Chapter 10 Flashcards
A partnership cannot recognize a gain or loss on a current distribution.
False
If a partnership asset with a deferred precontribution gain is distributed within seven years of acquisition in a nonliquidating distribution to a partner who did not contribute the asset, the precontribution gain must be recognized by the contributing partner.
True
In a current distribution, the partner’s basis in the partnership interest is reduced by the amount of money received and by the partnership’s bases in the distributed property.
True
A partner’s holding period for property distributed as a current distribution begins on the date of distribution.
False
A new partner, Gary, contributes cash and assumes a share of partnership liabilities. Diane’s capital, profits, and loss interest in the partnership is reduced by 5% due to the admission of Gary. The Sec. 751 rules do not apply. Partnership liabilities at the time Gary is admitted are $200,000, and all of the liabilities are recourse debts for which the partners share the economic risk of loss in the same way they share partnership profits. Diane’s basis in the partnership interest prior to Gary’s admission is $5,000. Due to the admission of Gary, partner Diane has
A) no recognized gain or loss and a partnership interest basis of $10,000.
B) no recognized gain or loss.
C) a recognized gain of $5,000 and a partnership interest basis of zero.
D) a recognized gain of $5,000 and a partnership interest basis of $5,000
C) a recognized gain of $5,000 and a partnership interest basis of zero.
Explanation: Diane’s reduction in partnership liabilities by the addition of Gary is $10,000 (0.05 × $200,000 = $10,000). Because the $10,000 reduction is deemed cash distributed, Diane has a gain equal to the excess of the cash deemed distributed over her basis:
Cash deemed distributed $10,000 Minus: original basis ( 5,000) Gain recognized $ 5,000
The new basis of Diane’s partnership interest is zero.
If a distribution occurs within \_\_\_\_\_\_\_\_ years of the contribution date, in a nonliquidating distribution that does not qualify for Sec. 751 treatment, the distribution event may trigger a precontribution gain or loss. A) three B) five C) seven D) unlimited
C) seven
Mirabelle contributed land with a $5,000 basis and a $9,000 FMV to MS Partnership four years ago. This year the land is distributed to Sergio, another partner in the partnership. At the time of distribution, the land had a $12,000 FMV. How much gain should Mirabelle and Sergio recognize?
Mirabelle; Sergio
a. $0; $0
b. $4,000; $0
c. $4,000; $3,000
d. $5,500; $1,500
b. $4,000; $0
Mirabelle contributed land with a $5,000 basis and a $9,000 FMV to MS Partnership four years ago. This year the land is distributed to Sergio, another partner in the partnership. At the time of distribution, the land had a $12,000 FMV. What is the impact of the distribution on Mirabelle's partnership basis? A) 0 B) $4,000 increase C) $4,000 decrease D) $7,000 increase
B) $4,000 increase
Susan contributed land with a basis of $6,000 and an FMV of $10,000 to the SH Partnership two years ago to acquire her partnership interest. This year, the land is distributed to Harry when its FMV is $11,000. No other distributions have been made since Susan became a partner. When the land is distributed, the partnership's basis in the land immediately before distribution is increased by A) $0. B) $1,000. C) $4,000. D) $5,000.
C) $4,000.
Helmut contributed land with a basis of $5,000 and an FMV of $10,000 to the HG Partnership five years ago to acquire a 50% partnership interest. This year the land is distributed to another partner, Gail, when its FMV is $11,000. No other distributions have been made since Helmut became a partner. When the land is distributed to Gail, Helmut recognizes a gain of A) $0. B) $2,500. C) $3,000. D) $5,000.
D) $5,000.
Becky has a $24,000 basis in her partnership interest. She receives a current distribution of $4,000 cash, unrealized receivables with a basis of $12,000 and an FMV of $16,000, and land held as an investment with a basis of $3,000 and an FMV of $8,000. The partners' relative interests in the Sec. 751 assets do not change as a result of the current distribution. The basis of her partnership interest following the distribution is A) $5,000. B) $1,000. C) $0. D) ($4,000).
A) $5,000.
Explanation: Pre-distribution basis $24,000 Minus: cash (4,000) unrealized receivables (12,000) land ( 3,000) Post-distribution basis $ 5,000
John has a basis in his partnership interest of $30,000. He receives a current distribution of $6,000 cash, unrealized receivables (FMV $11,000, basis $10,000), inventory (FMV $8,000, basis $4,000), and investment land (FMV $7,000, basis $6,000). The partners' relative interest in the Sec. 751 assets do not change as a result of the current distribution. His basis in the land is A) $5,000. B) $6,000. C) $7,000. D) $10,000.
B) $6,000.
Explanation: Pre-distribution basis $30,000 Minus: cash (6,000) unrealized receivables (10,000) Inventory (4,000) Basis available for land $10,000 Carryover basis of land $ 6,000
Danielle has a basis in her partnership interest of $12,000. She receives a current distribution of $8,000 cash and equipment with a basis of $7,000. There is no potential gain under Sec. 737. What is her basis in the equipment? A) $0 B) $4,000 C) $7,000 D) none of the above
B) $4,000
Identify which of the following statements is true.
A) If a partnership asset with a deferred precontribution gain is distributed in a nonliquidating distribution to the partner who contributed the asset, the precontribution gain must be recognized by the partner.
B) The partner’s basis in the partnership interest is normally reduced by the FMV of property distributed in a nonliquidating distribution.
C) When a current distribution from a partnership reduces the basis of the partnership interest to zero, the partner’s interest in the partnership is terminated.
D) All of the above are false.
D) All of the above are false.
Tenika has a $10,000 basis in her interest in the TF Partnership and no remaining precontribution gain immediately before receiving a current distribution that consisted of $4,000 in money, plastic tubes held in inventory with a $3,000 basis to the partnership and an FMV of $3,375, and drip irrigation pipe held as inventory with a $6,000 basis to the partnership and an FMV of $5,000. What is the basis in Tenika's hands of the distributed property? A) $10,000 B) $6,000 C) $9,000 D) $10,125
B) $6,000
Explanation: Predistribution basis in partnership interest $10,000 Minus: money received ( 4,000) Plus: Sec. 737 gain 0 Amount to be allocated $ 6,000
Tenika has a $10,000 basis in her interest in the TF Partnership and no remaining precontribution gain immediately before receiving a current distribution that consisted of $4,000 in money, plastic tubes held in inventory with a $3,000 basis to the partnership and an FMV of $3,375, and drip irrigation pipe held as inventory with a $6,000 basis to the partnership and an FMV of $5,000. What is Tenika's basis for the plastic tubes and drip irrigation pipe? Plastic Tubes; Drip Pipe a. 3,375, 5,000 b. 3,000, 6,000 c. 3,000, 5,000 d. 2,250, 3,750
D. Plastic tubes- $2,250
Drip Pipe- $3,750
Explanation:
Plastic Tube
Drip Pipe
Total
FMV of Asset
$3,375
$5,000
$8,375
- Partner basis
3,000
6,000
9,000
Difference
375
( 1,000)
( 625)
Step 1: Basis
$3,000
$6,000
$9,000
- Toby basis
6,000
Increase to allocate
$3,000 Step 2: Basis $3,000 $6,000 $9,000 Allocate decline in value
$3,000 (1,000) $5,000 ( 1,000) $8,000 Step 3: Allocate
( 750)* $2,250 ( 1,250)** $3,750 ( 2,000) $6,000
- $3,000 ÷ ($3,000 + $5,000) × 2,000 = 750
- *$5,000 ÷ ($3,000 + $5,000) × 2,000 = 1,250
The total bases of all distributed property in the partner’s hands following a nonliquidating distribution is limited to
A) the partner’s predistribution basis in his partnership interest.
B) the FMV of the property distributed.
C) the partnership’s bases in the distributed property.
D) the predistribution FMV of the partner’s partnership interest.
A) the partner’s pre-distribution basis in his partnership interest.
Carlos has a basis in his partnership interest of $30,000. He receives a current distribution of $6,000 cash, unrealized receivables (FMV $11,000, basis $10,000), inventory (FMV $8,000, basis $4,000), land held as an investment (FMV $7,000, basis, $6,000), and building (FMV $21,000, basis $9,000). The partners' relative interests in the Sec. 751 assets do not change as a result of the current distribution. Carlos's basis in the building is A) $2,500. B) $6,000. C) $7,500. D) $9,000.
B) $6,000.
Explanation:
Basis
$30,000
Minus: cash
( 6,000) $24,000 Minus: unrealized receivables ( 10,000) inventory ( 4,000) Basis to be allocated to land and building $10,000
[$9,000/($9,000 + $6,000)] × $10,000 = $6,000
Bart has a partnership interest with a $32,000 basis. He receives a current distribution of $6,000 cash, unrealized receivables (FMV $9,000, basis $10,000), inventory (FMV $8,000, basis $4,000), investment land (FMV $7,000, basis $4,000), and building (FMV $20,000, basis $8,000). No depreciation recapture applies with respect to the building. The partners' relative interests in the Sec. 751 assets do not change as a result of the current distribution. Bart's basis in the building is A) $3,000. B) $4,000. C) $6,000. D) $8,000.
D) $8,000.
Explanation:
Predistribution basis
$32,000
Minus: cash
receivables
inventory
( 6,000)
(10,000)
( 4,000)
Basis available for land and building*
$12,000
($8,000/$8,000+$4,000) × $12,000 = $8,000 basis for building*
Identify which of the following statements is true.
A) The basis for property distributed by a partnership cannot be increased above the carryover basis amount when it is received by a partner in a nonliquidating distribution.
B) A partner’s partnership capital account balance cannot be less than zero.
C) The length of time a partner owns a partnership interest is relevant when determining the holding period for distributed property.
D) All of the above are false.
A) The basis for property distributed by a partnership cannot be increased above the carryover basis amount when it is received by a partner in a nonliquidating distribution.
Two years ago, Tom contributed investment land with a basis of $50,000 and FMV of $62,000 to the RST Partnership. This year, Tom has a basis in his partnership interest of $53,000 when he receives a current distribution of $14,000 cash and inventory with a basis of $35,000 and FMV of $52,000. (There is no Sec. 751 exchange in connection with the inventory distribution.) The partnership continues to hold the land Tom contributed. How much gain (if any) must Tom recognize as a result of this distribution?
Precontribution gain = $62,000 - $50,000 = $12,000
Predistribution basis $53,000
Minus: cash distribution ( 14,000)
Total: $39,000
Minus: FMV of distribution other than cash ( 52,000)
Tentative Sec. 737 gain $13,000
Recognized gain = $12,000 [the smaller of precontribution gain ($12,000) or tentative Sec. 737 gain ($13,000)].
On November 30, Teri received a current distribution of cash of $4,000, marketable securities with a basis of $24,000 and an FMV of $30,000, and inventory with a basis of $2,000 and an FMV of $6,000. Prior to the distribution, Teri’s basis in her interest in the partnership was $30,000. (There is no Sec. 751 exchange as a result of the distribution.) How much gain (if any) must Teri recognize as a result of the distribution?
Predistribution basis $30,000
Minus: money received (cash and FMV of marketable securities) (34,000)
=Gain recognized $ 4,000
Jerry has a $50,000 basis for his interest in JJ Partnership before receiving a current distribution consisting of $8,000 in money, accounts receivable having a zero basis to the partnership, and land having a $28,000 basis to the partnership. What will Jerry’s basis be in these assets?
Generally, the partner’s basis for property distributed by the partnership carries over from the partnership. Jerry will take the carryover basis in the land and receivables.
Jerry has a $50,000 basis for his interest in JJ Partnership before receiving a current distribution consisting of $8,000 in money, accounts receivable having a zero basis to the partnership, and land having a $28,000 basis to the partnership. What is Jerry’s basis in his partnership interest after the distribution?
Pre-distribution basis in JJ- $50,000 Minus: money received ( 8,000) carry over basis in A/R (0) carry over basis in land (28,000) Post-distribution basis in JJ $14,000
When Rachel’s basis in her interest in the RST Partnership is $40,000, she receives a current distribution of office equipment. The equipment has an FMV of $60,000 and a basis of $50,000. Rachel will not use the office equipment in a business activity. What tax issues should Rachel consider with respect to the distribution?
- Does Rachel recognize a gain or loss on the current distribution?
- What is Rachel’s basis in the office equipment?
- When does Rachel’s holding period begin for the property?
- Does any depreciation recapture carry over to Rachel from the partnership?
- What is Rachel’s basis in her partnership interest following the distribution?
Rachel recognizes no gain or loss on the distribution. Her basis for the equipment would be a carryover basis from the partnership ($50,000) if that were possible, but it is limited to her basis in her partnership interest prior to the distribution ($40,000). Rachel’s holding period for the office equipment includes the holding period the partnership had for the property. Her basis in the partnership interest is zero following the distribution.
Under Sec. 751, unrealized receivables include potential Section 1245 or 1250 recapture on the partnership’s depreciable property.
True
For Sec. 751 purposes, “substantially appreciated inventory” means property held for sale to customers whose market value exceeds its adjusted basis.
False
Identify which of the following statements is true.
A) If a partner sells property received in a partnership distribution for a gain and the property was inventory in the hands of the distributing partnership, the partner will always recognize ordinary income.
B) The primary purpose of Sec. 751 is to prevent partnerships from converting capital gains into ordinary income.
C) Unrealized receivables include rights to payments on the sale of a capital asset.
D) All of the above are false.
D) All of the above are false.
Identify which of the following statements is true.
A) The depreciation recapture potential for a Sec. 1245 property is not included in the definition of a Sec. 751 asset.
B) For Sec. 751 purposes, “substantially appreciated inventory” means property held for sale to customers whose market value exceeds its adjusted basis.
C) Inventory for Sec. 751 purposes includes all property except cash, capital assets, and Sec. 1231 assets assets.
D) All of the above are false.
C) Inventory for Sec. 751 purposes includes all property except cash, capital assets, and Sec. 1231 assets assets.
For purposes of Sec. 751, inventory includes all of the following except
A) capital assets or 1231 property.
B) items held for sale in the ordinary course of business.
C) accounts receivable.
D) All of the above are inventory per Sec. 751.
A) capital assets or 1231 property.
The AB Partnership has a machine with an FMV of $25,000 and a basis of $20,000. The partnership has taken an $8,000 depreciation on the machine. The unrealized receivable related to the machine is A) $0. B) $5,000. C) $8,000. D) $20,000.
B) $5,000.
The Internal Revenue Code includes which of the following assets in the definition of Sec. 751 properties?
A) inventory, which is substantially appreciated
B) cash
C) capital assets
D) Sec. 1231 assets
A) inventory, which is substantially appreciated
The definition of “inventory” for purposes of Sec. 751 includes
A) cash.
B) land held for investment.
C) marketable securities not held by dealers.
D) depreciation recapture potential on Sec. 1231 assets.
D) depreciation recapture potential on Sec. 1231 assets.
The definition of “unrealized receivable” does not include the
A) right to payment for services performed by a cash-basis taxpayer.
B) recapture potential on Sec. 1245 property.
C) recapture potential on Sec. 1250 property.
D) right to payment for services performed by an accrual-basis taxpayer.
D) right to payment for services performed by an accrual-basis taxpayer.
What is the definition of “substantially appreciated inventory”?
A) inventory with a FMV greater than its basis
B) inventory and unrealized receivables with a FMV greater than their basis
C) inventory with a FMV greater than 120% of its basis
D) inventory and unrealized receivables with a FMV greater than 120% of their basis
D) inventory and unrealized receivables with a FMV greater than 120% of their basis
The ABC Partnership owns the following assets on December 31.
Basis;FMV Cash $20,000; $20,000 Unrealized receivables 0; 40,000 Inventory $20,000; 30,000 Land (Sec. 1231 asset) 50,000; 90,000
The indication that ABC owns substantially appreciated inventory is
A) the total FMV of all assets except cash is greater than their total basis.
B) the FMV of all assets except land is $90,000 while their bases is $40,000.
C) the FMV of the inventory is $30,000 while its adjusted basis is $20,000.
D) the FMV of the inventory and unrealized receivables is $70,000 while their adjusted bases is $20,000.
D) the FMV of the inventory and unrealized receivables is $70,000 while their adjusted bases is $20,000.
The XYZ Partnership owns the following assets on December 31:
Basis; FMV Cash $20,000; $20,000 Unrealized receivables 0; 15,000 Inventory $30,000; 35,000 Land (Sec. 1231 asset) 40,000; 70,000
By how much must XYZ reduce its unrealized receivables to avoid meeting the substantially appreciated inventory test?
A) $10,000
B) $14,000
C) $15,000
D) No amount of reduction of unrealized receivables will affect meeting the substantially appreciated inventory test.
B) $14,000
Explanation: ($15,000 + $35,000) - (120% × $30,000) = $14,000
The XYZ Partnership owns the following assets on December 31:
Basis; FMV Cash $10,000; $10,000 Unrealized receivables 0; 10,000 Inventory $25,000; 30,000
A partner has a 20% interest with a basis of $6,000 in XYZ before receiving a liquidating distribution of $10,000 cash. XYZ Partnership has no liabilities. His recognized gain is
A) $4,000 capital gain.
B) $3,000 capital gain and $1,000 ordinary income.
C) $3,000 ordinary income.
D) $3,000 ordinary income and $1,000 capital gain.
D) $3,000 ordinary income and $1,000 capital gain.
(1) FMV of receivables and inventory [0.20 × ($10,000 + $30,000)]
$8,000
Minus: basis of receivables and inventory if they
had been distributed in a current distribution
[0.20 × (0 + $25,000)]
( 5,000)
Ordinary income recognized
$3,000
(2) Pre-distribution basis $6,000 Minus: basis of Sec. 751 assets deemed distributed ( 5,000) Remaining basis in partnership interest $1,000 Minus: cash distributed after Sec. 751 transaction ( 2,000) Excess distribution and capital gain $1,000
Last year, Cara contributed investment land with an FMV of $24,000 and basis of $18,000 to the CDE Partnership. CDE made no distributions during last year, and Cara’s basis in her partnership interest on December 31 of last year was $28,000. On January 1 of this year, the partnership distributed cash of $30,000 to Cara and distributed the land contributed by Cara to another partner, David. On the distribution date, the land had a $27,000 FMV. Assume the CDE Partnership reported no profit or loss this year. How much gain (if any) must Cara recognize as a result of the distributions? What is her basis in the partnership after the distributions?
Cara must recognize a $6,000 capital gain ($24,000 FMV at contribution - $18,000 basis at contribution) on the distribution of the land to David. The gain recognized increases Cara’s basis in her partnership interest.
Cara’s predistribution basis $28,000
Plus: precontribution gain recognized 6,000
Total:$34,000
Minus: cash distribution ( 30,000)
Cara’s basis after distribution $ 4,000
No income is recognized as a result of the cash distribution.
The TK Partnership has two assets: $20,000 cash and a machine having a $28,000 basis and a $40,000 FMV. The partnership has claimed $16,000 in depreciation on the machine since its purchase. If the machine is sold for its FMV, would TK Partnership have an unrealized receivable item?
Yes. All of the $12,000 gain would be an unrealized receivable, since it is recaptured under Sec. 1245. Primary examples of unrealized receivables are the potential ordinary income recapture items like Sec. 1245 or Sec. 1250.
The Tandy Partnership owns the following assets on December 31:
Assets Basis Fair Market Value Cash Unrealized receivables Inventory Land, Sec. 1231 property Total $20,000 0 20,000 35,000 $75,000 $ 20,000 30,000 25,000 70,000 $145,000
Is the partnership’s inventory considered to be substantially appreciated for purposes of Sec. 751? Show your work.
For purposes of the substantially appreciated inventory test, both Tandy’s unrealized receivables and inventory are included. The “inventories” FMV of $55,000 exceeds 120% of its adjusted basis, $20,000. Therefore, the Tandy Partnership has substantially appreciated inventory.
What is included in the definition of unrealized receivables?
Unrealized receivables include not only the obvious cash-method accounts receivable that have yet to be recognized but also most of the potential ordinary income recapture provisions. Therefore, the term unrealized receivables is broader than it may appear.
Do most distributions made by a partnership require a Sec. 751 calculation?
No. Many current distributions are made pro rate to all partners, so Sec. 751 is not involved. Even if the distribution is not pro rate, the distribution often does not create an exchange of an interest in Sec. 751 assets for an interest in other assets. This exchange happens only when (1) the partner is reducing his or her overall interest in the partnership, or (2) an explicit agreement provides that the distribution results in a partner giving up all or part of his or her interest in some asset(s) maintained by the partnership.
Ed receives a $20,000 cash distribution from the EV Partnership, which reduces his partnership interest from one-third to one-fourth. The EV Partnership is a general partnership that uses the cash method of accounting and has substantial liabilities. EV’s inventory has appreciated substantially since it was purchased. What issues should Ed consider with regard to the distribution?
: Ed must determine:
• How much is his distribution?
• Does the partnership have Sec. 751 assets?
• If the partnership has Sec. 751 assets, did Ed exchange any interest in Sec. 751 assets for cash?
• How much ordinary income must Ed recognize if he exchanges Sec. 751 assets for cash?
• How must Ed treat any cash distribution received that exceeds the amount deemed to be part of the Sec. 751 exchange?
The amount of the distribution includes both the cash and the relief from liabilities that he received when his interest in the partnership changed from 1/3 to 1/4. It is likely that the partnership has Sec. 751 assets, since we know the partnership inventory is substantially appreciated. Further, it is likely that the cash-basis partnership has unrealized accounts receivable, and the partnership may have recapture potential if it has any depreciable personalty. Again, it is likely that an exchange of Sec. 751 assets for cash occurred, since Ed received only cash and probably gave up a portion of his interest (from 1/3 to 1/4) in each Sec. 751 asset. The amount of ordinary income is the difference between the amount of cash Ed is deemed to have received for the Sec. 751 assets and the adjusted basis that Ed would have had in the Sec. 751 assets had the Sec. 751 assets been distributed to Ed immediately before the deemed Sec. 751 sale (usually a carryover from the partnership’s basis in these Sec. 751 assets). Any cash or deemed cash exceeding the amount deemed to be part of the Sec. 751 exchange is simply treated as a current distribution. The current distribution will reduce his basis in his partnership interest. If the current distribution is greater than his basis in the partnership interest, Ed will recognize gain because he receives cash exceeding his basis.
A partner can recognize gain, but not loss, on a liquidating distribution
False
A partner’s holding period for a partnership interest is never considered when determining the holding period for property distributed in a liquidating distribution
True
The sale of a partnership interest always results in capital gain or loss rather than ordinary income.
False
Identify which of the following statements is true.
A) A liquidating distribution that terminates a partnership interest cannot include more than one distribution.
B) A partnership with a large amount of unrealized receivables and substantially appreciated inventory items liquidated and distributed all of its assets in kind to each partner in proportion to their partnership interests. Each partner will report ordinary income at the time these assets are received equal to their FMV.
C) The rule for recognizing gain on a liquidating distribution is the same rule that is used for a current distribution.
D) All of the above are false.
C) The rule for recognizing gain on a liquidating distribution is the same rule that is used for a current distribution.
Identify which of the following statements is true.
A) When unrealized receivables are distributed in a liquidating distribution, the basis of the receivables will be increased.
B) The bases of unrealized receivables and inventory distributed by a partnership in liquidation of a partnership interest are never increased above their bases in the hands of the partnership.
C) The basis of the partnership interest is apportioned between all of the assets received in a liquidating distribution based on the relative FMVs of the assets.
D) All of the above are false.
B) The bases of unrealized receivables and inventory distributed by a partnership in liquidation of a partnership interest are never increased above their bases in the hands of the partnership.
Ted King's basis for his interest in the Troy Partnership is $24,000. In complete liquidation of his interest, King receives cash of $4,000 and real property (not a Sec. 751 asset) having an FMV of $40,000. Troy's adjusted basis for this realty is $15,000. Section 736 does not apply. King's basis for this realty is A) $15,000. B) $20,000. C) $36,000. D) $40,000.
B) $20,000.
```
Explanation:
Predistribution basis
$24,000
Minus: cash received
4,000
Basis to partner
$20,000
~~~
Derrick’s interest in the DEF Partnership is liquidated when his basis in the interest is $30,000. He receives a liquidating distribution of $20,000 cash and inventory with a basis of $8,000 and an FMV of $30,000. Derrick will recognize
A) no gain or loss.
B) $2,000 capital loss.
C) $2,000 ordinary loss.
D) $10,000 capital loss and $20,000 ordinary loss.
B) $2,000 capital loss.
Before receiving a liquidating distribution, Kathy's basis in her interest in the KLM Partnership is $30,000. The distribution consists of $5,000 in money, inventory having a $1,000 basis to the partnership and a $2,000 FMV, and two parcels of undeveloped land (not held as inventory) having basis of $3,000 and $9,000 to the partnership with FMVs of $5,000 and $12,000, respectively. What is Kathy's basis in each parcel of land? A) Parcel One Parcel Two $5,000 $12,000
B) Parcel One Parcel Two $3,000 $9,000
C) Parcel One Parcel Two $7,059 $16,941
D) Parcel One Parcel Two $6,000 $18,000
C)
Parcel One $7,059
Parcel Two $16,941
Basis allocated to parcels = $30,000 - $5,000 - $1,000 = $24,000
Ten years ago, Latesha acquired a one-third interest in Dana Associates, a partnership, for $26,000 cash. This year, Latesha’s entire interest in the partnership is liquidated when her basis is $24,000. Dana’s assets consist of the following: cash, $20,000; inventory with a basis of $46,000 and an FMV of $40,000. Dana has no liabilities. Latesha receives the cash of $20,000 in liquidation of her entire interest. What is Latesha’s recognized loss on the liquidation of her interest in Dana?
B) $4,000 long-term capital loss
Explanation: Pre-distribution basis $24,000 Minus: liquidating distribution ( 20,000) Long-term capital loss $ 4,000
Identify which of the following statements is true.
A) On December 31 of the current year, Max Curcio’s adjusted basis for his interest in the Maduro & Motta Partnership is $36,000. Maduro & Motta distributes cash of $6,000 and a parcel of land held as an investment to Curcio in liquidation of his entire interest in the partnership. The land has an adjusted basis of $18,000 to the partnership and an FMV of $42,000. Curcio’s basis in the land is $18,000.
B) Jake has a basis in his partnership interest of $40,000 before receiving a liquidating distribution of $5,000 cash, inventory with a basis of $4,000 and an FMV of $5,000, and land with a basis of $3,000 and an FMV of $6,000. Jake will receive no further distributions. He can recognize a loss of $28,000 at the time the liquidating distribution is received.
C) A partner’s holding period for a partnership interest is never considered when determining the holding period for property distributed in a liquidating distribution.
D) All of the above are false.
C) A partner’s holding period for a partnership interest is never considered when determining the holding period for property distributed in a liquidating distribution.
Identify which of the following statements is false.
A) On June 30 of the current year, James Roe sells his interest in the Roe & Doe Partnership for $30,000. Roe’s adjusted basis in Roe & Doe at June 30 is $7,500 before apportionment of any partnership income for the current year. The Roe & Doe Partnership uses the calendar year as its tax year and has no liabilities on June 30. Roe’s distributive share of partnership income up to June 30 is $22,500. Roe acquired his interest in the partnership five years ago. Roe will have a long-term capital gain on the sale of his interest of $22,500.
B) Section 751 assets include all inventory and all unrealized receivables in a sale or exchange situation.
C) When a partnership interest is sold, the buyer and seller can allocate the sale price among the Sec. 751 assets and non-Sec. 751 assets in any reasonable manner.
D) Statements B and C are true.
A) On June 30 of the current year, James Roe sells his interest in the Roe & Doe Partnership for $30,000. Roe’s adjusted basis in Roe & Doe at June 30 is $7,500 before apportionment of any partnership income for the current year. The Roe & Doe Partnership uses the calendar year as its tax year and has no liabilities on June 30. Roe’s distributive share of partnership income up to June 30 is $22,500. Roe acquired his interest in the partnership five years ago. Roe will have a long-term capital gain on the sale of his interest of $22,500.
Kenya sells her 20% partnership interest having a $28,000 basis to Ebony for $40,000 cash. At the time of the sale, the partnership has no liabilities and its assets are as follows:
Basis; FMV Cash $20,000; $20,000 Unrealized receivables 0; 40,000 Inventory 10,000; 40,000 Land (Sec. 1231) 110,000; 100,000
Kenya and Ebony have no agreement concerning the allocation of the sales price. Ordinary income recognized by Kenya as a result of the sale is A) $6,000. B) $12,000. C) $14,000. D) $16,000.
C) $14,000.
Explanation:
Total; Sec. 751 Assets; Non-Sec. 751 Assets Amount realized $40,000; $16,000; $24,000 Minus: adjusted basis (28,000); (2,000); (26,000) Recognized gain/loss $12,000; $14,000; Ordinary income ($2,000) Capital loss
Steve sells his 20% partnership interest having a $28,000 basis to Nancy for $40,000 cash. At the time of the sale, the partnership has no liabilities and its assets are as follows:
Basis; FMV Cash $20,000; $20,000 Unrealized receivables 0; 40,000 Inventory 10,000; 40,000 Land (Sec. 1231) 110,000; 100,000
The receivables and inventory are Sec. 751 assets. There is no agreement concerning the allocation of the sales price. Steve must recognize
A) no gain or loss.
B) $12,000 ordinary income.
C) $12,000 capital gain.
D) $14,000 ordinary income and $2,000 capital loss.
D) $14,000 ordinary income and $2,000 capital loss.
Explanation: Total; Sec. 751 Assets; Non-Sec. 751 Assets Amount realized $40,000; $16,000; $24,000 Minus: adjusted basis (28,000); (2,000);(26,000) Recognized gain/loss $12,000;$14,000 Ordinary income;($2,000)Capital loss
Adnan had an adjusted basis of $11,000 for his interest in the Adnan and Donnell Partnership on December 31. On this date, Adnan received from the partnership, in complete liquidation of his interest, $10,000 cash and land with a $2,000 basis to the partnership and a $3,000 FMV. What is Adnan’s basis for the land distributed to him?
$11,000 - $10,000 cash = $1,000 remaining basis. This basis is assigned to the land.
Eicho’s interest in the DPQ Partnership is terminated when her basis in the partnership is $70,000. She receives a liquidating distribution of $20,000 cash and inventory with a $24,000 basis and a $40,000 FMV. What is her gain or loss, and what is her basis in the inventory received?
She has a recognized loss of $26,000 [($20,000 + $24,000) - $70,000]. Her basis in the inventory she receives is $24,000.
Eicho’s interest in the DPQ Partnership is terminated when her basis in the partnership is $70,000. She receives a liquidating distribution of $20,000 cash and inventory with a $24,000 basis and a $40,000 FMV. She also receives, as part of the distribution, a desk that has a $100 basis and a $200 FMV to the partnership. What is her gain or loss, and what is her basis in the items received?
She does not recognize any loss currently. The bases are computed as follows:
Pre-distribution basis in DPQ $70,000
Minus: money received ( 20,000)
Basis after money distribution 50,000
Minus: basis of inventory to DPQ ( 24,000)
Remaining basis of partnership interest $26,000
The entire $26,000 is allocated to the desk. This delays the loss recognition until the desk is either depreciated or sold.
What conditions are required for a partner to recognize a loss upon receipt of a distribution from a partnership?
A partner can recognize a loss on a distribution only if the distribution is a liquidating distribution that consists of money, unrealized receivables, and inventory. The partner recognizes a loss if the amount of money and the carryover basis of the receivables and inventory are less than the partner’s predistribution basis in his or her partnership interest.
What is the character of the gain/loss on the sale of a partnership interest?
Because a partnership interest is generally a capital asset, the sale of a partnership interest results in a capital gain or loss. However, if a partnership has Sec. 751 assets, the partner is assumed to sell his or her share of Sec. 751 assets directly with a corresponding ordinary gain or loss being recognized.
Can a partner recognize both a gain and a loss on the sale of a partnership interest? If so, under what conditions?
A partner must divide the sale of a partnership interest into two transactions if the partnership has Sec. 751 assets. First, the partner is deemed to sell his or her share of Sec. 751 assets for their FMV with their adjusted bases to the partner, being the basis the Sec. 751 assets would have had if the partner had received them in a current distribution. The remaining sales proceeds and the remaining adjusted bases are then considered to be the amounts to be reported from the sale of the remainder of the partnership interest (non-Sec. 751 assets). Possibly, one part of the transaction could generate a loss while the other part could generate a gain.
David sells his one-third partnership interest to Diana for $60,000 when his basis in the partnership interest is $48,000. On the date of sale, the partnership has no liabilities and the following assets:
Basis;FMV Cash $40,000;$40,000 Inventory 18,000;27,000 Building 75,000; 102,000 Land 11,000; 11,000
The building is depreciated on a straight-line basis. What tax issues should David and Diana consider with respect to the sale transaction?
- Does the partnership have Sec. 751 assets?
- What is the amount and character of the gain on the sale of David’s partnership interest?
There are no unrealized receivables, but the partnership does have inventory. David’s gain is calculated as follows:
Assets
Total Sec. 751 Other
Amount realized $60,000 $9,000 $51,000
Minus: adjusted basis (48,000) ( 6,000) (42,000)
Recognized gain $12,000 $3,000 $ 9,000
The gain attributable to the Sec. 751 assets is ordinary while the remainder of the gain is capital.
When a retiring partner receives payments that exceed the value of that partner’s partnership property, the excess payment is a guaranteed payment.
False
Under the check-the-box rules, an LLC with more than one member is taxed as a partnership unless it elects to be taxed as a corporation.
True
Identify which of the following statements is true.
A) John Albin is a retired partner of Brill & Crum, a personal service partnership. Albin has not rendered any services to Brill & Crum since his retirement six years ago. Under the provisions of Albin’s retirement agreement, Brill & Crum is obligated to pay Albin 10% of the partnership’s net income each year through the end of the current year. In compliance with the agreement, Brill & Crum pay Albin $25,000 in the current year. Albin should treat this $25,000 as a long-term capital gain.
B) An exchange of partnership interests in different partnerships qualifies under the like-kind exchange rules.
C) The payment for partnership property to a retiring partner is not deductible by the partnership and often not income to the retiring partner.
D) All of the above are false.
C) The payment for partnership property to a retiring partner is not deductible by the partnership and often not income to the retiring partner.
For tax purposes, a partner who receives retirement payments ceases to be regarded as a partner
A) on the last day of the taxable year in which the partner retires.
B) on the last day of the month in which the partner retires.
C) on the day on which the partner retires.
D) only after the partner’s last payment is received.
D) only after the partner’s last payment is received.
If a partnership chooses to form an LLC, under the check-the-box rules, and assuming no elections are made, the entity will be taxed as
A) a partnership if it has more than one member.
B) an S corporation.
C) a C corporation.
D) Unable to determine from the facts presented.
A) a partnership if it has more than one member.
Identify which of the following statements is true.
A) Under the check-the-box rules, an LLC with more than one member is taxed as a corporation unless it elects to be taxed as a partnership.
B) The partnership’s tax year closes with respect to a partner whose interest is transferred by gift.
C) An LLC has been taxed as a partnership for five years. Under the check-the-box rules, the LLC makes a timely election in 2009 to be taxed as a C corporation. The election of C corporation status is permitted and results in the LLC’s assets being transferred from a partnership to a C corporation under the federal income tax rules.
D) All of the above are false.
C) An LLC has been taxed as a partnership for five years. Under the check-the-box rules, the LLC makes a timely election in 2009 to be taxed as a C corporation. The election of C corporation status is permitted and results in the LLC’s assets being transferred from a partnership to a C corporation under the federal income tax rules.
If a partner dies, his or her tax year closes A) on the date of death. B) on the day after death. C) on the day before death. D) on some other date.
A) on the date of death.
A partnership terminates for tax purposes
A) only when it terminates under local partnership law.
B) when at least 50% of the total interest in partnership capital and profits changes hands by sale or exchange within twelve consecutive months.
C) when the sale of partnership assets is made only to an outsider(s) and not to an existing partner(s).
D) when a partnership tax return (Form 1065) ceases to be filed by the partnership.
B) when at least 50% of the total interest in partnership capital and profits changes hands by sale or exchange within twelve consecutive months.
Marc is a calendar-year taxpayer who owns a 30% capital and profits interest in the MN Partnership. Nancy sells the remaining 70% capital and profits interest to Henry on October 31. The partnership year-end is March 31 as permitted by the IRS for business purpose reasons. The MN Partnership A) terminates on March 31. B) terminates on October 31. C) terminates on December 31. D) does not terminate.
B) terminates on October 31.
A partnership terminates for federal income tax purposes if
A) a general partner who owns a majority interest dies.
B) state partnership law terminates the partnership.
C) a partnership interest of more than 50% is gifted.
D) within a 12-month period there is a sale or exchange of at least 50% of the total interest in partnership capital and profits.
D) within a 12-month period there is a sale or exchange of at least 50% of the total interest in partnership capital and profits.
Identify which of the following statements is true.
A) The partnership tax year closes when a partner transfers his interest by gift.
B) If a partner dies in a two-member partnership, the partnership terminates on the date of death, even though the successor-in-interest continues to share in the profits and losses of the partnership business.
C) When the interest of a partner who owns 60% of a partnership is completely liquidated by a partnership distribution, the partnership is considered terminated, even though three other partners remain.
D) All of the above are false.
D) All of the above are false.
Identify which of the following statements is false.
A) A sale or exchange of at least 50% of the capital and profits interest in a partnership within a 12- consecutive-month period will terminate the partnership and end all of the partnership’s elections.
B) When using the 50% rule to terminate a partnership, if an interest is sold more than once during the 12-month period, each sale is counted separately.
C) A partner’s individual income tax return, under some circumstances, may include the results of partnership operations for a period exceeding 12-months.
D) When several different transfers are made during a 12-month period, the partnership termination occurs on the date of the transfer that first crosses the 50% threshold.
B) When using the 50% rule to terminate a partnership, if an interest is sold more than once during the 12-month period, each sale is counted separately.
Sally is a calendar-year taxpayer who owns a 30% capital and profits interest in the SEM
Partnership. Eric sells the remaining 70% capital and profits interest to Michelle on October 3. The partnership year-end is March 31 as permitted by the IRS for business purposes. Which of the following statements is correct?
A) Sally must conform her tax year with the partnership tax year.
B) The new partnership is a continuation of the old partnership.
C) Sally’s tax return will include a partnership distributive share only for the period ending March 31.
D) Sally’s tax return will include partnership distributive shares for periods ending March 31 and October 3
D) Sally’s tax return will include partnership distributive shares for periods ending March 31 and October 3.
The AB, BC, and CD Partnerships merge into the ABCD Partnership. AB (owned by Austin and Ben) contributes assets worth $100,000. BC (owned by Ben and Charlie) contributes assets worth $200,000. CD (owned by Charlie and Dennis) contributes assets worth $300,000. The capital and profits interest in ABCD is owned by: Austin, 10%; Ben, 30%; Charlie, 25%; and Dennis, 35%. ABCD Partnership is a continuation of A) AB. B) BC. C) CD. D) none of the partnerships.
C) CD.
When must a partnership make mandatory basis adjustments?
A) on any sale of a 20% or greater partnership interest
B) on any sale of a partnership interest for $250,000 or more
C) on any distribution of assets with a value of $250,000 or more
D) on any sale of a partnership interest where the partnership’s adjusted basis in its assets exceeds their fair market value by $250,000 or more
D) on any sale of a partnership interest where the partnership’s adjusted basis in its assets exceeds their fair market value by $250,000 or more
Rod owns a 65% interest in the RRR Partnership, a general partnership, which he sells to the two remaining partners — Roger and Regis. The three partners have agreed that Rod will receive $160,000 in cash from the sale. Rod’s basis in the partnership interest before the sale is $125,000, which includes his $35,000 share of partnership recourse liabilities. The partnership has assets with a $310,000 FMV and a $210,000 adjusted basis. What issues should Rod, Roger, and Regis consider before this sale takes place?
Roger and Regis should consider the following:
• The sale as contemplated will terminate the partnership. Is termination of the partnership desirable for Roger and Regis?
• Will either individual have to recognize a gain? The recognition of gain is unlikely unless Roger and Regis have a small basis relative to the cash held by the partnership and deemed distributed in the liquidating distribution.
• What will be the basis for each of the assets? Under current Treasury Regulations, the termination will be deemed to result in the old partnership contributing the property directly to the new partnership so that no adjustment to asset bases is likely to occur.
• Will income be bunched into a single tax year if the partnership terminates? Termination of the partnership closes a tax year. If the partnership has the same tax year-end as Roger and Regis, no bunching of income will occur. If their tax years differ, however, some bunching will occur.
• When the partnership terminates, all elections are lost. Are there advantages or disadvantages from losing all existing elections? There are a few advantageous tax year-ends for old partnerships that were grandfathered when Congress enacted the rules about required partnership tax year-ends. The loss of this tax benefit would be a significant disadvantage.
• Would liquidation by the partnership be more advantageous than a sale to the other partners? Liquidation by the partnership cannot terminate the partnership.
Rod should consider:
• How much of his gain from the sale would be considered as a sale from his interest in Sec. 751 assets and, therefore, taxed as ordinary income? His sale will result in ordinary income to the extent the FMV of Sec. 751 assets exceeds the adjusted basis in those assets that Rod would have had if the assets had been distributed to Rod just before he sold his interest in the partnership.
• Will the sale cause a bunching of income from the partnership for Rod? Since the sale of the entire partnership interest closes the partnership tax year for the selling partner, the sale will cause bunching of income if Rod’s tax year-end is different from RRR’s tax year-end.
• Could the transaction be structured in such a way that a liquidation by the partnership would be more beneficial to Rod? Possibly. If Roger and Regis really do not want the partnership to terminate, they may be willing to pay Rod more in a liquidating distribution than they were willing to pay for an outright purchase.
Quinn and Pamela are equal partners in the QP Partnership. On December 30 of the current year, the QP Partnership agrees to liquidate Quinn’s partnership interest for a cash payment on December 30 of each of the next five years. What tax issues should Quinn and Pamela consider with respect to the liquidation of Quinn’s partnership interest?
- Does the partnership terminate for tax purposes?
- If so, when does the termination occur?
The partnership terminates since only one partner remains. The partnership terminates when the final Sec. 736 payment is made.
Han purchases a 25% interest in the CHOP Partnership from Huang for $600,000. The partnership has assets with a basis of $1,600,000. What is the amount of the basis adjustment, if the partnership has a 754 election in place?
A) $0
B) $150,000 increase in Han’s basis in his partnership interest
C) $200,000 increase in Han’s share of the basis in partnership assets
D) $1,000,000 increase in partnership assets
C) $200,000 increase in Han’s share of the basis in partnership assets
Patrick purchases a one-third interest in the PPP partnership for $600,000. The partnership has assets with a value of $1,500,000. PPP has a 754 election in effect. What is the amount of the basis adjustment?
A) $0
B) $300,000 increase in the basis of partnership assets
C) $100,000 increase in Patrick’s basis in the partnership assets
D) $100,000 increase in Patrick’s share of the basis in the partnership assets
D) $100,000 increase in Patrick’s share of the basis in the partnership assets
Which of the following statements is correct?
A) A partnership may make an annual election to adjust the basis of its assets upon the sale of a partnership interest.
B) The Sec. 754 election applies to both sales and distributions.
C) The Sec. 754 election applies to only current and nonliquidating distributions.
D) A partnership can revoke a Sec. 754 election every 5 years.
B) The Sec. 754 election applies to both sales and distributions.
Which of the following is valid reason for making a 754 election?
A) An incoming partner pays more for a partnership interest that his or her proportionate share of partnership assets.
B) Partners are able to increase their basis in the partnership interest upon the sale of a partnership interest.
C) Partnerships can increase, but not decrease, their basis in partnership assets.
D) A partnership can reduce its basis in assets upon cash distributions to partners.
A) An incoming partner pays more for a partnership interest that his or her proportionate share of partnership assets.
Patrick purchased a one-third interest in the PPP partnership for $600,000. At the time of the purchase, the partnership had a 754 election in effect and its only asset was land with a basis of $1,500,000. This year, PPP sells the land for $1,800,000. What is Patrick's recognized share of the gain on the sale of the land? A) $0 B) $100,000 C) $300,000 D) none of the above
A) $0
Explanation: $1,800,000 - 1,500,000 = 300,000 gain. Patrick’s share of the gain is $100,000, which is offset by the $100,000 754 adjustment. The 754 adjustment is 600,000 purchase price - (1,500,000/3) = 100,000.
Sean, Penelope, and Juan formed the SPJ partnership by each contributing assets with a basis and fair market value of $200,000. In the following year, Penelope sold her one-third interest to Pedro for $225,000. At the time of the sale, the SPJ partnership had the following balance sheet:
Basis; FMV Cash $200,000 $200,000 Land $400,000 $475,000 $600,000 $675,000
Shortly after Pedro became a partner, SPJ sold the land for $475,000. What are the tax consequences of the sale to Pedro and the partnership (1) assuming there is no Section 754 election in place, and (2) assuming the partnership has a valid Section 754 election?
(1) The partnership has a $75,000 gain ($475,000 - $400,000) and $25,000 of this gain is allocated to Pedro. (2) Pedro’s share of the basis of the land is increased by $25,000, the amount that he paid for the partnership interest in excess of the basis of the partnership assets. This basis increase is allocated entirely to the land. The partnership still has a $75,000 gain on the sale of the land, but Pedro’s $25,000 share is eliminated by the 754 adjustment to the basis of the land (1/3 × 475,000) - [(1/3 × 400,000) + 25,000] = 0.
What are some advantages and disadvantages of making a Section 754 election?
Advantages: Without a 754 election, if a new partner purchases a partnership interest when the partnership assets have a fair market value greater than their basis, the partner will be taxed on his/her proportionate share of any gain on a subsequent sale of these assets in addition to paying a higher purchase price for the partnership interest due to the assets’ appreciation. The partner will not be able to recover this “double taxation” until the partnership is liquidated, which may be several years in the future. Sec. 754 prevents this timing problem by adjusting the partner’s basis in partnership assets.
The Sec. 754 election has several disadvantages, including increased record-keeping. Partners and/or the partnership must maintain separate records showing the calculation and allocation of the basis adjustment. Once a 754 election is made, adjustments are required on all subsequent sales and distributions, even if the adjustment decreases the basis. For distributions, the basis adjustment belongs to the partnership as a whole. The 754 election can only be revoked with IRS approval.
A limited liability company is a form of business entity that combines the legal benefits of the corporate form with the tax benefits of the partnership form.
True
Identify which of the following statements is true.
A) When a partnership is divided into two or more new partnerships, all of the resulting partnerships must be considered new partnerships.
B) A partnership is “publicly traded” only if its interests are traded on an established securities exchange.
C) A limited liability company is a form of business entity that combines the legal benefits of the corporate form with the tax benefits of the partnership form.
D) All of the above are false.
C) A limited liability company is a form of business entity that combines the legal benefits of the corporate form with the tax benefits of the partnership form.
The STU Partnership, an electing Large Partnership, has no passive activities and reports the following transactions for the year: net long-term capital losses $50,000, Sec. 1231 gain $60,000, ordinary income $20,000, charitable contributions $15,000, and tax-exempt income $2,000. How much will be reported as ordinary income to its partners? A) $5,000 B) $17,000 C) $20,000 D) $22,000
B) $17,000
Explanation: [$20,000 - 10% (10,000 + 20,000)] = $17,000
The STU Partnership, an electing Large Partnership, has no passive activities and reports the following transactions for the year: net long-term capital losses $50,000, Sec. 1231 gain $60,000, ordinary income $20,000, charitable contributions $15,000, and tax-exempt income $2,000. How much will be reported as long-term capital gains to its partners? A) $0 B) $10,000 C) $50,000 D) $60,000
B) $10,000
What are the advantages of a firm being formed as a limited liability company (LLC) instead of as a limited partnership?
From a legal standpoint, all the owners of a limited liability company (LLC) have limited liability for the firm’s debts. In a limited partnership, all general partners have significant liability for firm debts. Under the check-the-box regulations, an LLC can choose whether to be taxed as a partnership or as an association taxed as a corporation. If the LLC chooses partnership taxation, there is virtually no difference between the taxation of the LLC and the limited partnership.
The limited liability company (LLC) has become a popular business form because of its limited liability protection for its owner. The S corporation also provides limited liability protection for its owner. What advantages does an LLC provide that are not available with an S corporation?
- The LLC is taxed as a partnership under the check-the-box rules. As such, the basic operating restrictions that are imposed on an S corporation do not apply to an LLC. These include, but are not limited to: a 100 shareholder limit; restrictions on the type of eligible shareholders; a single class of stock; and the limitation on amount of passive income that can be earned by an S corporation.
- The corporate-level taxes imposed on an S corporation, such as the built-in gains tax and excess net passive income tax, do not apply to an LLC.
- The loss limitation is larger for an LLC than for an S corporation because of the treatment of general debts incurred by the LLC under the partnership taxation rules.
- All states have enacted LLC laws, so that the problem with a lack of developed legal structure for handling general legal problems has disappeared. The application of basic legal principles to S corporations was no problem since in most cases they followed the basic rules for corporations.
What is an electing large partnership? What are the advantages to the partnership of electing to be taxed under the electing large partnership rules?
An electing large partnership is a partnership that is not a service partnership, is not engaged in commodity trading, has at least 100 partners, and files an election to be taxed as an electing large partnership. The primary advantage to the partnership of electing to be an electing large partnership is that the reporting of income to the large number of partners is simplified. Relatively few items are separately stated so that the reporting process is more difficult than a corporation but easier than a nonelecting partnership.
All states have adopted laws providing for limited liability companies. Describe a limited liability company (LLC).
An LLC often combines the legal benefits of a corporation with the tax benefits of a partnership. Whether an LLC is characterized as a corporation or a partnership for federal tax purposes depends on the number of corporate characteristics that are present. An LLC should be treated as a partnership if it has the centralized management and limited liability characteristics of a corporation, but does not have the free transferability of interest or continuity-of-life characteristics. If treated as a partnership, they offer more flexibility than an S corporation in that there is no limit on the number of shareholders, the number of classes of stock that can be outstanding, or the types of investments in related entities that can be made. The increased flexibility being written into some of the state LLC laws concerning the various corporate characteristics has resulted in the LLCs created in certain states being treated as corporations or partnerships, depending upon the terms of the LLC’s organizing document. However, the IRS implemented a system that allows LLCs to designate via a check-the-box mechanism whether they wish to be taxed as a partnership or as a corporation. It is anticipated that most new LLCs will desire to be taxed as a partnership (their default treatment) when they have two or more owners.
Brown Company recently has been formed as a limited liability company (LLC). Brown Company is owned equally by three individuals—Gene, Susan, and Sandra—all of whom have substantial income from other sources. Brown is a manufacturing firm and expects to earn approximately $130,000 of ordinary income and $30,000 of long-term capital gain each year for the next several years. Gene will be a full-time manager and will receive a salary of $60,000 each year. What tax issues should the owners consider regarding the LLC’s initial year of operations?
- Should Brown choose to be taxed as a partnership or as a corporation?
- How much will be kept in the business for growth, and how much will be distributed to the owners each year? The larger the percentage of earnings that will be distributed, the more advantageous a flow-through entity such as a partnership can be.
- What is the marginal tax rate for Gene, Susan, and Sandra? If Gene, Susan, and Sandra have lower marginal tax rates than does Brown, partnership status has advantages.
- How should Gene’s pay for operating the business be structured? If the business is taxed as a corporation, a generous but reasonable salary will decrease the amount of income subject to double taxation. If the business is structured as a partnership, the partners need to decide whether to structure the payment as distributive share, as an outright guaranteed payment, or whether to establish a guaranteed minimum that may be some combination of the two.
The Principle Limited Partnership has more than 300 partners and is publicly traded. The Principle was grandfathered under the 1987 Tax Act and has consistently been taxed as a partnership. In the current year, The Principle Limited Partnership will continue to be very profitable and will continue to pay out about 30% of its income to its owners each year. The managing partners of The Principle want to consider the firm’s options for taxation in the current and later years.
What method should The Principle Limited Partnership choose to use to operate under the publicly traded partnership rules?
- Pay the annual 3.5% of gross income tax and continue to be taxed as a publicly traded partnership?
- Buy back enough interests (or restrict opportunities for trading) so that the partnership is no longer publicly traded?
- Incorporate the entity and be taxed as a regular (C) corporation?
The best alternative will be a function of the amount of gross income, amount of taxable income, tax rates of the partners, amount of profits the firm wants to retain, and costs of buying back partnership interests, and/or restricting trading, or incorporating.
If The Principle Limited Partnership chooses to continue as a partnership, should it elect to come under the electing large partnership rules?
• The election reduces the partnership’s annual cost of providing information to partners but will require some start-up cost to make the change. The election also has the advantage of making it more difficult to accidentally terminate the partnership because of trades. However, the election significantly reduces the partners’ reporting and audit options.
