Chapter 13 Purchase or Inheritance Buyer/Beneficiary Side Outside Basis Purchase: Amount Paid to Seller + Share of Php. Debt

Transcription

1 Chapter 13 Purchase or Inheritance Buyer/Beneficiary Side 1 Outside Basis Purchase: Amount Paid to Seller + Share of Php. Debt 2

2 13-3 Example 13-1 S sells to B 3 In Year 1, A, C, and S form the ACS Limited Partnership. A and C each contribute $60,000 for a 40% general partnership interest. S contributes $30,000 for a 20% limited partnership interest. 4

3 The partnership purchases a building (on leased land) for $45,000 with the proceeds of a $45,000 nonrecourse loan from a bank. The partnership does not make an IRC sec. 754 election S (LP) is allocated $9,000 (20%) of the partnership nonrecourse debt of $45, The building is depreciated over 10 years straight-line (for simplicity)-- $4,500 per year. In years 1 through 10, the partnership incurs $195,000 of losses allocated as follows (no distributions): <$78,000> to GP A (40%) <$78,000> to GP C (40%) <$39,000> to LP S (20%) 6

4 None of the debt principal is repaid. Despite the annual operating losses, assume that, at the end of 10 years, the building has a fair market value of $135, ACS Partnership End of Year 10 Tax Basis FMV Cash $0 $0 Building Cost $45,000 Accum. Depr -$45,000 = Building Adj. Basis $0 $135,000 Total Assets $0 $135,000 Nonrecourse Debt $45,000 $45,000 O.B. A (40% GP) <$18,000> $36,000 $0 C (40% GP) <$18,000> $36,000 $0 S (20% LP) <$9,000> $18,000 $0 Total Debt + Capital $0 $135,000 8

5 Impact on Seller 9 Day 1, Year 11 S sells her entire 20% limited partnership interest to buyer, B, for $18,000. S s debt share on the date of sale is $9,000. S s outside basis is zero. 10

6 Example 2-1A S s Sale to B Amount Realized: Cash $18,000 Debt Relief $9,000 Total Amt. Realized $27,000 Outside Basis: Equity $0 Debt $0 Total Outside Basis -$0 Gain Recognized $27, S s capital gain or loss: = Pre-look-through capital gain $27,000 - S s share of section 1250 capital gain -$ 9,000 $9,000 = S s Residual Long-term capital gain $18,000 12

7 Impact on Buyer Outside basis = $27, ACS Partnership Tax Basis FMV Cash $0 $0 Building Cost $45,000 Accum. Depr -$45,000 = Building Adj. Basis $0 $135,000 Total Assets $0 $135,000 Non-recourse Debt $45,000 $45,000 O.B. A (40% GP) <$18,000> $36,000 $0 C (40% GP) <$18,000> $36,000 $0 Buyer (20% LP) <$9,000> $18,000 $27,000 Total Debt + Capital $0 $135,000 14

8 Alternate Rule: <$9,000> Cap. basis + $9,000 Debt + $27,000 Adjust.* =$27,000 B s O.B. *Buyer should keep a record. 15 No Change To Inside Basis Tax and Book 16

9 13-5 Death of Partner 17 Beneficiary Basis 13-5 Date-of-Death FMV + Share of Php. Debt - Share of IRD Php. assets 18

10 Example Same facts as Example 13-1 except S dies and daughter, B, inherits 19 ACS Partnership Tax Basis FMV Cash $0 $0 Building Cost $45,000 Accum. Depr -$45,000 = Building Adj. Basis $0 $135,000 Total Assets $0 $135,000 Non-recourse Debt $45,000 $45,000 O.B. A (40% GP) <$18,000> $36,000 $0 C (40% GP) <$18,000> $36,000 $0 B (20% LP) <$9,000> $18,000 $27,000 Total Debt + Capital $0 $135,000 20

11 Alternate Rule: 13-7 <$9,000> Cap. basis + $9,000 Debt + $27,000 Adjust.* =$27,000 B s O.B. *B should keep a record. 21 No Change To Inside Basis Tax and Book 22

12 13-8 Gift by Partner 23 Example Same facts as Example 13-1 except S gives her entire 20% LP interest to B her daughter. 24

13 13-8 Impact on Donor Bargain Sale Due To Donee Debt Assumption 25 Example 2-1C Bargain Sale to B Amount Realized: Cash $0 Debt Relief $9,000 Total Amt. Realized $9, Outside Basis: Equity $0 Debt $0 Basis Allocated To Sale -$0 Gain Recognized $9,000 Presumably only $3,000 (1/3) is IRC sec capital gain 26

14 Daughter s Basis 13-8 Outside basis = $9,000 Reg. sec says donee basis is greater of amount paid ($9,000) or donor basis ($0). 27 ACS Partnership Tax Basis FMV Cash $0 $0 Building Cost $45,000 Accum. Depr -$45,000 = Building Adj. Basis $0 $135,000 Total Assets $0 $135,000 Recourse Debt $45,000 $45,000 O.B. A (40% GP) <$18,000> $36,000 $0 C (40% GP) <$18,000> $36,000 $0 B (20% LP) <$9,000> $18,000 $9,000 Total Debt + Capital $0 $135,000 28

15 Alternate Rule: 13-8 <$9,000> Cap. basis + $9,000 Debt + $9,000 Adjust.* = $9,000 B s O.B. *Buyer should keep a record. 29 No Change To Inside Basis Tax and Book 30

16 Sec. 754 Election and Sec. 743(b) Adjustments Buyer s Sec. 743 Adjustment: O.B. > I.B. = Upward Adj I.B. > O.B. = Downward Adj. 31 Inside Basis Without Sec. 754 Election: No inside basis adjustment for buyer/beneficiary, unless mandatory. With Sec. 754 Election: Adjust inside basis with respect to the buyer/beneficiary 32

17 Sec. 743 Adjustment: O.B. > I.B. = I.B. > O.B. = Not a Sch. L common balance sheet adjustment 33 Example Same facts as Example 13-1 but focus on inside basis with and without an IRC sec. 754 election 34

18 Before S sells to B for $18,000: ACS Partnership End of Year 10 Tax Basis FMV Cash $0 $0 Building Cost $45,000 Accum. Depr -$45,000 = Building Adj. Basis $0 $135,000 Total Assets $0 $135,000 Recourse Debt $45,000 $45,000 O.B. A (40% GP) <$18,000> $36,000 $0 C (40% GP) <$18,000> $36,000 $0 S (20% LP) <$9,000> $18,000 $0 Total Debt + Capital $0 $135, Recall S s Gain on Sale to B Amount Realized: Cash $18,000 Debt Relief $9,000 Total Amt. Realized $27,000 Outside Basis: Equity $0 Debt $0 Total Outside Basis -$0 Gain Recognized $27,000 36

19 B, with IRC sec. 754 B gets a $27,000 upward special inside basis adjustment. B s K-1 would show MACRS depreciation on $27,000. No change in common balance sheet (Sch. L). 37 Same common balance sheet with or without 754 election ACS Partnership Tax Basis FMV Cash $0 $0 Building Cost $45,000 Accum. Depr -$45,000 = Building Adj. Basis $0 $135,000 Total Assets $0 $135,000 Recourse Debt $45,000 $45,000 O.B. A (40% GP) <$18,000> $36,000 $0 C (40% GP) <$18,000> $36,000 $0 Buyer (20% LP) <$9,000> $18,000 $27,000 Total Debt + Capital $0 $135,000 38

20 On these facts, even with the IRC sec. 754 election, because the IRC sec. 743(b) adjustment is not an adjustment to the common balance sheet assets, no IRC sec. 704(b) adjustment. (Reg. sec (b)-1(b)(2)(iv)(l) and (m)) (b) capital accounts are adjusted with a purchase or inheritance when the IRC sec. 743(b) adjustment is made to the common balance sheet basis under reg. sec (b)(1): A liquidating distribution to a partner with an unused IRC sec. 743(b) adjustment. Reg. sec (b)-1(b)(2)(iv)(m) 40

21 Same analysis with Beneficiary, B, following S s death: + $27,000 adjustment with IRC sec. 754 election 41 Similar analysis with Donee, B, following S s gift/bargain sale: + $9,000 adjustment with IRC sec. 754 election (the purchase portion) 42

22 Purchase v. Contribution 43 Example Partner A (1/3 GP) sells to Buyer For $22,000 No Sec. 754 Election 44

23 Assets: Tax Basis FMV Outside Before A Sells to Buyer Basis Cash $5,000 $5,000 Accounts Rec. $10,000 $10,000 Inventory 20,000 21,000 Depr. Real Prop. 20,000 $40,000 Total Assets $55,000 $76,000 Liabilities: $10,000 $10,000 Capital: A $15,000 $22,000 $18,333 B $15,000 $22,000 $18,333 C $15,000 $22,000 $18,333 Debt + Equity $55,000 $76, Impact on Selling Partner Capital Gain Absent Sec 751: Cash From Buyer. $22,000 Debt Relief $3,333 Total Amount Realized $25,333 Outside Basis: Tax Basis Cap Acct. $15,000 Debt Basis... $ 3,333 Total Outside Basis $18,333 Gain Without Sec. 751 $7,000

24 Seller s Sec 751 Ordinary Income or Loss: Share of the Inventory Inc. 333 Capital Gain or Loss: Gain Without Sec. 751 $7,000 - Share of the Inventory Inc. $333 = Sec Capital Gain (25%) $6,667 Summary of Seller s Tax Treatment: Ordinary Income = $ 333 Sec Cap Gain (25%) = $6,667 Buyer s outside basis is $25,333 ($22,000 (cost) + $3,333 (debt share)

25 Assets: Tax Basis FMV Outside Following Buyer s Purchase Basis Cash $5,000 $5,000 Accounts Rec. $10,000 $10,000 Inventory 20,000 21,000 Depr. Real Prop. 20,000 $40,000 Total Assets $55,000 $76,000 Liabilities: $10,000 $10,000 Capital: Buyer $15,000 $22,000 $25,333 B $15,000 $22,000 $18,333 C $15,000 $22,000 $18,333 Debt + Equity $55,000 $76, If, later, the inventory and real property were sold, how much of the $21,000 gain would be allocated to Buyer? $7,000 (33.3% x $21,000) An IRC sec. 754 election would have eliminated that gain! 50

26 Example Instead of a purchase from A, Buyer contributes $22,000 for a 25% Php. Interest 51 Balance Sheet Before Buyer Contributes $22,000: Assets: Tax Basis FMV O.B. Cash $5,000 $5,000 Accounts Rec. $10,000 $10,000 Inventory 20,000 21,000 Depr. Real Prop. 20,000 $40,000 Total Assets $55,000 $76,000 Liabilities: $10,000 $10,000 Capital: A $15,000 $22,000 $18,333 B $15,000 $22,000 $18,333 C $15,000 $22,000 $18,333 Debt + Equity $55,000 $76,000

27 After Buyer Contributes $22,000 for 25% Php. Int. Assets: Tax Basis FMV O.B. Cash $27,000 $27,000 Accounts Rec. $10,000 $10,000 Inventory 20,000 21,000 Depr. Real Prop. 20,000 $40,000 Total Assets $77,000 $98,000 Liabilities: $10,000 $10,000 Capital: A $15,000 $22,000 $17,500 B $15,000 $22,000 $17,500 C $15,000 $22,000 $17,500 Buyer $22,000 $22,000 $24,500 Debt + Equity $77,000 $98,000 Is Sec. 754 Relevant? No If, later, the inventory and real property were sold, how much of the $21,000 gain would be allocated to Buyer? None, per Sec. 704(c) or (b) 54

28 Buyer s IRC sec. 704(b) book and tax basis capital accounts are $22,000 (FMV) If permitted by the partnership agreement, the partnership can revaluation ALL partner IRC sec. 704(b) capital accounts. 55 After Book Cap Acct Revaluation Assets: Tax Book Basis O.B. Basis Cash $27,000 $27,000 Accounts Rec. $10,000 $10,000 Inventory 20,000 21,000 Depr. Real Prop. 20,000 $40,000 Total Assets $77,000 $98,000 Liabilities: $10,000 $10,000 Capital: A $15,000 $22,000 $17,500 B $15,000 $22,000 $17,500 C $15,000 $22,000 $17,500 Buyer $22,000 $22,000 $24,500 Debt + Equity $77,000 $98,000

29 Without Book Cap Acct Revaluation Assets: Tax Book Basis O.B. Basis Cash $27,000 $27,000 Accounts Rec. $10,000 $10,000 Inventory 20,000 20,000 Depr. Real Prop. 20,000 $20,000 Total Assets $77,000 $77,000 Liabilities: $10,000 $10,000 Capital: A $15,000 $15,000 $17,500 B $15,000 $15,000 $17,500 C $15,000 $15,000 $17,500 Buyer $22,000 $22,000 $24,500 Debt + Equity $77,000 $77,000 Sec. 743 Adjustment: O.B. > I.B. = I.B. > O.B. = Not a Sch. L common balance sheet adjustment 58

30 Buyer s Share of Inside Basis Previously Taxed Capital (PTC) Plus Debt Share PTC: Cash to buyer on hypothetical liquidation if all assets are sold for FMV. + loss allocated to buyer. - gain allocated to buyer. 59 Example Same as Ex but a Sec. 754 Election Buyer pays $22,000 + assumes $3,333 debt. 60

31 Assets: Tax Basis FMV Outside Following Buyer s Purchase Basis Cash $5,000 $5,000 Accounts Rec. $10,000 $10,000 Inventory 20,000 21,000 Depr. Real Prop. 20,000 $40,000 Total Assets $55,000 $76,000 Liabilities: $10,000 $10,000 Capital: Buyer $15,000 $22,000 $25,333 B $15,000 $22,000 $18,333 C $15,000 $22,000 $18,333 Debt + Equity $55,000 $76, Buyer s Share of Inside Basis PTC: $ 22,000 Cash on fictional liquid. - 7,000 Gain allocated to buyer = $15,000 PTC + $ 3,333 Buyer s debt share = $18,333 Buyer s inside basis Shortcut: $55,000 3 = $18,333 62

32 Buyer s Sec. 743(b) Adjustment $25,333 (O.B.) - $18,333 (I.B.) = $7,000 (Sec. 743 Adj.) $ 333 Adj. to Inventory $6,667 Adj. to Real Prop. 63 Buyer s IRC sec. 743(b) Adjustment Appears on Buyer s K-1 64

33 No Change in Common Partnership Balance Sheet Tax Basis or Book Basis Impact of Built-in Gain or Loss property (IRC sec. 704(c) Property) 66

34 Example Same as Ex but the inventory was contributed by Partner C (not the seller) with a built-in Sec. 704(c) gain of $1, Assets: Tax Basis FMV Outside Before A Sells to Buyer Basis Cash $5,000 $5,000 Accounts Rec. $10,000 $10,000 Inventory 20,000 21,000 Depr. Real Prop. 20,000 $40,000 Total Assets $55,000 $76,000 Liabilities: $10,000 $10,000 Capital: A $15,000 $22,000 $18,333 B $15,000 $22,000 $18,333 C $15,000 $22,000 $18,333 Debt + Equity $55,000 $76,000 68

35 Buyer s Share of Inside Basis PTC: $ 22,000 Cash on fictional liquid. - 6,667 Gain allocated to buyer = $15,333 PTC + $ 3,333 Buyer s debt share = $18,666 Buyer s inside basis Shortcut Fails: $55,000/3= $18, Buyer s Sec. 743(b) Adjustment $25,333 (O.B.) - $18,666 (I.B.) = $6,667 (Sec. 743 Adj.) $ 0 Adj. to Inventory $6,667 Adj. to Real Prop. 70

36 No Change in Common Partnership Balance Sheet Tax Basis or Book Basis 71 Example Same as Ex but the inventory was contributed by A (the seller) with a built-in Sec. 704(c) gain of $1,

37 Assets: Tax Basis FMV Outside Before A Sells to Buyer Basis Cash $5,000 $5,000 Accounts Rec. $10,000 $10,000 Inventory 20,000 21,000 Depr. Real Prop. 20,000 $40,000 Total Assets $55,000 $76,000 Liabilities: $10,000 $10,000 Capital: A $15,000 $22,000 $18,333 B $15,000 $22,000 $18,333 C $15,000 $22,000 $18,333 Debt + Equity $55,000 $76, Buyer s Share of Inside Basis PTC: $ 22,000 Cash on fictional liquid. - 7,667 Gain allocated to buyer = $14,333 PTC + $ 3,333 Buyer s debt share = $17,666 Buyer s inside basis Shortcut Fails: $55,000/3= $18,333 74

38 Buyer s Sec. 743(b) Adjustment $25,333 (O.B.) - $17,666 (I.B.) = $7,667 (Sec. 743 Adj.) $1,000 Adj. to Inventory $6,667 Adj. to Real Prop Example Same as Ex but no Sec. 754 Election 76

39 If, later, the inventory is sold for $21,000, the $1,000 gain is all taxed to Buyer Act Rule and 2014 Prop. Regs. 78

40 Sec. 704(c)(1)(C)(i) (2004 Act) Any built-in loss on contributed property can be allocated only to the contributing partner. 79 Sec. 704(c)(1)(C)(ii) Except as provided in regs., in determining items allocated to other partners, the basis of contributed property is FMV. 80

41 Example with Prop. Regs. Alice, Bill, and Carol Form ABC Partnership Partners Assets Basis FMV Alice Cash 100, ,000 Bill Cash 100, ,000 Carol Land 160, ,000 Per the Prop. Regs., Carol has a $60, (c)(1)(C) adjustment 81 Prop. Reg (a)-2(f)(3)(ii)(B) These adjustments to the section 704(c)(1)(C) partner s distributive share must be reflected on Schedules K and K-1 of the partnership s return (Form 1065). The adjustments to the section 704(c)(1)(C) partner s distributive shares do not affect the section 704(c)(1)(C) partner s [tax and book] capital account. 82

42 Assets: Sch. L. Balance Sheet After Formation Tax Basis FMV Outside Basis Cash $200,000 $200,000 Land $100,000 $100,000 Total Assets $300,000 $300,000 Liabilities: 0 0 Capital: Alice $100,000 $100,000 $100,000 Bill $100,000 $100,000 $100,000 Carol $100,000 $100,000 $160,000 Debt + Equity $300,000 $300,000 Assume that the partnership sells the land for $100,000: K-1 gain to Carol of zero but Carol s 704(c)(1)(C) adjustment of $60,000 generates a loss to Carol of <$60,000> 84

43 Assume that before the land is sold, Carol sells her ABC Php. Interest to Buyer for $100,000: $100,000 Amount Realized $160,000 Outside Basis <60,000> Carol s Loss on Sale 85 No Sec. 754 Election Is Made (undesirable to make the election) 86

44 2014 Prop. Regs: The 704(c)(1)(C) Adjustment of $60,000 disappears 87 Post-2004 Act Balance Sheet Following Sale to Buyer Tax Basis FMV Outside Assets: Basis Cash $200,000 $200,000 Land $100,000 $100,000 Total Assets $300,000 $300,000 Liabilities: 0 0 Capital: Alice $100,000 $100,000 $100,000 Bill $100,000 $100,000 $100,000 Buyer $100,000 $100,000 $100,000 Debt + Equity $300,000 $300,000

45 Impact of Subsequent Transfers On 743(b) Adj Example Second buyer determines own IRC sec. 743(b) adj. (donee gets donor s 743(b) adj.) 89 Impact of IRC sec. 743 Adj. On Partnership Distributions

46 Example The common partnership adjusted basis in Property X is $1,000. Partner D has a Sec. 743(b) special basis adjustment of $500 in Property X. Property X is distributed to Partner D. D s basis in Property X is $1,

47 Example Variation If property X were distributed to another partner (Partner A), then A s adjusted basis is only $1,000. In such case, D's $500 special basis adjustment may shift over to other property. See reg. sec (g). 93 Example Read Examples thru -16 after reading distribution material in Chapter 16 94

48 Partner A (1/3 GP) sells to Buyer for $13,000 and Buyer s Sec. 743 Adjustment is $3,000 ($13,000 - $10,000) allocated among partnership assets: Asset Basis Value Adj. Asset 1 10,000 10,000 0 Asset 2 4,000 6, Asset 3 6,000 6,000 0 Asset 4 7,000 4,000 <1,000> Asset 5 3,000 13,000 3, Total 30,000 39,000 3, PRS distributes Asset 2 to Buyer in partial liquidation. Buyer s basis in Asset 2 is $4,667 ($4,000 + $667) following the distribution. 96

49 Example Liquidation of C with Asset 5: C does not take Buyer's $3,333 Sec. 743(b) adjustment into account. The partnerships common basis in Asset 5 is $3,000. Buyer's $3,333 Sec. 743(b) basis adjustment is reallocated among the remaining partnership assets under (c). C s basis in Asset 5 is $10,000 (O.B.) 97 Example 13-15: Distribution of Asset 5 in Liquidation of BUYER Immediately prior to the distribution, PRS's basis in Asset 5 is equal to $6,000, which is the sum of: $3,000 PRS's common basis in Asset 5 + $3,333 Buyer's 743 Adj. + <$ 333> Buyer's 743 Adj. in Assets 2 and 4. = $6,000 PRS s Basis relating to BUYER Buyer s basis in Asset 5 is $13,000 (O.B.) 98

50 Special Adjustment to the Common Basis of Partnership Property Following a Liquidation 99 Example Father dies and son inherits a 50% partnership interest worth $10,000. Partnership Assets on DOD: $10,000 Cash $10,000 FMV of Farmland (I.B. $1,000) Son s Sec. 743(b) adj. is $4,500. S is liquidated for $10,000 in cash. 100

51 Partnership ACS Before S is Liquidated Assets Tax and Book Basis FMV Outside Basis Cash $10,000 $10,000 Farmland $1,000 $10,000 Total Assets $11,000 $20,000 Capital A (25%) $2,750 $5,000 $2,750 C (25%) $2,750 $5,000 $2,750 S (50%) $5,500 $10,000 $10,000 Total Capital $11,000 $20, Impact of Liquidation on Son: $10,000 Cash - $10,000 Pre-distribution O.B. $ 0 Gain or Loss (IRC sec. 731)

52 S s unused special tax basis adjustment of $4,500 will be allocated to the common partnership basis in the Farmland + book capital accounts should be adjusted. 103 Partnership AC After S is Liquidated Assets Tax Basis FMV O.B. and Book Farmland $5,500 $10,000 Total Assets $5,500 $10,000 Capital A (50%) $2,750 $5,000 $2,750 C (50%) $2,750 $5,000 $2,750 Total Capital $5,500 $10,

53 Example Same facts as prior example but the Partnership does not make an IRC sec. 754 election 105 Partnership ACS Before S is Liquidated Assets Tax Basis And Book FMV Cash $10,000 $10,000 Farmland $1,000 $10,000 Total Assets $11,000 $20,000 Outside Basis Capital A (25%) $2,750 $5,000 $2,750 C (25%) $2,750 $5,000 $2,750 S (50%) $5,500 $10,000 $10,000 Total Capital $11,000 $20,

54 Partnership AC After S is Liquidated Assets Tax and Book Basis FMV Farmland $1,000 $10,000 Total Assets $1,000 $10,000 O.B. Capital A (50%) $500 $5,000 $2,750 C (50%) $500 $5,000 $2,750 Total Capital $1,000 $10,000 Keep a record the $2,250 disparity between inside and outside basis for purposes of alternate rule (to calculate O.B. from I.B. + debt) 107 Depreciation Amortization Depletion

55 Depreciable Basis Increase Sec. 743(b) additional depreciation is reported on Sch K and K-1. Use recovery period as if the basis adjustment is newly purchased property. The additional depreciation will add to the buyer/beneficiary s distributive share of common depreciation for the year. 109 Example Depreciation Increase Depreciable Asset: FMV exceeds inside adjusted basis. Buyer s upward Sec. 743(b) depreciation deduction is $500 (like newly purchased property). BUYER's distributive share common depreciation is $1,000. Buyer s depreciation = $1,

56 Depreciable Basis Decrease Sec. 743(b) negative depreciation is reported on Sch K and K-1. Recovery period is the property s remaining useful life. The negative depreciation will reduce the buyer/beneficiary s distributive share of common depreciation for the year. 111 Example Decrease Depreciable Asset: FMV is less than adjusted basis. Buyer s negative Sec. 743(b) depreciation deduction is <$500> (remaining useful life). BUYER's distributive share of common depreciation is $1,000. Buyer s total depreciation is $500 ($1,000 common 500 (Sec. 743(b) adj.)). 112

57 Example Decrease Depreciable Asset: FMV is less than adjusted basis. Buyer s negative Sec. 743(b) depreciation deduction is <$1,000>. BUYER's distributive share of common depreciation is $500. Buyer reports $500 of ordinary income ($500 common 1,000 (Sec. 743(b) adj.)). 113 Example Depletion As a result of the Sec. 743(b) adjustment the buyer partner is better off with cost depletion while the other partners will continue to use percentage depletion. 114

58 Mandatory Sec. 743(b) Adjustments if a Substantial Built-in Loss 115 A substantial built-in loss exists when the total adjusted basis of partnership assets exceeds the value by more than $250,000 (section 743(d)(1)).

59 Example No Sec. 754 Election 117 Example Adjusted Basis Total Assets $4.3 Million Fair Market Value $4 Million Substantial Built-in Loss Partner A (O.B. of $1,075,000) sells A s 25% partnership interest to B for $1,000,

60 A substantial built-in loss exists here because the total adjusted basis of partnership assets exceeds the value by more than $250,000 (section 743(d)(1)) Example Sale of Partnership Interest Following Decline in Asset Value No Sec 754 Election.

61 Balance Sheet Following Alice s Sale To Bob For $1,100,000 Carol s capital loss = <$100,000>

62 A substantial built-in loss exists here because the total adjusted basis of partnership assets exceeds the value by more than $250,000 (section 743(d)(1)). The partnership must make a negative Sec. 743(b) adjustment of $100,000 for Bob and it is all attributed to the land (matches 754 election)

63 Example No Sec 754 Election. Balance Sheet Before Alice Dies Assume that the estate values Alice s partnership interest at $510,000 a 40% discount.

64 The partnership has a substantial built-in loss because the total adjusted basis of its assets exceed the total FMV of the assets by more than $250,000. As a result of the 2004 Act, the estate MUST make a section 743(b)(2) downward inside basis adjustment of $690,000 ($1,200,000 (estate s share of inside basis) minus $510,000 (estate s outside basis).

65 Estate s Appraisal May Be Evidence Used by IRS The estate s appraisal may inadvertently document (ammunition for the IRS) the decline in value of the partnership assets (prediscount). Proposed Regulations on IRC Sec. 743 Substantial Built-In Losses REG (Feb. 3, 2014)

66 Prop. Regs. Clarify Tiered Partnership Rules Prop. Reg. Example A and B are equal partners in UTP, a partnership. UTP has no liabilities and owns a 25 percent interest in LTP, a partnership [UTP s only asset]. UTP's interest in LTP has a fair market value of $100,000 and an adjusted basis of $500,000.

67 LTP has no liabilities and owns Land, which has a fair market value of $400,000 and an adjusted basis of $2 million. In Year 3, when UTP and LTP do not have section 754 elections in effect, B sells 50 percent of its interest in UTP to C for its fair market value of $25,000. A B UTP A.B. $500,000 FMV $100,000 25% LTP Land: A.B. $2,000,000 FMV $400,000

68 Because the adjusted basis of UTP's interest in LTP ($500,000) exceeds the fair market value of UTP's interest in LTP ($100,000) by more than $250,000 immediately after the transfer, UTP has a substantial built-in loss with respect to the transfer. Thus, UTP must adjust the basis of its interest in LTP, and LTP must adjust the basis of Land, as if it had made a section 754 election for Year 3.

69 13-32 Impact of Sec. 743(b) Adjustment on Tax and Book Capital Accounts Allocation of Sec. 743 Adjustments Sec

70 Valuation of Assets FMV of assets other than Sec. 197 Intangibles (Php level FMV) FMV of Sec. 197 Intangibles (the residual method) 139 Residual Method Steps 1) Partnership gross value 2) Value of assets other than Sec. 197 Intangibles. 3) Residual Sec. 197 intangibles (if any). (Step 1 minus Step 2) 4) Value of intangibles other than goodwill or going concern value 5) Value of goodwill or going concern value. (Step 3 minus Step 4) 140

71 Example (no residual value) and Example (residual value) Illustrate the Residual Method 141 Example $2,950,000 Php Gross Value - 3,000,000 Tangible Asset Value = 0 Sec. 197 Intangible Value 142

72 Example $4,000,000 Php Gross Value - 3,000,000 Tangible Asset Value =1,000,000 Sec. 197 Intangible Value $600,000 To Intangibles Other than Goodwill $400,000 To Goodwill 143 The Sec. 743(b) adjustment allocation is based upon a hypothetical sale of each asset at FMV 144

73 Two Classes of assets: (1) Capital gain property (2) Ordinary income property 145 Allocation to Ordinary Income Property: Gain or loss on the sale of ordinary income property. 146

74 Allocation to Capital Gain Property: The total Sec. 743(b) adjustment minus the portion allocated to ordinary income property. 147 Return To Example Above 148

75 Example No Sec 754 Election. Balance Sheet Before Alice Dies Assume that the estate values Alice s partnership interest at $510,000 a 40% discount.

76 The partnership has a substantial built-in loss because the total adjusted basis of its assets exceed the total FMV of the assets by more than $250,000. As a result of the 2004 Act, the estate MUST make a section 743(b)(2) downward inside basis adjustment of $690,000 ($1,200,000 (estate s share of inside basis) minus $510,000 (estate s outside basis).

77 The entire <$690,000> downward 743(b) adjustment is allocated to the real property (capital gain property). Assume the same 743(b) adjustment amount (for simplicity) but the partnership had zero basis unrealized receivables of $200,000 (ordinary income property).

78 Balance Sheet Assets Tax Basis FMV And Book Cash $300,000 $300,000 Unrealized Receivables 0 200,000 Real Estate $4,500,000 $3,100,000 Total Assets $4,800,000 $3,600,000 The partnership still has a substantial built-in loss 155 Allocation of <$690,000> Between Assets Ordinary Assets: $100,000 to Unrealized Receivables Capital Gain Assets (Real Estate): <690,000> Sec. 743(b) adj ,000 = <$790,000> To Real Estate 156

79 Example Balance Sheet Following 50% Partner A s Sale to Buyer for $1, Asset Basis Value Cap Gain Prop Asset Asset Ordinary Income Property Asset Asset Total 2,000 2,000 Sec. 743(b) Adj. = zero 157 Allocation to ordinary income property: <$125> to Buyer Allocation to capital gain property: $0 - <$125> = $125 Positive $125 Sec. 743 Adj. to Cap. Gain Prop 158

80 Example A & B Form AB Partnership Ptrs. Assets Basis FMV A Cash 50,000 50,000 Asset 1 25,000 50,000 B Cash 100, ,000 Asset 1 is contributed by A, thus is IRC sec. 704(c) built-in gain % Partner A Sells to Buyer for $120,000 Asset Basis Value Cap Gain Prop Asset 1 25,000 75,000 Asset 2 100, ,500 Ordinary Income Property Asset 4 40,000 45,000 Asset 5 10,000 2,500 Total 175, ,

81 Buyer s Share of Gain/Loss Asset Basis Value Cap Gain Prop Asset 1 25,000 75,000 $37,500 Asset 2 100, ,500 8,750 $46,250 Ordinary Income Property Asset 4 40,000 45,000 $2,500 Asset 5 10,000 2,500-3,750 ($1,250) 161 Total 175, ,000 $45,000 Buyer s Share of Inside Basis PTC: $120,000 Cash on fictional liquid. - 45,000 Gain allocated to buyer ($37, ,750 + $2,500 3,750 ) = $46,250 = ($1,250) = $75,000 PTC + $0 Buyer s debt share = $75,000 Buyer s inside basis 162

82 Buyer s Sec. 743(b) Adjustment $120,000 (O.B.) - $ 75,000 (I.B.) = $45,000 (Sec. 743 Adj.) 163 Allocation Between Classes Ordinary Assets: <$1,250> to B Capital Gain Assets: $45,000 Sec. 743(b) adjustment - <$1,250> = $46,250 to B 164

83 Allocations within Asset Classes: Generally based upon the hypothetical sale Example Allocating Within a Class Same facts as Ex

84 Sec. 755 Allocation Without a Discount Asset Basis Value 755 Alloc Cap Gain Prop Asset 1 25,000 75,000 $37,500 Asset 2 100, ,500 8,750 $46,250 Ordinary Income Property Asset 4 40,000 45,000 $2,500 Asset 5 10,000 2,500-3,750 ($1,250) 167 Total 175, ,000 $45, Example Purchase At A Discount Same facts as Ex. 24 but buyer paid $110,000 to A (instead of $120,000) (no change in net asset value) 168

85 Buyer s Sec. 743(b) Adjustment $110,000 (O.B.) - $ 75,000 (I.B.) = $35,000 (Sec. 743 Adj.) 169 Additional Reduction Needed $35,000 (Sec. 743 Adj.) - $45,000 (Hypo. Sale) = <$10,000> Reduction 170

86 The downward adjustment of <$10,000> is allocated to capital gain property. 171 Initial Sec. 755 Allocation Within Assets Without a Discount Asset Basis Value 755 Alloc Cap Gain Prop Asset 1 25,000 75,000 $37,500 Asset 2 100, ,500 8,750 $46,250 Ordinary Income Property Asset 4 40,000 45,000 $2,500 Asset 5 10,000 2,500-3,750 ($1,250) 172 Total 175, ,000 $45,000

87 Additional Reduction Needed $35,000 (Sec. 743 Adj.) - $45,000 (Hypo. Sale) = <$10,000> Reduction 173 Allocation Between Classes Ordinary Assets: <$1,250> Net ordinary loss to B Capital Gain Assets: $35,000 Sec. 743(b) adjustment - <$1,250> = $36,250 The $10,000 reduction is allocated between the two capital assets per FMV 174

88 Sec. 755 Allocation With 50% Discount Asset Basis Value 755 Alloc Cap Gain Prop Asset 1 25,000 75,000 $33,604 Asset 2 100, ,500 2,646 $36,250 Ordinary Income Property Asset 4 40,000 45,000 $2,500 Asset 5 10,000 2,500-3,750 ($1,250) 175 Total 175, ,000 $35,000 If the downward Sec. 743(b) adjustment to capital gain assets exceeds the partnership s basis in capital gain assets, then the basis of ordinary income assets is reduced. 176

89 Example Death of Partner With Investment Partnership No valuation discount 177 Tax Basis FMV Outside Assets: In Millions Basis Stock X (Cap) $4.0 $5.0 Stock Y (Cap) $9.0 $ Recap $.0 $2.0 Total Assets $13.0 $12.0 Liabilities: $0 $0 Capital: A $6.5 $6.0 $6.5 B $6.5 $6.0 $6.5 Debt + Equity $13.0 $

90 A Dies No Valuation Discount What is the Estate s IRC sec. 743(b) adjustment? 179 Assume no IRC sec. 754 Election Any 743 Adj.? 180

91 Mandatory Sec. 743(b) Adjustments 181 A substantial built-in loss exists here because the total adjusted basis of partnership assets exceeds the value by more than $250,000 (section 743(d)(1)).

92 Estate Sec. 743(b) Adjustment $6.0 Mil. O.B. (DOD FMV) - $6.5 Mil. I.B. = <.5 > Sec. 743 Adj. 183 Allocating Between Classes 184

93 Allocation to Ordinary Income Property: Hypothetical Gain or loss on the sale of ordinary income property. 185 Allocation to Capital Gain Property: The total Sec. 743(b) adjustment minus the portion allocated to ordinary income property. 186

94 Allocation Between Classes Ordinary Assets: $1.0 Adj. of Ord. Inc. Prop. Capital Gain Property: -.5 Total Sec. 743(b) Adj Adj. to Ord. Inc. Prop =<$1.5> Adj. to Cap Gain Prop 187 Allocating Within the Capital Gain Property Class 188

95 Sec. 755 Allocation of <.5> Sec. 743 Adjustment Asset Basis Value Adj. Stock X Stock Y Re Total Example Death of Partner With Investment Partnership 50% valuation discount 190

96 Tax Basis FMV Outside Assets: In Millions Basis Stock X (Cap) $4.0 $5.0 Stock Y (Cap) $9.0 $ Recap $.0 $2.0 Total Assets $13.0 $12.0 Liabilities: $0 $0 Capital: A $6.5 $6.0 $6.5 B $6.5 $6.0 $6.5 Debt + Equity $13.0 $ A Dies 50% Discount (but no change in net asset value) 192

97 Estate Sec. 743(b) Adjustment $3.0 Mil. O.B. (50% x 6.0) - $6.5 Mil. I.B. = < 3.5 > Mil. Sec. 743 Adj. (compared to <.5> without the discount) 193 Allocating Between Classes 194

98 Allocation Between Classes Ordinary Assets: $1.0 Adj. of Ord. Inc. Prop. Capital Gain Property: -3.5 Total Sec. 743(b) Adj Adj. to Ord. Inc. Prop =<$4.5> Adj. to Cap Gain Prop 195 Allocating Within the Capital Gain Property Class 196

99 Sec. 755 Allocation of Php Gains/Losses on Cap Assets Without Discount Asset Basis Value Gain/ Loss Stock X Stock Y Total Additional Reduction Needed Sec. 743 Adj for Cap. Gain Prop Hypothetical Sale Allocation -1.5 Reduction -3.0 Reduction allocated per relative FMV 198

100 Additional Reduction of $3 Million Allocated Per FMV Asset Gain/ Loss Excess Adj.* 755 Adj. Stock X.5-1.5* -1.0 Stock Y * -3.5 Total -4.5 *5/10 x - 3 Mil. = Sec. 755 Allocation With 50% Discount Asset Basis Value Adj. Stock X Stock Y Re Total

101 If the downward Sec. 743(b) adjustment to capital gain assets exceeds the partnership s basis in capital gain assets, then the basis of ordinary income assets is reduced. 201 Application of Sec. 755 Regulation Language Pg

102 .5 Gain on Hypo. Sale Adjustment (Pg. 2-27)* =<1> 755 Alloc = 3.0 Stock X 3.0 x 5/10 = Loss on Hypo. Sale Adjustment (Pg. 2-27)* =<3.5> 755 Allocation = 3.0 Stock Y 3.0 x 5/10 =

103 Example illustrates income in respect of a decedent (IRD) and also the residual method. 205 Sec. 754 Elections Involving Tiered Partnerships Rev. Rul

104 Sec. 754 Election Mechanics 207 How To Make 754 Election Form 1065 K-1 Instructions 208

105 9100 Relief Per IRS Form 1065 Instructions, the partnership can get an automatic 12-month extension to make the section 754 election provided corrective action is taken within 12 months of the original deadline for making the election. 209 Foreign Partnerships A foreign partnership, or U.S. partner on behalf of the foreign partnership, may wish to file Form 1065 solely for the purpose of making a Sec 754 election. 210

106 Reporting Sec. 743(b) Adjustments To the IRS 211 Form 1065 Schedule B, Question 12: 212

107 Sec. 743 Adjustments: On Sch. K and K-1 Not reflected on the partnership balance sheet 213 Sale or Exchange Buyer notifies the partnership within 30 days. Notice includes purchase price and information to determine outside basis. Partnership need not make Sec. 743 adjustments until it has notice. 214

108 Beneficiary on Death of Partner Beneficiary notifies the partnership within one year of death. Notice includes the FMV of the partnership interest and how determined. Partnership may generally rely on the notice to determine O.B. 215 If partnership is aware of a transfer but does not have the proper information from the transferee, then the partnership must make a statement on Form 1065 and the K-1 must state: RETURN FILED PURSUANT TO REG. SEC. Reg (k)(5). Upon later receipt of info, may amend or report on following years Form