Partnership Formation

Question 1

What is the definition of a partnership?

Answer 1

Per 761 – “a syndicate, group, pool, joint venture, or other unincorporated organization through, or by means of which any business, financial operation, or venture is carried on and which is not, within the meaning of this Title, a corporation or trust or estate.”

Per 301.7701-1(a) - a de facto partnership - A joint venture or other contractual arrangement may create separate entity for tax purposes if participants carry on business activity and divide profits.

Question 2

What is a de facto partnership?

Answer 2

An arrangement where participants carry on business activity and divide the profits therefrom.

Agreeing to share expenses, and mere co-ownership and renting does not create a business entity (but if you rent and provide services, it can qualify as partnership)

Question 3

What is a “limited partnership”?

Answer 3

Must have at least one general partner, who is liable jointly and severally with any other general partners.

Limited partners are not liable but therefore must remain passive otherwise they can be found to be general partners.

Question 4

What is a “general partnership”?

Answer 4

All general partners share management burden and control

All general partners are jointly and severally liable for partnership liabilities.

No continuity or transferability – if GP leaves, it’s not same partnership.

Don’t have to register with the state or even have a partnership agreement (default rules will apply).

Question 5

What is a “limited liability company”?

Answer 5

Best of all worlds. Members have same protection from liability as corporate shareholders, even if participating in management.

Can be an association or partnership.

Question 6

What is property for purposes of 721?

Answer 6

Generally includes cash, inventory, patents, installment obligations, and other intangibles

Goodwill is property

Services are not property

Know-how is debatable - Professor says it’s services unless taxpayer can show it’s legally defensible

Receivables for services already provided is property under 721.

Question 7

What is the outside basis for a partnership interest received in a 721 contribution?

Answer 7

Per 722: Carryover basis, equal to sum of money and adjusted bases of property contributed

○ Increased by any gain recognized under the investment partnership rule of 721(b).

○ Increased by share of any partnership liabilities for which partner is responsible (including share of liabilities on encumbered property). 752(b).

○ Decreased by any liability of partner that is assumed by partnership (including by contribution of encumbered property). 752(a).

Question 8

What holding period does a partner receive in a partnership interest received in a 721?

Answer 8

Tacked holding period from contributed property if the property is a capital asset under 1221 or a 1231 asset. 1223(1).

Otherwise the holding period begins on the date of the exchange.

If partnership interest is received for mixture of assets, it takes a split holding period based on relative FMV. 1.1223-3(b)(1).

Question 9

What holding period does the partnership receive in an asset contributed in a 721?

Answer 9

Partnership gets to tack on partner’s holding period. 1223(2).

Question 10

What if a partner contributes property with a built-in gain or built-in loss?

Answer 10

Under 704(c), any built in gain or loss will be allocated to the contributing partner using any “reasonable method” when property disposed of. 1.704-3(a).

Question 11

How is a non-compensatory option in a partnership treated?

Answer 11

Generally, an individual holding a non-compensatory option to acquire a partnership interest is not treated as a partner for purposes of allocating partnership income unless the option provides the holder with rights substantially similar to the rights afforded a partner. See. Prop. Reg. 1.761-3(a).

Question 12

Does 721 apply to a contribution of property to a partnership for a non-compensatory option?

Answer 12

Section 721 does not apply to the transfer of property to a partnership in exchange for a non-compensatory option, but it does apply when the option is exercised.

Thus, if a taxpayer transfers appreciated property to a partnership in exchange for a non-compensatory option to acquire a partnership interest, taxpayer recognizes gain on the transaction. However, a later exchange by the taxpayer of appreciated property to exercise the option is protected by 721 and is not taxable. See prop. Reg. 1.721-2(f).

Question 13

Is depreciation recapture triggered on a contribution of depreciable property to a partnership?

Answer 13

No. Section 721 overrides Section 1245.

But property remains subject to recapture on disposition by partnership. § 1245/1250.

Recapture attributable to contributing partner must be allocated to her. §704(c).

Partnership uses partner’s method of cost recovery. § 168(i)(7).

Question 14

Can A/R be contributed tax-free to a partnership?

Answer 14

Yes - it is entitled to § 721 treatment.

Partner does not recognize 453B gain when installment obligation is contributed.

But gain in hands of partnership will be ordinary and allocated to contributing partner. 1.453-9(c)(2) / 1.721-1(a).

Question 15

What character will property contributed to a partnership have in the partnership’s hands?

Answer 15

The character of contributed property will depend on how partnership holds it. § 702(b).

There are 3 main exceptions.

Question 16

What are the exceptions where property contributed to a partnership will not be as determined by how the partnership holds it?

Answer 16

Unrealized receivables – Gain/loss recognized by the partnership will be ordinary.

Inventory – Any gain/loss within 5 years of contribution will be ordinary.

Capital loss property – If property was a capital asset in partner’s hands and has BIL, any loss recognized by the partnership within 5 years of contribution will be capital to extent of the BIL.

Question 17

What does Section 752(a) provide?

Answer 17

Where a partner assumes a liability of the partnership, she receives an increase in outside basis as if she had made a cash contribution. 752(a).

Question 18

What does Section 752(b) provide?

Answer 18

Where a partner is relieved of a liability because the partnership assumes it, partner has a reduction in outside basis (but not below zero), as if she had received a cash distribution. 752(b).

If decrease exceeds outside basis, partner must recognize excess as capital gain from sale/exchange of partnership interest. 731(a)(1) / 741.

Question 19

What does Crane provide?

Answer 19

You get credit for debt. If you acquire property subject to a debt, you include the debt in basis (since it will be repaid). If you sell property subject to a debt, you include the debt relief in the amount realized (since relief of debt is the same as receipt of equivalent amount of cash).

Question 20

What is recourse debt?

Answer 20

A partner bears the economic risk of loss (the partner would be required to repay liability if partnership unable to do so)

Question 21

What is nonrecourse debt?

Answer 21

No partner bears economic risk of loss - the risk of loss is to the property only

Question 22

How is recourse debt allocated to partners?

Answer 22

It’s allocated in accordance with who bears economic risk of loss:

In a GP, equal partners bear risk equally

In a LP, limited partners don’t have liability for recourse liabilities except to extent required to contribute to partnership in the future

To determine who bears economic risk of loss, consider a hypothetical liquidation where partnership assets are worthless and all liabilities are due - which partners would be obligated to pay a creditor or contribute to the partnership to pay the liability. 1.752-2(b)(1).

For this purpose, guarantees, indemnifications, and other reimbursement arrangements are taken into account. 1.752-2(b)(3)(i).

Question 23

How is nonrecourse debt allocated to the partners?

Answer 23

It’s allocated in accordance with shares of partnership profits (because the debt will be repaid from profits).

No partner is personally liable (doesn’t matter if GP/LP).

Question 24

Can services be contributed tax-free to a partnership under 721?

Answer 24

No, services do not constitute property under 721.

A partner who receives an interest for services,whether past,present, or future, is receiving compensation income per 61 and 83.

Question 25

What does Section 83 provide?

Answer 25

Property received in exchange for the performance ofservices is income, equal to FMV of property received minus any amount paid for property.

It doesn’t matter if you pay full value for property. Alves.

The property will be includible in income and valued in first taxable year in which either (i) rights are fully transferable or (ii) SRF haslapsed. 83.

Question 26

What is a “profits interest”?

Answer 26

When granted, just aright to future profits - No right to underlying assets.

Thus, upon grant, the partner would have capital account of zero and not be entitled to anything upon liquidation.

It is often accomplished by giving existing partners a liquidation preference equal to value of the partnership at the time of issuance.

Very popular - It incentivizes service provider with upside but doesn’t give away a piece of the rock.

Question 27

What as the impact of the Diamond case?

Answer 27

Prior to the Diamond case, it was assumed that profits interests were not taxable.

Diamond held that they were taxable (bad facts - the interest obviously had a readily determinable value).

The case caused confusion and uproar, and for years after Diamond, the issue was unsettled. Rev. Proc. 93-27 was enacted to settle and clarify the issue.

Question 28

What does Rev. Proc. 93-27 provide?

Answer 28

A safe harbor that clarifies that profits interests are generally not taxable.

If a person receives a profits interest for the provision of services in partner capacity or anticipation of being partner (i.e., not performed as independent contractor or employee), receipt of profits interest is not a taxable event for partner or partnership unless:

Profits interest relates to substantially certain and predictable stream of income from partnership assets (high-quality debt securities or net lease).

Partner disposes of profits interest within 2 years of receipt

Interest is in a publicly traded limited partnership under § 7704(b).

(Doug views this as just a safe harbor - even if sold within 2 years, you’re probably okay as long as it’s not egregious. This is an anti-abuse provision.)

Question 29

What does Rev. Proc. 2001-43 provide?

Answer 29

It clarifies timing issues. The determination of whether an interest is a profits interest is made at time interest is granted even if not substantially vested under § 83.

If it’s a profits interest, neither the grant nor the vesting will be considered taxable (even though profits interest might be in the money when vesting occurs).

Therefore, no § 83(b) election is needed because transfer and vesting are not taxable.

Requirements:

Partnership and service provider must treat service provider as owner of interest from date of grant, and service provider must take into account distributive share of all items on interest for entire period, and

Neither PP nor partner may deduct any amount for FMV of interest upon grant or when substantially vested, and

All other requirements of Rev. Proc. 93-27 must be satisfied.

Question 30

What does Notice 2005-43 provide?

Answer 30

It sets forth proposed regulations (Prop. Reg. 1.83-1(l)) that would provide that “property” under 83 includes profits interests. Therefore, an 83(b) election should be filed to ensure no income will be recognized on the lapse of risk of forfeiture.

It also provides a safe harbor election for valuation of profits interests. The FMV of interest transferred is its liquidation value, which should be zero.

Doug says that since this was not finalized, you don’t have to make election (although it would be best practices to do so), but good to be consistent as to how all recipients of non-substantially vested profits interests are treated.

Question 31

What is the treatment of the receipt of a capital interest in exchange for performing services?

Answer 31

It will be a taxable receipt of property in exchange for the performance of services under 61 and 83(a) when interest is either transferable or no longer subject to substantial risk of forfeiture. 83(a).

Amount recognized will be FMV of interest when included in income less any amount paid. § 1.721-1(b)(1) / 83(a).

An 83(b) election can be made. Amount recognized will be FMV at time of transfer – however, no deduction is allowed if interest is subsequently forfeited.

Partnership may take 162 deduction when includible in income (unless nature of services requires amortization or capitalization). 83(h). Deduction should be allocated to old partners. 707(d)(1).

Proposed regulations take position that partnership does not recognize gain or loss upon transfer or vesting of capital interest to service partner. Prop. Reg. 1.721-1(b)(1).

Question 32

What is the result if a partner contributes encumbered property to a partnership?

Answer 32

The partnership replaces partner as obligor.

The partner is relieved of personal liability but as partner, takes on a share of partnership’s liabilities.

This results in a simultaneous decrease and increase in share of liabilities. Only the net change is taken into account. 1.752-1(f).

If net relief of liability is greater than outside basis, outside basis is reduced to zero and any excess will be treated as gain from sale or exchange of newly acquired partnership interest (capital under Section 741). 733.