Chapter 21 Dispositions of Partnership Interests and Partnership Distributions Discussion Questions 1. [LO 1] Joey is a 25 percent owner of Loopy LLC. He no longer wants to be involved in the business. What options does Joey have to exit the business? Joey’s two most common options are to sell or exchange his interest in the LLC to a third party or to have the LLC liquidate his interest. Joey may also exchange his interest for corporate stock, give the interest away, or transfer the interest upon his death. 2. [LO 1] Compare and contrast the aggregate and entity approaches for a sale of a partnership interest. Under the aggregate approach, the disposition of a partnership interest represents a sale of the partner’s share of each of the partnership assets. This approach would require complex tax rules because the partner would need to allocate the sales proceeds among the different assets and determine the character of the gain or loss from each asset. Under the entity approach, the sale of a partnership interest would be very similar to the sale of corporate stock. The partner would recognize capital gain or loss on the sale based on the difference between the sales price and the partner’s tax basis in the partnership interest. 3. [LO 1] What restrictions might prevent a partner from selling his partnership interest to a third party? Partnership agreements may specify whether a partner may voluntarily leave the partnership. If the agreement does not allow for a voluntary withdrawal, the partnership may need to be dissolved to effect the termination. A partnership agreement may also specify whether a partner may assign his interest to a third party. This will determine if the partner is free to sell his interest to someone other than the existing partners. 4. [LO 1] Explain how a partner’s debt relief affects his amount realized in a sale of partnership interest. When a partner sells his partnership interest, often he is relieved of his partnership debt obligations. As is the case in sales of other assets, debt relief will increase the amount realized in the sale of a partnership interest. Because the partner’s outside basis includes his share of the partnership debt, this negates the effect of debt on the gain or loss of the partnership interest sale. 5. [LO 1] Under what circumstances will the gain or loss on the sale of a partnership interest be characterized as ordinary rather than capital? To the extent that a gain or loss on the sale of a partnership interest is attributable to certain ordinary income assets held by the partnership, the gain or loss is ordinary. §751(a) defines the assets for which the gain or loss will be treated as ordinary. 6. [LO 1] What are “hot assets” and why are they important in the sale of a partnership interest? Hot assets are assets defined in §751 that will re-characterize the portion of a gain or loss on the sale of a partnership interest as ordinary. The two categories of hot assets under §751(a) are unrealized receivables and inventory items. Unrealized receivables include rights to receive payment for goods delivered or to be delivered, rights for services rendered or to be rendered, and items treated as ordinary income if the partnership were to sell the item at its fair market value. Under §751(a) inventory items include property held for sale to customers in the ordinary course of business and assets that are not capital assets or §1231 assets that would produce ordinary income if sold by the partnership. To the extent that a seller realizes any amounts from the sale of his partnership interest that are attributable to these unrealized receivables or inventory items, the gain or loss will be classified as ordinary. 7. [LO 1] For an accrual-method partnership, are accounts receivable considered unrealized receivables? Explain. No. For accrual-method taxpayers, accounts receivable are not considered unrealized receivables because these amounts have already been realized and recognized as ordinary income. 8. [LO 1] Can a partnership have unrealized receivables if it has no accounts receivable? The definition of unrealized receivables is broad enough to encompass assets other than accounts receivable. §751(a) also includes assets that are NOT capital assets or §1231 assets that would produce ordinary income if sold by the partnership. Items such as depreciation recapture are also classified as unrealized receivables. Thus, a partnership can have unrealized receivables without having accounts receivable. 9. [LO 1] How do hot assets affect the character of gain or loss on the sale of a partnership interest? Hot assets cause a portion of the gain or loss on the sale of a partnership interest to be classified as ordinary rather than capital. 10. [LO 1] Under what circumstances can a partner recognize both gain and loss on the sale of a partnership interest? A partner may recognize both gain and loss on the sale of a partnership interest in the situation where a partner’s share of the unrealized gain in hot assets is greater than his total gain or loss on the sale of his partnership interest. 11. [LO 1] Absent any special elections, what effect does a sale of partnership interest have on the partnership? When one partner sells his partnership interest, the sale generally has no effect on the partnership. However, if the partnership interest that is sold is large, the sale may terminate the partnership for tax purposes. 12. [LO 1] {Research} Generally, a selling partner’s capital account carries over to the purchaser of the partnership interest. Under what circumstances will this not be the case? In the case where the selling partner contributed built-in loss property to the partnership, the buyer’s capital account will be reduced by the amount of the inherent loss at the partnership interest sale date. This treatment ensures that only the partner that contributed the built-in loss property to the partnership benefits from the inherent loss. 13. [LO 2] What distinguishes operating from liquidating distributions? Operating or current distributions are made to partners whose interests in the partnership continue after the distribution. Liquidating distributions terminate a partner’s interest in the partnership. 14. [LO 3] Under what circumstances will a partner recognize a gain from an operating distribution? In general, partners do not recognize gain or loss from operating distributions. However, when the partnership distributes money that exceeds a partner’s basis in her partnership interest, she will recognize a gain equal to the excess. In this situation, the partner is unable to adjust the basis in property distributed in order to defer the gain. 15. [LO 3] Under what circumstances will a partner recognize a loss from an operating distribution? A partner never recognizes loss from operating distributions. 16. [LO 3] In general, what effect does an operating distribution have on the partnership? The partnership does not generally recognize gain or loss for tax purposes when making an operating distribution. This contrasts with the tax treatment of corporate distributions in which the corporation recognizes gain or loss on distributions of property other than cash. 17. [LO 3] If a partner’s outside basis is less than the partnership’s inside basis in distributed assets, how does the partner determine his basis of the distributed assets in an operating distribution? If only money is distributed, the partner recognizes gain equal to the difference between the money distributed and the basis in the partnership interest. If the partnership distributes money and hot assets only, the partner defers gain recognition by reducing the basis of the hot assets distributed. The partner first allocates basis to the assets received equal to the partnership basis (allocating to money first). Then, the partner allocates the required decrease (difference between the partnership’s basis in the distributed assets and the partner’s outside basis) to the assets with unrealized depreciation. Finally, the partner allocates any remaining required decrease to the distributed assets in proportion to their adjusted bases. If the partnership distributes other property in addition to money and hot assets, the partner defers gain by reducing the basis in the other property distributed. The partner first assigns basis to the distributed assets equal to the partnership basis. The partner then allocates the required decrease to property other than money, inventory and unrealized receivables to the extent of the unrealized depreciation in the assets. Finally, the partner allocates any remaining required decrease to the other property in proportion to the assets’ adjusted bases. 18. [LO 4] Under what conditions will a partner recognize gain in a liquidating distribution? In the situation in which a partnership distributes only money and the amount exceeds the partner’s basis in her partnership interest, she will recognize a gain equal to the excess. In this situation, the partner is unable to adjust the basis in property distributed in order to defer the gain. 19. [LO 4] Under what conditions will a partner recognize loss in a liquidating distribution? When a distribution includes only cash, unrealized receivables, and inventory and the partner’s basis in his partnership interest is greater than the sum of the bases of the distributed assets, the partner will recognize a loss on a liquidating distribution. The partner treats the loss as a capital loss. 20. [LO 4] Describe how a partner determines his basis in distributed assets in cases in which a partnership distributes only money, inventory, and/or unrealized receivables in a liquidating distribution. If the partner’s basis in the partnership interest is greater than the basis of the distributed assets, the partner is unable to defer loss without changing the character of the loss. Therefore, the partner assigns a basis to the money, inventory, and unrealized receivables equal to the partnership’s basis in the distributed assets. The partner recognizes a capital loss equal to the remaining outside basis after the distributed assets have been assigned a carryover basis. If the partner’s basis in the partnership interest is less than the basis of the distributed assets, the partner defers gain recognition by reducing the basis of the hot assets distributed. The required decrease is equal to the difference between the partnership’s basis in the distributed assets and the partner’s outside basis. The partner allocates the required decrease to assets with unrealized depreciation first to eliminate existing losses in the distributed assets. Then the partner allocates any remaining required decrease to the distributed assets in proportion to their adjusted bases. 21. [LO 4] How does a partner determine his basis in distributed assets when the partnership distributes other property in addition to money and hot assets? If the partner’s basis in the partnership interest is greater than the basis of the distributed assets, the partner defers loss recognition by increasing the basis of the other property distributed. The required increase equals the difference between the partner’s outside basis and the partnership bases in the distributed assets. The partner first assigns a basis to the distributed assets equal to the partnership’s basis. The partner then allocates the required increase to the other property with unrealized appreciation. Finally, the partner allocates any remaining required increase to the other property in proportion to their fair market values. When the partnership distributes other property in addition to money, inventory, and unrealized receivables and the partner’s basis in the partnership interest is less than the basis of the distributed assets, the partner defers gain by reducing the basis in the other property distributed. The partner first assigns basis to the distributed assets equal to the partnership basis. The partner then allocates the required decrease to property other than money, inventory and unrealized receivables to the extent of the unrealized depreciation in the assets. Finally, the partner allocates any remaining required decrease to the other property in proportion to the assets’ adjusted bases. 22. [LO 5] {Planning} SBT Partnership distributes $5,000 cash and a parcel of land with a fair market value of $40,000 and a $25,000 basis to the partnership to Sam (30 percent partner). What factors must Sam and SBT consider in determining the tax treatment of this distribution? SBT and Sam must determine if the distribution is an operating or a liquidating distribution. Sam may not recognize a loss if the distribution is an operating distribution. Sam must also consider whether the distributed cash exceeds her basis in SBT. If so, she will recognize a gain on the distribution. SBT and Sam must also consider whether the distribution is a disproportionate distribution. To the extent that SBT has any hot assets, this distribution to Sam will represent a disproportionate distribution that can cause both Sam and SBT to recognize gain or loss on the distribution. Finally, Sam must determine her basis in the distributed land. Her determination of basis will depend on whether the distribution is an operating or a liquidating distribution. 23. [LO 5] Discuss the underlying concern to tax policy makers in distributions in which a partner receives more or less than his share of the partnership hot assets. If a partner’s share of hot assets is altered from a distribution, the primary concern is that the partner will convert capital gain or loss to an ordinary gain or loss. Thus, if a partnership has §751 property, the partnership must determine whether any distribution is proportionate or disproportionate. If the distribution is disproportionate, the tax rules require the application of a complex set of rules to ensure that the distribute partner recognizes a proportionate amount of ordinary and capital gain or loss commensurate to his interest in the partnership. Most operating distributions are proportionate and do not require the application of these rules. However, in cases where a partner is reducing his interest in the partnership (e.g., from 40 percent to 25 percent) or in liquidating distributions, the application of these rules is more commonplace. 24. [LO 5] In general, how do the disproportionate distribution rules ensure that partners recognize their share of partnership ordinary income? Basically, the tax rules require partners to treat disproportionate distributions as though three separate events occur. To illustrate, assume a partner’s interest in the partnership hot assets decreases as a result of the distribution. First, the partner is treated as though a hypothetical current distribution of the hot assets occurs. The partner is treated as though she receives the fair market value of the decrease in hot assets as a current distribution. Next, the rules require the partner to act as though she has sold the hot assets received in the hypothetical distribution to the partnership for an amount equal to the amount of the cold assets that her interest increases. Finally, the last step is to treat the amount of the distribution that is proportionate as a normal distribution. 25. [LO 6] {Planning} Why would a new partner who pays more for a partnership interest than the selling partner’s outside basis want the partnership to elect a special basis adjustment? An investor who pays more for a partnership interest than the seller’s outside basis essentially has already paid for his share of any appreciation in the partnership’s assets. However, absent a special basis adjustment, the buyer inherits the seller’s inside basis, which does not reflect the gain realized on the sale of the partnership interest. As the partnership sells the appreciated assets, the partners recognize their share of the gain from the appreciated assets as a part of their annual distributive share of the partnership income. This means that the buyer pays for the appreciation of the assets as part of the acquisition price of the partnership interest AND recognizes gain again when the partnership recognizes income from the sale of the appreciated assets. Only upon the sale of his partnership interest will the over-taxation resolve itself. The special basis adjustment under §754 eliminates the disparity between a new partner’s inside and outside basis. 26. [LO 6] List two common situations that will cause a partner’s inside and outside basis to differ. The most common situations in which discrepancies between inside and outside bases occur are following sales of partnership interests and following distributions in which a partner receives more or less than her share of the inside basis in the partnership property. 27. [LO 6] Explain why a partnership might not want to make a §754 election to allow special basis adjustments. Once the partnership makes a §754 election, the election is binding for all future sales and distributions. The election may only be revoked with the consent of the IRS. The election may not always be advantageous and limits the partnership’s and partners’ ability to tax plan. For example, if partnership assets decrease in value, an incoming partner will have a downward basis adjustment. 28. [LO 6] When might a new partner have an upward basis adjustment following the acquisition of a partnership interest? A new partner will have an overall upward basis adjustment when he purchases an interest in the partnership for an amount greater than his inside basis immediately following the acquisition. Although the overall basis adjustment results in an increase in asset bases, it is possible for some individual asset bases to decrease if the asset has declined in value while held by the partnership. 29. [LO 6] When are partnerships mandated to adjust the basis of their assets (inside basis) when a partner sells a partnership interest or receives a partnership distribution? Two cases require a mandatory special basis adjustment. First, when a partnership has a substantial built-in loss at the time of a sale of a partnership interest, the adjustment is required. A substantial built-in loss occurs when the partnership’s adjusted basis in its assets exceeds the fair market value of the assets by more than $250,000. The second case where a mandatory special basis adjustment must be made is for distributions where there is a substantial basis reduction. A substantial basis reduction exists if the negative adjustments from a special basis adjustment exceed $250,000. Recall that negative basis adjustments only occur in liquidating distributions. Problems 30. [LO 1] Jerry is a 30 percent partner in the JJM Partnership when he sells his entire interest to Lucia for $56,000 cash. At the time of the sale, Jerry’s basis in JJM is $32,000. JJM does not have any debt or hot assets. What is Jerry’s gain or loss on the sale of his interest? Jerry will determine his gain or loss as the difference between the amount realized on the sale and his basis in the partnership interest. 31. [LO 1] Joy is a 30 percent partner in the JOM Partnership when she sells her entire interest to Hope for $72,000 cash. At the time of the sale, Joy’s basis in JOM is $44,000 (which includes her $6,000 share of JOM liabilities). JOM does not have any hot assets. What is Joy’s gain or loss on the sale of her interest? 32. [LO 1] Allison, Keesha, and Steven each own an equal interest in KAS Partnership, a calendar-year-end, cash-method entity. On January 1 of the current year, Steven’s basis in his partnership interest is $27,000. During January and February, the partnership generates $30,000 of ordinary income and $4,500 of tax-exempt income. On March 1, Steven sells his partnership interest to Juan for a cash payment of $45,000. The partnership has the following assets and no liabilities at the sale date: a. Assuming KAS’s operating agreement provides for an interim closing of the books when partners’ interests change during the year, what is Steven’s basis in his partnership interest on March 1 just prior to the sale? b. What are the amount and character of Steven’s recognized gain or loss on the sale? c. What is Juan’s initial basis in the partnership interest? d. What is the partnership’s basis in the assets following the sale? c. Juan’s basis in his partnership interest is his cost of $45,000. d. The partnership has a basis in its assets equal to the assets before the sale. The sale does not affect the partnership’s basis in its assets. 33. [LO 1] Grace, James, Helen, and Charles each own an equal interest in GJHC Partnership, a calendar-year-end, cash-method entity. On January 1 of the current year, James’ basis in his partnership interest is $62,000. For the taxable year, the partnership generates $80,000 of ordinary income and $30,000 of dividend income. For the first 5 months of the year, GJHC generates $25,000 of ordinary income and no dividend income. On June 1, James sells his partnership interest to Robert for a cash payment of $70,000. The partnership has the following assets and no liabilities at the sale date: a. Assuming GJHC’s operating agreement provides that the proration method will be used to allocate income or loss when partners’ interests change during the year, what is James’ basis in his partnership interest on June 1 just prior to the sale? b. What are the amount and character of James’ recognized gain or loss on the sale? c. If GJHC uses an interim closing of the books, what are the amount and character of James’ recognized gain or loss on the sale? 34. [LO 1] At the end of last year, Lisa, a 35 percent partner in the five-person LAMEC Partnership, has an outside basis of $60,000 including her $30,000 share of LAMEC debt. On January 1 of the current year, Lisa sells her partnership interest to MaryLynn for a cash payment of $45,000 and the assumption of her share of LAMEC’s debt. a. What are the amount and character of Lisa’s recognized gain or loss on the sale? b. If LAMEC has $100,000 of unrealized receivables as of the sale date, what are the amount and character of Lisa’s recognized gain or loss? c. What is MaryLynn’s initial basis in the partnership interest? 35. [LO 1] Marco, Jaclyn, and Carrie formed Daxing Partnership (a calendar-year-end entity) by contributing cash 10 years ago. Each partner owns an equal interest in the partnership and has an outside basis in his/her partnership interest of $104,000. On January 1 of the current year, Marco sells his partnership interest to Ryan for a cash payment of $137,000. The partnership has the following assets and no liabilities as of the sale date: The equipment was purchased for $240,000 and the partnership has taken $60,000 of depreciation. The stock was purchased seven years ago. a. What are the hot assets [I.R.C. §751(a)] for this sale? b. What is Marco’s gain or loss on the sale of his partnership interest? c. What is the character of Marco’s gain or loss? d. What is Ryan’s inside and outside bases in the partnership on the date of the sale? a. The hot assets include the potential depreciation recapture in the equipment ($45,000), the accounts receivable, and the inventory. c. To the extent Marco realizes any amounts attributable to hot assets, his gain will be classified as ordinary. If Daxing sold its assets for their fair market value at the sale date, the ordinary gain would be as follows: Marco recognizes $23,000 of ordinary income and $10,000 capital gain from the sale of his interest in Daxing. d. Ryan has an outside basis equal to his cost of the partnership interest: $137,000. His inside basis is equal to Marco’s inside basis before the sale: $104,000. 36. [LO 1] Franklin, Jefferson, and Washington formed the Independence Partnership (a calendar-year-end entity) by contributing cash 10 years ago. Each partner owns an equal interest in the partnership and has an outside basis in his partnership interest of $104,000. On January 1 of the current year, Franklin sells his partnership interest to Adams for a cash payment of $122,000. The partnership has the following assets and no liabilities as of the sale date: The equipment was purchased for $240,000 and the partnership has taken $60,000 of depreciation. The stock was purchased seven years ago. a. What is Franklin’s overall gain or loss on the sale of his partnership interest? b. What is the character of Franklin’s gain or loss? b. To the extent Franklin realizes any amounts attributable to hot assets, his gain will be classified as ordinary. If Independence sold its assets for their fair market value at the sale date, the ordinary gain would be as follows: Franklin recognizes $23,000 of ordinary income and a $5,000 capital loss from the sale of his interest in Independence. Note: The Independence Partnership uses the cash method of accounting under Rev Proc 2001-10, which permits certain small businesses to treat inventory items as non-incidental materials and supplies. 37. [LO 1] Travis and Alix Weber are equal partners in the Tralix Partnership, which does not have a §754 election in place. Alix sells one-half of her interest (25 percent) to Michael Tomei for $30,000 cash. Just before the sale, Alix’s basis in her entire partnership interest is $75,000 including her $30,000 share of the partnership liabilities. Tralix’s assets on the sale date are as follows: a. What are the amount and character of Alix’s recognized gain or loss on the sale? b. What is Alix’s basis in her remaining partnership interest? c. What is Michael’s basis in his partnership interest? d. What is the effect of the sale on the partnership’s basis in the assets? a. Amount realized: To the extent Alix realizes any amounts attributable to hot assets, her gain will be classified as ordinary. If Tralix sold its assets for their fair market value at the sale date, the ordinary gain would be as follows: Alix recognizes $15,000 of ordinary income and a $7,500 capital loss from the sale of half of her interest in Tralix. b. Alix has a remaining basis in Tralix of $37,500 ($75,000 x 50%). c. Michael has an outside basis in his 25% interest in Tralix equal to his $30,000 cash payment plus his share of Tralix's debt $15,000 ($30,000 × 50%) for a total basis of $45,000. d. The sale has no effect on Tralix’s basis in its assets. 38. [LO 1] Newton is a one-third owner of ProRite Partnership. Newton has decided to sell his interest in the business to Betty for $50,000 cash plus the assumption of his share of ProRite’s liabilities. Assume Newton’s inside and outside basis in ProRite are equal. ProRite shows the following balance sheet as of the sale date: What are the amount and character of Newton’s recognized gain or loss? To the extent Newton realizes any amounts attributable to hot assets, his gain will be classified as ordinary. If ProRite sold its assets for their fair market value at the sale date, the ordinary gain would be as follows: Newton recognizes $15,000 of ordinary income and a $(3,333) capital loss from the sale of his interest in ProRite. 39. [LO 3] Coy and Matt are equal partners in the Mat coy Partnership. Each partner has a basis in his partnership interest of $28,000 at the end of the current year, prior to any distribution. On December 31, each receives an operating distribution. Coy receives $10,000 cash. Matt receives $3,000 cash and a parcel of land with a $7,000 fair market value and a $4,000 basis to the partnership. Mat coy has no debt or hot assets. a. What is Coy’s recognized gain or loss? What is the character of any gain or loss? b. What is Coy’s ending basis in his partnership interest? c. What is Matt’s recognized gain or loss? What is the character of any gain or loss? d. What is Matt’s basis in the distributed property? e. What is Matt’s ending basis in his partnership interest? a. Coy does not recognize any gain or loss on the current distribution. b. Coy reallocates his basis in Mat coy to the cash in an amount equal to the distribution, $10,000. His remaining basis in Mat coy is $18,000 ($28,000 - 10,000). c. Matt does not recognize any gain or loss on the current distribution. d. Matt takes a carryover basis in the distributed property. The cash has a basis equal to $3,000 and the land has a basis equal to $4,000 (Macey’s basis in the land). e. Matt reallocates his basis in Mat coy to the cash in an amount equal to the distribution, $3,000. Matt takes a carryover basis in the land and allocates $4,000 of his Mat coy basis to the land. His remaining basis in Mat coy is $21,000 ($28,000 - 3,000 – 4,000). 40. [LO 3] Justin and Lauren are equal partners in the PJenn Partnership. The partners formed the partnership seven years ago by contributing cash. Prior to any distributions, the partners have the following bases in their partnership interests: On December 31 of the current year, the partnership makes a pro-rata operating distribution of: a. What are the amount and character of Justin’s recognized gain or loss? b. What is Justin’s remaining basis in his partnership interest? c. What are the amount and character of Lauren’s recognized gain or loss? d. What is Lauren’s basis in the distributed assets? e. What is Lauren’s remaining basis in her partnership interest? a. Because Justin receives only money in the distribution and the distribution exceeds his basis in the partnership, he must recognize a gain on the current distribution. Justin calculates his gain as the difference between his basis in the partnership and the distribution. b. Justin allocates his entire outside basis to the basis in the money received and therefore he has a zero basis remaining in his partnership interest. c. Lauren does not recognize any gain or loss on the current distribution. d. Lauren takes a carryover basis in the assets distributed. She receives $18,000 cash so she reduces her basis in PJenn by this amount. This leaves an outside basis of $4,000 ($22,000 – 18,000). Lauren assigns a basis of $2,000 to the property distributed, as this is PJenn’s basis. e. Lauren’s basis in PJenn following the distribution is $2,000, determined as follows: 41. [LO 3] Adam and Alyssa are equal partners in the PartiPilo Partnership. The partners formed the partnership three years ago by contributing cash. Prior to any distributions, the partners have the following bases in their partnership interests: On December 31 of the current year, the partnership makes a pro-rata operating distribution of: a. What are the amount and character of Adam’s recognized gain or loss? b. What is Adam’s remaining basis in his partnership interest? c. What are the amount and character of Alyssa’s recognized gain or loss? d. What is Alyssa’s basis in the distributed assets? e. What is Alyssa’s remaining basis in her partnership interest? a. Because Adam receives only money in the distribution and the distribution exceeds his basis in PartiPilo, he must recognize a gain on the current distribution. Adam calculates his gain as the difference between his basis in the partnership and the distribution. b. Adam allocates his entire outside basis to the basis in the money received and therefore he has a zero basis remaining in his partnership interest. c. Alyssa does not recognize any gain or loss on the current distribution. d. Alyssa reduces her basis in PartiPilo by $8,000 for the cash distribution, which leaves her with a basis of $4,000. Alyssa assigns a $4,000 basis to the property (a reduction of $2,000). e. Alyssa reduces her basis in Partipilo to $-0- after the distribution. 42. [LO 3] Karen has a $68,000 basis in her 50 percent partnership interest in the KD Partnership before receiving a current distribution of $6,000 cash and land with a fair market value of $35,000 and a basis to the partnership of $18,000. a. What are the amount and character of Karen’s recognized gain or loss? b. What is Karen’s basis in the land? c. What is Karen’s remaining basis in her partnership interest? a. Karen does not recognize any gain or loss on the current distribution. b. Karen takes a carryover basis in the land equal to $18,000. c. Karen’s outside basis in the partnership after the distribution is as follows: 43. [LO 3] Pam has a $27,000 basis (including her share of debt) in her 50 percent partnership interest in the Meddoc partnership before receiving any distributions. This year Meddoc makes a current distribution to Pam of a parcel of land with a $40,000 fair market value and a $32,000 basis to the partnership. The land is encumbered with a $15,000 mortgage (the partnership’s only liability). a. What are the amount and character of Pam’s recognized gain or loss? b. What is Pam’s basis in the land? c. What is Pam’s remaining basis in her partnership interest? a. Pam must consider the effects of debt changes before determining the effects of the distribution. Pam is treated as making a net contribution of cash to the partnership of $7,500, the difference between the full mortgage of $15,000 and her allocated share of the debt of $7,500. This deemed contribution increases Pam’s basis in Meddoc from $27,000 to $34,500. Pam doesn’t recognize gain from the distribution of the land because she is not receiving cash in excess of the basis of her partnership interest. She doesn’t recognize any loss because the distribution is not a liquidating distribution. b. Pam takes a carryover basis in the land equal to $32,000. c. Pam’s outside basis in the partnership after the distribution is as follows: 44. [LO 3] {Research} Two years ago, Kimberly became a 30 percent partner in the KST Partnership with a contribution of investment land with a $10,000 basis and $16,000 fair market value. On January 2 of this year, Kimberly has a $15,000 basis in her partnership interest and none of her pre-contribution gain has been recognized. On January 2, Kimberly receives an operating distribution of a tract of land (not the contributed land) with a $12,000 basis and an $18,000 fair market value. a. What are the amount and character of Kimberly’s recognized gain or loss on the distribution? b. What is Kimberly’s remaining basis in KST after the distribution? c. What is KST’s basis in the land Kimberly contributed after Kimberly receives this distribution? a. Kimberly recognizes $3,000 capital gain as a result of the distribution. Under §737, Kimberly must recognize her pre-contribution gain to the extent that the fair market value of the distributed property exceeds her partnership interest before the distribution (but after reduction for any money distributions). Kimberly recognizes the lesser of her unrecognized pre-contribution gain ($6,000) or the excess of the fair market value of the distributed land over her pre-distribution outside basis ($3,000; $18,000 FMV – 15,000 outside basis). b. If a partner recognizes a pre-contribution gain under §737, the recognized gain increases the partner’s outside basis. Kimberly’s outside basis in the partnership after the distribution is as follows: c. KST’s basis in the land that Kimberly originally contributed is $13,000 determined as follows: Kimberly’s recognized gain under §737 increases the partnership’s basis in the property that originated the pre-contribution gain. 45. [LO 4] Rufus is a one-quarter partner in the Adventure Partnership. On January 1 of the current year, Adventure distributes $13,000 cash to Rufus in complete liquidation of his interest. Adventure has only capital assets and no liabilities at the date of the distribution. Rufus’ basis in his partnership interest is $18,500. a. What are the amount and character of Rufus’s recognized gain or loss? b. What are the amount and character of Adventure’s recognized gain or loss? c. If Rufus’s basis is $10,000 at the distribution date rather than $18,500, what are the amount and character of Rufus’s recognized gain or loss? a. Rufus recognizes a capital loss on the distribution of $5,500 representing the difference between his basis in Adventure of $18,500 and the cash distribution of $13,000. He must recognize a loss because he receives only cash in the distribution and the cash is less than his basis in his partnership interest. b. Adventure does not recognize any gain or loss on the distribution. c. If Rufus’s outside basis is $10,000 prior to the distribution, he must recognize a capital gain of $3,000 on the distribution as follows: 46. [LO 4] The Taurin Partnership (calendar-year-end) has the following assets as of December 31 of the current year: On December 31, Taurin distributes $15,000 of cash, $10,000 (FMV) of accounts receivable, and $40,000 (FMV) of inventory to Emma (a 1/3 partner) in termination of her partnership interest. Emma’s basis in her partnership interest immediately prior to the distribution is $40,000. a. What are the amount and character of Emma’s recognized gain or loss on the distribution? b. What is Emma’s basis in the distributed assets? c. If Emma’s basis before the distribution was $55,000 rather than $40,000, what is Emma’s recognized gain or loss and what is her basis in the distributed assets? a. Emma does not recognize any gain or loss on the distribution. b. Because Taurin distributes only cash, accounts receivable, and inventory, and the adjusted bases of the property distributed is greater than her basis in the partnership, Emma will simply reduce the bases of the hot assets. Emma uses a three-step process to allocate her basis to the distributed property. 1. Emma assigns a basis of $15,000 (1/3 of $45,000) to the cash, $5,000 to the accounts receivable (1/3 of 15,000) and $27,000 (1/3 of $81,000) to the inventory. Since the sum ($47,000) exceeds her basis in Taurin, she has a required decrease of $7,000 ($47,000 – 40,000). 2. Emma allocates the required decrease to the assets with unrealized depreciation. Since there are no distributed assets with unrealized depreciation, Emma skips this step. 3. Emma decreases the basis of the assets in proportion to their relative adjusted bases. Accounts receivable: Basis allocation = $7,000 ($5,000/$32,000) = $1,094 Inventory: Basis allocation = $7,000 ($27,000/$32,000) = $5,906 After completing the allocation Emma’s basis in the distributed assets are: c. If Emma’s basis in Taurin were $55,000 rather than $40,000, she recognizes a capital loss on the distribution. Emma calculates her loss of $8,000 as the difference between her basis in her partnership interest ($55,000) and the sum of the adjusted bases of the distributed assets ($47,000). Her basis in the distributed assets is equal to the partnership’s basis in the assets. The carryover bases allow Emma to retain the character of the inherent gains in the accounts receivable and inventory she receives in the liquidating distribution. 47. [LO 4] Melissa, Nicole, and Ben are equal partners in the Opto Partnership (calendar-year-end). Melissa decides she wants to exit the partnership and receives a proportionate distribution to liquidate her partnership interest on January 1. The partnership has no liabilities and holds the following assets as of January 1: Melissa receives one-third of each of the partnership assets. She has a basis in her partnership interest of $25,000. a. What are the amount and character of any recognized gain or loss to Melissa? b. What is Melissa’s basis in the distributed assets? c. What are the tax implications (amount and character of gain or loss and basis of assets) to Melissa if her outside basis is $11,000 rather than $25,000? d. What are the amount and character of any recognized gain or loss from the distribution to Opto? a. Melissa does not recognize any gain or loss on the distribution. Rather, she will adjust the basis of the distributed assets. b. Melissa uses a three-step process to determine her basis in the distributed property. 1. Melissa assigns a basis of $6,000 (1/3 of $18,000) to the cash, $-0- to the accounts receivable, $2,500 (1/3 of $7,500) to the stock investment, and $10,000 (1/3 of $30,000) to the land. The sum ($18,500) of the inside basis is less than her outside basis so she will need to allocate the excess basis to the basis in the distributed assets other than §751(a) property. Melissa has a remaining basis of $6,500 to allocate ($25,000 - $18,500) among the distributed capital assets. 2. Melissa allocates the required increase to the capital assets with unrealized appreciation to the extent of the appreciation. Melissa allocates $1,500 ($4,000 {1/3 × $12,000} - $2,500 {1/3 × $7,500}) to the stock investment and $2,000 ($12,000 {1/3 × $36,000} - $10,000 {1/3 × $30,000}) to the land to bring the bases of these assets to their fair market value. This leaves $3,000 remaining to be allocated. 3. Melissa increases the basis of the capital assets in proportion to their relative fair market values. Stock investment: Basis allocation = $3,000 ($4,000/$16,000) = $750 Land: Basis allocation = $3,000 ($12,000/$16,000) = $2,250 After completing the allocation Melissa’s basis in the distributed assets are: c. If Melissa’s basis in Opto were $11,000 rather than $25,000, she will need to decrease the basis in the stock investment and land she receives in liquidation of her partnership interest. She will calculate her basis in the distributed assets as follows: 1. First she assigns a carryover basis to the distributed assets. Since the sum of the adjusted bases of the distributed assets ($18,500) is greater than her basis in Opto ($11,000), she has a required decrease of $7,500. 2. Melissa allocates her required decrease to the other property with unrealized depreciation. Since none of the distributed assets have any unrealized depreciation, Melissa skips this step. 3. In the final step, Melissa allocates the required decrease to the capital assets in proportion to their adjusted bases. Stock investment: Basis allocation = $7,500 ($2,500/$12,500) = $1,500 Land: Basis allocation = $7,500 ($10,000/$12,500) = $6,000 After completing the allocation Melissa’s basis in the distributed assets are: d. Opto does not recognize any gain or loss on the liquidating distribution. 48. [LO 4] {Planning} Lonnie Davis has been a general partner in the Highland Partnership for many years and is also a sole proprietor in a separate business. To spend more time focusing on his sole proprietorship, he plans to leave Highland and will receive a liquidating distribution of $50,000 in cash and land with a fair market value of $100,000 (tax basis of $120,000). Immediately before the distribution, Lonnie’s basis in his partnership interest is $350,000, which includes his $50,000 share of partnership debt. The Highland Partnership does not hold any hot assets. a. What are the amount and character of any gain or loss to Lonnie? b. What is Lonnie’s basis in the land? c. What are the amount and character of Lonnie’s gain or loss if he holds the land for 13 months as investment property and then sells it for $100,000? d. What are the amount and character of Lonnie’s gain or loss if he places the land into service in his sole proprietorship and then sells it 13 months later for $100,000? e. Do your answers to parts (c) and (d) above suggest a course of action that would help Lonnie to achieve a more favorable tax outcome? a. Lonnie does not recognize a gain because the $50,000 of actual cash he receives and debt relief of $50,000 are not greater than the tax basis in his interest of $350,000. Further, Lonnie does not recognize a loss on the liquidating distribution because he receives assets other than cash and/or hot assets in the distribution (i.e. the land). b. Lonnie’s basis in the land is equal to his basis in his partnership interest of $350,000 reduced by the actual cash distribution of $50,000 and the deemed cash distribution of $50,000 from debt relief leaving a basis of $250,000 in the land. c. Lonnie will recognize a long-term capital loss of $150,000 or $100,000 less his $250,000 substituted basis in the land. The loss is a long-term capital loss because Lonnie held the land as a capital asset for more than one year. d. Lonnie will recognize a Section 1231 loss of $150,000 ($100,000 less his $250,000 substituted basis in the land). The loss is a Section 1231 loss because Lonnie held the land as a trade or business asset for more than one year making the land Section 1231 property. Losses from the sale or exchange of Section 1231 property are treated as ordinary assuming there are no gains from the sale of other Section 1231 in the same tax year. e. Given the choice, Lonnie should consider holding the land as a trade or business asset rather than as a capital asset. In doing so, he will convert what would have otherwise been a capital loss into an ordinary loss if he also avoids selling other trade or business property at a gain in the same tax year. Note that if Lonnie had simply received an all cash liquidating distribution, he would also have recognized a $150,000 capital loss at the time of the distribution. 49. [LO 4] AJ is a 30 percent partner in the Trane Partnership, a calendar-year-end entity. On January 1, AJ has an outside basis in his interest in Trane of $73,000, which includes his share of the $50,000 of partnership liabilities. Trane generates $42,000 of income during the year and does not make any changes to its liabilities. On December 31, Trane makes a proportionate distribution of the following assets to AJ to terminate his partnership interest: a. What are the tax consequences (gain or loss, basis adjustments) of the distribution to Trane? b. What are the amount and character of any recognized gain or loss to AJ? c. What is AJ’s basis in the distributed assets? d. If AJ sells the inventory four years after the distribution for $70,000, what are the amount and character of his recognized gain or loss? a. Trane does not recognize any gain or loss on the distribution. Trane’s basis in its remaining property is unaffected by the distribution if it is assumed that a §754 election is not in effect. b. First, AJ must determine his basis in Trane as of the distribution. At the beginning of the year, his basis is $73,000. Trane earns $42,000 during the period of which 30 percent is allocable to AJ. He increases his basis by his $12,600 ($42,000 30%) share of Trane’s income. Thus, as of the distribution, AJ’s basis in Trane is $85,600 ($73,000 + $12,600). Next, AJ accounts for the deemed cash distribution relating to his reduction of Trane debt. His 30 percent share of Trane’s $50,000 debt is $15,000. AJ reduces his outside basis by the $15,000 leaving a basis of $70,600 to allocate to the distributed assets. He does not recognize any gain or loss on the distribution because the deemed cash distribution does not exceed his basis in Trane. c. AJ calculates his basis in the distributed assets as follows: 1. First he assigns a carryover basis to any distributed hot assets. Inventory $55,000 2. AJ allocates his basis in his partnership interest to the distributed land after reducing it by the basis allocated to the distributed inventory ($70,600 – $55,000). Land 15,600 d. AJ calculates the gain or loss on the subsequent sale of inventory as The gain is an ordinary gain under §735(a)(2) because AJ sells the inventory within five years of the distribution. 50. [LO 4] David’s basis in the Jimsoo Partnership is $53,000. In a proportionate liquidating distribution, David receives cash of $7,000 and two capital assets: (1) Land A with a fair market value of $20,000 and a basis to Jimsoo of $16,000 and (2) Land B with a fair market value of $10,000 and a basis to Jimsoo of $16,000. Jimsoo has no liabilities. a. How much gain or loss will David recognize on the distribution? What is the character of any recognized gain or loss? b. What is David’s basis in the distributed assets? c. If the two parcels of land had been inventory to Jimsoo, what are the tax consequences to David (amount and character of gain or loss and basis in distributed assets)? a. David does not recognize any gain or loss on the distribution. b. Since Jimsoo’s basis of the distributed assets is less than David’s outside basis and David receives other property in the distribution, David must adjust the basis of the land in order to defer his loss. He follows a three-step process to adjust the bases: 1. David assigns a basis of $7,000 to the cash, $16,000 to the first parcel of land, and $16,000 to the second parcel of land. The sum ($39,000) of the bases is less than David’s basis in Jimsoo so he will need to allocate the excess outside basis to the basis in the distributed assets. David has a remaining outside basis of $14,000 (required increase) to allocate ($53,000 - $39,000) between the two parcels of land. 2. David allocates the required increase to the land with unrealized appreciation to the extent of the appreciation. David therefore increases the basis of the first parcel land by $4,000 to $20,000. This leaves $10,000 remaining to be allocated. 3. David increases the basis of the two parcels of land in proportion to their relative fair market values. Land A: Basis allocation = $10,000 ($20,000/$30,000) = $6,667 Land B: Basis allocation = $10,000 ($10,000/$30,000) = $3,333 After completing the allocation David’s bases in the distributed assets are: c. If the land were inventory to Jimsoo, David would not be allowed to increase the basis of the distributed land. Instead, David would recognize a capital loss of $14,000 on the distribution. David would have a basis of $16,000 in each parcel of land (carryover basis). 51. [LO 4] Megan and Matthew are equal partners in the J & J Partnership (calendar year-end entity). On January 1 of the current year, they decide to liquidate the partnership. Megan’s basis in her partnership interest is $100,000 and Matthew’s is $35,000. The two partners receive identical distributions with each receiving the following assets: a. What are the amount and character of Megan’s recognized gain or loss? b. What is Megan’s basis in the distributed assets? c. What are the amount and character of Matthew’s recognized gain or loss? d. What is Matthew’s basis in the distributed assets? a. Megan does not recognize any gain or loss on the distribution although she realizes a loss on the distribution. b. Megan uses a three-step process to determine her basis in the distributed property. 1. Megan assigns a carryover basis of $30,000 to the cash, $5,000 to the inventory, and $500 to the land. The sum ($35,500) of the basis is less than her basis in J & J so she will need to allocate the excess basis to the basis in the distributed assets other than §751(a) property (i.e., the land). Megan has a remaining basis of $64,500 to allocate ($100,000 - $35,500) among the cold assets. 2. Megan allocates the required increase to the cold assets with unrealized appreciation to the extent of the appreciation. Therefore, Megan increases the basis of the land by $500 to $1,000. This leaves $64,000 remaining to be allocated. 3. Since Megan only receives one cold asset in the distribution, all of the required increase must increase the basis of the land. Megan increases the basis of the land by the remaining $64,000 required increase. After completing the allocation, Megan’s bases in the distributed assets are: The application of these rules demonstrates the sometimes strange results from the allocation process. In this case Megan now has a parcel of land with a basis of $65,000 even though its fair market value is only $1,000. When she sells the land, she will recognize a capital loss equal to the difference between the sale price and her extremely large basis. c. Matthew does not recognize any gain or loss on the distribution although he realizes a gain on the distribution. d. Matthew defers his gain through a basis decrease to the land he receives in liquidation of his partnership interest. He calculates his basis in the distributed assets as follows: 1. First he assigns a carryover basis to the distributed assets. Since the sum of the adjusted bases of the distributed assets ($35,500) is greater than his basis in J & J ($35,000), Matthew has a required decrease of $500. 2. Matthew allocates his required decrease to the cold assets property with unrealized depreciation. Since none of the distributed assets have unrealized depreciation, Matthew skips this step. 3. In the final step, Matthew allocates the entire $500 required decrease to the land. After completing the allocation, Matthew’s bases in the distributed assets are: 52. [LO 4] Bryce’s basis in the Markit Partnership is $58,000. In a proportionate liquidating distribution, Bryce receives the following assets: a. How much gain or loss will Bryce recognize on the distribution? What is the character of any recognized gain or loss? b. What is Bryce’s basis in the distributed assets? a. Bryce does not recognize any gain or loss on the distribution. b. Since Markit’s basis of the distributed assets is less than Bryce’s outside basis and Bryce receives other property in the distribution, Bryce must adjust the basis of the land in order to defer his loss. He follows a three-step process to adjust the bases. 1. Bryce assigns a basis of $8,000 to the cash, $20,000 to land A, and $20,000 to land B. The sum ($48,000) of the bases is less than Bryce’s basis in Markit so he will need to allocate the excess outside basis to the basis in the distributed assets. Bryce has a remaining outside basis of $10,000 (required increase) to allocate ($58,000 - $48,000) among the two parcels of land. 2. Bryce allocates the required increase to the land with unrealized appreciation to the extent of the appreciation. The combined appreciation in the two parcels of land is $30,000 ($25,000 for land A and $5,000 for land B). This exceeds Bryce’s required increase ($10,000). Therefore in this step Bryce must allocate the required increase to the two parcels of land based on their relative appreciation. Land A: Basis allocation = $10,000 ($25,000/$30,000) = $ 8,333 Land B: Basis allocation = $10,000 ($5,000/$30,000) = $ 1,667 3. All of Bryce’s outside basis has been allocated in Step 2, so he does not need to use Step 3 of the allocation process. After completing the allocation Bryce’s bases in the distributed assets are: 53. [LO 4] {Planning} Danner Inc. has a $395,000 capital loss carryover that will expire at the end of the current tax year if it is not used. Also, Danner Inc. has been a general partner in the Talisman Partnership for three years and plans to end its involvement with the partnership by receiving a liquidating distribution. Initially, all parties agreed that Danner Inc.’s liquidating distribution would include $50,000 in cash and land with a fair market value of $400,000 (tax basis of $120,000). Immediately before the distribution, Danner’s basis in its partnership interest is $150,000, which includes its $100,000 share of partnership debt. The Talisman Partnership does not hold any hot assets. a. What are the amount and character of any gain or loss to Danner Inc.? b. What is Danner Inc.’s basis in the land? c. Can you suggest a course of action that would help Danner Inc. to avoid the expiration of its capital loss carryover? a. Because Danner Inc.’s actual cash distribution of $50,000 and deemed cash distribution of $100,000 from the relief of debt do not exceed Danner Inc.’s tax basis of $150,000 prior to the distribution, it does not recognize any gain. Further, it does not recognize any loss because it received property other than cash and/or hot assets in the distribution. b. Danner Inc.’s basis in the land is zero because the $50,000 of actual cash and $100,000 deemed cash distributed reduce its tax basis in Talisman from $150,000 to zero. c. Danner Inc. could ensure that it fully utilizes its capital loss carryover prior to expiration by selling the land it receives in the distribution for $400,000 and recognizing a capital gain of $400,000 ($400,000 selling price for the land less the zero basis in land). If Danner Inc. needs land for its business operations, it could take the proceeds from the land sale and purchase a different piece of land suitable for its needs. Alternatively, Danner Inc. could suggest that the partnership distribute $400,000 of additional cash in lieu of the land if the partnership has the cash available. Under this scenario, Danner Inc.’s actual cash proceeds of $450,000 and deemed cash proceeds of $100,000 would again trigger a capital gain of $400,000 since the actual and deemed cash distributed would exceed Danner Inc.’s $150,000 basis in Talisman by $400,000. 54. [LO 1, LO 5] {Planning} Bella Partnership is an equal partnership in which each of the partners has a basis in his partnership interest of $10,000. Bella reports the following balance sheet: a. Identify the hot assets if Toby decides to sell his partnership interest. Are these assets “hot” for purposes of distributions? b. If Bella distributes the land to Toby in complete liquidation of his partnership interest, what tax issues should be considered? a. Hot assets under §751(a) for purposes of sales or exchanges of partnership interests include unrealized receivables and inventory items. Bella’s hot assets include the inventory with a basis of $20,000 and fair market value of $30,000. For purposes of distributions, §751(b) defines hot assets as substantially appreciated inventory and unrealized receivables. Inventory is considered substantially appreciated if its fair market value exceeds its basis by more than 120%. The value of Bella’s inventory does exceed its basis by more than 120 percent (100 $30,000/$20,000 = 150%) and is thus considered hot asset for purposes of distributions. b. If Bella distributes the land to Toby in complete liquidation of his partnership interest, the distribution would be a disproportionate distribution because Toby receives more than his share of the cold assets. In this case, Toby would be treated as having sold his share of hot assets to Bella in exchange for cold assets. The deemed sale would generate ordinary income to Toby. 55. [LO 1, LO 6] Michelle pays $120,000 cash for Brittany’s one-third interest in the Westlake Partnership. Just prior to the sale, Brittany’s basis in Westlake is $96,000. Westlake reports the following balance sheet: a. What are the amount and character of Brittany’s recognized gain or loss on the sale? b. What is Michelle’s basis in her partnership interest? What is Michelle’s inside basis? c. If Westlake were to sell the land for $264,000 shortly after the sale of Brittany’s partnership interest, how much gain or loss would the partnership recognize? d. How much gain or loss would Michelle recognize if the land were sold for 264,000? e. Suppose Westlake has a §754 election in place. What is Michelle’s special basis adjustment? How much gain or loss would Michelle recognize on a subsequent sale of the land in this situation? a. Amount realized: Brittany’s gain will be capital because Westlake has no hot assets. b. Michelle has an outside basis in her interest in Westlake equal to her $120,000 cash payment. Michelle steps into Brittany’s shoes and takes an inside basis of $96,000. c. Westlake would realize and recognize the following on the sale of the land: d. Michelle would recognize a one-third share of the partnership gain on the sale of the land: 1/3 $72,000 = $24,000. Because a §754 election was not in effect, Michelle must recognize her full share of the gain on the sale of the land despite having paid fair value for her interest in the partnership. Her basis will increase when she recognizes the gain and only when she sells her Westlake interest will she recognize an offsetting loss. e. Michelle’s special basis adjustment is the difference between her outside basis and inside basis in Westlake and is calculated as follows: The entire special basis adjustment relates to the appreciated land. Michelle would not recognize any gain on the subsequent sale of the land if Westlake has a §754 election in effect when she purchased her interest. 56. [LO 1, LO 6] Elaine pays $40,000 cash for Martha’s one-third interest in the Lakewood Partnership. Just prior to the sale, Martha’s basis in Lakewood is $140,000. Lakewood reports the following balance sheet: Assume the land had been purchased several years ago and the partnership does not have a §754 election in place. a. What are the amount and character of Martha’s recognized gain or loss on the sale? b. What is Elaine’s basis in her partnership interest? c. If Lakewood were to sell the land for $70,000 shortly after the sale of Martha’s partnership interest, how much gain or loss would Elaine recognize? a. Amount realized: Martha’s loss will be capital because Lakewood has no hot assets. b. Elaine has an outside basis in her interest in Lakewood equal to her $40,000 cash payment to purchase her interest. c. In this instance, the partnership has a substantial built-in loss because the total $420,000 inside basis of the its assets exceeds the total fair market value of its assets of $120,000 by more than $250,000. Thus, even without a §754 election in place, Elaine would have a negative §754 adjustment equal to her 1/3 share of the $300,000 unrealized loss on the land at the time of her purchase of $100,000. When Lakewood sells the land, it would realize the following: Absent her mandatory $100,000 negative §754 basis adjustment, Elaine would recognize a one-third share of the realized partnership loss on the sale of the land: 1/3 $(300,000) = $(100,000). However, her $100,000 share of the realized loss from the sale of land must be reduced by her mandatory negative §754 adjustment of $100,000 leaving her with no loss to recognize from the sale of the land. In this way, the mandatory §754 basis adjustment applied to Elaine ensures that she is unable to duplicate Martha’s loss from the sale of her interest. 57. [LO 4, LO 6] Cliff’s basis in his Aero Partnership interest is $11,000. Cliff receives a distribution of $22,000 cash from Aero in complete liquidation of his interest. Aero is an equal partnership with the following balance sheet: a. What are the amount and character of Cliff’s recognized gain or loss? What is the effect on the partnership assets? b. If Aero has a §754 election in place, what is the amount of the special basis adjustment? a. Cliff receives only money in the distribution and the amount exceeds his outside basis, so Cliff will recognize a capital gain on the liquidation of $11,000. Aero does not recognize any gain or loss and the distribution does not affect Aero’s basis in its assets. b. If Aero has a §754 election in effect at the time of the distribution, Aero will have a special basis adjustment. The adjustment will be $11,000 basis increase since Cliff recognized a gain on the liquidating distribution. 58. [LO 4, LO 6] Erin’s basis in her Kiybron Partnership interest is $3,300. Erin receives a distribution of $2,200 cash from Kiybron in complete liquidation of her interest. Kiybron is an equal partnership with the following balance sheet: a. What are the amount and character of Erin’s recognized gain or loss? What is the effect on the partnership assets? b. If Kiybron has a §754 election in place, what is the amount of the special basis adjustment? a. Erin receives only money in the distribution and the amount is less than her outside basis, so Erin will recognize a capital loss on the liquidation of $1,100. Kiybron does not recognize any gain or loss and the distribution does not affect Kiybron’s basis in its assets. b. If Kiybron has a §754 election in effect at the time of the distribution, Kiybron will have a special basis adjustment. The adjustment will be $1,100 and will be a basis decrease because Erin recognized a loss on the liquidating distribution. 59. [LO 4, LO 6] Helen’s basis in Haywood Partnership is $270,000. Haywood distributes all the land to Helen in complete liquidation of her partnership interest. The partnership reports the following balance sheet just before the distribution: a. What are the amount and character of Helen’s recognized gain or loss? What is the effect on the partnership assets? b. If Haywood has a §754 election in place, what is the amount of the special basis adjustment? a. Helen does not recognize any gain or loss on the distribution. Instead, she will simply adjust the basis in the distributed property to defer recognition of any gain or loss. Helen increases the basis in the land to $270,000. Haywood does not recognize any gain or loss and the distribution does not affect Haywood’s basis in its assets. b. If Haywood has a §754 election in effect at the time of the distribution, Haywood will have a special basis adjustment. The adjustment will equal $160,000 ($270,000 - $110,000) and will be a basis decrease because the basis of the property distributed to Helen was increased. Comprehensive Problems 60. Simon is a 30 percent partner in the SBD Partnership, a calendar year-end entity. As of the end of this year, Simon has an outside basis in his interest in SBD of $188,000, which includes his share of the $60,000 of partnership liabilities. On December 31, SBD makes a proportionate distribution of the following assets to Simon: a. What are the tax consequences (amount and character of recognized gain or loss, basis in distributed assets) of the distribution to Simon if the distribution is an operating distribution? b. What are the tax consequences (amount and character of recognized gain or loss, basis in distributed assets) of the distribution to Simon if the distribution is a liquidating distribution? c. Compare and contrast the results from parts (a) and (b). a. This distribution falls in the category of operating distributions that include property other than money. As such, Simon must allocate his outside basis to the distributed assets. First, Simon assigns basis ($40,000) to the money distributed. Next, he assigns basis equal to the inside basis ($55,000) of the inventory (hot asset). Finally, Simon assigns basis to the distributed land equal to the inside basis ($30,000). Simon does not recognize any gain or loss on the distribution because the cash distribution does not exceed his basis in SBD. His remaining outside basis is: b. Simon does not recognize a gain or loss if the distribution is a liquidating distribution. To determine the asset bases, Simon must first determine his allocable basis by considering the deemed cash distribution from the reduction of his debt: Simon calculates his basis in the distributed assets as follows: 1. First he assigns a carryover basis to the distributed assets. Since the sum of the adjusted bases of the distributed assets ($125,000) is less than his basis in SBD after the deemed cash distribution ($170,000), he has a required increase of $45,000. 2. Simon allocates his required increase to the other property with unrealized appreciation. Since the distributed land has unrealized appreciation of $15,000, Simon allocates this amount of the required increase to the land. Thus, at the end of this step, the basis in the land is $45,000. 3. In the final step, Simon allocates the remaining required increase $30,000 ($45,000 - $15,000) to the land. After completing the allocation Simon’s bases in the distributed assets are: c. Similar to the operating distribution result, Simon does not recognize a gain or loss if the distribution is a liquidating distribution. The determination of the bases of the distributed assets differs however between the operating and liquidating distributions: Simon’s basis in the inventory remains the same for both types of distributions because the tax rules prohibit any increases to hot assets in order to prevent the conversion of ordinary gain to capital gain. However, in the liquidating distribution, Simon must allocate his entire outside basis to the distributed assets resulting in a substantial increase to the basis of the other assets (land). 61. {Planning} Paolo is a 50 percent partner in the Capri Partnership and has decided to terminate his partnership interest. Paolo is considering two options as potential exit strategies. The first is to sell his partnership interest to the two remaining 25 percent partners, Giuseppe and Isabella, for $105,000 cash and the assumption of Paolo’s share of Capri’s liabilities. Under this option, Giuseppe and Isabella would each pay $52,500 for half of Paolo’s interest. The second option is to have Capri liquidate Paolo’s partnership interest with a proportionate distribution of the partnership assets. Paolo’s basis in his partnership interest is $110,000, including Paolo’s share of Capri’s liabilities. Capri reports the following balance sheet as of the termination date: a. If Paolo sells his partnership interest to Giuseppe and Isabella for $105,000, what are the amount and character of Paolo’s recognized gain or loss? b. Giuseppe and Isabella each has a basis in Capri of $55,000 before any purchase of Paolo’s interest. What are Giuseppe and Isabella’s basis in their partnership interests following the purchase of Paolo’s interest? c. If Capri liquidates Paolo’s partnership interest with a proportionate distribution of the partnership assets ($25,000 deemed cash from debt relief, $15,000 of actual cash, and half of the remaining assets), what are the amount and character of Paolo’s recognized gain or loss? d. If Capri liquidates Paolo’s interest, what is Paolo’s basis in the distributed assets? e. Compare and contrast Paolo’s options for terminating his partnership interest. Assume that Paolo’s marginal tax rate is 35 percent and his capital gains rate is 15 percent. a. Amount realized: To the extent Paolo realizes any amounts attributable to hot assets, his gain will be classified as ordinary. If Capri sold its assets for their fair market value at the sale date, the ordinary gain would be as follows: Paolo recognizes $15,000 of ordinary income and $5,000 capital gain from the sale of his interest in Capri. b. Giuseppe and Isabella will increase their bases in Capri by the cost of Paolo’s interest plus their increase in Capri’s allocable liabilities. Each partner will have an outside basis in Capri equal to $120,000 ($55,000 original basis + $52,500 additional investment + $12,500 additional debt). c. Paolo does not recognize any gain or loss on the distribution. Rather he adjusts the basis in the distributed assets. See answer d. d. In a proportionate distribution, Paolo will receive $25,000 of deemed cash from relief of his share of partnership debt, $15,000 of actual cash, and half of the remaining partnership assets. Paolo first reduces his basis for the deemed cash distribution relating to his reduction in Capri debt ($25,000) leaving an outside basis of $85,000 ($110,000 - $25,000). He determines his basis in the distributed assets as follows: Since the sum of the adjusted bases of the distributed assets ($85,000) is equal to his basis in Capri ($85,000), the distributed assets take a carryover basis. e. Under option 1 (sale of Paolo’s interest in Capri), Paolo must immediately recognize a gain of $20,000: $15,000 is ordinary income and $5,000 is capital gain. He has no future tax liability related to the transaction. The capital gain will be taxed at a maximum of 15 percent. Given Paolo’s ordinary marginal tax rate of 35 percent, he would have cash after tax of $99,000 [$105,000 – (15% $5,000) – (35% $15,000)] to invest in other projects as he wishes. Under option 2 (liquidation of Paolo’s interest), Paolo is able to defer any gain on the liquidation because he takes a carryover basis in the distributed assets. As he sells the assets, he will recognize gain or loss. If he holds onto the inventory for more than five years, Paolo will recognize a capital gain on the sale of the inventory rather than an ordinary gain. The potential downside is that Paolo only receives $15,000 actual cash in the distribution. His other proceeds are in the form of receivables (which bear some risk of default), inventory, and land. If Paolo were to immediately sell the distributed assets following the distribution, he would recognize $15,000 of ordinary income on the sale of the inventory and $5,000 capital gain on the sale of the land. He may incur additional costs to sell or collect on these assets. This option would leave Paolo with $99,000 after tax cash as follows: Note that under option 2, Paolo has the same after tax cash as under option 1 if he decides to sell the distributed assets immediately after the distribution. 62. {Tax Forms} Carrie D’Lake, Reed A. Green, and Doug A. Divot share a passion for golf and decide to go into the golf club manufacturing business together. On January 2, 2020, D’Lake, Green, and Divot form the Slice hook Partnership, a general partnership. Slice hook’s main product will be a perimeter-weighted titanium driver with a patented graphite shaft. All three partners plan to actively participate in the business. The partners contribute the following property to form Slice hook: Carrie had recently acquired the land with the idea that she would contribute it to the newly formed partnership. The partners agree to share in profits and losses equally. Slice hook elects a calendar year-end and the accrual method of accounting. In addition, Slice hook received a $1,500,000 recourse loan from Big Bank at the time the contributions were made. Slice hook uses the proceeds from the loan and the cash contributions to build a state-of-the-art manufacturing facility ($1,200,000), purchase equipment ($600,000), and produce inventory ($400,000). With the remaining cash, Slice hook invests $45,000 in the stock of a privately owned graphite research company and retains $55,000 as working cash. Slice hook operates on a just-in-time inventory system so it sells all inventory and collects all sales immediately. That means that at the end of the year, Slice hook does not carry any inventory or accounts receivable balances. During 2020, Slice hook has the following operating results: The partnership is very successful in its first year. The success allows Slice hook to use excess cash from operations to purchase $15,000 of tax-exempt bonds (you can see the interest income already reflected in the operating results). The partnership also makes a principal payment on its loan from Big Bank in the amount of $300,000 and a distribution of $100,000 to each of the partners on December 31, 2020. The partnership continues its success in 2021 with the following operating results: The operating expenses include a $1,800 trucking fine that one of their drivers incurred for reckless driving and speeding and meals expense of $6,000. By the end of 2021, Reed has had a falling out with Carrie and Doug and has decided to leave the partnership. He has located a potential buyer for his partnership interest, Indie Ruff. Indie has agreed to purchase Reed’s interest in Slice hook for $730,000 in cash and the assumption of Reed’s share of Slice hook’s debt. Carrie and Doug, however, are not certain that admitting Indie to the partnership is such a good idea. They want to consider having Slice hook liquidate Reed’s interest on January 1, 2022. As of January 1, 2022, Slice hook has the following assets: Carrie and Doug propose that Slice hook distribute the following to Reed in complete liquidation of his partnership interest: Slice hook has not purchased or sold any equipment since its original purchase just after formation. a. Determine each partner’s recognized gain or loss upon formation of Slice hook. b. What is each partner’s initial tax basis in Slice hook on January 2, 2020? c. Prepare Slice hook’s opening tax basis balance sheet as of January 2, 2020. d. Using the operating results, what are Slice hook’s ordinary income and separately stated items for 2020 and 2021? What amount of Slice hook’s income for each period would each of the partner’s receive? e. Using the information provided, prepare Slice hook’s page 1 and Schedule K to be included with its Form 1065 for 2020. Also, prepare a Schedule K-1 for Carrie. f. What are Carrie’s, Reed’s, and Doug’s bases in their partnership interest at the end of 2020 and 2021? g. If Reed sells his interest in Slice hook to Indie Ruff, what are the amount and character of his recognized gain or loss? What is Indie’s basis in the partnership interest? h. What is Indie’s inside basis in Slice hook? What effect would a §754 election have on Indie’s inside basis? i. If Slice hook distributes the assets proposed by Carrie and Doug in complete liquidation of Reed’s partnership interest, what are the amount and character of Reed’s recognized gain or loss? What is Reed’s basis in the distributed assets? j. Compare and contrast Reed’s options for terminating his partnership interest. Assume that Reed’s marginal tax rate is 35 percent and his capital gains rate is 15 percent. a. D'Lake Green Divot Recognized gain or loss on formation of Slice hook $ -0- $ -0- $ -0- b. D'Lake Green Divot Cash contributed - $400,000 $400,000 Basis in contributed land $460,000 Share of Debt {1/3 × ($60,000 mtg + $1,500,000 loan)} 520,000 520,000 520,000 Debt relief (60,000) Initial tax basis in Slice hook 920,000 920,000 920,000 c. Slice hook Balance sheet At Formation (January 2, 2020) Tax Basis Cash $ 2,300,000 Land 460,000 Total $ 2,760,000 Liabilities $ 1,560,000 Tax Capital: Carrie D'Lake 400,000 Reed A. Green 400,000 Doug A. Divot 400,000 Total $ 2,760,000 d. Slice hook Total Each Partner's share Ordinary Income: 2020 2021 2020 2021 Sales 1,126,000 1,200,000 375,333 400,000 Cost of goods sold (400,000) (420,000) (133,333) (140,000) Operating expenses (126,000) (124,200) (42,000) (41,400) Depreciation (105,000) (177,000) (35,000) (59,000) Interest expense (120,000) (96,000) (40,000) (32,000) Total ordinary income 375,000 382,800 125,000 127,600 Separately Stated Items: Qualified dividends 1,500 1,500 500 500 Tax-exempt interest 900 900 300 300 §179 expense (39,000) - (13,000) - Fines and penalties - (1,800) - (600) Meals Deductible Non-deductible - (3,000) (3,000) - (1,000) (1,000) e. Slice hook Partnership’s page 1 and Schedule K to be included with Form 1065 and Carrie’s Schedule K-1 are shown below: f. Outside Basis D'Lake Green Divot Initial tax basis (inc. debt) $ 920,000 $ 920,000 $ 920,000 Ordinary income 125,000 125,000 125,000 Dividends 500 500 500 Tax-exempt interest 300 300 300 §179 expense (13,000) (13,000) (13,000) Debt changes (100,000) (100,000) (100,000) Cash distributions (100,000) (100,000) (100,000) Basis at 12/31/20 $ 832,800 $ 832,800 $ 832,800 Ordinary income 127,600 127,600 127,600 Dividends 500 500 500 Tax-exempt interest 300 300 300 Fines and penalties (600) (600) (600) M&E (2,000) (2,000) (2,000) Basis at 12/31/21 958,600 958,600 958,600 g. Amount realized: To the extent Reed realizes any amounts attributable to hot assets, his gain will be classified as ordinary. If Slice hook sold its assets for their fair market value at the sale date, the ordinary gain from depreciation recapture would be as follows: Reed recognizes $89,000 of ordinary income from depreciation recapture on the equipment and $102,400 capital gain from the sale of his interest in Slice hook. Indie will take an outside basis in his Slice hook interest equal to his cash payment of $730,000 plus his 1/3 share of Slice hook’s liabilities of $420,000 for a total of $1,150,000. h. Indie’s inside basis is equal to Reed’s inside basis before the sale: $958,600 or one third of the total tax basis in all the partnership assets. Indie’s special basis adjustment would be the difference between his outside basis and inside basis (both net of liabilities) in Slice hook and is calculated as follows: The special basis adjustment relates to the investment in tax-exempt securities, equipment, building and land. If Slice hook were to make a §754 election, Indie would be allocated additional depreciation because of the increased basis in the equipment and building. In addition, if Slice hook were to sell the land, Indie would report less gain if Slice hook had a §754 election in effect when he purchased his interest. i. Reed does not recognize any gain or loss on the distribution. Rather he adjusts the basis in the distributed assets. Reed’s outside basis in Slice hook at the distribution is $958,600, including his $420,000 share of partnership liabilities. Reed will need to allocate this basis to the distributed assets. Reed first reduces his basis for the deemed cash distribution relating to his reduction in Slice hook debt ($420,000) leaving an outside basis of $538,600 ($958,600 - $420,000) to allocate to the distributed assets. He determines his basis in the distributed assets as follows: 1. First, he assigns a carryover basis to the distributed assets. Since the sum of the adjusted bases of the distributed assets ($641,000) is greater than his allocable basis in Slice hook ($538,600), Reed has a required decrease of $102,400. 2. The recapture potential inherent in the equipment should be assigned a basis of zero and treated as a hot asset. Reed reduces the basis in the cold assets (investment and equipment) distributed. The required decrease is allocated between the investment and equipment according to their relative tax basis amounts. Accordingly, the basis of investment should be reduced by $29,538 ($102,400 × $45,000/$156,000), and the basis of equipment should be reduced by $72,862 ($102,400 × $111,000/$156,000). After completing the allocation Reed’s bases in the distributed assets are: j. If Reed sells his interest to Indie, Reed must immediately recognize a gain of $191,400: $89,000 is ordinary income and $102,400 is capital gain. He has no future tax liability related to the transaction. The capital gain will be taxed at a maximum of 15 percent. Given Reed’s assumed ordinary marginal tax rate of 35 percent, he would have cash after tax of $683,490 [$730,000 – (15% $102,400) – (35% $89,000)] to invest in other projects as he wishes. Under his other alternative in which Slice hook distributes cash, stock, and equipment, Reed is able to defer any gain on the liquidation until the distributed assets are sold. However, as he sells the assets, he will recognize gain or loss. If Reed were to immediately sell the distributed assets, he would recognize a $29,538 capital gain on the investments ($45,000 FMV – $15,462 basis); and on the sale of the equipment he would recognize a gain of $161,862 ($200,000 FMV – $38,138 basis) of which $89,000 will be ordinary income due to depreciation recapture and $72,862 would be §1231 gain. This option would leave Reed with $683,490 after tax cash as follows: *After-tax cash from the sale of investments is $40,570 [$45,000 – (15% × $29,538)]. After-tax cash from the sale of the equipment is $157,920 [$200,000 – (15% × $72,862) – (35% × $89,000)], assuming the §1231 gain is taxed at capital gains rates. Note that under the second alternative, Reed’s after tax cash is the same as under the sale option. However, Reed may incur additional costs to sell these assets, which would reduce his after-tax cash. In addition, under the sale option, Carrie and Doug would have a new partner in their business. This might work out well if Indie agrees with the existing partners about how the business should run. Otherwise, this might generate some conflict between the partners. The partnership would retain all of its assets under this option so it would not incur any additional cost to replace the equipment that would be distributed to Reed under the distribution option. Under the distribution option, not only might Slice hook need to replace the distributed equipment but it would be left with only $391,800 of cash ($876,800 pre-distribution [given in problem] - $485,000 distribution). 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
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