2011 comp topics im ch19

©2010 CCH. All Rights Reserved. Chapter 19

345

Chapter 19Partnerships—Formation and Operation

SUMMARY OF CHAPTER The partnership form is probably the most common type of business organization involving more than one

owner. For federal income tax purposes, the term “partnership” is not confi ned to a partnership as defi ned under local law. In income tax law, the term is much broader and includes any unincorporated organization which carries on any business, fi nancial operation, or venture, unless the Internal Revenue Code defi nes such an organization as a trust, estate, or corporation. The income tax reporting process for a partnership and the income tax reporting of partnership income by a partner are examined in this chapter. Also discussed is the determination of basis of an interest in a partnership.

Defi nition of a Partnership

¶19,001 Characteristics of a Partnership

A partnership exists when there is an association of two or more persons who carry on as co-owners of a business for profi t. “Check-the-box” regulations currently allow unincorporated business entities to elect whether they want to be taxed as corporations or partnerships.

Partner Defi ned. For tax purposes, a “partner” is any member of a partnership, including, of course, members of joint ventures, syndicates, pools, and like groups classifi ed for tax purposes as partnerships.

Partnership Agreements. The partnership form enables owners to make special allocations of certain income, gain, loss, deductions, or credits that are not possible under the C or S corporation forms, and for this reason and others it is usually desirable to have a written partnership agreement. However, the parties cannot by their agreement abrogate the effect of the tax law.

“Check-the-Box” Classifi cation as a Partnership. Under the check-the-box regulations, business owners that have not incorporated may elect to be taxed as either a partnership (with two or more owners) or a C corporation.

Exclusion from Partnership Treatment. The Commissioner may excuse certain partnerships from the necessity of fi ling a partnership return. This privilege is available only when there is not the active conduct of a trade or business. Typically this applies to associations which are formed (1) for investment purposes only and (2) for the joint production, extraction, or use of property.

Partnership Reporting

¶19,005 Partnership Tax Filing

Form 1065 must be fi led by the 15th day of the fourth month following the close of the partnership’s tax year. Each partner receives a Schedule K-1, which shows that partner’s share of partnership items.

Taxation of Partners. For income tax purposes, partners report these items on their tax returns, even if no distributions have been made to them.

Partnership Accounting Concepts

¶19,025 Outside Basis

Outside basis generally refers to a partner’s tax basis in her partnership interest. It is used mainly in the computation of gain or loss from partnership distributions and for determining the gain or loss from the sale of a partnership interest. The partner’s outside basis is increased by (1) his or her basis of property contributed, (2) his or

346 CCH Federal Taxation—Comprehensive Topics

Chapter 19 ©2010 CCH. All Rights Reserved.

her share of an increase in partnership liabilities, and (3) every allocable type of income reported by the partnership whether it is taxable or tax-exempt. Downward adjustments to outside basis are required for (1) a partner’s share of a decrease in partnership liabilities, (2) withdrawals of money and other property from the partnership, and (3) every allocable type of loss or expense reported by the partnership, whether ordinary or capital, deductible or disallowed.

¶19,035 Inside Basis

Inside basis refers to the adjusted basis of the assets of the partnership. An inequality between inside basis and total outside basis often results from certain transactions. In many cases, the partnership is permitted to adjust the inside basis of its assets, thereby preserving equality between inside basis and outside basis. This adjustment to basis is accomplished by fi ling a Code Sec. 754 election.

¶19,055 Partner’s Interest in a Partnership

A partner usually owns both a capital interest and a profi ts or loss interest in the partnership. A capital interest ratio refl ects a partner’s percentage ownership in the net assets of the partnership. A profi ts or loss sharing ratio represents a partner’s percentage allocation of the partnership’s ordinary business income or loss and separately stated items. Each partner’s capital, profi t, and loss sharing ratios may appear on the partner’s Schedule K-1.

Formation of a Partnership—Contributions Requiring Special Consideration

¶19,105 Contributions in General

Contributions of property are generally treated as nontaxable exchanges with a carryover to the partnership of the partner’s basis in the property. Usually no gain or loss is recognized by the partner or the partnership upon a contribution of property in exchange for a partnership interest.

¶19,115 Transfers of Property with Precontribution Gain/Loss

If a partner contributes property that had an unrecognized gain or loss at the time of the contribution, the contributing partner will generally have to recognize that precontribution gain or loss if the property is later sold by the partnership.

¶19,125 Transfers of Accounts Receivable for Partnership Interest

The sale or collection of contributed unrealized receivables results in ordinary income to the partnership. This ordinary income will be allocated to the contributing partner to the extent of precontribution gain.

¶19,135 Transfers of Inventory for Partnership Interest

The disposition of contributed inventory within fi ve years of its contribution results in ordinary income or loss to the partnership, and that ordinary income or loss will be allocated to the contributor to the extent of precontribution gain or loss.

¶19,145 Transfers of Capital Loss Property for a Partnership Interest

Any loss from the disposition of a contributed capital loss asset within fi ve years of its contribution will, to the extent of the precontribution loss, be a capital loss and be allocated to the contributor.

¶19,155 Transfers of Depreciable Property for a Partnership Interest

When a partner contributes depreciable property to a partnership in exchange for a partnership interest, the depreciable property’s basis and the depreciation method and recovery period carry over to the partnership. However, to the extent the gain on a subsequent sale represents precontribution gain, that gain, including any precontribution recapture, will be allocated to the contributing partner.

347Instructor’s Manual


¶19,170 Personal-Use Property Conversions

Personal property which is converted into business property by contribution to the partnership has as its inside basis different amounts for purposes of computing depreciation and any subsequent gain or loss on disposition.

Formation of a Partnership—Recognition of Gain or Loss

¶19,205 Transfers to an Investment Company Partnership

Investors in marketable securities may diversify their risks to a limited degree by forming a partnership. The Code has created a defi nition of an “investment company” to which transfers of marketable securities are fully taxable whether the transferee is a partnership or a controlled corporation. However, the mechanical tests that defi ne an “investment company” can be rather easily avoided.

¶19,215 Transfer of Services for Partnership Capital Interest

The transfer of services for a capital interest usually requires an immediate recognition of income by the recipient of the partnership interest.

¶19,225 Transfer of Services for Ascertainable Partnership Income Interest

The transfer of an income interest in exchange for services usually requires the recognition of income by the recipient partner when the income is earned.

Deferral of Recognition of Income. The partner can defer the income until substantial risks of forfeiture have been satisfi ed or the interest is transferable.

Deductibility by Transferor of Partnership Interest. The transfer of a partnership interest in exchange for services entitles the transferor partnership to deduct (currently or over a deferred period) the value of the interest. The transfer can also cause the recognition of income by the transferor partners.

¶19,235 Disguised Sales

Two-Year Rule for Contributions and Distributions that are Directly Reciprocal. If within two years of a property contribution to a partnership the partnership transfers money or other property to the contributing partner, then all or part of the transfer is presumed to be a sale of the property to the partnership. Generally, a disguised sale will result if (1) a transfer of money or other consideration would not have been made but for the transfer of property to the partnership, and (2) assuming that the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations.

¶19,240 Disguised Sales Under the Seven-Year Rule

Seven-Year Rule for Transfers that are Directly Reciprocal. If a partner contributes appreciated property to a partnership and receives a distribution of any property other than cash or the originally contributed property within seven years of such contribution, the partner recognizes the lesser of:

the excess of the fair market value of the distributed property over the partner’s outside basis in (1) the partnership before distribution, reduced (but not below zero) by any money received in the distribution; or the remaining net precontribution (built-in) gain. (Code Sec. 737.) (2)

Seven-Year Rule for Transfers that are Indirectly Reciprocal. If contributed appreciated property is distributed to another partner or a third party within seven years of the contribution date, the contributing partner recognizes any remaining net precontribution gain on the property.

¶19,245 Contribution of Encumbered Property

When encumbered property is contributed to the partnership, the transfer of the liability is treated as a transfer of money between the partners and the partnership. The partners to whom the liability is shifted increase



their basis, just as they would if they had contributed money to the partnership. The partner being relieved of the liability reduces the basis of his or her partnership interest, just as they would if the partnership had distributed money to them. Gain is recognized by the contributing partner if it is necessary to eliminate a negative basis (i.e., to the extent their net debt relief exceeds their basis in their partnership interests).

¶19,250 Liabilities Assumed by Partnership

The face amount of liabilities assumed by the partnership is refl ected in the partners’ bases. When property is taken subject to a nonrecourse liability, the amount of the partner’s basis increase is limited to the lesser of the amount of the liability or the fair market value of the property.

Taxable Year of Partner and Partnership

¶19,275 Partner’s Year of Inclusion

The partners report on their individual returns the items reported by the partnership on its return for the tax year ending with or within the particular partner’s taxable year.

¶19,280 Taxable Year of the Partnership

In general, the partnership must use the same tax year as that used by those partners holding a majority interest in the partnership’s capital and income. If there is no such year, then the year must be that of all of those partners holding an interest of fi ve percent or more in either the partnership’s capital or income. If there is no such year, the tax year which results in the least aggregate deferral of income by the partners must be used. A limited option to use a fi scal year is permitted, but there is a toll charge in the form of advance deposits for estimated income tax on the deferred income. In all cases, the partnership may use a taxable year for which the partnership can establish a business purpose.

¶19,285 Elections by Partner or Partnership

Generally, all elections are made at the partnership level. A few elections which impact the treatment of certain items at the partner’s level may be made by the partners.

¶19,290 Initial Costs of a Partnership

In the initial stages of a partnership, expenses may be incurred in connection with forming the partnership (organization costs), admitting partners to the partnership, marketing and selling partnership units to prospective partners (syndication costs), and acquiring assets and conducting pre-operational activities (start-up costs). Organizational costs may, at the election of the partnership, be deducted for the taxable year in which the partnership begins business in an amount equal to the lesser of (a) actual organizational expenses, or (b) $5,000 (reduced dollar-for-dollar by the amount by which total organizational costs exceed $50,000). The remaining organizational costs are allowed as a deduction ratably over the 180-month period beginning with the month in which the partnership begins business. Syndication costs may be neither amortized nor deducted. Start-up expenses are generally deducted and amortized in the same manner as organization costs.

Operation of the Partnership

¶19,301 Liability for Tax

The partnership does not pay an income tax, although it must make a deposit for estimated income tax if it elects a fi scal year as mentioned above.

¶19,335 Gross Income of Partner

The character of any items of income or loss are determined at the partnership level. Any items that could potentially require special treatment by the partners are separately stated on Schedule K of Form 1065 and reported to the partners on Schedule K-1. All items not separately stated are netted together to calculate the partnership’s ordinary income.



There are simplifi ed reporting rules for “electing large partnerships,” defi ned as partnerships with 100 or more partners in the preceding year who elect to report using these rules. The large partnership rules allow the partnership to aggregate more items at the partnership level, which simplifi es the reporting to the partners.

¶19,345 Allocation of Items

The separate allocation of deductions may be desired in order to compensate existing partners for lost tax benefi ts (e.g., depreciation) when property is contributed with a value greater than its basis. Precontribution built-in gains and deductions economically incurred by a contributor prior to the contribution must be allocated to the contributor. Other partnership allocations of income or loss items must have an “economic effect” and that economic effect must be substantial.

Partner-Partnership Transactions

¶19,425 Indirect Ownership

The Code Sec. 267 attribution rules are applicable in determining indirect ownership in partnership relationships. Partnership interests owned by (1) the taxpayer’s family members and (2) entities owned (fully or partially) by the taxpayer can be attributed to the taxpayer. Review the example in the text.

¶19,445 Transactions Between Partner and Partnership

When a partner contracts to render a service to the partnership, the determination of whether the remuneration is a fee or a distribution of partnership income is based upon the certainty of the payment and the nature of the act. A partner can be deemed to not be acting in the capacity of a partner when making sales to a partnership, purchasing property from a partnership, rendering services to the partnership, or loaning money to the partnership.

¶19,501 Gain or Loss on Transactions Between Partner and Partnership

No loss is allowed on a sale or exchange of property between a partner and a controlled (more than 50 percent) partnership. Neither is a loss allowed between two commonly controlled partnerships. The transferee may offset the disallowed loss against any gain on a subsequent sale to an unrelated party. Any gain recognized on the sale or exchange of property between a partner and a controlled partnership (or between two commonly controlled partnerships) will be classifi ed as ordinary income unless the property is classifi ed as a capital asset in the hands of the transferee. The installment sale method of reporting may be used between a partner and the controlled partnership. The matching requirement for income/expense items between any partner and the partnership requires that these items be reported in the same year by both payer and payee if the payer is on the accrual basis and the payee is on the cash basis.

¶19,515 Guaranteed Payments

Guaranteed payments are made without regard to partnership income. They are ordinary income to the partner and an ordinary deduction to the partnership. With respect to guaranteed payments a general partner is considered to be a self-employed taxpayer and not an employee of the partnership (i.e., there is no FICA or federal income tax withheld from guaranteed payments).

A partnership agreement can be modifi ed up to the time for fi ling the partnership return, but retroactive allocations are prohibited and any allocation must refl ect the varying interest of the partner during the year. Certain cash-basis items of a cash-basis partnership are, in effect, placed on the accrual basis for purposes of allocation to incoming partners.

Deductibility of Losses

¶19,551 Loss-Limitations

The pass-through of losses to the partners is limited to the partner’s basis for the partnership interest, including a portion of the partnership’s liabilities. When pass-through losses exceed the partner’s basis, the excess



may be carried over indefi nitely, until the partner has a positive basis against which the loss can be applied. Ordinary losses and capital losses retain their character when carried over. In addition to the limitation of pass-through losses imposed by the partner’s basis, additional restrictions are imposed by the at-risk rules and the rules governing passive loss limitations.

Termination of Partnership

¶19,615 Closing of Taxable Year

The partnership’s taxable year closes with respect to any partner who ceases to be a partner during any year. For purposes of the remaining partners, the taxable year of the partnership closes on the usual closing date or (if applicable) on the date of termination of the partnership. The partnership is terminated on the sale of 50 percent or more of the interest in a partnership (both captial and profi ts interest) within a 12-month period. The partnership is not terminated on the withdrawal or retirement of a partner, or on the death of a partner with the estate serving as a surviving party in interest. Pragmatic rules apply to determine the successor when there is a merger, consolidation, or division of a partnership.

Family Partnerships

¶19,655 Bona Fide Partnership Relationship

In order for a family partnership to be valid, one of two requirements must be met: 1) for a partnership in which capital is a material income-producing factor, there must be an investment of capital that is the property of the partner, or 2) the partners genuinely intended to join together to carry on the business and share profi ts and losses.

¶19,665 Allocation of Income

A service partnership’s income allocation among family members (spouse, ancestors, lineal descendants, and trusts held for the benefi t of a family member) is subject to reallocation by the IRS if the partnership interest is not bona fi de or the donor is not allocated a reasonable amount of compensation for their services to the partnership. A reallocation may also be required if the portion of a donee-partner’s distributive share of income attributable to the donee’s capital is proportionately greater than that attributable to the donor-partner’s capital.

ANSWER TO KEYSTONE PROBLEM—CHAPTER 19

Sales $250,000Sales returns and allowances 4,800Net sales $245,200Less: Cost of goods sold 110,000Gross margin $135,200Expenses:

Salaries $50,000Rents 12,000Interest 6,000Real estate taxes 2,500

Depreciation:Building $3,377

Amortization of organization cost 200Bad debt expense 1,500 5,077 75,577Net profi t $59,623Code Sec. 1245 recapture 1,801



Acey DeucyPartnership ordinary income $61,424 $36,854 $24,570Separately reported items:

Foreign dividend income 750 450 300Domestic dividend 1,000 600 400Long-term capital gain domestic stock 2,500 1,500 1,000Short-term capital gain foreign stock 1,075 645 430Sec. 179 write-off 20,000 12,000 8,000Code Sec. 1231 gain 3,125 1,875 1,250Foreign income tax withholding 225 135 90Charitable contribution 400 240 160

Note: Since this is a retail sales business, there is no qualifi ed production activities income (QPAI). Since there is no QPAI, no Form W-2 wages will pass through to the partners.

ANSWERS TO QUESTIONS—CHAPTER 19

Topical List of Questions Reporting Partnership Income: Entity and Aggregate Theories (Overview, ¶19,285, ¶19,335, and ¶19,445) 1. Characteristics of a Partnership (¶19,001) 2. Adjustments to Outside Basis (¶19,025) 3. Basis of Partnership Interest: Tax-Exempt Items (¶19,025) 4. Allocation of Partnership Items: Contributed Property (¶19,115, ¶19,125, ¶19,135, and ¶19,145) 5. Gain Recognition on Receipt of a Partnership Interest (¶19,205, ¶19,215, ¶19,225, ¶19,235, ¶19,240, and 6. ¶19,245) Contributions to Partnership: Transfer of Services (¶19,215 and ¶19,225) 7. Disguised Sale (¶19,235) 8. Allocation of Items: Varying Interest Rule; Cash Basis Items (¶19,275) 9. Taxable Year of Partnership: Code Sec. 444 Election (¶19,280) 10. Taxable Year of Partnership: Deferral of Income (¶19,280) 11. Partnership Elections and Organization Costs (¶19,285 and ¶19,290) 12. Reporting Partnership Income: Separate Items (¶19,335) 13. Family Partnerships: Sale of Property (¶19,501) 14. Reporting Partnership Income: Guaranteed Payments (¶19,515) 15. Reporting Partnership Income: Guaranteed Payments—Partner Not Treated as Employee of the Partnership 16. (¶19,515) NOL Limitation on Current Deduction and Carryover (¶19,551) 17. Net Operating Losses: At-Risk and Passive Activity Rules (¶19,551) 18. Taxable Year of the Partner and the Partnership: Sale of Partnership Interests (¶19,615) 19. Termination of Partnership: Death of Partner (¶19,615) 20. Family Partnerships: Minor as Partner (¶19,655) 21. Family Partnerships: Allocation of Income (¶19,665) 22.



Answers to Questions

Reporting Partnership Income: Entity and Aggregate Theories

The “entity theory” of partnership taxation is the application of the income tax laws to the partnership as if 1. it were a “person” separate and distinct from its owners, the partners. The “bottom line” on page 1 of Form 1065 reveals the partnership’s “ordinary income” in much the same way as the income of a corporation would be shown. The “aggregate theory” of partnership taxation is the application of the income tax laws to the partnership as if the partnership did not exist but was merely an aggregation, a group of individuals acting together. Those items which are required to be reported separately by the partners illustrate this theory.

Characteristics of a Partnership

Under the federal income tax regulations, an unincorporated domestic business may elect to be taxed as a 2. partnership, whether it is a partnership under state law or not.

Adjustments to Outside Basis

A partner’s basis in the partnership interest is increased by (1) the contribution of money or property to the 3. partnership, (2) the partnership’s income, taxable or nontaxable, and (3) the partnership’s debts increasing. The partner’s basis in the partnership interest will decrease if (1) there is a withdrawal by the partner of assets from the partnership, (2) the partnership incurs losses, and (3) the liabilities of the partnership decrease.

Basis of Partnership Interest: Tax-Exempt Items

The partnership reports to the partners all items of income, both taxable and nontaxable. However, the 4. income item retains its character when passed through to the partners. Therefore, tax-exempt income items, such as the interest income from municipal bonds, would not be taxed to the partners. The receipt by the partnership of such items, however, increases the basis of the partner by the partner’s proportionate share of these items.

Allocation of Partnership Items: Contributed Property

When the cash-basis taxpayer contributes accounts receivable to an accrual partnership, the collection 5. of those items, whenever, generates ordinary income. When the contribution is of inventory items, their sale within fi ve years of their contribution generates ordinary income or loss no matter to what use the partnership has put them, and capital assets contributed with “built-in” losses will generate capital losses, to the extent of the built-in loss, if disposed of at a loss within fi ve years of their contribution to the partnership, even if they are not capital assets to the partnership.

Gain Recognition on Receipt of a Partnership Interest

First, if property is contributed to a partnership which is treated as an investment company, and there is 6. realized gain, it is recognized by the contributing partner. If there is realized loss, it is not recognized under the usual nonrecognition rules which cover property transfers to a partnership for an interest in the partnership. (Code Sec. 721(b).) Second, when a partner performs services in exchange for an interest in partnership capital and profi ts, the service partner recognizes income. The amount of income recognized equals the fair market value of the interest in partnership capital and profi ts. (Code Secs. 721(a), 61(a), and 83(a); Reg. § 1.721-1(b)(1).) Third, a partner may also recognize gain or loss if, within two years of a property contribution to a partnership, the partnership transfers money or other property to the partner. In such situations, all or part of the transfer is presumed by the IRS to be a sale of the property to the partnership.



Fourth, if a partner contributes appreciated property to a partnership and receives a distribution of any property other than cash or the originally contributed property within seven years of such contribution, the partner may be required by the IRS to recognize the lesser of: (i) the excess of the fair market value of the distributed property over the partner’s outside basis in the partnership before distribution, reduced by any money received in the distribution; or (ii) the remaining net precontribution gain. Fifth, if a partner contributes appreciated property to a partnership and that property is distributed to another partner or third party within seven years of the contribution date, the contributing partner may be required by the IRS to recognize any remaining precontribution gain on the property. Sixth, if property is encumbered with a mortgage, and it is transferred by a partner to a partnership in exchange for an interest in the partnership, in some situations gain may have to be recognized by the contributing partner. Gain must be recognized when the net liability relief to the transferring partner exceeds the partner’s basis in the partnership interest before considering the effects of the liability. (Code Secs. 731(a) and 752(a) and (b).)

Contributions to Partnership: Transfer of Services

When the partner contributes services for an interest in the partnership and receives an immediate interest 7. in the partnership’s capital, the contributing party recognizes ordinary income to the extent of the fair market value of the partnership interest. If the interest is a future interest in the profi ts of the partnership, the contributing partner generally recognizes ordinary income when the profi ts are earned. If there are substantial risks of forfeiture and no Section 83(b) election is made, the contributing partner recognizes ordinary income when the risk of forfeiture passes.

Disguised Sale

One interpretation is a tax-free contribution of property and, assuming Bobby’s basis for his partnership 8. interest is at least $75,000 before the August 7 distribution, a tax-free distribution of cash. Another interpretation is a sale of the property by Bobby to the Morley Partnership, causing Bobby to recognize $35,000 of gain. The IRS will interpret the transaction as a sale. The reason for the IRS interpretation is that, under the Treasury regulations, there is a presumptive two-year rule: Contributions and related later distributions which occur within two years are rebuttably presumed to be disguised sales.

Allocation of Items: Varying Interest Rule—Cash Items

In essence, the varying interest rule places the allocation of items on a day/share basis. With respect to 9. “allocable cash-basis items,” an incoming partner may not be allocated more of those items than are incurred during the period the incoming partner holds an interest in the partnership. Thus, if an incoming partner on December 1 received a 20 percent interest in a calendar-year, cash-basis partnership, which paid an annual charge for an expense item amounting to $24,000 for benefi ts received during the entire year, no more than $400 [($24,000 ÷ 12) × .2] can be allocated to the incoming partner.

Taxable Year of Partnership: Code Sec. 444 Election

A partnership electing a fi scal year under Code Sec. 444 must deposit with the IRS the amount of tax 10. which would be due if the income for the deferred period were currently taxed at a rate equal to the highest individual tax rate plus one percent. The deposit is not refunded until the amount of deferred income drops below the initially deferred amount. For example, a partnership electing a September 30 fi scal year is deferring three months’ income, October-December. A balance in the tax deposit account of the partnership must equal the tax on this deferred balance by the due date of the partnership return.

Taxable Year of Partnership: Deferral of Income

A calendar-year partner has a permanent deferral of partnership income when the partnership reports on 11. a fi scal year because each partner will report a share of the partnership’s earnings in the taxable year of the partner with which or in which the partnership’s taxable year ends. Thus for the partner’s tax return



for 2010, due by April 15, 2011, the partner would report a share of the partnership’s income earned from February 1, 2009, to January 31, 2010. Eli will defer recognition of his share of the partnership income for the 11 months from February 2010 to December 2010.

Partnership Elections and Organization Costs

12. With few exceptions, the partnership makes all elections which affect the computation of partnership a. taxable income. The following three elections are made by partners: (1) the election to treat foreign income taxes which the partnership pays or accrues as a deduction or a credit; (2) the election relating to treatment of certain mining exploration expenditures; and (3) the election to reduce the basis of property when partnership debt is forgiven. (Code Sec. 703(b).) Elections regarding depreciation and Code Sec. 179 expensing of costs are made by the partnership. One of the elections which the partnership makes relates to its organization costs. A partnership may b. elect to immediately deduct up to $5,000 worth of qualifying organization costs, and amortize the remainder ratably over 180 months from when the partnership begins business. Syndication costs which do not qualify, as well as organization costs for which the election is not made, must be capitalized and not amortized. The $3,000 of legal and accounting fees are qualifying organization costs; the $4,500 of brokerage and registration fees are not. If the partnership properly elects, it could take a $3,000 deduction with respect to the organization costs on its current year’s Form 1065. (Code Sec. 709 and Reg. § § 1.709-1 and 1.709-2.)

Reporting Partnership Income: Separate Items

Under present law, a taxpayer claiming a deduction for meals reports that deduction as a miscellaneous 13. deduction on Schedule A, Form 1040. Expenditures for meals are subject to a 50 percent reduction before applying the two percent of AGI fl oor. Since each individual may have a different allowable deduction, the meal expenditure must be reported separately on the partnership return so each partner can make their own calculation. It is likely that the excess of the expense over the reimbursement will be 50 percent deductible on Schedule A, Form 1040.

Family Partnerships: Sale of Property

If a partner owns directly or indirectly more than 50 percent of the capital interest or the profi ts interest in 14. the partnership and the sale results in a loss, the loss is disallowed. If the partner’s interest is more than 50 percent and the property is sold at a gain and it is not a capital asset in the hands of the partnership, all the gain is ordinary income. Through attribution rules a partner is deemed to own the interests owned by certain members of the partner’s family, so a family member/partner in a family partnership will probably own more than 50 percent of the partnership after attribution.

Reporting Partnership Income: Guaranteed Payments

A guaranteed payment is by defi nition a distribution of income from the partnership made without regard to 15. the amount of the income which the partnership reports. A corollary rule is that the income of the partnership retains its character in the conduit through to the partners. Thus, tax-exempt income remains exempt, capital gains remain capital gains, and the guaranteed payments will reduce ordinary income or generate an ordinary loss to the partnership. Since they are typically paid for services rendered or capital contributed, guaranteed payments are ordinary income to the partner who receives them. The payment will not reduce the capital gain at the partnership level. Rather, it creates an ordinary deduction to the partnership.

Reporting Partnership Income: Guaranteed Payments—Partner Not Treated as Employee of the Partnership

A partner, not being treated as an employee, may not be entitled to the many fringe benefi ts of an employee, 16. e.g., tax-free meals and lodging provided at the convenience of the employer, employee group-term life



insurance, medical coverage, and employee death benefi ts. On the other hand, while there is no withholding of income tax or Social Security by the employer, a general partner’s share of partnership income is income from self-employment, and the partner must pay both parts of the Social Security tax.

NOL Limitation on Current Deduction and Carryover

A partner’s deduction for partnership losses is limited to the basis of their partnership interest. If the 17. partner’s share of the losses exceeds the basis of their partnership interest, the deduction must be deferred until basis is increased before the losses can be used. It is possible for a partner whose basis has not increased suffi ciently, even over 20 years, to contribute property to the partnership after that time, thereby increasing basis, and at that time claim the loss. Similar deferrals can be made under the at-risk and passive activity loss limitation rules.

Net Operating Losses: At-Risk and Passive Activity Rules

The basis of a partner in a partnership interest includes a share of nonrecourse debts. The at-risk rules 18. generally prevent a partner from taking a pass-through loss against nonrecourse liabilities. Additionally, the passive loss rules prevent the current deductibility of a loss in excess of the income from passive activities. The excess passive loss is suspended until later passive income is recognized, either currently or by taxable disposition of the passive activity.

Taxable Year of the Partner and the Partnership: Sale of Partnership Interests

With respect to the selling of a 49 percent partnership interest, the partnership year ends with respect to 19. that partner but not with respect to the remaining partners. If, within a 12-month period, there is a sale or exchange of an additional one percent or more so that the total interests sold within that period are 50 percent or more of the total interests in the partnership capital and profi ts, the partnership year is terminated with respect to all partners upon the sale of the 50th percent.

Termination of Partnership: Death of Partner

Unless the partnership agreement so provides, as a general rule, the partnership year does not end upon 20. the death of the partner but continues to its normal year-end. If the partnership continues after a partner’s death, the deceased partner’s successor in interest will be treated as a partner. The partnership’s year-end will close with respect to the deceased partner. The deceased partner’s fi nal income tax return will include the partner’s share of income up to the date of death. The successor partner’s (estate or heir) income tax return will include the partnership income attributable to the partnership interest for the remainder of the partnership’s year.

Family Partnerships: Minor as Partner

The IRS will closely examine the claim that a minor child is a partner in a service partnership. By 21. defi nition, the income of such a partnership is generated by personal service and any allocation of income to a minor child must reasonably refl ect the services rendered to the partnership by that child. Where capital is a major income-producing item, the IRS is more lenient in recognizing minor children as partners who receive a share of the profi ts generated by their capital interest. In these cases, also, the services rendered by the adults must be adequately compensated for before distributions may be made with respect to capital.

Family Partnerships: Allocation of Income

In this manufacturing business, it is presumed that capital is an income-producing factor. The IRS would 22. likely attribute to the father the reasonable value of his services, $60,000, but disallow the “salary” for the son. Thus, the partnership’s ordinary income is $40,000 and this would be shared by the father, 60 percent, and the son, 40 percent.



ANSWERS TO PROBLEMS—CHAPTER 19

Topical List of Problems Partnership Interest—Adjusted Basis at Year-End (¶19,025) 23. Reporting by Partners of Partnership Income: Adjustments to Outside Basis (¶19,025) 24. Partnership Interest—Initial Adjusted Basis (¶19,025 and ¶19,035) 25. Transfer of Property with Precontribution Gain/Loss (¶19,115) 26. Transfer of Accounts Receivable for Partnership Interest (¶19,125) 27. Transfers of Inventory and Capital Loss Property for a Partnership Interest (¶19,135 and ¶19,145) 28. Transfer of Capital Loss Property for a Partnership Interest (¶19,145) 29. Partial Disguised Sale (¶19,235) 30. Disguised Sales: Two-Year Rule (¶19,235) 31. Disguised Sales: Seven-Year Rule for Transfers That Are Indirectly Reciprocal (¶19,240) 32. Formation of a Partnership—Contribution of Encumbered Property (¶19,245) 33. Formation of a Partnership—Contribution of Encumbered Property (¶19,245) 34. Liabilities as Part of Partnership Basis (¶19,250) 35. Required Tax Year of a Partnership (¶19,280) 36. Fee for Services v. Distributable Partnership Income (¶19,335 and ¶19,515) 37. Sale of Assets by Minority Partner to the Partnership (¶19,445) 38. Sale of Assets by Partnership to the Majority Partner (¶19,501) 39. Time of Reporting Guaranteed Payments: Concurrent Reporting of Items (¶19,501 and ¶19,515) 40. Ordinary Income Insuffi cient to Cover Guaranteed Payments (¶19,515) 41. Suspended Loss Carryovers (¶19,551) 42. Allocation of Recourse Debt—Constructive Liquidation Scenario (¶19,551) 43. Allocation of Partnership Income: Closing of Taxable Year (¶19,615) 44. Family Partnerships—Allocation of Income (¶19,665) 45. Multiple Choice—Partnership Defi nition (¶19,001) 46. Multiple Choice—Basis of Partner’s Interest (¶19,025) 47. Multiple Choice—Closing of a Partnership Tax Year (¶19,615) 48. Multiple Choice—Partnership Agreement (¶19,615) 49. Comprehensive Problem—Basis of Partnership Interest 50. Comprehensive Problem—Reporting Partnership Ordinary Income and Separate Items51. Practice Problem —Tax Return Issues 52. Research Problem—Partnership Defi nition and Electing Out of Partnership Provisions 53.



Answers to Problems

Partnership Interest—Adjusted Basis at Year-End

23.

Joe Jane Adjusted basis, beginning of year $10,000 $2,000Ordinary income 30,000 30,000Section 1231 gains 500 500Interest income from municipal bonds 250 250Short-term capital losses (1,000 ) (1,000 )Charitable contributions (1,500 ) (1,500 )Withdrawals (25,000 ) (20,000 )

Adjusted basis, end of year $13,250 $10,250

Reporting by Partners of Partnership Income: Adjustments to Outside Basis

24.

Ester's beginning basis 1/1 $60,000Increased by 75 percent of:

Partnership ordinary income $18,750Tax-exempt interest 750Long-term capital gain 3,750Total $23,250

Less: Withdrawals 5,000 18,250Ending basis 12/31 $78,250

Partnership Interest—Initial Adjusted Basis

Paul’s basis is $22,000, computed as the $20,000 basis in cash contributed plus his one-third share of the 25. $6,000 liabilities. Joe’s basis is $7,000, the $5,000 basis in the machinery contributed increased by his one-third share of the $6,000 liabilities. David’s basis is $6,000, the $10,000 basis in land contributed decreased by the two-thirds of the $6,000 liabilities allocated to the other two partners. The PJD partnership has a basis of $20,000 in cash, $5,000 in the machinery, and $10,000 in the land.

Transfer of Property with Precontribution Gain/Loss

Leonard has a built-in gain of $80,000, the excess of the fair market value of the contributed asset over its 26. basis to him. The basis of the property to the partnership was $120,000, its basis to the contributing partner. The sale at $500,000 generated a $380,000 gain. $80,000 is attributed to Leonard for his built-in gain, the remaining $300,000 is shared according to their profi t and loss ratio. Thus, Leonard has a total gain of $140,000 consisting of his $80,000 built-in capital gain plus $60,000, his 20 percent of the $300,000 gain refl ecting postcontribution appreciation. The gain probably will be classifi ed as Section 1231 gain. (Code Sec. 704(a) and (c).)

Transfer of Accounts Receivable for Partnership Interest

The accounts receivable retain their character in the hands of Lawyers Unlimited, so upon their collection 27. they are reported as ordinary income. As they were precontribution gain items, the income generated from their collection is attributable to the contributing partner. When the receivables are collected, they are ordinary income to Elder. The $50,000 balance of the partnership income will be taxed equally to all of the partners.



Transfers of Inventory and Capital Loss Property for a Partnership Interest

Summary: 28.

Bob Carl Don Ordinary income $20,000 $20,000 $20,000Sale of inventory contributed by Carl 4,000 10,000 4,000Sale of capital asset contributed by Don

Capital loss (20,000 )Ordinary loss ( 2,000 ) ( 2,000 ) ( 2,000 )

The $60,000 of ordinary income is allocated equally to each partner according to his one-third interest in the partnership. With respect to the inventory contributed by Carl, the $6,000 of precontribution gain is allocated to Carl. Code Sec. 704(c). The $12,000 of postcontribution gain is allocated equally, one-third to each. With respect to the capital asset contributed by Don, up to the amount of built-in capital loss at contribution, $20,000 is treated as such, regardless of how the property is used by the partnership. Code Sec. 724(c). Also, it is allocated entirely to Don. Code Sec. 704(c). The character of the remaining $6,000 of loss is determined by its use by the partnership, and it is allocated to each partner according to his interest in the partnership: thus, each partner receives $2,000 of ordinary loss from the sale of the capital asset contributed by Don, which subsequently is inventory to the Bamber partnership.

Transfer of Capital Loss Property for a Partnership Interest

29.

Basis of the land to Kelley precontribution $200,000FMV at time of contribution 100,000“Built-in” loss $100,000

Since the contributed property was sold by the partnership within fi ve years of its contribution, the partnership will report a capital loss of $80,000 ($120,000 − $200,000) because the built-in loss was at least this large. 100 percent of this loss will be allocated to Kelley. If the property is held by the partnership for more than fi ve years, the character of the loss will be determined by the character of the asset in the hands of the partnership. Thus, if the property were held for sale to customers in the ordinary course of the partnership business, after fi ve years the sale would result in an ordinary loss from the sale of an inventory item.

Partial Disguised Sale: Two-Year Rule

30. The IRS would seek to classify the transactions as a disguised sale because of the two-year rule in the a. Treasury Regulations. (Reg. §1.707-3.) That is, the November 23, 2009, contribution and the March 15, 2010, distribution take place within a two-year period, so there is a presumption that it is a disguised sale. Marvin will be deemed to have sold part of the property to the Munson Partnership. For the part sold, b. Marvin receives $187,500 cash. $56,250 of the property’s basis [($187,500 ÷ $250,000) × $75,000] is allocated to the partial sale. Thus, Marvin recognizes $131,250 of gain ($187,500 − $56,250) on the sale portion, and the partnership takes a cost basis of $187,500 in the sale portion of the property. Also, Marvin is deemed to contribute part of the property tax-free to the Munson partnership. The part contributed has a basis of $18,750 ($75,000 total basis − $56,250 basis allocated to the sale). Marvin increases the basis of his partnership interest by $18,750, and the partnership takes a basis of $18,750 in the part of the property contributed. The partnership’s total basis in the property will be $187,500 + $18,750 = $206,250 (Code Secs. 707(a)(2)(B), 722, and 723.)



Disguised Sales: Two-Year Rule

The Internal Revenue Service will contend that Jeff’s transfer of property to the Willing and Able 31. partnership, followed by a cash distribution to Jeff, is a disguised sale. As such, Jeff will be deemed to have sold two-thirds of the property to the partnership and contributed the remaining one-third interest in the property. The sale for $40,000 will be offset by $6,667 of the property’s basis (two-thirds of Jeff’s $10,000 basis in the property), resulting in a gain of $33,333.

Disguised Sales: Seven-Year Rule for Transfers That Are Indirectly Reciprocal

Whirligig’s adjusted basis in the land is $500,000, the same as Susan’s adjusted basis was in the land at the 32. time of her contribution. Whirligig does not recognize any gain upon distribution of the land. Susan will recognize the $300,000 of precontribution gain and her basis in Whirligig will increase by $300,000.

Formation of a Partnership—Contribution of Encumbered Property

The partnership assumes the $40,000 liability. Since Jed is a 60-percent partner, he is allocated $24,000 of 33. the liability, which increases his basis to $114,000. Ned is relieved of the $24,000 ($40,000 × Jed’s 60%) of liabilities which reduces his basis to $6,000 ($30,000 − $24,000). Neither partner recognizes any gain on the transfer of the assets to the partnership. The partnership has a basis in the assets equal to the partners’ bases in the assets. The basis in the cash is $90,000, and the basis in the building is $30,000.

Formation of a Partnership—Contribution of Encumbered Property

The partnership assumes the $40,000 liability. Since Jed is a 60-percent partner, he is allocated $24,000 of 34. the liability, which increases his basis to $114,000. Ned is relieved of the $24,000 of liabilities. However, since his basis in the building is only $20,000, he must recognize a gain of $4,000, and his basis in the partnership interest is zero. The partnership has a basis in the assets equal to the partners’ bases in the assets. The basis in the cash is $90,000, and the basis in the building is $30,000.

Liabilities as Part of Partnership Basis

35.

Investment in partnership for ⅓ interest $25,000⅓ of the mortgage of the partnership 50,000⅓ of partnership income 0Basis to James for his interest $75,000Sales price:Cash $62,500James's share of partnership mortgage debt 50,000Total sales price of James's interest $112,500James's gain ($112,500 − $75,000) $37,500

Held for less than one year, the sale of the partnership interest generates a short-term capital gain. (There is no evidence of Section 751 assets being present.)

Required Tax Year of a Partnership

Code Section 706(b) requires, in the absence of a business purpose, that the partnership adopt the tax year that 36. is common to partners who own a majority interest (more-than-50-percent aggregate interest in partnership profi ts and capital) in the partnership. A tax year cannot be adopted under this requirement because no majority-interest partners have the same tax year. Next, the partnership must use the tax year which is common to all of its principal partners (fi ve-percent-or-more interest in partnership profi ts or capital). A tax year cannot be adopted under this requirement because the principal partners don’t have the same tax year. Next, the partnership must use the tax year which results in the least aggregate deferral of income to the partners. (Code Sec. 706(b)(1)(B)(iii) and Reg. §1.706-1T(a).) Each partner’s tax year must be tested.



Test #1: 12/31 Tax Year-End

Partner Year-End Interest

in Profi ts Months of Deferral

Interest × Months

of Deferral

A 12/31 .04 0 0B 12/31 .45 0 0C 6/30 .21 6 1.26D 9/30 .30 9 2.70

3.96




Interest × Months

of Deferral

A 12/31 .04 6 .24B 12/31 .45 6 2.70C 6/30 .21 0 0D 9/30 .30 3 .90

3.84




Interest × Months

of Deferral

A 12/31 .04 3 .12B 12/31 .45 3 1.35C 6/30 .21 9 1.89D 9/30 .30 0 0

3.36The Nelson partnership is required to adopt a tax year which runs from October 1 through September 30 because that produces the least aggregate deferral (3.36). Assuming that there are no changes in the make-up of its partners, it will fi le its fi rst Form 1065 for the short tax year, July 17, 2010, through September 30, 2010. The return must be fi led by January 15, 2011.

Fee for Services v. Distributable Partnership Income

Ozone’s income, exclusive of Archie’s arrangement, is $40,000. Apparently there would be no problem 37. allocating $10,000 of the income to Archie since he contributed cash for his 25 percent interest. However, the $25,000 cash payments, in view of the relative certainty of their payment, would not be recognized as either a distribution of partnership income or a deductible fee. Probably they would be treated by Ozone as a capitalizable construction charge, a fee earned by Archie for his architectural services and depreciated by the partnership. Archie would recognize each $25,000 as income for services rendered.



Sale of Assets by Minority Partner to the Partnership

$5,000 short-term capital gain. As a 20 percent partner, Henry is treated as if he were a stranger dealing 38. with the partnership. Accordingly, the gain on the sale is reported in full even though in fact he is selling 20 percent of the asset to himself.

Sale of Assets by Partnership to the Majority Partner

As this was a sale by Henry to the partnership, there is no carryover basis or carryover holding period; the 39. basis of the stock to the partnership is its $10,000 cost, its acquisition date commencing with its holding period. Thus, the partnership would have a short-term capital gain of $5,000 upon the sale to Isaac, $1,000 of which would be reportable by Henry. If Isaac were a dealer in securities, the $5,000 gain would not be a short-term capital gain but would be classifi ed as ordinary income. This is a sale of an asset to a more-than-50-percent partner in whose hands the asset is not a capital asset.

Time of Reporting Guaranteed Payments: Concurrent Reporting of Items

40.

Baker's distributive share of partnership ordinary income FY 09-10 $30,000Baker's salary (guaranteed payment) 12,000

Total $42,000

Baker must report his distributive share of partnership ordinary income and his guaranteed payments from the partnership for the partnership year ending with or within his taxable year as reported by the partnership whether or not those funds are actually paid over to the partner within that same year.

Ordinary Income Insuffi cient to Cover Guaranteed Payments

41.

Partnership ordinary loss prior to guaranteed payment $(8,000 )Guaranteed payment “salary” to Bob 12,000Partnership ordinary loss $(20,000 )

Bob Jack Share of partnership ordinary loss $(10,000 ) $(10,000 )Guaranteed payment 12,000Ordinary income (loss) $2,000 $(10,000 )Long-term capital gain 3,000 3,000Tax-exempt interest 1,000 1,000

Net Operating Loss Carryovers

42.

Basis Suspended

Loss 1/1/07 at time of investment $10,0002007 30% of $50,000 loan 15,0002007 30% of $100,000 loss ($30,000reportable loss limited to basis) (25,000 ) $ 5,00012/31/07 basis 02008 30% of $10,000 income $ 3,0002007 loss carryover limited to basis (3,000 ) (3,000 )



12/31/08 basis 0 $ 2,0002009 30% of $50,000 income 15,0002009 30% of liability reduction (15,000 )12/31/09 basis 02010 30% of $100,000 income $30,0002007 loss carryover (2,000 ) (2,000 )2010 reportable income and 12/31/10 basis $28,000 $ 0

Allocation of Recourse Debt—Constructive Liquidation Scenario

Recourse debt is allocated to the partners using the constructive liquidation scenario. Under this method, 43. all partnership assets are deemed to be sold for zero. The resulting hypothetical losses are allocated to the partners using their loss-sharing ratios. Partners with defi cits in their capital accounts are hypothetically required to contribute cash in the amount necessary to restore their capital account to zero. This amount they are “required” to contribute is the amount of the liability they are allocated. Under this approach, the $150,000 of losses are allocated $90,000 to Jack and $60,000 to Jake. This reduces Jack’s capital account to a defi cit of $60,000 and Jake’s capital account to a defi cit of $30,000. Therefore, the debt is allocated $60,000 to Jack and $30,000 to Jake.

Allocation of Partnership Income: Closing of Taxable Year

44.

Frank's share of the partnership's fi scal year ending 9/30/2010 $15,000His share of the partnership's short year ending with termination of the partnership 12/31/2010 4,500Total income reportable in 2010 $19,500

Family Partnerships—Allocation of Income

Wilhelm’s basis for his interest is $55,000, the cash he invested. It is immaterial that the cash originated 45. with his father; its transfer to Wilhelm would be subject to gift tax rules. There is nothing inherently wrong in recognizing goodwill as an existing asset at the formation of a partnership. As this is a consulting fi rm, the question concerns the relative contribution to the fi rm’s earnings by William and Wilhelm. As William generated two-thirds of the gross income and Wilhelm only one-third, the IRS could insist that the division of income should refl ect this division of labor, i.e., $40,000 to William, $20,000 to Wilhelm.

Multiple Choice—Partnership Defi nition

e. A partnership is an association of two or more persons. The word “persons” is given its widest meaning 46. so as to include any natural person or any legal entity.

Multiple Choice—Basis of Partner’s Interest

b. Unless the basis of the partner’s interest was increased by the receipt by the partnership of tax-exempt 47. items, a subsequent sale of the partnership interest could cause this tax-exempted income to be taxed.

Multiple Choice—Closing of a Partnership Tax Year

a. The taxable year of a partnership closes with respect to all partners only when the partnership terminates. 48. (Code Sec. 706(c).) The partnership terminates when no business is carried on by its partners in a partnership or there is a sale or exchange of 50 percent or more of the total interest in the partnership’s capital and profi ts within a 12-month period. (Code Sec. 708.) Only in response (a) is there a partnership taxable year closing with respect to all of the partnership’s partners.



Multiple Choice—Partnership Agreement

e. A partnership year normally does not end with the death of a partner; items of income and deduction, 49. when they refl ect contributed items, must be allocated to refl ect the unrecognized gain or loss of the contributor; a partnership year ends with the sale of a partnership interest with the respect to the selling partner regardless of the percentage of his or her ownership interest, and no partner is entitled to compensation for his services or payment for use of his capital in the absence of a provision in the partnership agreement.

Comprehensive Problem—Basis of Partnership Interest

If Hazel contributes all of her assets to the partnership, her basis for her partnership interest will be 50. $65,000, the sum of the adjusted bases of the property she contributed. There would be no recapture of depreciation with respect to either the building or the equipment. The accounts receivable and the gold would each have a zero basis. The accounts receivable would be taxed to Hazel when collected and the accounts payable deductible by her when paid. If she were to borrow the money and transfer the property subject to the liability, she would be deemed to receive “money” equal to the portion of the debt, $50,000, now the liability of the other party. As this money would not exceed the adjusted bases of the property transferred, there should be no problem. However, the IRS could challenge the transaction as part sale and part contribution. If she were to retain the building, the depreciation charge would be the same as that which could be taken by the partnership, but this would be a cash shelter for her. The $25,000 rental seems modest as she would have to bear the maintenance costs. (Code Secs. 704(c), 707(a)(2)(B), 721, and 752.)

Comprehensive Problem—Reporting Partnership Ordinary Income and Separate Items

Items of partnership ordinary income and those to be reported separately are listed as follows. 51.

Separate Items Partnership

Ordinary Income Barbara Colleen

Profi ts from the business $10,000Dividends: Domestic corporations $ 500 $ 500Charitable contributions (250 ) (250 )Long-term capital gains 1,000 1,000Short-term capital losses (250 ) (250 )Sec. 1245 Gain—Sale of equipment 800Casualty loss—Cash theft (1,200 )Casualty loss—Personal 0 *Royalty check—Investment income 200 200Percentage depletion (1,000 ) 500 ** 500 **Sec. 179 write-off (1,000 ) (1,000 )Contribution to Capital—Barbara 4,500 ***

* This would be a personal casualty loss and would not be refl ected on the partnership return. ** Reported as a tax preference item. Depletable property other than oil and gas. *** Not taxable income to the partnership but would be reported as a contribution to capital on Barbara's K-1.

Note: Since this is apparently a retail business, there would be no qualifi ed production activities income to report.



Practice Problem—Tax Return Issues

52. Ordinary business income:a.

Sales $400,000COGS

Purchases $180,000Ending inventory −40,000 140,000

Gross profi t $260,000Interest expense 1,500Salaries 40,000Guaranteed payment 15,000Depreciation 30,000Rent expense 20,000Total expenses −106,500Ordinary business income $183,500

Separately stated items:b.

Interest income 5,000Dividend income 1,000Section 179 expense −25,000Total separately stated income $19,000

Total tax net income:c.

Ordinary business income $183,500Total separately stated income −19,000,Total tax net income $164,500

Book/tax differences:Bad debt expense 4,000Depreciation (incl. Sec. 179) 35,000Overall book/tax difference 31,000Book net income $195,500

Ending cash balance (computed to confi rm balance sheet):d.

Beginning balance $200,000Total tax income $164,500Ending inventory −40,000Purchases of equipment −150,000Accounts receivable −35,000Depreciation 55,000Decrease in cash −5,500Ending cash $194,500



Balance sheet

Beginning EndingCash $200,000 $194,500Accounts Rec. (net) 31,000Inventory 0 40,000Equipment 0 150,000Accum. Depr. 0 −20,000Land 130,000 130,000Assets $330,000 $525,500

Liabilities and Owner’s Equity:

Mortgage $30,000 $30,000Capital

Adam 100,000 165,167Barbara 100,000 165,167Charlotte 100,000 165,166

Total Liabilities and Owner’s Equity 300,000 525,500

Research Problem—Partnership Defi nition and Electing Out of Partnership Provisions

53. Yes. An arrangement between two oil companies and an individual, where each sold his or its share (1) of the production directly to a purchaser, was held to be a partnership. Each co-owner did not have the authority to sell any other co-owner’s share of the production. See Bentex Oil Corporation v. Commissioner (20 TC 565). In Madison Gas and Electric Company (72 TC 521, CCH Dec. 36,142, aff’d, 80-2 USTC ¶ 9754, 633 F.2d 512 (CA-7, 1980)), the U.S. Court of Appeals for the Seventh Circuit affi rmed the Tax Court in holding that, as long as the requisite degree of business activity was carried on, the participants in a joint venture did not have to produce a single joint cash profi t to be classifi ed as a partnership for federal income tax purposes. In Revenue Ruling 68-344 (1968-1 CB 569), the IRS held that a venture formed by four electrical power corporations (in which the participants owned several large electrical generating units as tenants in common and each corporation had the right to and took its share of the power generated, and each corporation, through its own system, separately sold and distributed this power to its own customers) was classifi ed as a partnership for federal tax purposes. Yes. The arrangement here seems to be in the form of an operating agreement, as described in Reg. (2) §1.761-2(a)(3). It appears that the arrangement meets the following three criteria spelled out in the Regulation, and, accordingly, should be able to elect out of the application of Subchapter K:

The plant is owned by Mary, Nell, and Louise as co-owners. a. Each reserves the right separately to take in kind and dispose of their shares of the plant’s production. b. They do not jointly sell the property produced. c.

Also, the participants must be able to compute their income without the necessity of computing partnership taxable income. See Revenue Ruling 68-344 (1968-1 CB 569) and Revenue Ruling 82-61 (1982-1 CB 13), which specify that participants in a joint venture, where each participant has the right to take his or its share of production, may elect under Section 761(a) to be excluded from the Subchapter K partnership provisions.

Yes. In (3) Estella G. Johnson (TC Memo. 1990-461, 60 TCM 603, CCH Dec. 46,834(M)), the Tax Court stated that an election out of Subchapter K does not free the participants from other provisions of the Internal Revenue Code. Therefore, a partner in a venture which elects out of the Subchapter K partnership provisions under Section 761(a), if not a limited partner, is subject to self-employment tax on the partner’s distributive share of the partnership’s earnings.

2011 comp topics im ch19

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