Tax 5-2 Identify tax mechanisms that enable direct participation programs to provide specific tax advantages.

Question 1

Tax Benefits

The benefits that flow through from a partnership entity may be enhanced by the potential, under certain circumstances, for the ______ of certain items of income, expense, gain, or loss. This is an allocation of one or more items of income, gain, losses, deductions, or credits that depart from the partner’s general profit and loss sharing ratio.

tax credits

accelerated deductions

special allocation

leverage

(5-2, 11)

Answer 1

“special allocation”

In other words, it may not be necessary to split all of these items pro rata among all of the owners. Rather, it may be possible to make a special allocation of certain items to a particular partner or class of owners (the limited partners of a limited partnership, for example) who will obtain the greatest individual tax advantage from the allocation. Note, however, that the rules regarding substantial economic effect discussed below might limit the effectiveness of an attempted special allocation.

Question 2

Direct Participation Program

Explain the tax treatment of the following items for an individual owner of a direct participation program. Assume the owner does not materially or actively participate in the activity.

operating losses: extent deductible

(5-1,2,3, 48)

Answer 2

Passive losses are deductible against passive income only and may not be used to offset active or portfolio income.

Question 3

Direct Participation Program

Explain the tax treatment of the following items for an individual owner of a direct participation program. Assume the owner does not materially or actively participate in the activity.

operating losses: impact of allowable deduction on AMT

(5-1,2,3, 48)

Answer 3

The amount of any passive loss allowed as a deduction may be comprised of preference items or adjustments for AMT purposes.

Question 4

Direct Participation Program

Explain the tax treatment of the following items for an individual owner of a direct participation program. Assume the owner does not materially or actively participate in the activity.

operating losses: treatment of nondeductible amount (carryover)

(5-1,2,3, 48)

Answer 4

Any loss disallowed may be carried over for possible use in future years.

Question 5

Direct Participation Program

Explain the tax treatment of the following items for an individual owner of a direct participation program. Assume the owner does not materially or actively participate in the activity.

operating income: portion attributable to portfolio investments by the partnership

(5-1,2,3, 48)

Answer 5

If a limited partnership, or other passive activity, invests funds in a way that generates portfolio income, this income retains its character as portfolio income when it flows through to the partners. This is important because portfolio income may not be offset by passive losses.

Question 6

Direct Participation Program

Explain the tax treatment of the following items for an individual owner of a direct participation program. Assume the owner does not materially or actively participate in the activity.

operating income: portion attributable to the partnership’s trade or business

(5-1,2,3, 49)

Answer 6

Income generated through operation of the partnership’s trade or business will be passive income to the partners.

Question 7

Direct Participation Program

Discuss the following concepts and mechanisms as they relate to the potential tax advantages provided by a direct participation program.

tax conduit

(5-1,2,3, 48)

Answer 7

Income flows through without double taxation; losses flow through to be used to reduce tax on other income (subject to limits).

Question 8

Direct Participation Program

Discuss the following concepts and mechanisms as they relate to the potential tax advantages provided by a direct participation program.

special allocation

(5-1,2,3, 48)

Answer 8

Income and losses need not be allocated pro rata among the partners, but rather may be allocated in a way that derives the greatest tax benefit (subject to substantial economic effect rules).

Question 9

Direct Participation Program

Discuss the following concepts and mechanisms as they relate to the potential tax advantages provided by a direct participation program.

accelerated deductions

(5-1,2,3, 48)

Answer 9

Accelerated “noncash” deductions may result in a net loss for tax purposes, even though there is positive cash flow.

Question 10

Direct Participation Program

Discuss the following concepts and mechanisms as they relate to the potential tax advantages provided by a direct participation program.

tax credits

(5-1,2,3, 48)

Answer 10

Tax credits flow through to reduce individual tax liability (subject to passive activity loss and credit limits).

Question 11

Direct Participation Program

Discuss the following concepts and mechanisms as they relate to the potential tax advantages provided by a direct participation program.

leverage

(5-1,2,3, 48)

Answer 11

Leverage (borrowing) may be used to magnify tax impacts, subject to at-risk rules.

Question 12

Direct Participation Program

Module Check

2. A special allocation typically results in
   a. the partner in the lowest tax bracket receiving more deductions.
   b. an allocation of gains and losses based upon the ownership percentage of the partner.
   c. an allocation of income and deductions that differs from the partners’ general income and loss sharing ratio.

(LO 5-2)

Answer 12

c. an allocation of income and deductions that differs from the partners’ general income and loss sharing ratio.

A special allocation allocates items in a different percentage than that of the normal share of profits and losses.

a. is incorrect because “A special allocation typically will result in benefits being allocated to the partner who is most in need (in the highest tax bracket, for example).”
b. is incorrect because “A special allocation will result in an allocation other than that of the partner’s ownership percentage.”

Question 13

Direct Participation Program

Module Check

4. Qualified nonrecourse financing is financing
   a. that is convertible into an equity interest.
   b. for which the partners are personally liable.
   c. that is secured by the real property.

(LO 5-2)

Answer 13

c. that is secured by the real property.

Qualified nonrecourse financing is financing that is not convertible into an equity interest, that is secured by the real property, and for which the partners are not personally liable. Additionally, the financing must be provided by an unrelated entity such as a bank, or, if a related person, on commercially reasonable terms.

a. is incorrect because “Qualified nonrecourse financing may not be convertible into an equity interest.”
b. is incorrect because “Qualified nonrecourse financing is financing for which the partners are not personally liable.”

Question 14

Direct Participation Program

18. Which of the following is a requirement for a special allocation to have substantial economic effect?
    a. Upon liquidation, distributions must be made according to ownership percentages.
    b. Positive capital account balances must be kept.
    c. Upon liquidation, negative capital account balances must be restored to zero.

(LO 5-2)

Answer 14

c. Upon liquidation, negative capital account balances must be restored to zero.

A requirement of the substantial economic effect rule is that negative capital account balances must be restored to zero upon liquidation.

a. is incorrect because “Distributions upon liquidation must be made according to the partners’ capital account balances, not ownership percentages.”
b. is incorrect because “Capital account balances may not always be positive and are sometimes negative.”

Question 15

Direct Participation Program

19. The alternative minimum tax is significant as it applies to investors in direct participation programs (DPPs) because
    a. the IRS has a tendency to audit more DPPs.
    b. many of the benefits provided by DPPs are preference items or adjustments.
    c. the AMT exemption amount is smaller for investors in DPPs.

(LO 5-3)

Answer 15

b. many of the benefits provided by DPPs are preference items or adjustments.

The AMT is significant with regard to DPPs because of the existence of preference items and adjustments passed through by the DPPs, not because of the likelihood of audit or the exemption amount.

a. is incorrect because “Even if the IRS audits a higher proportion of DPPs, this has nothing to do with the alternative minimum tax.
c. is incorrect because “The AMT exemption amount is the same whether or not the taxpayer has invested in a DPP.”

Question 16

Practice Test 2

Direct Participation Program

69. Which of the following are considered advantages of direct participation programs?

I. leverage
II. tax conduit
III. special allocations
IV. substantial economic effect

a. I and II only
b. I and III only
c. II and IV only
d. I, II, and III only

(LO 5–2)

Answer 16

d. I, II, and III only

All of the characteristics are advantages of a direct participation program except option IV, substantial economic effect. Substantial economic effect is actually a disadvantage that serves to limit the potential effectiveness of a direct participation program. Leverage enables the taxpayer to use losses in excess of the amount invested. A tax conduit potentially enables the taxpayer to deduct losses of the business on his or her individual income tax return. Special allocations allow for the optimum use of the tax benefits and deductions of a partnership.

Question 17

Practice Test 2

Direct Participation Program

70. Sam Platt invested in a low-income housing limited partnership in the current tax year. Which of the following tax mechanisms may enable the investment to achieve tax advantages for the limited partner?

I. The investment in the limited partnership qualifies for tax credits.

II. A fixed percentage of gross income earned from rent can be excluded.

III. The tax impact may be magnified by the use of qualified nonrecourse financing.

IV. The cost of the investment can be recovered using special accelerated depreciation.

a. I and III only
b. I and IV only
c. II and III only
d. II and IV only

(LO 5–2)

Answer 17

a. I and III only

The low-income housing limited partnership would generate tax credits that the investor may use. Also, the use of qualified nonrecourse financing would magnify, or increase, the tax impact of the investment. The other two choices are clearly incorrect. Option II is incorrect because all of the rent must be included as income. Also, the investment may not use any type of special cost recovery deductions.

Question 18

Practice Test 1

15. Which one of the following best describes the role of a special allocation in a limited partnership?
    a. It allows an allocation of items of income and expense that is not pro rata.
    b. A special allocation allows an allocation of items in a manner that differs from the “normal” allocation of deduction, income, credit, etc.
    c. It requires all items to be distributed pro rata, based on a partner’s capital account balance.
    d. It establishes the standards for allocating the proceeds of non-routine or “special” items of income.
    e. It allocates management responsibility to the general partners.

(LO 5-2)

Answer 18

It allows an allocation of items of income and expense that is not pro rata.

A special allocation allows an allocation of items in a manner that differs from the “normal” allocation of deduction, income, credit, etc.