What is a? Section 761(a)---not very helpful (a) PARTNERSHIP. For purposes of this subtitle, the term partnership includes a syndicate, group, pool, joint venture or other unincorporated organization which any business, financial operation, or venture is carried on, and which is not a corporation or a trust or estate. State Law---not determinative Intent of Parties---Critical 4 The Agreement Includes all agreements among the partners or between partners and the partnership either written or oral. Can be modified up to the due date of the partnership tax return. Any document or oral agreement which bears on the underlying economic arrangement of the partners, is considered by the IRS to be part of the partnership agreement. Examples of such documents may be: - Loan and credit agreements - Assumption agreements - Indemnification agreements - Subordination agreements - Correspondence with a lender - Guarantees 2 Formation 721 Partners The amount of interest each partner receives depends upon the partnership agreement. There is no control requirement similar to corporate rules. The only prohibition is that property does not 3 include services. Service-Related Property Neither 721 nor the regulations define the term property. Services do not qualify for tax-free treatment, but certain service-related assets might. Property rights and assets created by the personal efforts of the transferor might qualify. Transfers of intangible assets such as receivables, contracts, patents, and technical know-how have been held to qualify as property contributions. Property rights and assets that result from the performance of services for, or on behalf of, the partnership will be treated as an exchange of services for a partnership interest. 4 1
Definition of Property Types of Interest Money Installment obligations [Treas. Reg. 1.721-1(a)] Personal note of transferor-partner [Rev. Rul. 68-629] Contract negotiated by partner [See Ungar, Stafford] Technical know-how, secret formulas, etc. [Rev. Rul. 64-56] Accounts receivable [See Roberts] Goodwill [Rev. Rul. 70-45] Letter of intent [See Stafford] Property does not include services performed by a 5 partner on behalf of the partnership 6 Capital Interest An interest that entitles the partner to share in distribution of partnership assets upon liquidation Profits Interest An interest that entitles the partner to share only in the future profits of the partnership Basis of Contributed Property Section 722 describes basis to the partner Substituted basis Referred to as outside basis Section 723 describes basis to the partnership Carryover basis Referred to as inside basis A substitutes her basis in the Land to the partnership interest Determining Outside Basis A 50% Partner Land FMV $10,000 Basis $ 2,000 A-B Outside Basis of Partner A = $2,000 B 50% Partner 7 8 2
Determining Inside Basis 9 The partnership takes a carryover basis in the Land contributed by A Land A 50% Partner FMV $10,000 Basis $ 2,000 A-B Inside Basis of A-B = $2,000 B BuiIt-in 50% Gain Partner of $8,000 still in the Pship Opening Balance Sheet of ABC 10 Assets Basis FMV Cash $20,000 $20,000 Equipment 15,000 20,000 Land 2,000 20,000 Total assets $37,000 $60,000 Partner s Capital Partner A $20,000 $20,000 Partner B 15,000 20,000 Partner C 2,000 20,000 Total capital $37,000 $60,000 The s Inside Basis Is: The Partner s Outside Basis Is: The basis in the land that carries over to the partnership The basis in the partnership interest that the partner takes 11 12 3
Recording Book Value or Book Basis Capital Account Valuation The partner s initial capital account valuation Entry to record the land on the partnership s books 13 14 Balance Sheet Presentation Effect of Liabilities The Basics How do partnerships report their balance sheets on Page 4 of Form 1065? Most commonly, book values If audit client, directly from working papers For tax, inside bases don t always match outside bases 752(a) Assumed Liabilities Deemed contribution of cash Increase outside basis 752(b) Decreased Liabilities Deemed distribution of cash Decrease outside basis Future $ Pship Liabilities + Basis + $ Distribution Pship Liabilities Basis 15 16 4
Liability Transfers Example If both increases and decreases occur as a result of a single transaction, only the net increase is treated as a contribution of money and only the net decrease is treated as a distribution of money. Gain is recognized to the extent that a deemed distribution exceeds the adjusted basis of the partner s interest. 17 On October 15, 2004, the ABC partnership, on a June 30 fiscal year, admits new partner D, which receives a 25% interest. Partner C, whose interest dropped from 33% to 25%, has an outside basis of $1,000. If the partnership has recourse debt of $30,000, what tax affect will the admittance of D have on calendar year partner C? C Answer must $1,500 recognize on June $1,500 30. on The June partners 30. The need partners not need not redetermine their their adjusted adjusted basis basis in their in their partnership interest until the end of the partnership s taxable year. 18 Treas. Reg. 1.752-1 Effect of Liabilities Advanced Rules How are liabilities shared? Recourse General partners loss-sharing ratio Limited partners only to extent of required future contributions Non-Recourse All partners profit-sharing ratio 752(a) Assumed Liabilities Deemed contribution of cash Increase outside basis 752(b) Decreased Liabilities Deemed distribution of cash Decrease outside basis Future $ Pship Liabilities + Basis + $ Distribution Pship Liabilities Basis 19 20 5
Raphan Scenario - Risk of Loss Raphan Scenario - Risk of Loss $100,000 Raphan General Partner Guarantees $100,000 Raphan General Partner $1,000,000 N/R Loan LP 10% $1,000,000 N/R Loan LP 10% $900,000 90% Investors Limited Partners $900,000 90% Investors Limited Partners 21 22 polling Raphan Scenario - Risk of Loss What was Raphan trying to do when he guaranteed the loan? A. Show his partners he was a team player B. Make the loan allocable according to profit sharing ratios and not loss sharing ratios C. Steal the basis from the limited partners D. Keep the loan a nonrecourse debt E. Show the IRS he was insane Guarantees $1,000,000 $1,000,000 N/R Loan $900,000 LP 90% 10% Raphan General Partner Investors Limited Partners 23 24 6
Treas. Reg. 1.752-1 to 5 Recourse Liability Definition Goal: To share liabilities in a manner which... Take account of current commercial practices... Based on manner...partners, and persons related to the partners, share the economic risk of loss Result: Lengthy and complex rules Under Treas. Reg. 1.752-1(a)(1): A recourse liability is any liability for which any partner (or person related to a partner) bears the economic risk of loss for the liability 25 26 Nonrecourse Liability Defined Economic Risk Of Loss (EROL) Treas. Reg. 1.752-1(a)(2): A nonrecourse liability is any liability for which no partner (or person related to a partner) bears the economic risk of loss for the liability Generally, a partner bears EROL if: The partner would be obligated to make A payment to any person or A contribution to the partnership Upon constructive liquidation of the partnership 27 28 7
Constructive Liquidation Constructive Liquidation Treas. Reg. 1.752-2(b)(1) aka On the determination date the following events are deemed to occur: Atom Bomb or Doomsday Test 1. Assets become worthless Including cash Excluding specially pledged assets 2. Assets are deemed sold for the worthless value 3. All assets securing non-recourse debt are transferred to creditors for no consideration other than relief of the non-recourse debt 4. Gain or loss recognized on the deemed asset dispositions are allocated to the partners 5. Partners and related parties fulfill their obligations to the partnership and creditors 29 30 Constructive Liquidation Example Constructive Liquidation Example Buys Business B Buys Business B $70 Loan AB $70 Loan AB -0- -0- Capital A Capital B $30 Capital A $ 30 Capital B $ -0- $30 A A 31 32 8
Constructive Liquidation Example Constructive Liquidation Example Buys Business $70 Loan AB B -0- Doomsday 1. Asset Worthless 2. Assets Sold 3. No N/R Assets 4. Losses Allocated 5. Deficits Paid Off. Sales Price -0- Basis 100 Buys Business Loss Buys $100 <100> * $70 Loan AB B -0- Capital A $ 30 Capital B $ -0- $30 Capital A $ 30 Capital B $ -0- $30 A A 33 34 Constructive Liquidation Example 1. Asset Worthless 2. Assets Sold 3. No N/R Assets 4. Losses Allocated 5. Deficits Paid Off. 35 Capital A $ 30-50 -20 Capital B $ -0- -50-50 Sales Price -0- Basis 100 Buys Business Loss Buys $100 <100> * $70 Loan AB B -0- $30 A Reimbursements & Third Parties Subrogation rights Reimbursement from another partner or the partnership Third party reimbursements The regulations treat the lending partner (or related party) as bearing the full risk of loss to the extent of any loan made to the partnership. 36 Treas. Reg. 1.752-2(b) & (c) requires the following be taken into account: 9
polling Non-Recourse Debt Recourse Liabilities Risk of Loss A general partner (G) and limited partner (L) form a partnership. The partnership makes a loan of $100,000 in which L guarantees the repayment. 1. $100K Note recourse. Guarantees GL L G 37 1. If the partnership loan is recourse, who bears the economic risk of nonpayment? 2. If the partnership loan is a nonrecourse, who bears the economic risk of nonpayment? Answer: L Sues Pship for $100K GL Therefore, G bears economic risk of loss. G Non-Recourse Debt Receipt of a Interest for Services 2. $100K Note Nonrecourse. Guarantees GL L G Services rendered Answer: L Sues Pship for $100K GL G Partner interest Therefore, L bears economic risk of loss. Taxation is determined under IRC 83 33 10
Interest Received for Services (3-step Approach) If partnership interest received has no substantial risk of forfeiture or is freely transferable: Step 1: Partner Recognizes Ordinary Income Step 2: Deducts or Capitalizes Amount Step 3: X Recognized by Partners Non-service Partners Recognize Gain on Sale of Assets Prop. Regs. 1.83-3(l) 34 83 Illustrated Balance Sheet Before Entry of Service Partner Assets Basis FMV Cash $12,000 $12,000 Land $18,000 $24,000 Total $30,000 $36,000 Capital Account Partner A $15,000 $18,000 Partner B $15,000 $18,000 Total $30,000 $36,000 40 83 Illustrated $12,000 Ordinary Income Partner C 43 Assets Basis FMV Cash $12,000 $12,000 Land $18,000 $24,000 Total $30,000 $36,000 Capital Account Partner A $15,000 $18,000 Partner B $15,000 $18,000 Total $30,000 $36,000 Services rendered 2 1 Pay Cash $4,000 F $4,000 B Land $8,000 F $6,000 B}1/3 FMV $36,000 $12,000 Deduction 44 Partner C Assets Basis FMV Cash $12,000 8,000 $12,000 8,000 Land $18,000 12,000 $24,000 16,000 Total $30,000 20,000 $36,000 24,000 Capital Account Partner A $15,000 10,000 $18,000 12,000 Partner B $15,000 10,000 $18,000 12,000 Total $30,000 20,000 $36,0 00 24,000 3 Basis = FMV Cash $4,000 F/B Land $8,000 F/B Pship Interest Value Immediately after distribution but before re-contribution. FMV $24,000 11
Partner C 3 Cash $4,000 F/B Land $8,000 F/B Pship Interest Balance Sheet After Entry of Service Partner Assets Basis FMV Cash $12,000 $12,000 Land $20,000* $24,000 Total $32,000 $36,000 Capital Account Partner A $10,000** $12,000 Partner B $10,000** $12,000 Partner C $12,000 $12,000 Total $32,000 $36,000 FMV $24,000 * $18,000-6,000 + 8,000 ** $15,000-6,000 + 1,000 Exceptions to 721(a) Deferral Treatment Contributions of liabilities to a partnership Contributions of services to a partnership Contributions to investment partnerships Deemed redemption rule for corporate partners Contributions that are, in substance, disguised sales transactions (later courses) Contributions of certain properties to foreign partnerships (later courses) 46 Investment s Gain is recognized on contributions to a partnership that would be treated as an investment company. A partnership will be treated as an investment company if more than 80% of the value of its assets, including cash, is held for investment and consists of stocks, securities, interests in RISC and REITs, and other specified investment-type assets. Nonrecognition under 721(a) should apply if diversification of assets does not take place. 47 Example Mr. Whiz transfers 2,000 shares of appreciated General Electric (GE) stock valued at $50,000 to the new WB. Ms. Bang transfers 5,000 shares of appreciated GE stock valued at $250,000. No other transactions are made by either partner. Is Whiz-Bang an investment partnership? Based Answer these upon facts, these the facts, new the partnership new partnership will not be will treated not be treated as an investment as an investment partnership partnership because no diversification is taking place. 48 12
Partners Holding Periods in Interest The holding period of a partnership interest includes the holding period of the transferred property if the property is a capital or 1231 asset; otherwise, it begins on the date of the 721 exchange. It is unclear how the holding period is determined when different asset types are transferred under 721. The character of property is determined by the partner s use immediately before the exchange. Holding Periods The transferee s holding period for property received includes the holding period of the transferor. This rule extends to any property received in a 721 transaction. Tacking applies even when gain is recognized by the transferor under 721(b). 49 50 Depreciation Recapture A step into the shoes rule applies for contributions of depreciable property. A contributing partner who contributes property subject to depreciation recapture does not trigger the recapture unless gain is recognized. A contributing partner s share of depreciation remains chargeable to that partner. Assignment of Income A contribution of property to a partnership might not be respected when the transferor is considered to have made an anticipatory assignment of income. Could arise in the following situations: Family partnerships Non-familial situations Zero-based accounts receivables Section 704(c) applications 51 52 13
Character Taints Section 724 prevents partnerships from serving as vehicles to artificially convert the characterization of a partner s gain or loss. Applies to contributions of: Unrealized receivables Inventory Capital assets Example Chris, a securities dealer, contributes 100 shares of GM stock (FMV $20,000, basis $60,000) to ABC partnership, along with some land (FMV $35,000, basis $50,000). The land was a capital asset to Chris, but ABC holds the property as inventory. The GM stock is a capital asset to ABC. Four years after the contribution, ABC sells the land for $16,000 and, 6 years later, the GM stock for $70,000. 53 What is the character of the gain or loss to ABC? 54 Example Solution ABC s loss on the sale of the land is a $15,000 capital loss and a $19,000 ordinary loss. The GM stock generates a long-term capital gain of $10,000. The character is not tainted because it was sold more than 5 years after it was contributed. 55 14