BUSINESS - TOUGH QUESITONS Flashcards
David and Robert form an equal partnership. David contributed $10,000 cash to the partnership and Robert contributed depreciable property with a fair market value of $10,000 and an adjusted basis of $4,000. What is the partnership’s basis for depreciation of the property and how is the depreciation deduction allocated among the partners (assuming the depreciation rate is 10% per year)?
Partnership’s Basis for Depreciation / Annual Depreciation Deduction (David / Robert)
A. $4,000 Basis / $200 David / $200 Robert
B. $4,000 Basis / $400 David / $0 Robert
C. $4,000 Basis / $0 David / $400 Robert
D. $10,000 Basis / $500 David / $500 Robert
B. $4,000 Basis / $400 David / $0 Robert
EXPLANATION:
The basis of a partnership interest is the money plus the adjusted basis of any property the partner contributed. If the FMV value of the property is greater than the adjusted basis there may be a built-in gain on the contribution. The partnership must allocate among the partners any income, deduction, gain, or loss on the property in a manner that will account for the difference. This built-in gain must be allocated appropriately between the partners using a reasonable method as described in 26 CFR 1.704-3 to avoid shifting the tax consequences of the built-in gain or loss. If the partnership sells contributed property and recognizes gain or loss, built-in gain or loss is allocated to the contributing partner. If contributed property is subject to depreciation or other cost recovery, the allocation of deductions for these items takes into account built-in gain or loss on the property. Tax allocations to the noncontributing partners of cost recovery deductions with respect to section 704(c) property generally must, to the extent possible, equal book allocations to those partners.
Since Robert contributed property with an adjusted basis of $4,000 and FMV of $10,000, there is a built-in gain of $6,000.
The FMV of the property contributed by Robert was $10,000. The depreciation rate is 10%. Therefore the total allowable depreciation for the partnership on the property is $1,000 per year ($10,000 × 10%) if the adjusted tax basis of the property had equaled its fair market value at the time of contribution. If this were the case each partner would be allocated $500 of the allowable depreciation expense because they are equal partners ($500 + $500 = $1,000 depreciation per year). David would have been entitled to a depreciation deduction of $500 per year for both book and tax purposes. Although each partner is allocated $500 of book depreciation per year, the partnership is allowed a tax depreciation deduction of only $400 per year (10% of $4,000).
The total depreciation, depletion, gain, or loss allocated to partners cannot be more than the depreciation or depletion allowable to the partnership or the gain or loss realized by the partnership. The partnership can allocate only $400 of tax depreciation under the ceiling rule, and it must be allocated entirely to David.
ADDITIONAL NOTE 01:
Kristina - 09/6/2020, 9:55 am
Tax depreciation is allocated to the noncontributing partner up to the amount of the share of their book depreciation, if possible. Any remaining contributions are allocated to the contributing partner. Robert is the contributing partner because he contributed the property. David is the noncontributing partner.
There is only $4,000 in depreciation available. The entire amount will be allocated to David, the non-contributing partner, as his share of book depreciation on the property would be $500 and there is only $400 of depreciation to claim. Once the property is fully depreciated, there is nothing left for anybody to deduct. If the depreciable basis were $6,000 instead of $4,000, David would receive $500 and Robert would receive $100, until the $6,000 is used up.
ADDITIONAL NOTE 02:
Kristina - 08/10/2019, 12:49 pm
Another community member (Lori), posted this explanation and I think it will clarify the question for you…
The amount of depreciation available for tax purposes is calculated based on the tax basis of the property, which is generally the basis carried over from the contributing partner, as adjusted ($4,000). Tax depreciation is allocated to the noncontributing partner up to the amount of the share of their book depreciation, if possible. Any remaining contributions are allocated to the contributing partner. Robert is the contributing partner because he contributed the property.
There is only $4,000 in depreciation available. The entire amount will be allocated to David, the non-contributing partner, as his share of book depreciation on the property would be $500 and there is only $400 of depreciation to claim. Once the property is fully depreciated, there is nothing left for anybody to deduct. If the depreciable basis were $6,000 instead of $4,000, David would receive $500 and Robert would receive $100, until the $6,000 is used up.
Sharon’s basis in S & P partnership is $185,000. In a complete liquidation of Sharon’s interest in S & P, Sharon received the following:
S & P
’
s Basis Fair Market Value
Cash $5,000 (B) $5,000 (FMV)
Building $50,000 (B) $100,000 (FMV)
Land $40,000 (B) $50,000 (FMV)
What is Sharon’s basis in the building?
A. $50,000
B. $100,000
C. $116,667
D. $120,000
D. $120,000
EXPLANATION
The basis of property received in complete liquidation of a partner’s interest is the adjusted basis of the partner’s interest in the partnership reduced by any money distributed to the partner in the same transaction.
Sharon’s basis in the partnership is $185,000. After subtracting the $5,000 received in cash she has an additional $180,000 to allocate to the property.
First, she must allocate basis equal to the partnership’s adjusted basis ($50,000 to building and $40,000 to land).
Next she must allocate an amount to each property to the extent of the unrealized appreciation. She allocates $50,000 to the building and $10,000 to the land.
Each property has a basis equal to FMV, but she still has $30,000 of unallocated basis remaining ($185,000 – $155,000 allocated thus far). Since she still has $30,000 to allocate she must increase the basis of property received by the amount of the excess, pro rata according to FMV.
The Building at $100K is 66.67% of the Assets, and the Land at $50K is 33.33% of the Assets.
The building represents 2/3 of the total value; therefore, an additional $20,000 is allocated to it. The basis of the building is $120,000.
OR EXPLAINED ANOTHER WAY:
With a complete liquidation of a partner’s interest there is a specific process used to allocate a basis increase. The starting point is the adjusted basis of the properties to the partnership. Next take into account any unrealized appreciation. After this step any remaining basis increase is allocated among the properties affected in proportion to their respective FMV’s.
The building has unrealized appreciation of $50,000 for the difference between the FMV ($100,000) and the partnerships adjusted basis for the building ($50,000). In addition, the land has unrealized appreciation of $10,000 for the difference between the FMV (50,000) and the partnership’s adjusted basis for the land ($40,000).
Following this step, there is an additional $30,000 ($180,000 - $50,000 basis of building - $50,000 unrealized appreciation - $40,000 basis of land - $10,000 unrealized appreciation) remaining to be allocated between the building and the land.
Any remaining basis increase is allocated among all the properties in proportion to their respective fair market values.
The FMV of the building is $100,000 and the FMV of the land is $50,000. The total FMV of both items is $150,000 and the building will be allocated 2/3 ($100,000 / $150,000) of the remaining basis increase.
The building will be allocated $20,000 of the remaining $30,000 basis increase ($30,000 x 2/3).
Sharon’s basis in the Building is $120,000 ($100,000 + (2/3 x $30,000)).
You purchased a candy making machine for your business. The machine cost $50,000 and you claimed a $20,000 Internal Revenue Code section 179 deduction for that machine. You sold the machine for $52,000. Your accumulated depreciation was $18,974 (not including the section 179 deduction). How much is your taxable gain and what portion of that gain must be reported as ordinary income under Internal Revenue Code Section 1245?
A. Taxable gain of $40,974 / ordinary income recapture of $38,974
B. Taxable gain of $40,974 / ordinary income recapture of $40,974
C. Taxable gain of $20,974 / ordinary income recapture of $18,974
D. Taxable gain of $2,000 / ordinary income recapture of $2,000
A. Taxable gain of $40,974 / ordinary income recapture of $38,974
EXPLANATION
Reduce the purchase price of $50,000 by $38,974 of depreciation ($18,974 and the Section 179 deduction of $20,000) to arrive at the adjusted basis of $11,026. The taxable gain of or $40,974 is the difference between adjusted basis and the sales proceeds of $52,000.
Any property (other than depreciable real property), that is or has been subject to an allowance for depreciation or amortization is subject to Sec. 1245 recapture rules. Section 1245 property does not include buildings and structural components. The taxpayer recaptures a portion of the gain from the disposition of the property due to depreciation as ordinary income. Section 1245 requires that all gain be treated as ordinary gain to the extent of the depreciation taken on the property disposed of. Since the gain on this transaction is larger than the amount of depreciation claimed, all $38,974 in depreciation is recaptured as ordinary income.
ADDED EXPLANATION:
You initially claim a depreciation expense ($20,000 in this case) due to the §179 deduction. This taxpayer also claims an additional $18,974 in depreciation, for a total of $38,974.
For 1245 property (tangible business property other than real estate) treat any part of the gain due to depreciation (including any accelerated depreciation under Section 179) as ordinary gain UP TO THE AMOUNT of gain on the sale.
NOTE 03:
The remaining $2,000 in gain will be a LONG-TERM CAPITAL GAIN income.
John died on January 1. A calendar year was elected for his estate. No distributions were made by the estate. Based on the following, what is the taxable income (Form 1041) of the estate for the December 31 year end? Allow for the estate’s exemption amount.
Taxable interest $2,000
Tax-exempt interest $1,000
Capital gain $3,000
Executor’s fees $300
A. $6,300
B. $4,200
C. $4,100
D. $4,900
B. $4,200
EXPLANATION
If an estate with tax-exempt income elects to deduct administrative expenses on Form 1041, an allocation of a portion of those expenses is made to tax-exempt income. When figuring the estate’s taxable income on Form 1041, you cannot deduct administration expenses allocable to any of the estate’s tax-exempt income. However, you can deduct these administration expenses when figuring the taxable estate for federal estate tax purposes on Form 706. That portion is not a deduction in arriving at the net income of the estate. As a result, a portion of the administration expenses will be lost.
The executor may allocate expenses not attributable to a specific class of income (such as executor fees or legal expenses) to any item of income included in computing the distributable net income (DNI) of the estate. Capital gains are not part DNI. Taxable interest ($2,000) represents two-thirds of total interest ($2,000 taxable interest + $1,000 tax-exempt interest = $3,000 total interest), so only $200 of the executor’s fees are allowed as a deduction (two-thirds of the $300 executor’s fees = $200 executor’s fees deduction allowed).
The gross income is the $2,000 in taxable interest and the $3,000 capital gain; a total gross income of $5,000. A decedent’s estate is allowed a $600 exemption. Deducting the $600 estate exemption and executor fees of $200 results in taxable income for the estate of $4,200 ($5,000 gross income – $600 exemption – $200 executor’s fees deduction allowed).
On January 1, Year One, Ramierez contributes cash of $30,000 and equipment with a tax basis of $12,000 but a fair value of $21,000 to a new business called STR Partnership. As a result, Ramierez becomes a partner with a 40 percent ownership. In Year One, the business reports total income of $70,000 and paid each partner $20,000 in cash. What was Ramierez’s basis in this business at the end of Year One?
A. $42,000
B. $50,000
C. $59,000
D. $70,000
B. $50,000
EXPLANATION
In a partnership or S corporation, property conveyed to or from an owner keeps its tax basis. Therefore, the initial investment by Ramierez is viewed as $42,000 ($30,000 in cash plus equipment with a $12,000 tax basis to the partner). This partner is entitled to 40 percent of the income ($28,000 or $70,000 × 40%). The cash distribution of $20,000 reduces the capital investment (in both a partnership and an S corporation). Consequently, by the end of the year the capital investment is $50,000 ($42,000 + $28,000 – $20,000).
John owned a printing business and sold the following assets in 20X2.
Printing press: Sales price $25,000; Original cost $20,000; Allowed or allowable depreciation $8,000
Computer equipment: Sales price $30,000; Original cost $28,000; Allowed or allowable depreciation $14,000
John had a net Section 1231 loss of $6,000 in 20X1. What is the amount and character of John’s gain for 20X2?
A. $14,000 ordinary income; $15,000 capital gain
B. $22,000 ordinary income; $7,000 capital gain
C. $28,000 ordinary income; $1,000 capital gain
D. $0 ordinary income; $29,000 capital gain
C. $28,000 ordinary income; $1,000 capital gain
EXPLANATION
In this example, the realized gain on the property sold is $29,000 ($55,000 received – $26,000 basis).
Any property (other than depreciable real property), that is or has been subject to an allowance for depreciation or amortization is subject to Sec. 1245 recapture rules. The taxpayer recaptures a portion of the gain from the disposition of the property due to depreciation as ordinary income.
Of this gain, treat $22,000 ($8,000 + $14,000) due to prior depreciation as ordinary income (Sec. 1245 recapture).
Under non-recaptured Sec. 1231 loss rules, any current year net Section 1231 gains are ordinary gains up to the amount of non-recaptured section 1231 losses from the five prior years, the rest is a long-term capital gain.
The $6,000 prior year Section 1231 loss is recaptured as ordinary income.
Of this $29,000 gain, $28,000 is ordinary income ($22,000 depreciation recapture + $6,000 prior year §1231 loss) and the remaining $1,000 is a capital gain.
EXTRA NOTES:
The resulting profit on the transaction does not change, but the way it is taxed does. Under §1231, losses are ordinary but gain is capital gain. This is quite beneficial to a taxpayer. Keep in mind, that under §1231 a gain is ordinary gain if the taxpayer deducted §1231 losses in the previous five years.
The total gain on this transaction is $29,000. Under §1245 the taxpayer must treat $22,000 due to depreciation as ordinary gain. Under §1231 the taxpayer must treat $6,000 of the gain (to account for prior year §1231 loss) as ordinary gain, and the remaining $1,000 is capital gain.
The Englander Company bought land two years ago for $20,000. The property is now worth $24,000 although the corporation still owes $15,000 on its purchase. The company makes a nonliquidating distribution of this property to one of its stockholders who also accepted the obligation for the debt. What is the tax effect to Englander of making this distribution?
A. It is a dividend; there is no tax effect.
B. Englander recognizes a gain of $4,000.
C. Englander recognizes a gain of $9,000.
D. Englander recognizes a gain of $19,000.
B. Englander recognizes a gain of $4,000.
EXPLANATION
For the nonliquidating distribution of property by a corporation, the corporation must report the transfer as if the property had been sold and the money conveyed as a dividend. The form of the dividend should not change the tax implications. Although the property had originally cost $20,000, it could have been sold for $24,000 and a gain of $4,000 incurred. The company could have then taken $15,000 of that amount to pay off the liability with the remaining $9,000 paid to the owner as a dividend. Giving the property directly to the owner should not change that tax effect; the gain is $4,000 as if the property had been sold.
Tracy has a one-fourth interest in the TANY Partnership. The adjusted basis of her interest at the end of the current year is $30,000. She sells her interest in the TANY Partnership to Roy for $50,000 cash. There was no agreement between Tracy and Roy for any allocation of the sales price. The basis and fair market value of the partnership’s assets (there are no liabilities) are as follows:
Adjusted Basis Fair Market Value Cash $40,000 $40,000 Unrealized receivables 0 36,000 Inventory 40,000 92,000 Land 40,000 32,000 Total $120,000 $200,000 What is the amount and character of Tracy's gain or loss?
A. $0 ordinary income, $0 capital gain
B. $20,000 ordinary income, $0 capital gain
C. $10,000 ordinary income, $10,000 capital gain
D. $22,000 ordinary income, $2,000 capital loss
D. $22,000 ordinary income, $2,000 capital loss
EXPLANATION
The first step is determining the total gain on the sale of the partnership interest. $50,000 received – $30,000 basis = $20,000 total gain.
If a partner receives money or property in exchange for any part of a partnership interest, the amount due to his or her share of the partnership’s unrealized receivables or inventory items results in ordinary income or loss. This amount is treated as if it were received for the sale or exchange of property that is not a capital asset.
Tracy has a 1/4 interest in the partnership and must recognize her share of unrealized receivables and appreciated inventory items as ordinary gain. Inventory appreciation is $52,000 ($92,000 FMV – $40,000 Adjusted Basis). $36,000 unrealized receivables + $52,000 inventory appreciation = $88,000 unrealized receivables and appreciated inventory items. Her 1/4 share of $88,000 is $22,000. She will recognize a $22,000 ordinary gain, representing her 1/4 share of these Section 751 assets (unrealized receivables and appreciated inventory items).
The difference between the amount of capital gain or loss that the partner would realize in the absence of section 751 and the amount of ordinary income or loss is the transferor’s capital gain or loss on the sale of its partnership interest.
$20,000 total gain – $22,000 ordinary gain = $2,000 capital loss on the sale of the partnership interest.
