Share of nondeductible expenses iii) Share of ordinary business loss iv) Separately stated expense/loss items c) A partner’s tax basis may not be negative. d) Work through Examples 20-21 and 20-22. e) Cash distributions in operating partnerships i) Even after a partnership has been formed, partners are likely to continue to receive actual and deemed cash distributions. ii) If cash is distributed when partners have a positive tax basis in their partnership interests, the distribution effectively represents: (1) A distribution of profits that have been previously taxed. (2) A return of capital previously contributed by the partner to the partnership. (3) A distribution of cash the partnership has borrowed. (4) A combination of the three given above. iii) Work through Example 20-23. 6) Loss Limitations a) Tax-basis limitation i) Partnership losses in excess of a partner’s tax basis are suspended and carried forward until additional basis is created. ii) A partner’s basis represents the amount a partner has invested in a partnership and it limits the amount of partnership losses the partner can use to offset other sources of income. iii) Partners may create additional tax basis in the future by making capital contributions, by guaranteeing more partnership debt, and by helping their partnership to become profitable. iv) Work through Example 20-24. b) At-risk limitation i) Remaining partnership losses are further suspended by the at-risk rules to the extent a partner is allocated nonrecourse debt not secured by real property. ii) Partners apply the at-risk limitation after the tax-basis limitation. iii) Work through Example 20-25. c) Passive activity loss limitation i) Passive activity loss (PAL) rules: these rules were enacted as a backstop to the at-risk rules and are applied after the tax-basis and at-risk limitations. ii) It limits the ability of partners in rental real estate partnerships and other partnerships they don’t actively manage from using their ordinary losses from these activities (remaining after the application of the tax basis and at-risk limitations) to reduce other sources of taxable income. (1) Passive activity defined (a) The passive activity rules define a passive activity as “any activity which involves the conduct of a trade or business, and in which the taxpayer does not materially participate.” (b) Participants in all other activities are passive unless their involvement in an activity is “regular, continuous, and substantial.” (2) Refer to Exhibit 20-9 for Tests for Material Participation. iii) Income and loss baskets (1) Losses from the passive basket are not allowed to offset income from other baskets. (2) The three baskets are: (a) Passive activity income or loss. (b) Portfolio income. (c) Active business income. (3) Refer to Exhibit 20-10 for Income and Loss Baskets. (4) Work through Examples 20-26 and 20-27. d) Excess Business Loss Limitation i) Partnership losses otherwise deductible under the basis, at-risk, and passive loss rules are only deductible by noncorporate partners to the extent of their other trade or business income for the year plus a threshold amount. ii) The threshold amount is a function of the noncorporate partner’s filing status and is indexed for inflation. Class Activities 1. Suggested class activities ○ Elimination: Develop several multiple-choice questions (A, B, C answers) or draw questions from the test bank relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C). Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing. ○ Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem (problems 77 and 79 focus on determining partners’ shares of ordinary business income and separately stated items while problem 78 focuses more on partner loss limitations). Make yourself available to students to answer questions but try to get them to work together to resolve their questions. You could choose one question (“what does the partner report?” or “how much loss is deductible currently?”) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest. ○ Partnership or LLC agreement activity: Obtain a redacted partnership or LLC agreement from a local CPA firm. Bring the agreement to class and assign students to work in groups (two to four students) to analyze a provision in the tax section of the agreement and describe how it relates to material you are discussing from the chapter. After sufficient time has passed, have the group’s report their findings to the rest of the class. Use this activity to reinforce concepts already learned and to introduce new concepts as well. ○ Web activity: Have students use their laptops to search for promotional materials on master limited partnerships or hedge fund partnerships. Use this material to help them understand that some partnerships may have many partners. Students typically think of partnerships as being closely held with just a few partners. ○ Ethics activity: See the ethics discussion points below, then refer students to the situation discussed in the ethics box in the chapter and solicit their input. Time permitting, have them find authority to support their positions. At a minimum, they should locate Reg. §1.469-5T(f)(4), which provides the following: “The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Reasonable means for purposes of this paragraph may include but are not limited to the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” Conclude by asking students how they would advise Carlo if he were their client. 2. Ethics discussion From page 20-34: Discussion points: • For Carlo to deduct his share of the loss this year, he must establish that he worked more than 500 hours in the business this year. • Refer students to Reg. Sec. 1.469-5T(f)(4), which allows taxpayers to “approximate” the number of hours of work performed based on appointment books or calendars. • Ask students if they believe Carlo’s process for approximating his time spent is sufficiently precise to allow him to claim he worked more than 500 hours during the year. • Finally, if most students believe Carlo meets the requirement, ask what process for documenting time spent would not be acceptable to the IRS or the courts. Note that the courts have typically not accepted a taxpayer’s oral testimony without supporting evidence. Chapter 21 Dispositions of Partnership Interests and Partnership Distributions Learning Objectives 21-1. Determine the tax consequences to the buyer and seller of the disposition of a partnership interest, including the amount and character of gain or loss recognized. 21-2. List the reasons for distributions, and compare operating and liquidating distributions. 21-3. Determine the tax consequences of proportionate operating distributions. 21-4. Determine the tax consequences of proportionate liquidating distributions. 21-5. Explain the significance of disproportionate distributions. 21-6. Explain the rationale for special basis adjustments, determine when they are necessary, and calculate the special basis adjustment for dispositions and distributions. Teaching Suggestions This chapter provides an overview of partnership dispositions (i.e., sales of partnership interests) and distributions. In the distribution area, the chapter focuses primarily on proportionate operating and liquidating distributions; however, disproportionate distributions are discussed without going into great depth. In addition, the chapter briefly discusses special basis adjustments under §754 and the general treatment when an adjustment arises from sales of partnership interests and distributions. One objective of the chapter is to provide a fundamental structure for thinking about these issues so that students may ultimately use their knowledge to engage in more complicated tax planning involving partnerships. It seems reasonable to expect that much of the time spent covering this chapter will be on the distribution area. To that end, the chapter provides a structure of five different scenarios to illustrate the consequences of distributions of cash, hot assets, and other property when the partner’s basis is either greater or less than the amount of the distribution. These scenarios can be useful to help students understand the key factors (type of assets distributed and amount of distribution relative to partnership basis) that determine the tax treatment of these transactions. In teaching the chapter, you may want to highlight the important differences in partner tax consequences if a partner exits his/her interest in a partnership by selling the interest or by receiving a liquidating distribution. The chapter provides an extended example to use as an illustration of these differences and how individual partners may place differing weights on the tax consequences from each alternative to arrive at a decision about which alternative is best for their situation. Assignment Matrix Learning Objectives Text Feature Difficulty LO1 LO2 LO3 LO4 LO5 LO6 Research Planning Tax Forms DQ21-1 10 min. Easy X DQ21-2 10 min. Easy X DQ21-3 10 min. Easy X DQ21-4 20 min. Medium X DQ21-5 20 min. Medium X DQ21-6 20 min. Medium X DQ21-7 20 min. Medium X DQ21-8 20 min. Medium X DQ21-9 20 min. Medium X DQ21-10 20 min. Medium X DQ21-11 20 min. Medium X DQ21-12 10 min. Medium X X DQ21-13 10 min. Medium X DQ21-14 10 min. Medium X DQ21-15 10 min. Medium X DQ21-16 10 min. Medium X DQ21-17 25 min. Hard X DQ21-18 25 min. Hard X DQ21-19 25 min. Hard X DQ21-20 20 min. Hard X DQ21-21 20 min. Medium X DQ21-22 25 min. Hard X X DQ21-23 20 min. Hard X DQ21-24 20 min. Hard X DQ21-25 20 min. Hard X X DQ21-26 20 min. Hard X DQ21-27 20 min. Hard X DQ21-28 25 min. Hard X DQ21-29 25 min. Hard X P21-30 15 min. Easy X P21-31 15 min. Easy X P21-32 15 min. Easy X P21-33 15 min. Easy X P21-34 15 min. Medium X P21-35 20 min. Medium X P21-36 20 min. Medium X P21-37 20 min. Medium X P21-38 20 min. Medium X P21-39 20 min. Medium X P21-40 20 min. Medium X P21-41 20 min. Medium X P21-42 20 min. Medium X P21-43 20 min. Medium X P21-44 20 min. Medium X X P21-45 20 min. Medium X P21-46 30 min. Medium X P21-47 30 min. Medium X P21-48 30 min. Medium X X P21-49 30 min. Medium X P21-50 30 min. Medium X P21-51 25 min. Medium X P21-52 25 min. Medium X P21-53 30 min. Medium X X P21-54 20 min. Medium X X X P21-55 25 min. Medium X X P21-56 25 min. Medium X X P21-57 25 min. Medium X X P21-58 25 min. Medium X X P21-59 25 min. Medium X X CP21-60 45 min. Hard CP21-61 60 min. Hard X CP21-62 60 min. Hard X Lecture Notes 1) Basics of Sales of Partnership Interests a) Seller issues (1) Realized gain or loss = Cash and fair market value of property received plus debt relief − Basis in partnership interest (2) Work through Example 21-1. (3) Hot assets (a) A portion of the gain or loss will be ordinary if a seller realizes any amounts attributable to unrealized receivables or inventory items, which are referred to as hot assets. (b) The process for determining the gain or loss follows: (i) Step 1: Total gain or loss = Amount realized − Outside basis (ii) Step 2: Calculate the partner’s share of gain or loss from hot assets as if the partnership sold these assets at their fair market value. This represents the ordinary portion of the gain or loss. (iii) Step 3: Capital gain or loss from the sale = Step 1 − Step 2 (c) Work through Examples 21-2, 21-3, 21-4, and 21-5. b) Buyer and partnership issues i) Outside basis = cost of the partnership interest + share of partnership’s liabilities. ii) Inside basis—selling partner’s inside basis at sale date. iii) No changes to partnership asset bases (unless §754 election is in effect). iv) Tax year closes with respect to selling partner. v) Work through Examples 21-6, 21-7, 21-8, and 21-9. 2) Basics of Partnership Distributions a) Partners often receive distributions of the partnership profits, known as operating distributions. b) Partners may also receive liquidating distributions. Because the market for partnership interests is much smaller than for publicly traded stock, partners may have a difficult time finding buyers for their interests. c) Liquidating distributions are similar to corporate redemptions of a shareholder’s stock. d) Operating distributions i) Operating distributions of money only (1) Partners generally do not recognize gain or loss. One exception occurs when the partnership distributes money only and the amount is greater than the partner’s outside basis. (2) Work through Examples 21-10 and 21-11. ii) Operating distributions that include property other than money (1) Partners generally take a carryover basis in the distributed assets. (2) If the partnership distribution includes other property and the combined inside basis is greater than the partner’s outside basis, the bases of the other property distributed will be reduced. (3) In general, partners reduce outside basis by money and other property distributed. (4) Work through Examples 21-12, 21-13, and 21-14. e) Liquidating distributions i) The tax issues in liquidating distributions for partnerships are basically twofold: (1) To determine whether the terminating partner recognizes gain or loss and (2) To reallocate his or her entire outside basis to the distributed assets. ii) The rationale behind the rules for liquidating distributions is simply to replace the partner’s outside basis with the underlying partnership assets distributed to the terminating partner. iii) Gain or loss recognition in liquidating distributions (1) Generally (a) Partners and partnerships do not recognize gain or loss. (2) Exceptions (a) Gain: Partner recognizes gain when partnership distributes money and the amount exceeds the partner’s outside basis in the partnership interest. (b) Loss: Partner recognizes loss when two conditions are met: (i) Distribution consists of only cash and hot assets. (ii) The partner’s outside basis exceeds the sum of the bases of the distributed assets. iv) Basis in distributed property (1) Refer to Exhibit 21-1 for Alternative Scenarios for Determining Basis in Distributed Property. f) Partner’s outside basis is greater than inside basis of distributed assets i) Scenarios (1) Scenario 1: Distributions of money, inventory, and /or unrealized receivables. (a) Work through Example 21-16. (2) Scenario 2: Other property included in distributions. (a) Work through Examples 21-17 and 21-18. g) Partner’s outside basis is less than inside bases of distributed assets i) Scenarios (1) Scenario 3: Distributions of money only. (2) Scenario 4: Distributions of money, inventory, and/or unrealized receivables. (a) Work through Examples 21-19 and 21-20. (3) Scenario 5: Other property included in distributions. (a) Work through Example 21-21. ii) Character and holding period of distributed assets (a) Work through Examples 21-22 and 21-23. 3) Disproportionate distributions a) Both operating and liquidating distributions can be disproportionate distributions. b) When distribution changes a partner’s relative share of unrealized appreciation or losses in a partnership’s hot assets. c) It helps to prevent partners from converting ordinary income into capital gains through distributions. d) Partner and partnership must treat distribution as a sale or exchange, which may change the character and timing of income or losses that are recognized. e) Work through Example 21-24. 4) Special Basis Adjustments a) The tax rules allow the partnership to make an election for a special basis adjustment to eliminate discrepancies between the inside and outside bases and correct the artificial income or loss at the partnership level. b) It is elective with a §754 election in effect and: i) When a new investor purchases a partnership interest, or ii) When a partner recognizes a gain or loss in a distribution, or iii) When a partner takes a basis in distributed property that differs from the partnership basis in the property. c) It is mandatory: i) When a partner sells a partnership interest and the partnership has a substantial built-in loss at the time of sale, or ii) When a partnership has a substantial basis reduction from a distribution. d) It helps to prevent partners from being temporarily overtaxed or undertaxed after a partnership interest is transferred or after a distribution occurs. e) Work through Example 21-25. f) Refer to Exhibit 21-2 for Special Basis Adjustments. g) Special basis adjustments for dispositions i) It must be allocated to the assets under allocation rules in §755. h) Special basis adjustments for distributions i) A positive basis adjustment will increase the basis in the partnership assets: (1) When a partner receiving distributed property recognizes a gain on the distribution, and (2) When a partner receiving distributed property takes a basis in the property less than the partnership’s basis in the property. The positive adjustment will equal the sum of the gain recognized by the partners receiving distributed property and the amount of the basis reduction. ii) A negative basis adjustment will decrease the basis in partnership assets: (1) When a partner receiving distributed property in a liquidating distribution recognizes a loss on the distribution, and (2) When a partner receiving distributed property takes a basis in the property greater than the partnership’s basis in the property. The negative adjustment will equal the sum of the recognized loss and the amount of the basis increase made by the partners receiving the distribution. Class Activities 1. Suggested class activities ○ One versus the class: Have one student volunteer as the “one” with the other class members being the “group.” Use the Key Facts boxes in the text to develop multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, he or she is eliminated from the competition. After six (or some other number) questions, those students left standing receive bonus participation points for the day. ○ Group teaching liquidating distributions: Divide the class into five groups. These groups will each be assigned to one of the five scenarios in Exhibit 21-1. Essentially, each group will be responsible for “teaching” the remaining groups the material necessary for understanding the tax consequences in their particular scenario. Give the groups 10–15 minutes to read their material and prepare their presentation for discussion. Ask each group to present their scenario to the class. Each of the non-presenting groups should be responsible for asking one to two questions of the presenting group during their presentation time. After all groups have presented, the instructor should do a quick five-minute summary of the topic. ○ Disposition or distribution? Using the facts in Example 21-22 (or another similar set of facts) have half of the class determine the tax consequences if the partner sells his/her partnership interest and the other half determine the tax consequences if the partner receives a liquidating distribution from the partnership. Have a volunteer from each half present their results. Then have the students engage in a discussion about which structure they would recommend and why. ○ Ethics discussion: Have students refer to the Ethics box included in the chapter. Ask them why the valuation of hot assets would matter to Sarah. Discuss how valuation concerns are applicable in this area as well as in other areas. Solicit student’s opinions and add your own thoughts and insights. See the ethics discussion points above. 2. Ethics discussion From page 21-7: Discussion points: • Reg. Sec. 1.751-1(a)(2) requires that Sarah’s ordinary gain or loss be determined through a deemed sale of the partnership’s hot assets at its “fair market value.” Further, Reg. Sec. 1.751-1(a)(3) requires that Sarah attach a separate statement to her return supporting her calculation of gain or loss attributable to the partnership’s hot assets. Thus, if the dollar amounts involved are material, the transaction will likely invite IRS scrutiny. • Ask students which appraisal they would use and why two appraisals could be different. • Finally, conclude by pointing out that valuations issues frequently come up in tax practice and that taxpayers are not necessarily obligated to use an appraisal that favors the government. However, emphasize that taxpayers should only rely on appraisals that are reasonable given the facts and circumstances. Instructor Manual for McGraw-Hill's Taxation of Individuals and Business Entities 2021 Brian C. Spilker, Benjamin C. Ayers, John A. Barrick, Troy Lewis, John Robinson, Connie Weaver, Ronald G. Worsham 9781260247138, 9781260432534
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