CH-20 Forming and Operating Partnerships – McGraw-Hill’s Taxation of Individuals and Business Entities 2021 : Book Guide

Chapter 20 Forming and Operating Partnerships Discussion Questions 1. [LO 1] What is a flow-through entity, and what effect does this designation have on how business entities and their owners are taxed? Flow-through entities are entities that are not taxed on the entity level; rather, these entities are taxed on the owner’s level. These types of entities conduct a regular business; however, the income earned and deductions allowed are passed to the owners of these flow-through entities. The owners are then taxed on the amount allocated to them. Thus, flow-through entities provide a way for income and deductions to be taxed only once instead of twice. 2. [LO 1] What types of business entities are taxed as flow-through entities? The two main business entities that are taxed as flow-through entities are partnerships and S corporations. Partnerships are taxed under Subchapter K and consist of general partnerships, limited partnerships, and limited liability companies (LLC). S corporations are taxed under Subchapter S. Both these types of business entities are treated as flow-through entities and are taxed accordingly. 3. [LO 1] Compare and contrast the aggregate and entity concepts for taxing partnerships and their partners. The aggregate concept treats partnerships more like a conglomeration of individual owners. Each partnership is viewed as an aggregation of the partners’ separate interests in the assets and liabilities of the partnership. For example, each partner, rather than the partnership, pays tax on their individual share of partnership income. The entity concept treats partnerships more like a corporation. Each partnership is an entity separate from its partners. For example, the partnership decides on which tax method to use and which tax elections to make rather than the individual partners. 4. [LO 2] What is a partnership interest, and what specific economic rights or entitlements are included with it? A partnership interest is an equity interest in a partnership. This interest is created through a transfer or sale of cash, property, or services in exchange for an equity interest in the partnership. A partnership interest gives each partner certain rights or entitlements. The two main economic rights are a capital interest and profit interest in the partnership. A capital interest is the right for a partner to receive a share of the partnership assets during liquidation. A profit interest is the right or obligation for a partner to receive a share of the future income or losses of the partnership. 5. [LO 2] What is the rationale for requiring partners to defer most gains and all losses when they contribute property to a partnership? The rationale for requiring partners to defer most gains and losses when contributing property to a partnership is twofold. First, the IRS desires that entrepreneurs have a way to start their own business without having to pay any taxes upfront. Second, the partners are considered as still owning the property they have contributed to the partnership. While they don’t own the property outright, each partner has a small percentage of the property contributed in her/his partnership interest she/he exchanged for. This second reasoning helps further support the idea that partnerships follow the aggregate concept. 6. [LO 2] Under what circumstances is it possible for partners to recognize gain when contributing property to partnerships? Partners have the potential of recognizing gain on the contribution of property when the property contributed is secured by debt. In determining whether gain must be recognized, the partner must assess the cash deemed to have received from the partnership distribution compared with the tax basis of the partner’s partnership interest prior to the deemed distribution. This happens if the assumption of the partner’s liabilities is in excess of the partner’s basis of the contributed property. If the cash deemed to have received exceeds the tax basis immediately before the deemed distribution, then a gain must be recognized. This circumstance occurs due to the negative basis created for the partner, which is not allowed under partnership tax law. 7. [LO 2] What is inside basis and outside basis, and why are they relevant for taxing partnerships and partners? An inside basis, in relation to partnerships, is the basis the partnership takes in the assets that the partnership holds. An outside basis, in relation to partnerships, is the tax basis each partner has in the partnership. The inside basis is necessary to compute the gain/loss recognized on all property sold by the partnership. The outside basis is necessary to compute the gain/loss recognized on the partnership interest when sold. For tax purposes, the inside basis is similar to the basis the partner had in the property prior to contribution. On the other hand, the outside basis corresponds not only to the contributed property, but also to the debt and income/losses of the partnership that have been allocated to the individual partners. 8. [LO 2] What is recourse and nonrecourse debt, and how is each generally allocated to partners? Recourse debt is debt for which partners are considered to have an economic risk of loss. Partners are legally liable for recourse debt and must satisfy this type of debt personally if the partnership cannot. An example of recourse debt is accounts payable owed by a general partnership. Nonrecourse debt is debt for which no partners are considered to have an economic risk of loss because nonrecourse debt is typically secured by real property. An example of nonrecourse debt is a mortgage on a building. In regards to a partnership’s debt, recourse debt is allocated to those partners that have the ultimate responsibility of paying the debt. The debt is allocated to the partners that have an economic risk of loss. On the other hand, nonrecourse debt is generally allocated to the partners according to their profit sharing ratios. Despite the partners not being legally liable for some debt, all debt is allocated to adjust the outside basis of the partners. 9. [LO 2] How does the amount of debt allocated to a partner affect the amount of gain a partner recognizes when contributing property secured by debt? A partner that contributes property secured by debt is not only contributing the property to the partnership but also the debt. The partner’s tax basis in his or her partnership interest would be increased by the basis of the assets contributed. Next, the property’s debt is allocated to each partner according to who is ultimately responsible for it or by each partner’s profit-sharing ratio. The basis of the contributed assets plus the allocation of debt would represent the partner’s tax basis in the partnership immediately before the deemed distribution of cash as a result of the relief of debt attached to the contributed property. If the partner is not allocated enough debt, the partner’s outside basis will become negative and a gain must be recognized. Thus, a partner can only avoid gain by being allocated enough of the partnership debt to keep her/his basis at least above zero. 10. [LO 2] What is a tax basis capital account, and what type of tax-related information does it provide? A tax basis capital account is an equity account that is created for each partner of the partnership. This account is measured using the tax accounting rules. The account reflects tax basis of any capital contributions (i.e., property and cash), capital distributions, and future earnings and losses allocated to that partner. Additionally, a tax basis capital account can provide more tax-related information for each partner. For instance, each partner’s share of inside basis of the partnership’s assets can be calculated by adding the partner’s share of debt to her/his capital account. 11. [LO 2] Distinguish between a capital interest and a profits interest, and explain how partners and partnerships treat each when exchanging them for services provided. A partnership interest can be broken down into two distinct rights: (1) capital interest and (2) profits interest. To become a partner in a partnership, you will receive at least one of these rights. A capital interest is the right to receive a share of the partnership assets at liquidation. A profits interest is the right to share in the future earnings and losses of the partnership. While these rights are given to most partners that contribute cash or property, special rules exist when these rights are given to partners in exchange for services. When a partner receives a capital interest in exchange for services rendered to the partnership, the partner must treat the liquidation value of the capital interest as ordinary income. Further, the tax basis for the partner will be equivalent to the amount of ordinary income recognized. The holding period for this tax basis will begin on the date the capital interest is received. From the partnership’s perspective, the partnership can deduct or capitalize the value of the capital interest depending upon the type of services rendered. This is determined on a fact and circumstance basis. Additionally, the amount deducted by the partnership is allocated to the non-service partners as consideration for effectively transferring a portion of their capital interest to the service partner. When a partner receives a profits interest in exchange for services rendered to the partnership, the partner has no immediate tax impact because the profits interest has no liquidation value at the time the interest is received. Thus, the non-service partners will not receive any deductions for adding the additional partner to the partnership. As the partnership makes future profits and losses, the service partner will be allocated her/his portion of these losses according to the profit sharing ratios. The debt allocated to non-service partners must also be redistributed with the additional service partner receiving her/his portion of debt. Therefore, the initial tax basis of a service partner with only a profits interest will either be zero or the portion of debt the partner is allocated (if any). 12. [LO 2] How do partners who purchase a partnership interest determine the tax basis and holding period of their partnership interests? When a partner purchases a partnership interest, the initial tax basis for the partner is determined by taking the cost basis of the interest the partner purchased and adding to this basis any debt allocated to the partner’s interest. The holding period for this purchased interest will begin on the date that the partner purchased the partnership interest. 13. [LO 3] Why do you think partnerships, rather than the individual partners, are responsible for making most of the tax elections related to the operation of the partnership? The responsibility for the partnership, not the partners, to make the majority of tax elections regarding the operation of the partnership is twofold. First, partnerships can consist of many different types and amounts of partners ranging from two to hundreds. The hassle to obtain every partner’s approval on what elections to make would be very time consuming. The costs would more than likely outweigh the benefits in performing this function. Second, in many partnerships only a few partners are actively involved in the management of the partnership. The limited partners have little to no working knowledge of the operations of the partnership and would be ill-equipped to make such decisions. Thus, the entity concept would appear more reasonable when dealing with the actual operations of the partnership. 14. [LO 3] If a partner with a taxable year-end of December 31 is in a partnership with a March 31 taxable year-end, how many months of deferral will the partner receive? Why? A partner with a calendar year end will receive nine months of deferral in her/his partnership interest that has a March 31 year end. A partner must report the income or loss of the partnership not at the partnership’s year end but at the partner’s year end. Thus, the first year of the partnership will be reported by the partner on her/his return which includes the partnership’s year end. This allows the partner to defer the reporting of the first nine months of income or loss from the partnership into the succeeding tax year when the partner’s income tax return is filed. 15. [LO 3] In what situation will there be a common year-end for the principal partners when there is no majority interest taxable year? The principal partner test states that the required tax year is the taxable year all the principal partners have in common. A principal partner is a partner that owns at least 5 percent interest in the partnership profits and capital. For the principal partner test to pass and not the majority interest test, the partnership must consist of numerous partners that (1) own less than 5 percent profit and capital interest and (2) have a variety of fiscal year ends. For example, if four partners with a calendar year end owned 10 percent each and 20 additional partners with differing fiscal year ends owned less than 5 percent, then the majority test would not pass, but the principal partners test would. 16. [LO 3] Explain the least aggregate deferral test for determining a partnership’s year-end and discuss when it applies. The least aggregate deferral test is the last resort test that a partnership must follow when figuring out the partnership year end. The first test is the majority interest test. The second test is the principal partners test. If these two tests don’t apply, along with the exception to elect an alternative year end, then the least aggregate deferral test goes into effect. The least aggregate deferral test selects the tax year which provides the partner group as a whole the smallest amount of aggregate tax deferral. This is calculated by taking each partner’s months of deferral under the potential tax year and weighting it with the partner’s profit interest percentage. Then, each partner’s weighted totals are summed up to come up with an aggregate deferral number. The potential tax year that produces the smallest aggregate deferral must be the one chosen by the partnership. 17. [LO 3] When are partnerships eligible to use the cash method of accounting? Under the tax accounting rules, a partnership with a corporate partner must use the accrual method of accounting unless the following exception applies. A partnership with a corporate partner is eligible to use the cash method of accounting when the partnership has average gross receipts over the past three taxable years less than or equal to $26 million. 18. [LO 4] What is a partnership’s ordinary business income (loss) and how is it calculated? Through the course of business, partnerships create income or losses. Some of these items are considered to affect a specific partner or groups of partners differently. Thus, these separately-stated items must be reported on a partner-by-partner basis. Then, after adjusting the partnership’s business income (loss) for these separately-stated items, the partnership reports the remaining amount of business income (loss) to ordinary business income (loss). The total amount will be allocated to each partner according to the special allocation rules agreed upon or else based upon the profit sharing ratios of the partnership. 19. [LO 4] What are some common separately stated items, and why must they be separately stated to the partners? Separately-stated items must be taken out of ordinary income (loss) because these items either (1) relate only to a specific partner in the partnership or (2) the item is taxed differently for each partner depending upon the entity of the partner and the partner’s current tax situation. The following is a partial list of items that are separately stated on a partnership return. 1. Short-term capital gains (losses) 2. Long-term capital gains (losses) 3. Section 1231 gains (losses) 4. Charitable contributions 5. Dividends 6. Interest income 7. Guaranteed payments 8. Net earnings (losses) from self-employment 9. Tax-exempt income 10. Net rental real estate income (loss) 11. Investment interest expense 12. Section 179 deductions 20. [LO 4] Is the character of partnership income/gains and expenses/losses determined at the partnership or partner level? Why? In keeping with the entity concept, the character of all income/gains and expenses/losses is determined at the partnership level. Despite the chance that specific items would change character depending upon the partner who holds them, Congress has decided to unify the character of all items by looking at the character from the partnership’s perspective. Thus, partnerships are required to file a form 1065 return along with all partners’ K-1s to help properly report the amounts and character of various items that show up on the individual partner’s return. 21. [LO 4] What are guaranteed payments and how do partnerships and partners treat them for income and self-employment tax purposes? Guaranteed payments are similar to cash salary payments for services provided. Fixed payments made to a partner in the capacity as a partner no matter the profit (loss) of the partnership for that tax year are known as guaranteed payments. Thus, on the partnership level, they are treated like a salary payment to an unrelated party. The partnership deducts the guaranteed payment in computing the partnership’s ordinary business income (loss). On the partner level, the partner that receives a guaranteed payment must account for the guaranteed payment as a separately-stated item that is taxed as ordinary income. Further, the partner must include the amount of the guaranteed payment in computing self-employment income for tax purposes. This reporting requirement is required no matter if the partner is a general partner, limited partner, or LLC member. 22. [LO 4] How do general and limited partners treat their share of ordinary business income for self-employment tax purposes? In determining how different partners treat their share of ordinary business income, the IRS assesses the involvement the partner has in the partnership. General partners are considered to be actively involved in the management of the partnership. Thus, the general partner’s share of ordinary business income is treated as trade or business income and is subject to self-employment tax. Conversely, limited partners are generally not actively involved with managing the partnership. The limited partner’s share of ordinary business income is treated as investment income and not subject to self-employment tax. Both types of partners must treat guaranteed payments as income relating to self-employment; however, the treatment of ordinary business income for purposes of self-employment tax depends on the type of partner. 23. [LO 4] What challenges do LLCs face when deciding whether to treat their members’ shares of ordinary business income as self-employment income? Before a string of relatively recent Tax Court decisions, only Proposed Reg. §1402(a)-2 provided guidance on this matter; however, the regulation was never finalized leaving LLCs without any authoritative guidance to help resolve this issue. The proposed regulation provided that if an LLC member is involved in the operations of the LLC, the member should treat the ordinary business income as self-employment income. The regulation listed the following three criteria that would demonstrate active involvement in the LLC: (1) personal liability for the debt of the LLC as an LLC member, (2) authority to contract on behalf of the LLC, or (3) more than 500 hours participating in the LLC’s trade or business during the taxable year. If any one of these requirements were met, then the LLC member would be more associated as a general partner and should account for their share ordinary business income as self-employment income. The recent Tax Court decisions providing authoritative guidance in this area are consistent with the spirit of the Proposed Regulation issued years earlier by the IRS. These decisions provide that LLC members with either management control or that provide significant services to the LLC should treat their share of ordinary business income as self-employment income (see Renkemeyer, Campbell & Weaver, LLP, et al. v. Commissioner, 136 TC 137 (2011), Riether, 919 F.Supp.2d 1140 (D. N.M. 2012), and Castigliola T.C. Memo. 2017-62.) With these decisions to consult, LLCs and their advisors should face less uncertainty than in the past when deciding how to treat an LLC member’s share of ordinary business income for self-employment tax purposes. 24. [LO 4] How much flexibility do partnerships have in allocating partnership items to partners? Partnerships have a great deal of flexibility in determining how to allocate partnership items to partners, both separately-stated and non-separately stated items. The determining factors must be (1) the partners agree upon the allocations and (2) the allocations either have substantial economic effect or are in accordance with the partners’ interests in the partnership. The second factor is put into place to make sure the allocations are being accomplished for a business objective and not just to reduce or avoid taxes. While both of these items need to be met for a special allocation of a partnership item, certain items have mandatory allocations to specific partners. For example, contributed property built-in gain (loss) must be allocated to the partner who contributed the property when the property is sold. Any additional gain (loss) will be allocated according to the partnership agreement. Overall, if the partnership has no mandatory allocations or does not specify and meet the requirements for special allocations, the partnership will allocate partnership income and losses according to the capital or profit and/or loss interests of each partner. 25. [LO4] What are the basic tax-filing requirements imposed on partnerships? While a partnership does not pay taxes, the IRS still requires all partnerships to file an information return to the IRS – Form 1065 (U.S. Return of Partnership Income). This form must be filed by the 15th day of the 3rd month of the partnership’s year end. For calendar year end partnerships, the form must be filed by March 15th. An extension is available to file by the due date of the original return and provides the partnership an additional six months to file Form 1065. The extension must be filed on Form 7004. The tax return that must be filed by all partnerships consists of a detailed calculation of the partnerships ordinary business income (loss) on page 1 of Form 1065. On page 3 of Form 1065, Schedule K must be filled out which lists the ordinary business income (loss) along with any separately-stated items. This schedule is an aggregate of each partner’s share of items both separately-stated and non-separately stated. In addition, each partner’s proportion of the above items is reported on a Schedule K-1. A Schedule K-1 for every partner must be filed with Form 1065, and each individual partner will receive her/his own Schedule K-1 from the partnership. 26. [LO 5] In what situations do partners need to know the tax basis in their partnership interests? Partners should always keep track of the tax basis in their partnership interest because certain situations require partners to actually know their tax basis. These situations occur when a partner sells her/his partnership interest or when a partner receives a distribution from the partnership. Tracking the tax basis in the partnership interest helps the partner determine the amount of gain or loss that must be reported on the partner’s tax return. 27. [LO 5] Why does a partner’s tax basis in her partnership interest need to be adjusted annually? A partner’s tax basis needs to be adjusted annually for the following three reasons. First, a partner does not want to double count any income/gain from the partnership when she/he sells her/his partnership interest or receive a distribution from the partnership. Second, the IRS does not want partners to double count any expenses/losses from the partnership in a similar situation from above. Last, partners want to make sure they adjust for tax-exempt income and non-deductible expenses, so these items will not ultimately be taxed or deducted at the time of selling a partnership interest or receiving a distribution from the partnership. 28. [LO 5] What items will increase a partner’s basis in his partnership interest? The following items will increase a partner’s basis and must be adjusted for on an annual basis in the order given. 1. Actual and deemed cash contributions to the partnership 2. Partner’s share of ordinary business income 3. Partner’s share of separately-stated income/gain items and 4. Partner’s share of tax-exempt income 29. [LO 5] What items will decrease a partner’s basis in her partnership interest? The following items will decrease a partner’s basis and must be adjusted for on an annual basis in the order given. These items will be adjusted after all the increases to a partner’s basis have been taken into effect. 1. Actual and deemed cash distributions from the partnership 2. Partner’s share of non-deductible expenses (fines, penalties, etc.) 3. Partner’s share of ordinary business losses and 4. Partner’s share of separately-stated expenses/loss items 30. [LO 6] What hurdles (or limitations) must partners overcome before they can ultimately deduct partnership losses on their tax returns? While a partnership can create an ordinary business loss, the individual partners potentially will not be able to deduct the entire amount in the year of the loss. The partner must potentially overcome four loss limitation rules before the deduction is available. If the loss does not pass any of the limitations, then the loss is suspended indefinitely under that specific hurdle. The four loss limitations are (1) the tax basis limitation, (2) the at-risk loss limitation, (3) the passive activity loss limitation, and (4) the excess business loss limitation. First, a partner is not able to take any losses that exceed the tax basis of the partner, the partner’s outside basis. This limitation prevents partners from taking losses beyond their investment or basis in their partnership interests. Second, a partner cannot take any losses that exceed the at-risk amount for the partner. The at-risk amount is generally the same as the partner’s tax basis, except that it excludes the partner’s share of nonrecourse debt. This limit still includes recourse debt and qualified nonrecourse debt. In the case of a passive participant in a partnership, losses cannot be taken if the loss exceeds the amount of passive income reported by the partner. Passive losses such as losses from rental activities or losses allocated to a limited partner can only be offset with passive income and gains. Finally, losses remaining after overcoming the prior three hurdles are limited to the sum of the partner’s aggregate business gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $510,000 for married taxpayers filing jointly and $255,000 for other taxpayers. 31. [LO 6] What happens to partnership losses allocated to partners in excess of the tax basis in their partnership interests? Losses that are allocated to partners that exceed the partner’s tax basis cannot be used during the current taxable year. The excess loss will be suspended and carried forward indefinitely until the partner has sufficient basis to utilize the losses. A partner would be able to increase her/his tax basis by (1) making a capital contribution, (2) guaranteeing more partnership debt, or (3) helping the partnership become more profitable. Once the partner’s tax basis is positive, the losses previously suspended can be used. 32. [LO 6] In what sense is the at-risk loss limitation rule more restrictive than the tax-basis loss limitation rule? While the at-risk loss limitation and tax basis loss limitation are basically the same, one difference exists between the two different hurdles a partner must overcome when faced with losses. The at-risk loss limitation only accounts for those items that the partner is at risk for. The major item that is not included under the at-risk calculation but is included in the tax basis is nonrecourse debt. As a note, qualified nonrecourse debt is still considered to be part of the partner’s at-risk calculation. 33. [LO 6] How do partners measure the amount they have at risk in the partnership? A partner will measure her/his partnership at-risk amount by looking at what items affect the partner’s economic risk of loss. In most cases, items included in the at-risk amount would include cash contributed, tax basis of property contributed, recourse debt, qualified nonrecourse debt, and any other adjustments to the partner’s tax basis excluding nonrecourse debt. Nonrecourse debt is considered a part of the tax basis but not a part of the at-risk basis since the partner does not have an economic risk of loss for this type of debt. 34. [LO 6] In what order are the loss limitation rules applied to limit partner’s losses from partnerships? The order of the hurdles a partner must pass through for the loss limitation rules are (1) tax basis loss limitation, (2) at-risk loss limitation, (3) passive activity loss limitation, and excess business loss limitation. As the losses exceed the limitation in the tax basis, at-risk, and passive activity loss hurdles, the suspended losses will be carried forward indefinitely within each group until enough basis or income is generated to cover these losses. Excess business losses are treated by partners as net operating losses to be carried forward and utilized to the extent allowable in future years. 35. [LO 6] How do partners determine whether they are passive participants in partnerships when applying the passive activity loss limitation rules? According to the Code, a partner is considered to be a passive participant if the activity conducted is a trade or business and the partner does not materially participate in the activity. The IRS has made it clear that those participants in rental activities and limited partners within a partnership are automatically considered to be passive participants. Further, regulations help clarify whether a partner would be considered a material participant. If the partner meets any of the conditions below, then the partner would be a material participant and the activity would not be considered a passive activity to the partner. 1. The individual participates in the activity more than 500 hours during the year. 2. The individual’s activity constitutes substantially all of the participation in such activity by individuals. 3. The individual participates more than 100 hours during the year and the individual’s participation is not less than any other individual’s participation in the activity. 4. The activity qualifies as a “significant participation activity” (individual participates for more than 100 hours during the year) and the aggregate of all other “significant participation activities” is greater than 500 hours for the year. 5. The individual materially participated in the activity for any 5 of the preceding 10 taxable years. 6. The activity involves personal services in health, law, accounting, architecture, and so on, and the individual materially participated for any three preceding years. 7. Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year. 36. [LO 6] Under what circumstances can partners with passive losses from partnerships deduct their passive losses? A partner may deduct the passive losses she/he has generated from a partnership under three circumstances. First, a passive loss is not deductible until the taxpayer generates current year passive income in the activity producing the loss. Second, a passive loss is not deductible until the taxpayer generates current year passive income from another passive activity the taxpayer is involved with. Last, a passive loss will not be deductible unless the taxpayer sells the activity that has produced the passive loss. In this case, the taxpayer will report a gain or loss on the sale and can use the passive loss to offset this or any other source of income (i.e., active income, portfolio income, or other passive income). Problems 37. [LO 2] Joseph contributed $22,000 in cash and equipment with a tax basis of $5,000 and a fair market value of $11,000 to Berry Hill Partnership in exchange for a partnership interest. a. What is Joseph’s tax basis in his partnership interest? b. What is Berry Hill’s basis in the equipment? a. $27,000. Joseph’s tax basis is considered to be his outside basis in the partnership. The tax basis includes the $22,000 in cash and his original basis in the equipment, $5,000. Joseph’s holding period for his outside basis would depend upon the holding period of the assets contributed. If property contributed is a capital or Section 1231 asset, the holding period for that portion of the partnership interest includes the holding period of the contributed property. Otherwise, the holding period of the partnership interest begins on the date it is received. b. $5,000. Berry Hill Partnership’s basis in the equipment is a carryover basis from the partner who contributed the equipment. The basis in the equipment plus the basis in the cash will give us Berry Hill Partnership’s inside basis. The holding period for the equipment carries over to the Berry Hill Partnership from Joseph. 38. [ LO 2] Lance contributed investment property worth $500,000, purchased three years ago for $200,000 cash, to Cloud Peak LLC in exchange for an 85 percent profits and capital interest in the LLC. Cloud Peak owes $300,000 to its suppliers but has no other debts. a. What is Lance’s tax basis in his LLC interest? b. What is Lance’s holding period in his interest? c. What is Cloud Peak’s basis in the contributed property? d. What is Cloud Peak’s holding period in the contributed property? a. $455,000. Lance’s basis in his LLC interest is made up of the $200,000 basis of the investment property he transferred to the LLC and his $255,000 share of the LLC debt (85% x $300,000). Because LLC general debt obligations are treated as nonrecourse debt, Lance’s profit sharing ratio is used to allocate a portion of the LLC debt to him. b. Three years. Because Lance contributed a capital asset, the holding period of the contributed assets “tacks onto” his partnership interest. c. $200,000. The LLC takes a carryover basis in the contributed property. d. Three years. The LLC inherits Lance’s holding period in the contributed property. 39. [ LO 2] Laurel contributed equipment worth $200,000, purchased 10 months ago for $250,000 cash and used in her sole proprietorship, to Sand Creek LLC in exchange for a 15 percent profits and capital interest in the LLC. Laurel agreed to guarantee all $15,000 of Sand Creek’s accounts payable, but she did not guarantee any portion of the $100,000 nonrecourse mortgage securing Sand Creek’s office building. Other than the accounts payable and mortgage, Sand Creek does not owe any debts to other creditors. a. What is Laurel’s initial tax basis in her LLC interest? b. What is Laurel’s holding period in her interest? c. What is Sand Creek’s initial basis in the contributed property? d. What is Sand Creek’s holding period in the contributed property? a. $280,000. Laurel’s basis in her LLC interest is made up of the $250,000 basis in the equipment (no depreciation was taken on the equipment prior to the contribution because it was acquired and contributed within the same calendar year) Laurel contributed, her $15,000 share of accounts payable that she guaranteed, and her $15,000 share of the nonrecourse mortgage securing Sand Creek’s office building (15% x $100,000). Laurel’s profit sharing ratio is used to allocate a portion of the mortgage to her because it is nonrecourse debt. b. Laurel’s holding period begins the day the LLC interest is acquired because the asset she contributed is not a capital or Section 1231 asset. The equipment is not a Section 1231 asset because it was used in a trade or business for one year or less. c. $250,000. The LLC takes a carryover basis in the contributed property. d. Ten months. Laurel’s holding period is included in the LLC’s holding period regardless of the nature of the property Laurel contributed. 40. [LO 2] {Planning} Harry and Sally formed the Evergreen partnership by contributing the following assets in exchange for a 50 percent capital and profits interest in the partnership: a. How much gain or loss will Harry recognize on the contribution? b. How much gain or loss will Sally recognize on the contribution? c. How could the transaction be structured a different way to get a better result for Sally? d. What is Harry’s tax basis in his partnership interest? e. What is Sally’s tax basis in her partnership interest? f. What is Evergreen’s tax basis in its assets? g. Following the format in Exhibit 20-2, prepare a tax basis balance sheet for the Evergreen partnership showing the tax capital accounts for the partners. a. $0. Generally, partners recognize gain on property contributed to a partnership only when the cash they are deemed to receive from debt relief exceeds their basis in the partnership prior to the deemed distribution. Harry did not have any debt relief. b. $0. Partners may never recognize loss when property is contributed to a partnership even when they are relieved of debt. c. Sally should consider the possibility of selling the equipment to an unrelated party and contributing $150,000 in cash to the partnership in lieu of the equipment. By selling the property, she could recognize the $50,000 built-in loss on the equipment. d. $130,000. Harry’s basis in his partnership interest is simply the combined tax basis in the cash and land he contributed to the partnership. e. $200,000. Sally’s basis in her partnership interest equals $200,000 basis in the equipment she contributed. f. $330,000. The partnership’s basis in its assets equals the sum of the partners’ bases in the cash ($30,000), in the land ($100,000), and in the equipment ($200,000). g. The partnership’s tax basis balance sheet would appear as follows: Evergreen Partnership Tax Basis Balance Sheet Tax Basis Assets: Cash $30,000 Equipment 200,000 Land 100,000 Totals $330,000 Capital: Capital-Harry $130,000 Capital-Sally 200,000 Totals $330,000 41. [LO 2] Cosmo contributed land with a fair market value of $400,000 and a tax basis of $90,000 to the Y Mountain partnership in exchange for a 25 percent profits and capital interest in the partnership. The land is secured by $120,000 of nonrecourse debt. Other than this nonrecourse debt, Y Mountain partnership does not have any debt. a. How much gain will Cosmo recognize from the contribution? b. What is Cosmo’s tax basis in his partnership interest? a. $0. As reflected in the table below, Cosmo does not recognize any gain because the $120,000 of cash he is deemed to receive from debt relief does not exceed his basis in Y Mountain prior to this deemed distribution. Description Cosmo Explanation (1) Basis in contributed Land $90,000 (2) Nonrecourse mortgage in excess of basis in contributed land $30,000 Nonrecourse debt > basis is allocated only to Cosmo (3) Remaining nonrecourse mortgage $22,500 25% × [120,000 – (2)] Basis immediately prior to debt relief $142,500 (4) Relief from mortgage debt ($120,000) Cosmo’s initial tax basis in Y Mountain $22,500 (1) + (2) + (3) + (4) b. $22,500 as indicated in the table above. 42. [LO2] When High Horizon LLC was formed, Maude contributed the following assets in exchange for a 25 percent capital and profits interest in the LLC: *Nonrecourse debt secured by the land equals $160,000 James, Harold and Jenny each contributed $220,000 in cash for a 25 percent profits and capital interest. a. How much gain or loss will Maude and the other members recognize? b. What is Maude’s tax basis in her LLC interest? c. What tax basis do James, Harold, and Jenny have in their LLC interests? d. What is High Horizon’s tax basis in its assets? e. Following the format in Exhibit 20-2, prepare a tax basis balance sheet for the High Horizon LLC showing the tax capital accounts for the members. a. $0. None of the members recognize gain because their debt relief was not in excess of their bases in their LLC interest prior to any debt relief. See table below: Description Maude Each Other Member Explanation (1) Basis in contributed Land $100,000 (2) Cash contributed $20,000 $220,000 (3) Nonrecourse mortgage in excess of basis in contributed land $60,000 Nonrecourse debt > basis is allocated only to Maude (4) Remaining nonrecourse mortgage $25,000 $25,000 25% × [160,000 – (3)] Basis immediately prior to debt relief $205,000 $245,000 (5) Relief from mortgage debt ($160,000) Each member’s initial tax basis in the LLC $45,000 $245,000 (1) + (2) + (3) + (4) + (5) b. $45,000. See table in part a. above. c. $245,000 each. See table in part a. above. d. $780,000. High Horizon takes a $100,000 carryover basis in the land Maude contributes and a $680,000 basis in the cash all the members contributed. High Horizons, LLC Tax Basis Balance Sheet Tax Basis Assets: Cash $680,000 Land 100,000 Totals $780,000 Liabilities and Capital: Mortgage debt $160,000 Capital-Maude (40,000) Capital-James 220,000 Capital-Harold 220,000 Capital-Jenny 220,000 Totals $780,000 Note that the members’ tax capital accounts are equal to their bases in the LLC interests less their individual shares of LLC debt. 43. [LO2] Kevan, Jerry, and Dave formed Albee LLC. Jerry and Dave each contributed $245,000 in cash. Kevan contributed the following assets: *Nonrecourse debt secured by the land equals $210,000 Each member received a one-third capital and profits interest in the LLC. a. How much gain or loss will Jerry, Dave and Kevan recognize on the contributions? b. What is Kevan’s tax basis in his LLC interest? c. What tax basis do Jerry and Dave have in their LLC interests? d. What is Albee LLC’s tax basis in its assets? e. Following the format in Exhibit 20-2, prepare a tax basis balance sheet for the Albee LLC showing the tax capital accounts for the members. What is Kevan’s share of the LLC’s inside basis? f. If the lender holding the nonrecourse debt secured by Kevan’s land required Kevan to guarantee 33.33 percent of the debt and Jerry to guarantee the remaining 66.67 percent of the debt when Albee LLC was formed, how much gain or loss will Kevan recognize? g. If the lender holding the nonrecourse debt secured by Kevan’s land required Kevan to guarantee 33.33 percent of the debt and Jerry to guarantee the remaining 66.67 percent of the debt when Albee LLC was formed, what are the members’ tax bases in their LLC interests? a. $0. None of the members recognize gain because their debt relief was not in excess of their bases in their LLC interest prior to any debt relief. See table below: Description Kevan Each Other Member Explanation (1) Basis in contributed Land $120,000 (2) Cash contributed $15,000 $245,000 (3) Nonrecourse mortgage in excess of basis in contributed land $90,000 Nonrecourse debt > basis is allocated only to Kevan (4) Remaining nonrecourse mortgage $40,000 $40,000 33.3% × [$210,000 – (3)] Basis immediately prior to debt relief $265,000 (5) Relief from mortgage debt ($210,000) Each member’s initial tax basis in the LLC $55,000 $285,000 (1) + (2) + (3) + (4)+ (5) b. $55,000. See table in part a. above. c. $285,000 each. See table in part a. above. d. $625,000. Albee, LLC takes a $120,000 carryover basis in the land Kevan contributes and a basis of $505,000 in the total cash the members contributed. e. Albee, LLC’s tax basis balance sheet would appear as follows: Albee, LLC Tax Basis Balance Sheet Tax Basis Assets: Cash $505,000 Land 120,000 Totals $625,000 Liabilities and Capital: Mortgage debt $210,000 Capital-Kevan (75,000) Capital-Jerry 245,000 Capital-Dave 245,000 Totals $625,000 Note that the members’ tax capital accounts are equal to their bases in the LLC interests less their individual shares of LLC debt. f. $5,000. See table below: Description Kevan Jerry Dave Explanation (1) Basis in contributed Land $120,000 (2) Cash contributed $15,000 $245,000 $245,000 (3) Mortgage Guarantee $70,000 $140,000 $0 33.33% x $210,000 for Kevan and 66.67% × $210,000 for Jerry (4) Basis immediately prior to debt relief $205,000 $385,000 $245,000 1+2+3 (5) Relief from mortgage debt ($210,000) $0 $0 (6) Gain Recognized $5,000 $0 $0 (4) + (5) Each member’s initial tax basis in the LLC $0 $385,000 $245,000 (4) + (5) + (6) g. Kevan’s basis is $0, Jerry’s basis is $385,000, and Dave’s basis is $245,000. See the table in part f. above. 44. [LO2] {Research} Jim has decided to contribute some equipment he previously used in his sole proprietorship in exchange for a 10 percent profits and capital interest in Fast Choppers LLC. Jim originally paid $200,000 cash for the equipment. Since then, the tax basis in the equipment has been reduced to $100,000 because of tax depreciation, and the fair market value of the equipment is now $150,000. a. Must Jim recognize any of the potential § 1245 recapture when he contributes the machinery to Fast Choppers? {Hint: See § 1245(b)(3).} b. What cost recovery method will Fast Choppers use to depreciate the machinery? {Hint: See § 168(i)(7).} c. If Fast Choppers were to immediately sell the equipment Jim contributed for $150,000, how much gain would Jim recognize and what is its character? {Hint: See § 1245 and 704(c).} a. According to Section 1245(b)(3), recapture potential on property contributed to a partnership is only recognized to the extent any gain is recognized from the contribution of property. Because Jim was not relieved of any debt in the transaction, he will not recognize gain from the contribution under Section 721. Therefore, Jim does not recognize any of the Section 1245 recapture potential on the equipment at the time of contribution. b. According to Section 168(i)(7), a transferee partnership will step into the shoes of the transferor partner for purposes of depreciating contributed equipment. In this situation, Fast Choppers will continue to depreciate the equipment using the same method instituted by Jim over the remaining useful life of the equipment. In other words, the annual depreciation calculation will proceed as if the property were still held by Jim. c. Under Section 704(c), all $50,000 of gain recognized from the sale of the equipment would be allocated to Jim because this gain was built-in at the time the equipment was contributed. Moreover, the Section 1245 recapture potential remains with the equipment after the contribution; as a result, all $50,000 of gain recognized (the lesser of the $50,000 gain recognized or the $100,000 depreciation taken) must be characterized as Section 1245 recapture income. 45. [LO2] {Research} Ansel purchased raw land three years ago for $200,000 to hold as an investment. After watching the value of the land drop to $150,000, he decided to contribute it to Mountainside Developers LLC in exchange for a 5 percent capital and profits interest. Mountainside plans to develop the property and will treat it as inventory, like all of the other real estate it holds. a. If Mountainside sells the property for $150,000 after holding it for one year, how much gain or loss does it recognize, and what is the character of its gain or loss? {Hint: See §724.} b. If Mountainside sells the property for $125,000 after holding it for two years, how much gain or loss does it recognize, and what is the character of the gain or loss? c. If Mountainside sells the property for $150,000 after holding it six years, how much gain or loss is recognized, and what is the character of the gain or loss? a. According to Section 724(c), recognized losses on assets that were capital assets in the hands of contributing partners are treated as capital losses up to the amount of loss built into the assets at the time they were contributed if they are sold within a five-year period beginning on the date of contribution. Thus, Mountainside Developers will recognize a $50,000 loss characterized as a capital rather than an ordinary loss. b. In this instance, Mountainside Developers will recognize a $75,000 loss from the sale of the land. The built-in loss at the time the land was contributed or $50,000 will be characterized as a capital loss, and the remaining $25,000 loss will be characterized as an ordinary loss per Section 724(c). c. Because Mountainside Developers held the land as inventory for more than five years, it will recognize a $50,000 ordinary loss per Section 724(c). 46. [LO2] {Research} Claude purchased raw land three years ago for $1,500,000 to develop into lots and sell to individuals planning to build their dream homes. Claude intended to treat this property as inventory, like his other development properties. Before completing the development of the property, however, he decided to contribute it to South Peak Investors LLC when it was worth $2,500,000, in exchange for a 10 percent capital and profits interest. South Peak’s strategy is to hold land for investment purposes only and then sell it later at a gain. a. If South Peak sells the property for $3,000,000 four years after Claude’s contribution, how much gain or loss is recognized and what is its character? {Hint: See § 724.} b. If South Peak sells the property for $3,000,000 five and one-half years after Claude’s contribution, how much gain or loss is recognized and what is its character? a. Under Section 724(b), any gain or loss on contributed property that was treated as inventory by the contributing partner and sold by the partnership during the five-year period beginning on the date of contribution is treated as ordinary gain or loss. Thus, the entire $1,500,000 gain from the sale of the land will be treated as ordinary gain. b. Section 724(b) only applies if contributed property is sold during the five-year period beginning on the date of contribution. Because South Peak sold the land after the expiration of this time period and held the land as investment property, it should recognize $1,500,000 of capital gain. 47. [LO2] {Research} Reggie contributed $10,000 in cash and a capital asset he had held for three years with a fair market value of $20,000 and tax basis of $10,000 for a 5 percent capital and profits interest in Green Valley LLC. a. If Reggie sells his LLC interest thirteen months later for $30,000 when the tax basis in his partnership interest is still $20,000, how much gain does he report and what is its character? b. If Reggie sells his LLC interest two months later for $30,000 when the tax basis in his partnership interest is still $20,000, how much gain does he report and what is its character? {Hint: See Reg. §1.1223-3} a. Reggie sold his LLC interest, a capital asset, for $30,000 when he had a basis in the LLC interest of $20,000. Thus, he will recognize a $10,000 capital gain. The capital gain is treated as a long-term capital gain because he has held his LLC interest for more than twelve months. In this situation, the holding period of his LLC interest at the date he contributed property is irrelevant. b. Under Reg. §1.1223-3(b)(1), the holding period of Reggie’s LLC interest is based on the relative fair market value of the property he contributed. Since two-thirds of the value of the property he contributed was a capital asset held for three years, two- thirds of his LLC interest is treated as being held for three years and the remaining one-third of his LLC interest has a holding period that begins on the date of contribution. Under Reg. §1.1223-3(c)(1), two-thirds or $6,667 of the resulting $10,000 capital gain from the sale will be treated as long-term capital gain and the remaining one-third or $3,333 will be treated as short-term capital gain. 48. [LO2] Connie recently provided legal services to the Winter haven LLC and received a 5 percent interest in the LLC as compensation. Winter haven currently has $50,000 of accounts payable and no other debt. The current fair market value of Winter haven’s capital is $200,000. a. If Connie receives a 5 percent capital interest only, how much income must she report, and what is her tax basis in the LLC interest? b. If Connie receives a 5 percent profits interest only, how much income must she report, and what is her tax basis in the LLC interest? c. If Connie receives a 5 percent capital and profits interest, how much income must she report, and what is her tax basis in the LLC interest? a. Connie reports $10,000 of ordinary income or 5 percent of the LLC’s capital of $200,000. Her basis in the LLC interest is also $10,000. Connie is not allocated any of the accounts payable because she only received a capital interest. b. Connie will not report any income but will have a basis in the LLC interest equal to her share of the LLC’s debt. Because the LLC’s debt is a nonrecourse debt, it must be allocated to her using Connie’s profits interest. Thus, her basis in the LLC equals $2,500 or 5 percent of the LLC’s $50,000 accounts payable. c. Connie reports $10,000 of ordinary income or 5 percent of the LLC’s capital of $200,000. Her basis in the LLC is $12,500 consisting of the $10,000 of income she recognizes for the receipt of her capital interest and her $2,500 share of the LLC’s nonrecourse accounts payable. 49. [LO2] Mary and Scott formed a partnership that maintains its records on a calendar-year basis. The balance sheet of the MS Partnership at year-end is as follows: At the end of the current year, Kari will receive a one-third capital interest only in exchange for services rendered. Kari’s interest will not be subject to a substantial risk of forfeiture and the costs for the type of services she provided are typically not capitalized by the partnership. For the current year, the income and expenses from operations are equal. Consequently, the only tax consequences for the year are those relating to the admission of Kari to the partnership. a. Compute and characterize any gain or loss Kari may have to recognize as a result of her admission to the partnership. b. Compute Kari’s basis in her partnership interest. c. Prepare a balance sheet of the partnership immediately after Kari’s admission showing the partners’ tax capital accounts and capital accounts stated at fair market value. d. Calculate how much gain or loss Kari would have to recognize if, instead of a capital interest, she only received a profits interest. a. Kari will recognize one-third of the fair market value of the partnership’s capital or $100 as ordinary income. b. Kari’s basis in her partnership interest will be equal to the amount of income she reports or $100. c. Immediately after Kari’s admission into the partnership the partnership’s balance sheet will appear as follows: MS Partnership Balance Sheet Tax Basis 704(b)/FMV Assets: Cash $60 60 Land 60 180 Inventory 72 60 Totals $192 300 Capital: Capital-Mary 46 100 Capital-Scott 46 100 Capital-Kari 100 100 Totals $192 $300 Essentially, the tax capital and 704(b) capital accounts for both Scott and Mary are reduced by their $50 share of the $100 compensation expense the partnership will deduct for the capital interest Kari receives. d. If Kari only receives a profits interest, she will not recognize any income until she receives a profits allocation from the partnership. 50. [LO2] Dave LaCroix recently received a 10 percent capital and profits interest in Cirque Capital LLC in exchange for consulting services he provided. If Cirque Capital had paid an outsider to provide the advice, it would have deducted the payment as compensation expense. Cirque Capital’s balance sheet on the day Dave received his capital interest appears below: *Assume that Lance’s basis and Robert’s basis in their LLC interests equal their tax basis capital accounts plus their respective shares of nonrecourse debt. a. Compute and characterize any gain or loss Dave may have to recognize as a result of his admission to Cirque Capital. b. Compute each member’s tax basis in his LLC interest immediately after Dave’s receipt of his interest. c. Prepare a balance sheet for Cirque Capital immediately after Dave’s admission showing the members’ tax capital accounts and their capital accounts stated at fair market value. d. Compute and characterize any gain or loss Dave may have to recognize as a result of his admission to Cirque Capital if he receives only a profits interest. e. Compute each member’s tax basis in his LLC interest immediately after Dave’s receipt of his interest if Dave only receives a profits interest. a. The tax consequences of giving Dave both a 10 percent capital and profits interest are summarized in the following table: Description Dave Lance Robert Explanation (1) Beginning Basis in LLC $0 $250,000 $250,000 $200,000 tax basis capital account + [.5 × $100,000 nonrecourse debt] (2) Ordinary Income $100,000 Liquidation Value of Capital Interest (.1 × $1,000,000 fair market value of LLC capital) (3) Ordinary Deduction ($50,000) ($50,000) Capital Shift from Non-Service Partners. (2) × .5 (4) Increase in Debt Allocation $10,000 [$100,000 nonrecourse debt x 10% profit sharing ratio] (5) Decrease in Debt Allocation (5,000) (5,000) (4) × .5 (6) Ending Basis in LLC $110,000 $195,000 $195,000 (1) + (2) + (3) + (4) + (5) As indicated in line (2) of the table above, Dave recognizes $100,000 of ordinary income. b. As indicated in line (6) of the table above, the member’s tax bases in the LLC interests immediately after Dave is admitted are as follows: $110,000 for Dave and $195,000 for Lance and Robert. c. Immediately after Dave’s admission into the LLC, the LLC’s balance sheet will appear as follows: Cirque, LLC Balance Sheet Tax Basis 704(b/)FMV Assets: Cash $150,000 $150,000 Investments 200,000 700,000 Land 150,000 250,000 Totals $500,000 $1,100,000 Capital: Nonrecourse Debt $100,000 100,000 Capital-Lance 150,000 450,000 Capital-Robert 150,000 450,000 Capital-Dave 100,000 100,000 Totals $500,000 $1,100,000 d. The tax consequences of giving Dave only a 10 percent profits interest are summarized in the following table: Description Dave Lance Robert Explanation (1) Beginning Basis in LLC $0 $250,000 $250,000 $200,000 tax basis capital account + [.5 × $100,000 nonrecourse debt] (2) Ordinary Income $0 Dave does not recognize any income because he only receives a profits interest. (3) Increase in Debt Allocation $10,000 [$100,000 nonrecourse debt × 10% profit sharing ratio] (4) Decrease in Debt Allocation (5,000) (5,000) (3) × .5 (5) Ending Basis in LLC $10,000 $245,000 $245,000 (1) + (2) + (3) + (4) Dave does not recognize any income because he only received a profits interest. e. As reflected in line (5) of the table above, Dave’s basis is $10,000, Lance’s basis is $245,000, and Robert’s basis is $245,000. 51. [LO 2] Last December 31, Ramon sold the 10 percent interest in the Del Sol Partnership that he had held for two years to Garrett for $400,000. Prior to selling his interest, Ramon’s basis in Del Sol was $200,000 which included a $100,000 share of nonrecourse debt allocated to him. a. What is Garrett’s tax basis in his partnership interest? b. If Garrett sells his partnership interests three months after receiving it and recognizes a gain, what is the character of his gain? a. Garrett’s basis in his partnership interest is equal to the $400,000 amount he paid for it plus his $100,000 share of partnership debt or $500,000. b. Because Garrett purchased his partnership interest, his holding period for the interest begins on the date the interest was purchased. As a result, he only has a three-month holding period before the partnership interest is sold. This means his capital gain from the sale of his partnership interest will be short-term capital gain. 52. [LO 3] Broken Rock LLC was recently formed with the following members: Name Tax Year End Capital/Profits % George Allen December 31 33.33% Elanax Corp. June 30 33.33% Ray Kirk December 31 33.34% What is the required taxable year-end for Broken Rock LLC? George Allen and Ray Kirk together own more than 50 percent of the profits and capital of Broken Rock. Because both George and Ray have a December 31 year end, December 31 is majority interest taxable year and is also the required year end for Broken Rock. 53. [LO 3] Granite Slab LLC was recently formed with the following members: Name Tax Year End Capital/Profits % Nelson Black December 31 22.0% Brittany Jones December 31 24.0% Lone Pine LLC June 30 4.5% Red Spot Inc. October 31 4.5% Pale Rock Inc. September 30 4.5% Thunder Ridge LLC July 31 4.5% Alpen see LLC March 31 4.5% Lakewood Inc. June 30 4.5% Streamside LLC October 31 4.5% Burnt Fork Inc. October 31 4.5% Snowy Ridge LP June 30 4.5% Whitewater LP October 31 4.5% Straw Hat LLC January 31 4.5% Wildfire Inc. September 30 4.5% What is the required taxable year-end for Granite Slab LLC? Because none of the partners with the same year end together own more than 50 percent of the capital and profits of Granite Slab, there is no majority interest taxable year. However, Nelson Black and Brittany Jones are principal partners because they individually own 5 percent or more of the profits and capital of Granite Slab. Moreover, they both have a December 31 year-end. Therefore, the required year end of the partnership is the year end of the principal partners or December 31. 54. [LO 3] Tall Tree LLC was recently formed with the following members: Name Tax Year End Capital/Profits % Eddie Robinson December 31 40% Pitcher Lenders LLC June 30 25% Perry Homes Inc. October 31 35% What is the required taxable year-end for Tall Tree LLC? Tall Tree does not have a majority interest taxable year because no member or group of members with the same year end owns more than 50 percent of the profits and capital interests in Tall Tree. Also, because all three principal members in Tall Tree have different year ends, the principal partner test is not met. As a result, Tall Tree must decide which of three potential year ends, December 31, June 30, or October 31, will provide its members the least aggregate deferral. The table below illustrates the required computations: Possible Year Ends 12/31 Year End 6/30 Year End 10/31 Year End Members % Tax Year Months Deferral* (MD) % × MD Months Deferral* (MD) % × MD Months Deferral* (MD) % × MD Eddie Robinson 40% 12/31 0 0 6 2.4 2 .8 Pitcher Lenders 25% 6/30 6 1.5 0 0 8 2 Perry Homes 35% 10/31 10 3.5 4 1.4 0 0 Total Aggregate Deferral 5 3.8 2.8 *Months deferral equals number of months between proposed year end and member’s year end. As the table above indicates, Tall Tree must use October 31 as its year end because it provides the least amount of aggregate deferral to the members. 55. [LO 3] Rock Creek LLC was recently formed with the following members: Name Tax Year End Capital/Profits % Mark Banks December 31 35% Highball Properties LLC March 31 25% Chavez Builders Inc. November 30 40% What is the required taxable year-end for Rock Creek LLC? Rock Creek does not have a majority interest taxable year because no member or group of members with the same year end owns more than 50 percent of the profits and capital interests in Rock Creek. Also, because all three principal members in Rock Creek have different year ends, the principal partner test is not met. As a result, Rock Creek must decide which of three potential year ends, December 31, March 31, or November 30, will provide its members the least aggregate deferral. The table below illustrates the required computations: Possible Year Ends 12/31 Year End 3/31 Year End 11/30 Year End Members % Tax Year Months Deferral* (MD) % × MD Months Deferral* (MD) % × MD Months Deferral* (MD) % × MD Mark Banks 35% 12/31 0 0 9 3.15 1 .35 Highball Properties, LLC 25% 3/31 3 .75 0 0 4 1 Chavez Builders Inc. 40% 11/30 11 4.4 8 3.2 0 0 Total Aggregate Deferral 5.15 6.35 1.35 *Months deferral equals number of months between proposed year end and member’s year end. As the table above indicates, Rock Creek must use November 30 as its year end because it provides the least amount of aggregate deferral to the members. 56. [LO 3] {Research} Ryan, Dahir, and Bill have operated Broken Feather LLC for the last four years using a calendar year-end. Each has a one-third interest. Since they began operating, their busy season has run from June through August, with 35 percent of their gross receipts coming in July and August. The members would like to change their tax year-end and have asked you to address the following questions: a. Can they change to an August 31 year-end and, if so, how do they make the change? {Hint: See Rev. Proc. 2002-38, 2002-1 CB 1037.} b. Can they change to a September 30 year-end and, if so, how do they make the change? {Hint: See §444.} a. If Broken Feather can establish that 25 percent of its gross receipts for the current twelve-month period ending on August 31 fell within the months of July and August, and it can establish the same thing for the two preceding years ending on August 31, then Broken Feather can change its year end to August 31 under Rev. Proc. 2002-38. b. Under Section 444, Broken Feather can elect to have its year end fall up to three months ahead of its normal required calendar year end. Thus, it may elect to have a September 30, October 31, or November 30 year end under Section 444. However, if it makes the Section 444 election, it must calculate and deposit a Section 7519 payment with the IRS to offset the deferral benefit the partners receive by having the year end fall before December 31. 57. [LO 3] {Research}Ashlee, Hiroki, Kate, and Albee LLC each own a 25 percent interest in Tally Industries LLC, which generates annual gross receipts of over $10 million. Ashlee, Hiroki, and Kate manage the business, but Albee LLC is a non-managing member. Although Tally Industries has historically been profitable, for the last three years losses have been allocated to the members. Given these facts, the members want to know whether Tally Industries can use the cash method of accounting. Why or why not? {Hint: See § 448(b)(3)} Generally, partnerships without corporate partners may use the cash method of accounting. However, partnerships that are tax shelters may not use the cash method of accounting. According to Section 448(b)(3), partnerships defined as “tax shelters” are ineligible to use the cash method. Section 461(i)(3)(B) includes “syndicates” among the other categories of “tax shelters”. Section 1256(e)(3)(B) defines a syndicate as any partnership that allocates more than 35 percent of its losses to either limited partners or “limited entrepreneurs”. In addition to limited partnerships, this provision likely also applies to LLCs because Section 464(e)(2) defines a limited entrepreneur as any person, including LLC members, other than a limited partner, who does not actively participate in the management of the enterprise. In summary, if more than 35 percent of losses in a given year are allocated to either limited partners or to LLC members not actively participating in the management of an LLC, the limited partnership or LLC will be not be permitted to use the cash method. Because of these restrictions, a significant number of limited partnerships and LLCs that would otherwise qualify are denied the use of the cash method. Because only 25 percent of Tally Industries’ loss for the year is allocated to a member that does not actively participate in management and it does not have a corporate member, Tally will be able to use the cash method. 58. [LO 4] Turtle Creek Partnership had the following revenues, expenses, gains, losses, and distributions: a. Given these items, what is Turtle Creek’s ordinary business income (loss) for the year? b. What are Turtle Creek’s separately stated items for the year? Turtle Creek’s ordinary business income and separately stated items are calculated and listed in the table below: Note that guaranteed payments must be separately disclosed to the partners that receive them, and cash distributions must be separately disclosed so that partners can reduce the tax basis of their partnership interests by the amount of the distributions. 59. [LO 4] Georgio owns a 20 percent profits and capital interest in Rain Tree LLC. For the current year, Rain Tree had the following revenues, expenses, gains, and losses: *Assume the §179 property placed in service limitation does not apply. a. How much ordinary business income (loss) is allocated to Georgio for the year? b. What are Georgio’s separately stated items for the year? a. Georgio’s allocation of ordinary business income is reflected in the table below: b. Georgio’s separately stated items are calculated in the table below: Description Total Amount 20% Allocated to Georgio Separately Stated Items on Schedule K-1: Section 1231 gains $11,000 $2,200 Section 179 deduction (10,000) (2,000) Short-term capital gains 4,000 800 Municipal bond interest* 6,000 1,200 Nondeductible fines and penalties* (3,000) (600) *Although these amounts are not included in Georgio’s taxable income computation, they must be separately disclosed because they affect Georgio’s tax basis in his LLC interest. 60. [LO4] {Research} Richard Meyer and two friends from law school recently formed Meyer and Associates as a limited liability partnership (LLP). Income from the partnership will be split equally among the partners. The partnership will generate fee income primarily from representing clients in bankruptcy and foreclosure matters. While some attorney friends have suggested that the partners’ earnings will be self-employment income, other attorneys they know from their local bar association meetings claim just the opposite. After examining relevant authority, explain how you would advise Meyer and Associates on this matter. {Hint: See §1402(a)(13) and Renkemeyer, Campbell & Weaver LLP v. Commissioner, 136 T.C. 137 (2011)} Section 1402(a)(13) provides that a limited partner’s share of partnership ordinary business income is not self-employment income, but the Code does not specifically address the treatment of ordinary business income allocated to partners of limited liability partnerships or LLP’s. In attempting to address how the self-employment tax rules should apply to LLC members, partners in LLP’s, and other partners with limited liability (other than limited partners in a limited partnership), Prop. Reg. § 1.1402(a)-2(h)(5) states that service partners in service partnerships such as law firms, accounting firms, etc. may not be treated as limited partners for self-employment tax purposes. Nonetheless, proposed regulations are not authoritative and taxpayers are not required to follow them. However, the Tax Court, in Renkemeyer, Campbell & Weaver LLP v. Commissioner, 136 TC 137(2011) decided to follow the approach in the proposed regulations and treat law partners in a law firm organized as an LLP as subject to the self-employment tax. Thus, to avoid controversy with the IRS, Richard and his partners should treat their earnings as self-employment income. However, if they are willing to litigate in a court other than the Tax Court (U.S. District Court or Federal Court of Claims), they might consider taking a position that their earnings from the partnership are not self-employment income. 61. [LO 4] The partnership agreement of the G&P general partnership states that Gary will receive a guaranteed payment of $13,000, and that Gary and Prudence will share the remaining profits or losses in a 45/55 ratio. For year 1, the G&P partnership reports the following results: a. Compute Gary’s share of ordinary income (loss) and separately stated items to be reported on his year 1 Schedule K-1, including his self-employment income (loss). b. Compute Gary’s share of self-employment income (loss) to be reported on his year 1 Schedule K-1, assuming G&P is a limited partnership and Gary is a limited partner. c. What do you believe Gary’s share of self-employment income (loss) to be reported on his year 1 Schedule K-1 should be, assuming G&P is an LLC and Gary spends 2,000 hours per year working there full time? a. Gary’s ordinary business income, separately stated items, and self-employment income are calculated in the table below: Description Total Amount Allocated to Gary Explanation Sales revenue $70,000 Less: Cost of goods sold (38,000) Depreciation - MACRS (9,000) Employee wages (14,000) Other expenses (2,000) Guaranteed payments (13,000) Ordinary Business Loss ($6,000) ($2,700) 45% allocation to Gary Separately Stated Items on Schedule K-1: Section 1231 gains $8,000 $3,600 45% allocation to Gary Cash charitable contributions ($3,000) ($1,350) 45% allocation to Gary Guaranteed payment $13,000 $13,000 Gary’s guaranteed payment Municipal bond interest $2,000 $900 45% allocation to Gary Self-employment income $7,000 [$13,000 guaranteed payment - $6,000 ordinary loss] $10,300 ($2,700) ordinary business loss allocated to Gary + $13,000 guaranteed payment b. If Gary is a limited partner, then his self-employment income would equal the $13,000 guaranteed payment he received. c. Under Proposed Reg. §1.1402(a)-2, Gary’s $2,700 share of ordinary business loss will reduce his $13,000 guaranteed payment leaving him with $10,300 of self-employment income (because he spent more than 500 hours working in the trade or business of the LLC). In this instance, the proposed regulations provide Gary with a favorable interpretation of the law. 62. [LO 4] {Research} Hoki Poki, a cash-method general partnership, recorded the following items for its current tax year: As part of preparing Hoki Poki’s current year return, identify the items that should be included in computing its ordinary business income (loss) and those that should be separately stated. {Hint: See Schedule K-1 and related preparer’s instructions at www.irs.gov.} Hoki Poki’s ordinary business income is computed as follows: Description Total Amount (1)Sales revenue $70,000 (2) Section 1245 recapture income 8,000 (3)Cost of goods sold (38,000) (4)Depreciation – MACRS (9,000) (5)Supplies expense (1,000) (6)Employee wages (14,000) (7)Partner’s medical insurance premiums (3,000) (8)Ordinary business income $13,000 Hoki Poki’s separately stated items are reflected in the table below: Separately Stated Items Explanation (1)$2,000 Rental real estate income See line 2 of Schedule K-1 (2)$2,000 Interest income See line 5 of Schedule K-1 (3)$1,000 Investment interest expense See instructions for line 13 of Schedule K-1, Code H (4)$3,000 Medical insurance premiums or $3,000 Guaranteed Payments See instructions for line 13 of Schedule K-1, Code M (to provide partners with the information needed to compute the for AGI deduction for medical insurance) According to Rev. Rul. 91-26, partner’s medical insurance premiums paid by the partnership are treated as guaranteed payments to the partners. $8,000 Self-Employment Income Line (8) from the table above (general partners treat ordinary business income as self-employment income) + (4) (guaranteed payments are always treated as self-employment income) – line (2) from table above (Per §1402(a)(3)(C), gains from the sale of property are not included in self-employment income). See Line 14 of Schedule K-1. 63. [LO 4] {Research} On the last day of its current tax year, Buy Rite LLC received $300,000 when it sold a machine it had purchased for $200,000 three years ago to use in its business. At the time of the sale, the basis in the equipment had been reduced to $100,000 due to tax depreciation taken. How much did the members’ self-employment earnings from Buy Rite increase when the equipment was sold? {Hint: See §1402(a)(3).} Buy Rite’s self-employment income does not increase due to the sale of the equipment. According to §1402(a)(3)(C), gains from the sale of equipment are not included in Buy Rite’s self-employment income. Thus, Buy Rite must ensure that the $100,000 of ordinary Section 1245 recapture is subtracted from its ordinary business income or loss when calculating its self-employment income. Because the remaining $100,000 of Section 1231 gain is separately stated, it is not included in ordinary business income or loss and therefore will not be included in self-employment income. 64. [LO 4] Jhumpa, Stewart, and Kelly are all one-third partners in the capital and profits of Firewalker General Partnership. In addition to their normal share of the partnership’s annual income, Jhumpa and Stewart each receive an annual guaranteed payment of $10,000 to compensate them for additional services they provide. Firewalker’s income statement for the current year reflects the following revenues and expenses: a. Given Firewalker’s operating results, how much ordinary business income (loss) and what separately stated items [including the partners’ self-employment earnings (loss)] will it report on its return for the year? b. How will it allocate these amounts to its partners? c. How much self-employment tax will each partner pay assuming none have any other source of income or loss? a. Firewalker’s ordinary business income consists of sales revenues less operating expenses. Separately stated items are interest income, long-term capital gains, guaranteed payments, and self-employment income. b. The table above reflects the partner’s shares of ordinary business income and her/his separately stated items. Note that each partner’s self-employment income consists of her/his individual shares of ordinary business income plus the guaranteed payment she/he received, if any. c. The table below reflects the partner’s self-employment tax liability: Description Stewart Jhumpa Kelly Explanation (1) Self-employment income $40,833 $40,833 $30,833 (2) Percentage of self-employment income subject to self-employment tax 92.35% 92.35% 92.35% (3) Earnings from self-employment $37,709 $37,709 $28,474 (1) × (2) (4) Self-employment tax rate 15.3% 15.3% 15.3% (5) Self-employment tax liability $5,769 $5,769 $4,357 (3) × (4) 65. [LO 4] This year, Darrel’s distributive share from Alcove Partnership includes $6,000 of interest income, $3,000 of dividend income, and $70,000 ordinary business income. a. Assume that Darrel materially participates in the partnership. How much of his distributive share from Alcove Partnership is potentially subject to the net investment income tax? b. Assume that Darrel does not materially participate in the partnership. How much of his distributive share from Alcove Partnership is potentially subject to the net investment income tax? a. If Darrel materially participates in the business, the ordinary income is not passive to him and should not be subject to the net investment income tax. The $6,000 of interest income and the $3,000 of dividend income are potentially subject to the net investment income tax. b. If Darrel is not a material participant in the partnership, the $6,000 of interest income, the $3,000 of dividend income, and the $70,000 of ordinary business income are potentially subject to the net investment income tax. 66. [LO 4] This year, Alex’s distributive share from Eden Lakes Partnership includes $8,000 of interest income, $4,000 of net long-term capital gains, $2,000 net section 1231 gain from the sale of property used in the partnership’s trade or business, and $83,000 of ordinary business income. a. Assume that Alex materially participates in the partnership. How much of his distributive share from Eden Lakes Partnership is potentially subject to the net investment income tax? b. Assume that Alex does not materially participate in the partnership. How much of his distributive share from the Eden Lakes partnership is potentially subject to the net investment income tax? a. If Alex materially participates in the business, the ordinary income is not passive to him and should not be subject to the net investment income tax. Further, the $2,000 net section 1231 gain from the sale of trade or business property will not be subject to the net investment income tax. However, the $8,000 of interest income and the $4,000 of net long-term capital gains are potentially subject to the net investment income tax. b. If Alex does not materially participate in the business, then Alex’s distributive share of interest, net-long term capital gains, net 1231 gain from the sale of property used in the trade or business, and ordinary business income are all potentially subject to the net investment income tax. 67. [LO 4] {Research} Lane and Cal each own 50 percent of the profits and capital of High Yield LLC. High Yield owns a portfolio of taxable bonds and municipal bonds, and each year the portfolio generates approximately $10,000 of taxable interest and $10,000 of tax-exempt interest. Lane’s marginal tax rate is 35 percent while Cal’s marginal tax rate is 12 percent. To take advantage of the difference in their marginal tax rates, Lane and Cal want to modify their operating agreement to specially allocate all of the taxable interest to Cal and all of the tax-exempt interest to Lane. Until now, Lane and Cal had been allocated 50 percent of each type of interest income. a. Is High Yield’s proposed special allocation acceptable under current tax rules? Why or why not? {Hint: See Reg. §1.704-1(b)(2)(iii)(b) and §1.704-1(b)(5) Example (5).} b. If the IRS ultimately disagrees with High Yield’s special allocation, how will it likely reallocate the taxable and tax-exempt interest among the members? {Hint: See Reg. §1.704-1(b)(5) Example (5)(ii).} a. According to IRC §704 partnership allocations will be respected by the IRS unless they do not have “substantial economic effect.” The facts provided are almost identical to the general scenario described in Reg. §1.704-1(b)(2)(iii)(b) and to the detailed facts described in §1.704-1(b)(5) Example (5) given that the special allocation to Lane and Cal simply changes the character of the income allocated to Lane and Cal but not the amount. Thus, this allocation is not appropriate because it is not substantial. b. As described in Reg. §1.704-1(b)(5) Example (5)(ii), the IRS will likely assert that 50 percent of both the taxable and tax-exempt bond interest should be allocated to Lane and Cal. 68. [LO 5] Larry’s tax basis in his partnership interest at the beginning of the year was $10,000. If his share of the partnership debt increased by $10,000 during the year and his share of partnership income for the year is $3,000, what is his tax basis in his partnership interest at the end of the year? $23,000 as computed in the table below: Description Total Amount Beginning Tax Basis $10,000 Increase in Partner’s Share of Debt 10,000 Partner’s Share of Income 3,000 Ending Tax Basis $23,000 69. [LO 5] Carmine was allocated the following items from the Piccolo LLC for last year: Ordinary business loss Nondeductible penalties Tax-exempt interest income Short-term capital gain Cash distributions Rank these items in terms of the order they should be applied to adjust Carmine’s tax basis in Piccolo for the year (some items may be of equal rank). Partners first adjust their bases for items that increase basis, then for distributions, then by nondeductible expenses, and then by deductible expenses and losses. Thus, the items above should be applied in the following order to adjust Camine's basis: Tax Exempt Income and Short-Term Capital Gain (basis increasing items come first) Cash Distribution (distributions come after basis increasing items) Nondeductible Penalties Ordinary Business Loss (basis reducing items come last) 70. [LO 5] Oscar, Felix, and Marv are all one-third partners in the capital and profits of Eastside general partnership. In addition to their normal share of the partnership’s annual income, Oscar and Felix receive annual guaranteed payments of $7,000 to compensate them for additional services they provide. Eastside’s income statement for the current year reflects the following revenues and expenses: In addition, Eastside owed creditors $120,000 at the beginning of the year but managed to pay down its debts to $90,000 by the end of the year. All partnership debt is allocated equally among the partners. Finally, Oscar, Felix and Marv had a tax basis of $80,000 in their interests at the beginning of the year. a. What tax basis do the partners have in their partnership interests at the end of the year? b. Assume the partners began the year with a tax basis of $10,000 and all the debt was paid off on the last day of the year. How much gain will the partners recognize when the debt is paid off? What tax basis do the partners have in their partnership interests at the end of the year? a. All of the partners have an ending tax basis of $87,333 as calculated in the table below: Description Oscar Felix Marv Explanation (1)Beginning tax basis (including partners’ share of debt) $80,000 $80,000 $80,000 (2)Dividend income $1,900 $1,900 $1,900 $5,700 × 33.33% (3)Short-term capital gains $933 $933 $933 $2,800 × 33.33% (4)Partner’s share of ordinary business income $14,500 $14,500 $14,500 [$52,000 overall net income – ($5,700 Dividend Income + $2,800 Short-Term Capital Gains)] × 33.33 % (5)Deemed distribution from debt repayment ($10,000) ($10,000) ($10,000) [$120,000 – $90,000] × 33.33% (6)Guaranteed payments received 0 0 Partners don’t increase the basis of their partnership interests by the amount of guaranteed payments received (7)Ending tax basis $87,333 $87,333 $87,333 (1)+(2)+(3)+(4)+(5) b. Each partner recognizes gain of $12,667 and has an ending basis of zero as calculated in the table below: Description Oscar Felix Marv Explanation (1)Beginning tax Basis (including partners’ share of debt) $10,000 $10,000 $10,000 (2)Dividend income $1,900 $1,900 $1,900 $5,700 × 33.33% (3)Short-term capital gains $933 $933 $933 $2,800 × 33.33% (4)Partner’s share of ordinary business income $14,500 $14,500 $14,500 [$52,000 overall net income – ($5,700 Dividend Income + $2,800 Short-Term Capital Gains)] × 33.33 % (5)Deemed distribution from debt repayment ($40,000) ($40,000) ($40,000) [$120,000 – $0] × 33.33% (6)Guaranteed payments received 0 0 Partners don’t increase the basis of their partnership interests by the amount of guaranteed payments received (7)Gain recognized by partners $12,667 $12,667 $12,667 (5) – [(1)+(2)+(3)+ (4)] (8)Ending tax basis 0 0 0 Generally (1)+(2)+(3)+(4) + (5) but may not go lower than zero 71. [LO 5] Pam, Sergei, and Mercedes are all one-third partners in the capital and profits of Oak Grove General Partnership. Partnership debt is allocated among the partners in accordance with their capital and profits interests. In addition to their normal share of the partnership’s annual income, Pam and Sergei receive annual guaranteed payments of $20,000 to compensate them for additional services they provide. Oak Grove’s income statement for the current year reflects the following revenues and expenses: In addition, Oak Grove owed creditors $90,000 at the beginning and $150,000 at the end of the year, and Pam, Sergei and Mercedes had a tax basis of $50,000 in their interests at the beginning of the year. Also, on December 31 of the current year, Sergei and Mercedes agreed to increase Pam’s capital and profits interest from 33.33 percent to 40 percent at the end of the tax year in exchange for additional services she provided to the partnership. The current liquidation value of the additional capital interest Pam received at the end of the tax year is $40,000. a. What tax basis do the partners have in their partnership interests at the end of the year? b. If, in addition to the expenses listed above, the partnership donated $12,000 to a political campaign, what tax basis do the partners have in their partnership interests at the end of the year assuming the liquidation value of the additional capital interest Pam receives at the end of the year remains at $40,000? a. Pam’s basis is $140,000, Sergei’s basis is $65,000, and Mercedes’s basis is $65,000 as computed in the table below: Description Pam Sergei Mercedes Explanation (1) Beginning tax basis (including partners’ share of debt) $50,000 $50,000 $50,000 Given (2) Dividends income $2,200 $2,200 $2,200 $6,600 × 33.33% (Pam’s profits interest doesn’t increase until the end of the year) (3) Partner’s share of ordinary business income $19,067 $19,067 $19,067 [$60,000 overall net income – ($6,600 Dividend Income – ($3,800) Section 1231 Losses)] × 33.33 % (4) Debt increase (deemed cash contribution) $30,000 $15,000 $15,000 Pam :[( $150,000 × 40%) – ($90,000 × 33.33%)] Other Partners: [($150,000 × 30%) – ($90,000 × 33.33%)] (5) Pam’s new 6.67% capital interest $40,000 ($20,000) ($20,000) Additional 6.67% capital interest to Pam is a guaranteed payment to Pam and a deduction allocated equally to other partners (6) Cash guaranteed payments received 0 0 Partners don’t increase the basis of their partnership interests by the amount of cash guaranteed payments received (7) Section 1231 losses ($1,267) ($1,267) ($1,267) ($3,800) × 33.33% (8) Ending tax basis $140,000 $65,000 $65,000 Sum of (1) through (7) b. Pam’s basis is $136,000, Sergei’s basis is $61,000, and Mercedes’s basis is $61,000 as computed in the table below. Nondeductible expenses reduce each partner's tax basis, so each partner's basis computed in part (a) is reduced by $4,000 ($12,000 x 33.33%. Description Pam Sergei Mercedes Explanation Ending tax basis given facts in part a. $140,000 $65,000 $65,000 See solution to part a. above Campaign contribution ($4,000) ($4,000) ($4,000) ($12,000) × 33.33% Non-deductible expenses must reduce a partner’s tax basis New ending basis given facts in part b. $136,000 $61,000 $61,000 72. [LO 6] {Research} Laura Davis is a member in a limited liability company that has historically been profitable but is expecting to generate losses in the near future because of a weak local economy. In addition to the hours she works as an employee of a local business, she currently spends approximately 150 hours per year helping to manage the LLC. Other LLC members each work approximately 175 hours per year in the LLC, and the time Laura and other members spend managing the LLC has remained constant since she joined the company three years ago. Laura’s tax basis and amount at-risk are large compared to her share of projected losses; however, she is concerned that her ability to deduct her share of the projected losses will be limited by the passive activity loss rules. a. As an LLC member, will Laura’s share of losses be presumed to be passive as they are for limited partners? Why or why not? [Hint: See §469(h)(2), Garnett v. Commissioner, 132 T.C. 368 (2009), and Prop. Reg. § 1.469-5(e)(3)(i).] b. Assuming Laura’s losses are not presumed to be passive, is she devoting sufficient time to the LLC to be considered a material participant? Why or why not? c. What would you recommend to Laura to help her achieve a more favorable tax outcome? a. Section 469(h)(2) specifies that limited partners are presumed to be passive participants. However, Laura is not a limited partner; rather she is a member in an LLC. For a time, the IRS argued that LLC members should be treated as limited partners in this context because of their limited liability. Nonetheless, the Tax Court in Garnett v. Commissioner, 132 T.C. 368 (2009) and in subsequent memorandum decisions determined that §469(h)(2) does not always apply to LLC members. In response to the Garnett decision, the Treasury provided in Prop. Reg. § 1.469-5(e)(3)(i) that LLC members will not automatically be treated as limited partners as long as they have management rights for some portion of the year. Thus, if Laura can satisfy any one of the seven tests for material participation in Reg. §1.469-5T(a), she may treat her losses as active. b. In all likelihood, Laura is not spending enough time managing the LLC to be considered a material participant. Given the facts provided, the only test for material participation in Reg. §1.469-5T(a ) she might satisfy is the seventh test which provides that an individual must participate on a “regular, continuous, and substantial basis” during the year to be treated as a material participant. It is not clear that she would satisfy this subjective test given her current level of involvement. c. Laura should be advised to increase her time spent managing the LLC from 150 to 175 hours per year. If she does this, she will clearly satisfy the test for material participation found in Reg. §1.469-5T(a )(3) which provides that Laura will be a material participant if she works more than 100 hours during the year in the LLC and the number of hours she works is not less than the number of hours other individual LLC members spend managing the LLC during the year. 73. [LO 6] Alfonso began the year with a tax basis in his partnership interest of $30,000. His share of partnership debt at the beginning and end of the year consists of $4,000 of recourse debt and $6,000 of nonrecourse debt. During the year, he was allocated $40,000 of partnership ordinary business loss. Alfonso does not materially participate in this partnership and he has $1,000 of passive income from other sources. a. How much of Alfonso’s loss is limited by his tax basis? b. How much of Alfonso’s loss is limited by his at-risk amount? c. How much of Alfonso’s loss is limited by the passive activity loss rules? a. Because Alfonso’s basis before the loss allocation is $30,000, $10,000 of his $40,000 loss allocation is limited by his tax basis and will carry over to the following year. b. Of the $30,000 loss not already limited by Alfonso’s tax basis, $6,000 is limited because Alfonso’s at-risk amount is only $24,000 ($30,000 regular tax basis less the $6,000 nonrecourse debt not allowed in calculating the at-risk amount). Thus, $24,000 of loss remains after the tax basis and at-risk limitations, and Alfonso has a $6,000 at-risk carryover. c. Because Alfonso doesn’t materially participate in the partnership, he may only deduct the $24,000 loss remaining after the tax basis and at-risk limitations to the extent he has passive income from other sources. Thus, he may deduct $1,000 of the $24,000 loss currently and will have a $23,000 passive activity loss carryover. 74. [LO 6] Jenna began the year with a tax basis of $45,000 in her partnership interest. Her share of partnership debt consists of $6,000 of recourse debt and $10,000 of nonrecourse debt at the beginning of the year and $6,000 of recourse debt and $13,000 of nonrecourse debt at the end of the year. During the year, she was allocated $65,000 of partnership ordinary business loss. Jenna does not materially participate in this partnership and she has $4,000 of passive income from other sources. a. How much of Jenna’s loss is limited by her tax basis? b. How much of Jenna’s loss is limited by her at-risk amount? c. How much of Jenna’s loss is limited by the passive activity loss rules? a. Because Jenna’s share of nonrecourse debt increased by $3,000 during the year, her basis prior to any loss allocation is $48,000 ($45,000 beginning tax basis plus $3,000 increase in nonrecourse debt allocation). Thus, $48,000 of her $65,000 loss allocation is not limited by her tax basis and the remaining $17,000 is limited and carried over to the following year. b. Of the $48,000 loss not already limited by Jenna’s tax basis, $13,000 is limited because Jenna’s at-risk amount is only $35,000 ($48,000 regular tax basis less the $13,000 nonrecourse debt not allowed in calculating the at-risk amount at the end of the year). Thus, $35,000 of loss remains after the tax basis and at-risk limitations, and Jenna has a $13,000 at-risk carryover. c. Because Jenna doesn’t materially participate in the partnership, she may only deduct the $35,000 loss remaining after the tax basis and at-risk limitations to the extent she has passive income from other sources. Thus, she may deduct $4,000 of the $35,000 loss currently and will have a $31,000 passive activity loss carryover. 75. [LO 5, LO 6] {Research} Juan Diego began the year with a tax basis in his partnership interest of $50,000. During the year, he was allocated $20,000 of partnership ordinary business income, $70,000 of §1231 losses, $30,000 of short-term capital losses, and received a cash distribution of $50,000. a. What items related to these allocations does Juan Diego actually report on his tax return for the year? {Hint: See Reg. §1.704-1(d)(2) and Rev. Rul. 66-94.} b. If any deductions or losses are limited, what are the carryover amounts and what is their character? {Hint: See Reg. §1.704-1(d).} a. According to Rev. Rul. 66-94, 1966-1 CB 166 Juan Diego should increase his basis first by his $20,000 share of ordinary business income and then reduce it by his $50,000 cash distribution. At this point, his remaining basis of $20,000 will be reduced to zero by the $70,000 Section 1231 losses and $30,000 short-term capital losses allocated to him. Reg. §1.704-1(d)(2) describes how Juan Diego’s $20,000 tax basis before considering the loss allocations should be allocated to the two types of losses. The table below illustrates the required calculations: (1) Original Loss (2) Amount Deducted Currently (1) – (2) Loss Carryover Section 1231 losses $70,000 $14,000 ($20,000 × $70,000/$100,000) $56,000 Short-term capital losses $30,000 $6,000 ($20,000 × $30,000/$100,000) $24,000 b. As indicated in the table above, Juan Diego’s $80,000 loss carryover (due to his $20,000 tax basis limitation) will be characterized as a $56,000 Section 1231 loss and a $24,000 short-term capital loss. 76. [LO 6] Farell is a member of Sierra Vista LLC. Although Sierra Vista is involved in a number of different business ventures, it is not currently involved in real estate either as an investor or as a developer. On January 1, year 1, Farell has a $100,000 tax basis in his LLC interest that includes his $90,000 share of Sierra Vista’s general debt obligations. By the end of the year, Farell’s share of Sierra Vista’s general debt obligations has increased to $100,000. Because of the time he spends in other endeavors, Farell does not materially participate in Sierra Vista. His share of the Sierra Vista losses for year 1 is $120,000. As a partner in the Riverwoods Partnership, he also has year 1 Schedule K-1 passive income of $5,000. Farell is single and has no other sources of business income or loss. a. Determine how much of the Sierra Vista loss Farell will currently be able to deduct on his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations. b. Assuming Farell’s Riverwoods K-1 indicates passive income of $30,000, determine how much of the Sierra Vista loss he will ultimately be able to deduct on his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations. c. Assuming Farell is deemed to be an active participant in Sierra Vista, determine how much of the Sierra Vista loss he will ultimately be able to deduct on his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations. d. Assuming Farell is deemed to be an active participant in Sierra Vista and he has a $280,000 loss from a sole proprietorship, determine how much total trade or business loss Farell will deduct on his return in year 1. a. Farell may only deduct $5,000 currently, and he will have a $10,000 loss suspended by the tax basis limitation, a $100,000 loss suspended by the at-risk limitation, and a $5,000 loss suspended under the passive activity limitation as illustrated in the table below: Description Tax Basis Limitation At-risk Limitation Passive Activity Limitation Explanation (1) Beginning Tax basis and At-risk amount $100,000 $10,000 General debt obligations of LLCs are treated as nonrecourse debt. Thus, Farell’s beginning at-risk amount is $90,000 less than his beginning tax basis. (2) Increase in nonrecourse debt $10,000 $0 Nonrecourse debt increases by $100,000 – $90,000. Nonrecourse debt not included in at-risk amount. (3) Tax basis and At-risk amount before ordinary business loss $110,000 $10,000 (1) + (2) (4) Ordinary business loss ($120,000) (5) Loss clearing the Tax basis hurdle ($110,000) Loss limited to $110,000 tax basis (6) Loss suspended by Tax basis hurdle ($10,000) (4) – (5) (7) Loss clearing Tax basis hurdle ($110,000) (5) (8) Loss clearing At-risk hurdle ($10,000) Loss limited to $10,000 at-risk amount (9) Loss suspended by At-risk hurdle ($100,000) (7) – (8) (10) Passive activity loss ($10,000) (8) Farell is not a material participant (11) Passive income $5,000 From Riverwoods Partnership (12) Loss used to offset Passive income ($5,000) Loss only used to the extent of passive income (13) Passive activity loss carryover ($5,000) (10) – (12) b. Farell may only deduct $10,000 currently, and he will have a $10,000 loss suspended by the tax basis limitation, and a $100,000 loss suspended by the at-risk limitation as illustrated in the table below: Description Tax Basis Limitation At-risk Limitation Passive Activity Limitation Explanation (1) Beginning tax basis and At risk amount $100,000 $10,000 General debt obligations of LLCs are treated as nonrecourse debt. Thus, Farell’s beginning at-risk amount is $90,000 less than his beginning tax basis. (2) Increase in nonrecourse debt $10,000 $0 Nonrecourse debt increases by $100,000 – $90,000. Nonrecourse debt not included in at-risk amount. (3) Tax basis and At-risk amount before ordinary business loss $110,000 $10,000 (1) + (2) (4) Ordinary business loss ($120,000) (5) Loss clearing the Tax basis hurdle ($110,000) Loss limited to $110,000 tax basis (6) Loss suspended by Tax basis hurdle ($10,000) (4) – (5) (7) Loss clearing Tax basis hurdle ($110,000) (5) (8) Loss clearing At-risk hurdle ($10,000) Loss limited to $10,000 at-risk amount (9) Loss suspended by At-risk hurdle ($100,000) (7) – (8) (10) Passive activity loss ($10,000) (8) Farell is not a material participant (11) Passive income $30,000 From Riverwoods Partnership (12) Loss used to offset Passive income ($10,000) Loss used to the extent of passive income (13) Passive activity loss carryover $0 (10) – (12) c. Farell may only deduct $10,000 currently, and he will have a $10,000 loss suspended by the tax basis limitation, and a $100,000 loss suspended by the at-risk limitation as illustrated in the table below: Description Tax Basis Limitation At-risk Limitation Explanation (1) Beginning Tax basis and At-risk amount $100,000 $10,000 General debt obligations of LLCs are treated as nonrecourse debt. Thus, Farell’s beginning at-risk amount is $90,000 less than his beginning tax basis. (2) Increase in nonrecourse debt $10,000 $0 Nonrecourse debt increases by $100,000 – $90,000. Nonrecourse debt not included in at-risk amount. (3) Tax basis and At-risk amount before ordinary business loss $110,000 $10,000 (1) + (2) (4) Ordinary business loss ($120,000) (5) Loss Clearing the Tax basis hurdle ($110,000) Loss limited to $110,000 tax basis (6) Loss suspended by Tax basis hurdle ($10,000) (4) – (5) (7) Loss clearing Tax basis hurdle ($110,000) (5) (8) Loss clearing At-risk hurdle and deducted on tax return ($10,000) Loss limited to $10,000 at-risk amount on line (3). This amount is deducted on Farell’s return because he is an active participant and his sources of business losses for the year are less than his sources of business income plus $259,000. (9) Loss suspended by At-risk hurdle ($100,000) (7) – (8) d. Per the excess business loss limitation rule under §461(l), single individuals may deduct up to $259,000 of net business losses in any given year. Farell will only be able to deduct $259,000 of his total net business losses of $285,000 for the year ($10,000 of loss from Sierra Vista, $280,000 loss from the sole proprietorship, and $5,000 of income from Riverwoods) The remaining $26,000 will become a net operating loss that can be utilized in future years. 77. [LO 6] {Research} Jenkins has a one-third capital and profits interest in the Maverick General Partnership. On January 1, year 1, Maverick has $120,000 of general debt obligations and Jenkins has a $50,000 tax basis (including his share of Maverick’s debt) in his partnership interest. During the year, Maverick incurred a $30,000 nonrecourse debt that is not secured by real estate. Because Maverick is a rental real estate partnership, Jenkins is deemed to be a passive participant in Maverick. His share of the Maverick losses for year 1 is $75,000. Jenkins is not involved in any other passive activities and this is the first year he has been allocated losses from Maverick. a. Determine how much of the Maverick loss Jenkins will currently be able to deduct on his tax return for year 1, and list the losses suspended due to tax basis, at-risk, and passive activity loss limitations. b. If Jenkins sells his interest on January 1, year 2, what happens to his suspended losses from year 1? [Hint: See §706(c)(2)(A), Reg. §1.704-1(d)(1), Prop. Reg. §1.465-66(a), and Sennett v. Commissioner 80 TC 825 (1983).] a. Jenkins may not deduct any losses currently, and he will have a $15,000 loss suspended by the tax basis limitation, a $10,000 loss suspended by the at-risk limitation, and a $50,000 loss suspended by the passive activity loss limitation as illustrated in the table below: Description Tax Basis Limitation At-risk Limitation Passive Activity Limitation Explanation (1) Beginning Tax basis and At-risk amount $50,000 $50,000 General debt obligations of general partnerships are treated as recourse debt. Thus, Jenkins’ beginning at-risk amount is the same as his beginning tax basis. (2) Increase in nonrecourse debt $10,000 $0 Nonrecourse debt generally not included in at-risk amount. (3) Tax basis and At-risk amount before ordinary business loss $60,000 $50,000 (1) + (2) (4) Ordinary business loss ($75,000) (5) Loss clearing the Tax basis hurdle ($60,000) Loss limited to $60,000 tax basis (6) Loss suspended by Tax basis hurdle ($15,000) (4) – (5) (7) Loss clearing Tax basis hurdle ($60,000) (5) (8) Loss clearing At-risk hurdle ($50,000) Loss limited to $50,000 at-risk amount (9) Loss suspended by At-risk hurdle ($10,000) (7) – (8) (10) Passive activity loss ($50,000) (8)Jenkins is not a material participant (11) Passive income $0 Given (12) Loss used to offset Passive income $0 Loss only used to the extent of passive income (13) Passive activity loss carryover ($50,000) (10) – (12) b. According to Sennett v. Commissioner 80 TC 825 (1983), losses suspended by the tax basis limitation disappear when the partnership interest is sold. Thus, Jenkins will lose the $15,000 loss suspended by the tax basis limitation. In addition, Prop. Reg. §1.465-66(a) provides that Jenkins may utilize the $10,000 loss suspended by the at-risk limitation to offset any gain he would otherwise report from the disposition of his partnership interest. Finally, Jenkins may deduct the $50,000 passive activity loss carryover in the year of disposition. 78. [LO 6] {Research} Suki and Steve own 50 percent capital and profits interests in Lorinda LLC. Lorinda operates the local minor league baseball team and owns the stadium where the team plays. Although the debt incurred to build the stadium was paid off several years ago, Lorinda owes its general creditors $300,000 (at the beginning and end of the year) that is not secured by firm property or guaranteed by any of the members. At the beginning of the current year, Suki and Steve had a tax basis of $170,000 in their LLC interests including their share of debt owed to the general creditors. Shortly before the end of the year they each received a $10,000 cash distribution, even though Lorinda’s ordinary business loss for the year was $400,000. Because of the time commitment to operate a baseball team, both Suki and Steve spent more than 1,500 hours during the year operating Lorinda. Both Suki and Steve are single and neither of them have any business income or losses from other sources. a. Determine how much of the Lorinda loss Suki and Steve will each be able to deduct on their current tax returns, and list their losses suspended by the tax basis, at-risk, and passive activity loss limitations. b. Assume that sometime before receiving the $10,000 cash distribution, Steve is advised by his tax advisor that his marginal tax rate will be abnormally high during the current year because of an unexpected windfall. To help Steve utilize more of the losses allocated from Lorinda in the current year, his advisor recommends refusing the cash distribution and personally guaranteeing $100,000 of Lorinda’s debt, without the right to be reimbursed by Suki. If Steve follows his advisor’s recommendations, how much additional Lorinda loss can he deduct on his current tax return? How does Steve’s decision affect the amount of loss Suki can deduct on her current return and the amount and type of her suspended losses? a. The members (either Steve or Suki) may deduct $10,000 in losses currently, and they will have a $40,000 loss suspended by the tax basis limitation, and a $150,000 loss suspended by the at-risk limitation as illustrated in the table below: Description Tax Basis Limitation At-risk Limitation Explanation (1) Beginning Tax basis and At-risk amount $170,000 $20,000 General debt obligations of LLCs are treated as nonrecourse debt. Thus, Suki or Steve’s beginning at-risk amount is $150,000 less than their beginning tax basis. (2) Distribution ($10,000) ($10,000) (3) Tax basis and At-risk amount before ordinary business loss $160,000 $10,000 (1) + (2) (4) Ordinary business loss ($200,000) $400,000 ×50% (5) Loss clearing the Tax basis hurdle ($160,000) Loss limited to $160,000 tax basis (6) Loss suspended by Tax basis hurdle ($40,000) (4) – (5) (7) Loss clearing Tax basis hurdle ($160,000) (5) (8) Loss clearing At-risk hurdle and currently deductible ($10,000) Loss limited to $10,000 at-risk amount on line (3). This amount is currently deductible because Steve and Suki are active participants in the activity and their individual sources of business losses for the year are less than their individual sources of business income plus $255,000. (9) Loss suspended by At-risk hurdle ($150,000) (7) – (8) b. b. Under these facts, Steve may deduct $120,000 in losses currently (a $110,000 increase over the loss he could deduct in part a.), and will have a $80,000 loss suspended by the at-risk limitation as illustrated in the table below: Description Tax Basis Limitation At-risk Limitation Explanation (1) Beginning Tax basis and At-risk amount $170,000 $20,000 General debt obligations of LLCs are treated as nonrecourse debt. Thus, Steve’s beginning at-risk amount is $150,000 less than his beginning tax basis. (2) Increase in debt allocation $50,000 $100,000 [(100,000 + 50% × $200,000) – $150,000] for tax basis and [100,000 – 0] for at-risk amount because guaranteeing the debt makes it recourse debt (3) Tax basis and At-risk amount before ordinary business loss $220,000 $120,000 (1) + (2) (4) Ordinary business loss ($200,000) (5) Loss clearing the Tax basis hurdle ($200,000) Loss is less than tax basis limitation (6) Loss suspended by Tax basis hurdle $0 (4) – (5) (7) Loss clearing Tax basis hurdle ($200,000) (5) (8) Loss clearing At-risk hurdle and currently deductible ($120,000) Loss is limited to at-risk amount on line (3). This amount is currently deductible because Steve is an active participant in the activity and his sources of business losses for the year are less than his sources of business income plus $255,000. (9) Loss suspended by At-risk hurdle ($80,000) (7) – (8) Suki may deduct $10,000 in losses currently (the same amount of loss as in part a.), and she will have a $90,000 loss suspended by the tax basis limitation and a $100,000 loss suspended by the at-risk limitation as illustrated in the table below: Description Tax Basis Limitation At-risk Limitation Explanation (1) Beginning Tax basis and At-risk amount $170,000 $20,000 General debt obligations of LLCs are treated as nonrecourse debt. Thus, Suki’s beginning at-risk amount is $150,000 less than her beginning tax basis. (2) Distribution ($10,000) ($10,000) (3) Decrease in debt allocation ($50,000) $0 [($200,000 × 50% ) –($300,000 × 50%)] (4) Tax basis and At-risk amount before ordinary business loss $110,000 $10,000 (1) + (2)+ (3) (5) Ordinary business loss ($200,000) (6) Loss clearing the Tax basis hurdle ($110,000) Loss is limited to the tax basis (7) Loss suspended by Tax basis hurdle ($90,000) (5) – (6) (8) Loss clearing Tax basis hurdle ($110,000) (6) (9) Loss clearing At-risk hurdle and currently deductible ($10,000) Loss is limited to at-risk amount on line (4). This amount is currently deductible because Suki is an active participant in the activity and her sources of business losses for the year are less than her sources of business income plus $255,000. (10) Loss suspended by At-risk hurdle ($100,000) (8) – (9) 79. [LO 6] {Research} Ray and Chuck own 50 percent capital and profits interests in Alpine Properties LLC. Alpine builds and manages rental real estate, and Ray and Chuck each work full time (over 1,000 hours per year) managing Alpine. Alpine’s debt (both at the beginning and end of the year) consists of $1,500,000 in nonrecourse mortgages obtained from an unrelated bank and secured by various rental properties. At the beginning of the current year, Ray and Chuck each had a tax basis of $250,000 in his LLC interest, including his share of the nonrecourse mortgage debt. Alpine’s ordinary business losses for the current year totaled $600,000 and neither member is involved in other activities that generate passive income. a. How much of each member’s loss is suspended because of the tax basis limitation? b. How much of each member’s loss is suspended because of the at-risk limitation? c. How much of each member’s loss is suspended because of the passive activity loss limitation? {Hint: See §469(c)(7).} d. If both Ray and Chuck are single and Ray has a current year loss of $50,000 from a sole proprietorship, how much trade or business loss can each deduct on their tax returns? a. Each member will have $50,000 of loss suspended because of the tax basis limitation as reflected in the table below: Description Losses suspended by Tax Basis Limitation Losses suspended by At-risk Limitation Losses suspended by Passive Activity Limitation Explanation (1) Beginning Tax basis and At-risk amount $250,000 $250,000 Because the LLC’s mortgage debt is qualified nonrecourse financing, it is included in both the tax basis and at-risk amount (2) Ordinary business loss ($300,000) 50% × $600,000 (3) Loss clearing the Tax basis hurdle ($250,000) Loss limited to $250,000 tax basis (4) Loss suspended by Tax basis hurdle ($50,000) (2) – (3) (5) Loss clearing Tax basis hurdle ($250,000) (3) (6) Loss clearing At-risk hurdle ($250,000) Loss limited to $250,000 at-risk amount (7) Loss suspended by At-risk hurdle $0 (5) – (6) b. As indicated in the table above, none of the members’ loss allocation will be suspended because of the at-risk limitation. c. Each member’s $250,000 loss remaining after the tax basis and at-risk limitations (see table in part a.) in considered to be an active trade or business loss. Although rental real estate ventures are generally treated as passive activities under §469(c)(2), §469(c)(7) provides an exception for taxpayers that work more than half of the time in real property trades or businesses and work more than 750 hours in real property trades or businesses in a given year. Given the facts in this problem, both members will be treated as active participants and will therefore be able to immediately deduct $250,000. d. Per the excess business loss limitation rule under §461(l), single individuals may deduct up to $259,000 of overall business losses in any given year. Ray will only be able to deduct $259,000 of his total business losses of $300,000 for the year from Alpine Properties and Ray’s sole proprietorship. On the other hand, Chuck may deduct his business loss from Alpine Properties in full since it does not exceed $259,000 for the year. Comprehensive Problems 80. {Tax Forms} Aaron, Deanne, and Keon formed the Blue Bell General Partnership at the beginning of the current year. Aaron and Deanne each contributed $110,000 and Keon transferred an acre of undeveloped land to the partnership. The land had a tax basis of $70,000 and was appraised at $180,000. The land was also encumbered with a $70,000 nonrecourse mortgage for which no one was personally liable. All three partners agreed to split profits and losses equally. At the end of the first year Blue Bell made a $7,000 principal payment on the mortgage. For the first year of operations, the partnership records disclosed the following information: a. Compute the adjusted basis of each partner’s interest in the partnership immediately after the formation of the partnership. b. List the separate items of partnership income, gains, losses, and deductions that the partners must show on their individual income tax returns that include the results of the partnership’s first year of operations. c. Using the information generated in answering parts (a) and (b), prepare Blue Bells’ page 1 and Schedule K to be included with its Form 1065 for its first year of operations along with Schedule K-1 for Deanne. d. What are the partners’ adjusted bases in their partnership interests at the end of the first year of operations? a. This initial adjusted basis for Keon is $23,333, for Aaron is $133,333, and for Deanne is $133,333 as shown in the calculations with table below: Description Keon Aaron Deanne Explanation (1) Basis in contributed land $70,000 (2) Cash contributed $110,000 $110,000 (3) Debt allocated to partners $23,333 $23,333 $23,333 (4) Relief from nonrecourse mortgage ($70,000) (5) Gain recognized $0 $0 $0 (4 ) – [(1)+ (2)+ (3)] if positive, otherwise 0 (6) Partners’ initial tax basis $23,333 $133,333 $133,333 (1) + (2) + (3)+ (4) + (5) b. The partners’ shares of ordinary business loss and separately stated items are reflected in the table below: Description Total Keon Aaron Deanne Explanation (1) Partners’ initial Tax basis $23,333 $133,333 $133,333 See problem a. above (2) Sales revenue $470,000 Less: (3) Cost of goods sold (410,000) (4) Operating expenses (70,000) (5) Guaranteed payments (3,000) (6) Ordinary Business Loss ($13,000) ($4,333) ($4,333) ($4,333) [Sum of (2) through (5)] × 33.33% Separately Stated Items on Schedule K-1: (7) Long-term capital gains $2,400 $800 $800 $800 $2,400 × 33.33% (8) Section 1231 gains $900 $300 $300 $300 $900 × 33.33% (9) Municipal bond interest $300 $100 $100 $100 $300 × 33.33% (10) Charitable contributions ($300) ($100) ($100) ($100) ($300) × 33.33% (11) Mortgage reduction (deemed cash distribution) ($7,000) ($2,333) ($2,333) ($2,333) ($7,000) × 33.33% (12) Self-employment Loss ($10,000) ($4,333) ($4,333 ) ($1,333) Line 6 + 13 (13) Guaranteed Payment 3,000 Partners’ ending tax basis $17,767 127,767 127,767 (1) + (6)+ (7) through (11) c. Blue Bell Partnership’s page 1 and Schedule K to be included with Form 1065 and Deanne’s Schedule K-1 are shown below: d. Keon has an ending basis of $17,767, Aaron has an ending basis of $127,767 and Deanne has an ending basis of $127,767. These amounts are calculated in the table included with the solution to part b. above. 81. {Tax Forms} The TimpRiders LP has operated a motorcycle dealership for a number of years. Lance is the limited partner, Francesca is the general partner, and they share capital and profits equally. Francesca works full-time managing the partnership. Both the partnership and the partners report on a calendar-year basis. At the start of the current year, Lance and Francesca had bases of $10,000 and $3,000 respectively, and the partnership did not carry any debt. During the current year, the partnership reported the following results from operations: On the last day of the year, the partnership distributed $3,000 each to Lance and Francesca. a. What outside basis do Lance and Francesca have in their partnership interests at the end of the year? b. How much of their losses are currently not deductible by Lance and Francesca because of the tax basis limitation? c. To what extent does the passive activity loss limitation apply in restricting their deductible losses for the year? d. Using the information provided, prepare TimpRiders’ page 1 and Schedule K to be included with its Form 1065 for the current year. Also, prepare a Schedule K-1 for Lance and Francesca. a. Lance has an ending basis of $5,000 and Francesca has an ending basis of $0 as illustrated in the table below: Description Total Lance (Limited) Francesca (General) Explanation (1) Partners’ initial Tax basis $10,000 $3,000 Given Basis Increasing Items: (2) Section 1231 gain $6,000 $3,000 $3,000 $6,000 × 50% (3) Tax-exempt interest $2,000 $1,000 $1,000 $2,000 × 50% (4) Basis Before Distributions $14,000 $7,000 Sum of lines (1) through (3) (5) Cash distributions ($3,000) ($3,000) Given (6) Basis Before Loss Allocations $11,000 $4,000 (4) + (5) (7) Sales revenue $650,000 Less: (8) Cost of goods sold (500,000) (9) Operating expenses (160,000) (10) Ordinary business loss ($10,000) ($5,000) ($5,000) [Sum of (7) through (9)] × 50% (11) Short-term capital loss ($2,000) ($1,000) ($1,000) ($2,000) × 50% Partners’ ending tax basis $5,000 $0 (6) + (10) + (11) or limited to a basis of zero. Thus, the tax basis limitation applies to Francesca. b. As indicated in the table in part a., Lance's loss allocations are not limited by his tax basis; however, Francesca's has $2,000 of losses that are not deductible currently because of the tax basis limitation. c. Although Lance’s loss allocations are not limited because of his tax basis, his share of the ordinary business loss is classified as a passive activity loss because he is a limited partner. Thus, he must carryover his $5,000 ordinary business loss as a passive activity loss until he either receives passive income or he sells his partnership income. His $1,000 short-term capital loss is not limited because it is a portfolio rather than a passive loss. The passive activity loss rules don’t apply to Francesca because she works full time managing the partnership and would be classified as a material participant. d. TimpRiders LP’s page 1 and Schedule K to be included with Form 1065 and both partner’s Schedule K-1 are shown below: 82. LeBron, Dennis, and Susan formed the Bar T LLC at the beginning of the current year. LeBron and Dennis each contributed $200,000 and Susan transferred several acres of agricultural land she had purchased two years earlier to the LLC. The land had a tax basis of $50,000 and was appraised at $300,000. The land was also encumbered with a $100,000 nonrecourse mortgage (i.e., qualified nonrecourse financing) for which no one was personally liable. The members plan to use the land and cash to begin a cattle-feeding operation. Susan will work full-time operating the business, but LeBron and Dennis will devote less than two days per year to the operation. All three members agree to split profits and losses equally. At the end of the first year, Bar T had accumulated $40,000 of accounts payable jointly guaranteed by LeBron and Dennis and had made a $9,000 principal payment on the mortgage. None of the members have passive income from other sources or business income from other sources. LeBron and Dennis are married, while Susan is single. For the first year of operations, the partnership records disclosed the following information: a. Compute the adjusted basis of each member’s interest immediately after the formation of the LLC. b. When does each member’s holding period for his or her LLC interests begin? c. What is Bar T’s tax basis and holding period in its land? d. What is Bar T’s required tax year-end? e. What overall methods of accounting were initially available to Bar T? f. List the separate items of partnership income, gains, losses, deductions and other items that will be included in each member’s Schedule K-1 for the first year of operations. Use the proposed self-employment tax regulations to determine each member’s self-employment income or loss. g. What are the members’ adjusted bases in their LLC interests at the end of the first year of operations? h. What are the members’ at-risk amounts in their LLC interests at the end of the first year of operations? i. How much loss from Bar T, if any, will the members be able to deduct on their individual returns from the first year of operations? a. LeBron’s adjusted basis is $216,667, Dennis’ adjusted basis is $216,667, and Susan’s adjusted basis is $16,667 as calculated in the table below: Description LeBron Dennis Susan Explanation (1) Basis in contributed land $50,000 (2) Cash contributed $200,000 $200,000 (3) Debt allocated to Susan only $50,000 Nonrecourse debt > Susan’s tax basis in contributed property (4) Debt allocated to partners $16,667 $16,667 $16,667 [$100,000 - $50,000] × 33.33% (5) Relief from nonrecourse mortgage ($100,000) (6) Gain recognized $0 $0 $0 (5) – [(1)+ (2)+ (3)+ (4)] if positive, otherwise 0 (7) Partners’ initial tax basis $216,667 $216,667 $16,667 (1) + (2) + (3) + (4) +(5) b. The holding period for LeBron and Dennis begins when they receive their LLC interests because they only contributed cash. In contrast, Susan’s holding period includes the holding period for the land she contributed since Susan held the land as either a capital or Section 1231 asset. c. Bar T receives a $50,000 tax basis in the land and will include Susan’s holding period as part of its holding period. d. Bar T must adopt a calendar year end because all of its members have calendar year ends. e. Bar T may adopt either the cash or accrual method of accounting. It may generally use the cash method because it does not have a corporate member. However, it must use the accrual method in accounting for its inventory related transactions (i.e., the hybrid method). f. The member’s separately stated items are listed on lines (2), (3), (11), and (13) in the table below. Note that LeBron and Dennis have self-employment income under the proposed regulations because they are responsible for some of Bar T’s debt. Susan clearly has self-employment income under the proposed regulations because she works full time in the enterprise. Description Total LeBron Dennis Susan Explanation (1) Members’ Initial Tax Basis $216,667 $216,667 $16,667 See part a. above (2) Dividends $1,200 $400 $400 $400 $1,200 × 33.33% (3) Municipal bond interest $300 $100 $100 $100 $300 × 33.33% (4) Deemed cash contribution from accounts payable $40,000 $20,000 $20,000 Accounts payable are only allocated to LeBron and Dennis because they guaranteed them (5) Cash distributions ($3,000) ($1,000) ($1,000) ($1,000) (6) Deemed cash distribution to Susan for mortgage repayment ($9,000) ($9,000) Because Susan was originally allocated the first $50,000 of the nonrecourse mortgage, the repayment goes to reduce her share of the debt. (7) Member’s Tax Basis Before Loss Allocation $236,167 $236,167 $7,167 Sum of (1) through (6) (8) Sales revenue $620,000 Less: (9) Cost of goods sold (380,000) (10) Operating expenses (670,000) (11) Guaranteed payments (10,000) (12) Ordinary Business Loss ($440,000) ($146,667) ($146,667) ($146,667) [Sum of (8) through (11)] × 33.33% (13) Self-employment loss ($430,000) ($146,667) ($146,667) ($136,667) Line (12) + $10,000 guaranteed payment for Susan only. Members’ ending Tax basis $89,500 $89,500 $0 (7)+ (12) but not less than zero. Susan must carry over $7,167 + ($146,667) or ($139,500) of ordinary loss. g. As indicated in the table in part f. above, the ending basis for LeBron is $89,500, the ending basis for Dennis is $89,500, and the ending basis for Susan is $0. h. Generally, the members’ at-risk amounts will be less than the amount of their tax bases to the extent they are allocated nonrecourse debt that is not qualified nonrecourse financing. In this case, the members’ at-risk amounts are the same as their tax bases in part g. because the nonrecourse mortgage is qualified nonrecourse financing and the accounts payable are treated as recourse debt (i.e., they are guaranteed by LeBron and Dennis). i. As indicated in the table in part f. above, the $146,667 loss allocated to LeBron and Dennis is not limited by their tax bases. However, given the facts provided, they cannot deduct their losses currently, and each has a $146,667 passive activity loss carryforward because they are not material participants in the enterprise. As for Susan, her $146,667 loss is initially limited to her $7,167 tax basis leaving her with a $139,500 loss carryforward. Because Susan is a material participant in Bar T and her sources of business losses for the year are less than her sources of business income plus $255,000, she may deduct the $7,167 loss in the current year. Solution 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