Tax Accounting Chapter 21 "Partnerships"

33. for problem 32 a. Construct a B/S for SD LLC assuming that Drew's services are completed immediately after forming SD. The B/S should reflect the LLC's basis in the assets and FMV of these assets b. outline any planning opportunities that may minimize current taxation to any of the parties

a) Tax Basis: Assets: - Cash - 150k - Land - 100k - Land Improvements - 50k Sam's Capital - $100,000 Drew's Capital - $200,000 Capital/GAAP/FASB Assets: - Cash - 150k - Land - 200k - Land Improvements - 50k Sam's Capital - 200k Drew's Capital - 200k b) Drew could draw up the plan BEFORE FORMATION, and added $50,000 to the $100,000 basis of land. A completed plan would be considered "property," no portion of his LLC interest would be received in exchange for services if this were done

13) Discuss situations in which the partnership entity form might be more advantageous (or disadvantageous) than operating as a Subchapter C or S Corporation

Advantageous: - avoid double taxation - keep identity of income - easy formation - good to pass on loss to partners - good for taxpayers in low tax brackets - can consist of corporations, or people as partners (flexible: almost any entity can be part of a Partnership) - can't easily become a S-corp (certain criteria make S-corp more difficult to form) - entity will only exist for a short period of time - entity owners want to make special allocations of income, expenses, cash flow, etc. - the partnership generates net passive income which offsets passive losses of owners Disadvantages: - high tax bracket - unlimited liability (only for general partnership)

The Partner's Basis (Tax/IRS)

- the basis is usually a bigger number than the capital account - the partner's basis is their risk of loss. It is the IRS's perspective of what you have in the partnership - It includes: + book value of assets (would be FMV under capital account) + N/I - Dividends (withdrawals) - Disbursements + Debt (this is the biggest difference. A partner adds a percentage of the partnership's debts/liabilities to its basis that it is now responsible for!)

30. Mike and Melissa form the equal MM P/S. Mike contributes cash of $40,000 and land (FMV $100,000, adj basis $120,000) and Melissa contributes the assets of her sole proprietorship (FMV $140,000, adj basis $115,000). What are the tax consequences of the P/S formation to Mike, Melissa, and MM P/S?

- there are no immediate tax consequences (no taxable income/loss items) - Mike's Basis = $160,000 (40k + 120k) - Melissa's Basis = $115,000 - P/S Basis (outside basis) = $275,000 - Melissa has a built-in gain of $25,000 (140-115k) - Mike has a built in loss of $20,000 (100-120)

17) Henrietta transfers cash of $75,000 and equipment with a FMV of $25,000 (basis to her as sole proprietor, $10,000) in exchange for a 40% profit and loss interest worth $100,000 in a partnership. a) How much are Henrietta's realized and recognized gains? b) What is the amount of Henrietta's basis in her partnership interest? c) What is the partnership's basis in the contributed equipment?

a) - Realized gain of $15,000 (25,000 FMV - 10,000 basis) - Recognized gain of $0 b) $85,000 (75,000 cash + 10,000 equipment carryover basis) c) $10,000 - the carryover basis (Section 721)

28) Kenisha and Shawna form an LLC with a cash contribution of $360,000 from Kenisha and a property contribution (basis $380,000, fair market value of $360,000) from Shawna a) how much gain/loss does Shawna realize on transfer? recognize? b) what is Kenisha's basis in her LLC interest? c) what is Shawna's basis in her LLC interest? d) what basis does LLC take in property transferred by Shawna? e) are there more effective ways to structure the formation?

a) Shawna realizes $20,000 loss, but she recognizes $0 b) Kenisha's basis is $360,000 c) Shawna's basis is $380,000 carryover (built-in loss of $20,000) d) $380,000 carryover basis e) could have sold property first and recognized loss (by contributing property to the P/S, she won't get the loss. Instead she could sell the property first and get the loss)

20) When Padgett Properties LLC was formed, Nova contributed land (value of $200,000 and basis of $50,000) and $100,000 cash, and Oscar contributed cash of $300,000. Both members received a 50% interest in LLC profits and capital. a) How is the land recorded for book capital account purposes? b) What is Padgett's tax basis in the land? c) If Padgett sells the land several years later for $300,000, how much tax gain will Nova and Oscar report?

a) debit Cash for 100,000, debit Land for 200,000, and credit Nova Capital 300,000. - debit Cash 300,000, credit Oscar Capital 300,000 b) $50,000 carryover basis c) Nova will report $200,000 =150,000 built in gain + 50,000 (50% of 100,000 P/S gain). Oscar will report $50,000 gain

27) Emma and Laine form the equal P/S. Emma contributes cash of $100,000. Laine contributes property with an adjusted basis of $40,000 and a FMV of $100,000. a) How much gain, if any, must Emma recognize on the transfer? Laine? b) What is Emma's basis in her P/S interest? c) what is Laine's basis? d) what basis does the P/S take in the property transferred by Laine?

a) no gain recognized for either party b) $100,000 basis c) $40,000 substituted basis d) $40,000 carryover basis

Section 721

- refers to Tax (IRS) - for the Basis

31. Assume the same facts as #30, except that Mike sells his land to a 3rd party for $100,000 and then contributes that cash to the P/S in addition to the original $40,000 contribution. The P/S locates equivalent land that it purchases for $110,000. How do these changes affect the tax and economic result for Mike and P/S?

- Mike has a taxable transaction when he sells the assets to a 3rd party. He receives cash of $100,000 in exchange for assets with a basis of $120,000 and recognizes a $20,000 loss - When Mike contributes the $140,000 cash to the P/S, he recognizes no gain or loss and has a basis of $140,000 in his P/S interest. - The P/S would need to use $110,000 of Mike's cash contribution to acquire new equivalent land. In this situation, the tax result to Mike is improved ( he can recognize a $20,000 realized loss), but there is a $10,000 economic cost to the P/S when it acquires assets for $110,000 instead of $100,000 n

29. Liz and John formed the equal LJ Partnership on Jan 1 of the current year. Liz contributed $80,000 of cash and land with a FMV of $90,000 and an adjusted basis of $75,000. John contributed equipment with a FMV of $170,000 and an adjusted basis of $20,000. John had previously used the equipment in his sole proprietorship. a. How much gain/loss will Liz, John, and the P/S realize? b. How much gain/loss will Liz, John, and the P/S recognize? c. What bases will Liz and John take in their P/S interests? d. What bases will LJ take in the assets it receives? e. Are there any differences between inside & outside basis? Explain. f. How will the P/S depreciate any assets it receives from the partners?

a. Liz will realize a $15,000 gain (90k-75k). John will realize a $150,000 gain (170k-20k). The P/S will realize $340,000 gain (FMV of all property it receives) b. None will recognize gain/loss (under Section 721) c. Liz will take a $155,000 basis. John will take a $20,000 basis. d. The P/S will take a carryover basis in all the assets it receives (80k, 75k, 20k) e. No difference. The partners' outsides basis = $175,000 and the P/S basis in the assets = $175,000 f. The partnership will "step into John's shoes" in determining its depreciation expense. (on the $20,000 basis of equipment). It will use the remaining depreciable life and the same depreciation rates that John would have used

25) When Bruno's basis in his LLC interest is $150,000, he receives cash of $55,000, a proportionate share of inventory, and land in a distribution that liquidates both the LLC and his entire LLC interest. The inventory has a basis to the LLC of $45,000 and FMV of $48,000. The land's basis is $70,000 and the FMV is $60,000. How much gain/loss does Bruno recognize, and what is his basis in the inventory and land received in the distribution?

* Liquidating Distribution - dissolving a P/S is usually not taxed (there is no real cash flow) - Partners are taxed later, so IRS wants the basis to be SMALL - Pecking Order: 1st: Cash comes out 2nd: inventory and receivables 3rd: all other items Bruno does not recognize any gain or loss Instead, he plugs in a substituted basis for land - His basis for inventory is $45,000 - His basis for land is $50,000 (plugged in number to make basis = 0)

21) On June 1, 2015, Elisha and Ezra (equal partners) contribute property to form Double E Partnership. Elisha contributes cash of $200,000. Ezra contributes a building and land with an adjusted basis and fair market value of $340,000, subject to a liability of $140,000. The partnership borrows $20,000 to finance construction of a parking lot in front of the building. At the end of the first year, the accrual basis partnership owes $8200 in trade A/P. The partnership reported net income of $30,000 for the year, which they share equally. Assume Elisha and Ezra share equally in partnership liabilities. How much are their bases in the partnership interest?

- Elisha's Basis: 200,000 cash + 70,000 P/S liability for land + 10,000 liability + 4,100 liability + $15,000 NI = $299,100 - Ezra's Basis: 340,000 land, (140,000) liability taken over by P/S, + 70,000 P/S liability, + 10,000 liability, + 4,100 liability + 15,000 NI = $299,100

Capital Account - Section 704(b)

+ Beginning Balance - Contribution (FMV) + N/I - N/L - Withdrawal + Contributions + non-taxable income - non deductible expenses R/E CAN go negative

Basis Account - Section 721

+ Beginning Balance Contribution (old basis/carryover) + N/I - Withdrawals + Contributions + your share of Partnership liabilities (debt) - your share of Partnership liabilities (if decrease) - when partnership assumes your liability Your basis NEVER goes below zero!

18) On Jan 2 of the current year, Fenton and Myers form the FM LLC. Their contributions to the LLC are as follows. (From Fenton: Cash $50,000, A/R FMV $90,000, Inventory - adjusted basis $25,000 & FMV $60,000. From Myers: Cash $200,000) Within 30 days of formation, FM collects the receivables and sells the inventory for $60,000 cash. How much income does FM recognize from these transactions, and what is its character?

- A/R are only taxed/recognized once they are received. - Inventory only recognize the basis (amount paid) so that partners have to pay tax on the gain when inventory is sold - FM recognizes $90,000 of ordinary income upon collection of the cash basis Accounts Receivable, and $35,000 of ordinary income upon sale of inventory (FMV of $60,000 - $25,000) = $125,000 recognized income

2. What is the difference between a general partnership and a limited liability company? When might each type of entity be used? Why?

- General Partnership: personal assets can be used to pay partnership debt - LLC: personal assets cannot be used to pay partnership debt - most partnerships choose to start an LLC - General partnerships are usually used only for arrangements such as corporate joint ventures where the corporate partners are established with limited assets

14) What is the difference between the definition of a proportionate non-liquidating distribution and a proportionate liquidating distribution? What is the significance of the word proportionate?

- Proportionate Non-liquidating Distribution - the partnership makes a routine distribution to one or more partners that will remain partners in a continuing partnership. (simply pulling money out of your basis) - Proportionate Liquidating Distribution - either 1) the partnership itself liquidates and distributes all of its assets to the partners (you liquidate share of partnership and leave; remaining partners just split up the liquidating partner's interest proportionately) 2) a continuing partnership distributes assets to one or more partners in liquidation of those partnership interests "Proportionate" - refers to a distribution that DOES NOT CHANGE each partner's respective ownership of the partnership's ordinary income-producing assets (hot assets)

23) Heather sells land (adjusted basis $75,000; fair market value, $95,000) to a partnership in which she controls an 80% capital interest. The partnership pays her only $50,000 for the land. a) How much loss does Heather realize and recognize? b) If the P/S later sells the land to a 3rd party for $80,000, how much gain does that P/S realize and recognize?

- This is a sale that equals a related transaction because Heather owns more than 50% of P/S - She can't recognize a loss if she sells to herself - She must recognize a gain as ordinary income (ignore 95,000 FMV because she is selling land in a related transaction rather than contributing it to P/S) a) Heather realizes a $25,000 loss (75,000-50,000) - it is deferred; she cannot recognize a loss (only if sells it later) b) $5,00 gain recognized by P/S, $30,000 realized gain by P/S (Heather can offset her $25,000 deferred loss)

11. What is a partner's capital account? Describe how a partner's ending capital account balance is determined.

- a partner's capital account is a determination of the partner's financial interest in the partnership (GAAP/FASB) - The partner's capital account reflects contributions & distributions of cash/property to or from the partner. It accumulates the partner's share of increases/decreases from operations, including amounts that are otherwise tax-exempt or nondeductible. - even if capital accounts are determined on a tax basis, a partner's capital account will differ from a partner's basis in the partnership interest because the capital account does not include the partner's share of partnership liabilities - capital account is like a R/E statement (+N/I, -Div, +Contributions, -Disbursements) S/E = A-L - capital account is NOT THE SAME as the Basis

1. What is a partnership agreement? What types of provisions does it include?

- a partnership agreement is a legal binding document * Provisions include: - withdrawal agreement (when? how much? what form? - cash, car, stock, bonds, inventory) - ownership percentage/ capital percentage - profit/loss percentage - guaranteed payment (taxed like profit) - conditions for termination (cause, financial) - employees (provisions against family employees) - work hours (may stipulate that partners must work 40 hours a week on the premises) - personal use of partnership assets - if spouses can be paid as employee - hiring criteria (degree, hours, references) - firing criteria (a partnership agreement is an agreement among the partners regarding the rights & obligations of the partners, the allocation of partnership income and deductions, allocation and distribution of partnership cash flows, requirements for current and future capital contributions, conditions under which the partnership is terminated, etc.)

Do taxpayers want a bigger or smaller basis?

- almost always, a taxpayer wants a BIGGER basis - if the basis is bigger, the gain that will be taxable as a LTCG when you sell it will be smaller, so you pay LESS taxes

19) During 2016, the Tastee Partnership reported income before guaranteed payments of $92,000. Stella owns 90% profits interest and works 1,600 hours per year in the business. Euclid owns a 10% profits interest and performs no services for the partnership during the year. For services performed in 2016, Stella receives a "salary" of $6,000 per month (guaranteed payment). Euclid withdrew $10,000 from the partnership during the year. a) What is the amount of guaranteed payments made by the partnership during 2016? b) How much is the partnership's ordinary income after any deductions for guaranteed payments? c) How much income will Stella report? Euclid?

- guaranteed payment - give partner a salary. It comes before any partner gets a proportionate share a) $72,000 (6,000 X 12 guaranteed payment to Stella) b) $20,000 (92,000-72,000 guaranteed payment) of ordinary income c) Stella will report $90,000 (72,000 + 90% of 20,000). Euclid will report $2,000 (20,000 X 10%)

7. When can a partnership use the cash method of accounting?

- in 90% of situations, you can use the cash method of accounting for partnerships - however, you can't use cash basis for inventory/COGS (instead, use modified cash basis) - big corporations must use the accrual method for everything (partnership cannot use cash method if any partners are C-corps or is classified as a tax shelter)

Section 704(b)

- refers to GAAP/FASB - for Retained Earnings in Capital Accounts

5. How does a partnership calculate depreciation on property that is contributed by a partner? If the partnership incurs additional costs that must be capitalized, how are those costs treated?

- the partnership will depreciate the property in the same way that the partner depreciated it (use the carryover basis - partner's cost - rather than FMV) - additional costs would be treated using MACRS as a separate calculation. It is treated with a new basis and commences depreciation at the date the costs were incurred

Recognized Gains v. Realized Gains v. Unrealized Gains scenario

Land: FMV = $100,000 Cost = $20,000 - unrealized gain = $80,000 (before contributing) - realized gain (built-in gain) = $80,000 (after contributing land) - recognized gain = $0

36. In 2015, Tom and Missy form a P/S. Tom contributed land, and Missy contributed cash. The P/S incurred expenses of $30,000 for forming the entity and $60,000 for starting the business. It also paid $5,000 in transfer taxes for changing ownership of property to P/S name. The brokerage firm that sold the interests to the limited partners charged a 6% commission, which totaled $600,000. - The calendar year P/S started business in November 2015 (2 months). Describe how all these initial expenses are treated by the P/S

Organizational Expenses: (same rules for startup expenses) - you can expense the first $5,000 (if less than $50,000) - capitalize the remaining asset and divide by 180 months - amortize as a normal business expense Syndication Expenses - nothing can be deducted The first $5,000 of organization expenses are deducted. The remainder is amortized over 180 months (25,000X 2/180 = $278) = $5,278 of organizational costs could be deducted The first $5,000 of startup expenses can be deducted with a limit dollar for dollar of costs exceeding $50,000. No portion of the expense is currently deductible because it is over $55,000. Instead, the full amount is amortized over 180 months: (60,000X 2/180) = $667 of startup expenses deductible The $5,000 transfer tax is treated as a cost of acquiring the land and is added to the P/S basis in the land. The $600,000 of brokerage commissions is treated as a syndication cost of the P/S and these costs cannot be deducted

16) Enercio contributes $100,000 in exchange for a 40% interest in the calendar year ABC LLC, which is taxed as a partnership. In 2015, the LLC generates $80,000 of ordinary taxable income. Enercio withdrew $10,000 from the partnership during 2015. Enercio is taxed on what amount of the LLC's 2015 income? On how much of the $10,000 distribution will Enercio be taxed?

Partner's Basis: + 100,000 contribution + 32,000 ordinary income (40% X 80,000) - 10,000 withdrawal = 122,000 basis - Enercio will only be taxed on its proportion of the ordinary income: $32,000 (80,000 X 40%) - partners DO NOT PAY TAX ON WITHDRAWALS. You will only pay tax on a withdrawal if you withdraw more than your basis (take out more than you ever put in the partnership), and this will be taxed as a LTCG.

3. Describe how a partnership reports its income for tax purposes. Who makes most elections related to partnership income and deductions? What theory underlies this treatment?

Partnership: a partnership reports on From 1065 and K. It is not a taxable entity - the partners make income elections at the partnership level - entity theory - a partnership is a distinct separate entity - aggregate (conduit) theory - the income flows through to the partners - this theory justifies a partnership more, as the partnership is simply a flow-through entity for the partners (under the "entity" theory, the partnership files a return and makes most elections regarding the treatment of partnership items. Under the "aggregate" theory, the partnership does not calculate or pay any tax with the return)

26) Sweeney originally contributed $175,000 in cash for a 1/4 interest in the Gilbert LLC. During the time Sweeney was a member, his share of the income was $90,000 and he withdrew $75,000 cash. The LLC's liabilities are $80,000 of which Sweeney's share is $20,000. Sweeney sells his LLC interest to Jana for $225,000 cash, with Jana assuming his share of liabilities. How much is Sweeney's gain on the sale, and how much is Jana's adjusted basis for her LLC interest?

Sweeney's Basis: +175,000, +90,000, (75,000), +20,000 = $210,000 - Sweeney's gain on sale is $35,000 ($15,000 plus she takes over his 20,000 liability) - Jana's adjusted basis = $245,000 (225,000 + 20,000 liability that she took on)

32. Sam and Drew are equal partners in SD LLC formed on June 1. Sam contributed land that he inherited from his uncle in 2007. Sam's uncle purchased the land in 1982 for $30,000. The land was worth $100,000 when Sam's uncle died. The FMV of the land was $200,000 at the date contributed to LLC. Drew has significant experience developing real estate. After the LLC is formed, he will prepare a plan for developing the property and secure zoning approvals. Drew would normally bill a 3rd party $50,000 for these efforts. Drew will also contribute $150,000 of cash in exchange for his 50% interest in the LLC. The value of his 50% interest is $200,000. a. How much gain/income will Sam recognize on his contribution of the land? What is the character of gain/income recognized? b. What basis will Sam take in his LLC interest? c. How much gain/income will Drew recognize on the formation of the LLC? What is the character? d. What basis will Drew take in his LLC interest?

a) none b) Sam will take a basis of $100,000. Death is a taxable settlement, so the Uncle's estate will be taxed for the 70,000 gain (100,000-30,000). Thus, Sam must take the $100k adjusted basis. The basis a beneficiary takes in property received from an estate generally equals the FMV of the assets at the date of death. c) Drew will recognize $50,000 of ordinary income. Services do not constitute "property" for purposes of Section 721 non-recognition treatment. (The IRS never lets you defer taxes on service income) d) Drew takes a basis of $200,000 (150k cash contributed + 50k ordinary income recognized for services rendered to P/S ) Drew gets to add the $50,000 to the basis so that he isn't taxed on it twice