Tax 5-3 Identify factors that may limit the availability of federal income tax benefits from a direct participation program.

Question 1

Limitations of Tax Benefits

A special allocation of partnership items is allowed only if the allocation has a _____ _____ _____ apart from the tax consequences. There must be substantial non-tax economic consequences for the partner receiving the special allocation.

(5-3, 13)

Answer 1

substantial economic effect

In addition, to have substantial economic effect, a partnership must

(1) keep capital accounts that reflect the allocation;
(2) provide that, upon liquidation, partners with negative capital account balances must restore the balance to zero; and
(3) upon liquidation, make distributions based upon the capital account balance.

Question 2

Limitations of Tax Benefits

A partner may deduct losses only to the extent of the amount that he or she is…

(5-3, 13)

Answer 2

“at risk.”

The amount at risk equals the sum of

1. the money invested (except to the extent the money invested was borrowed and was secured only by the investment);
2. the adjusted basis of other property contributed to the partnership;
3. amounts borrowed for use in the activity, but only to the extent that the partners are personally liable for repayment of the debt (recourse indebtedness);
4. the partner’s share of income, less the partner’s share of losses or withdrawals from the partnership;
5. the proportionate share of qualified non-recourse financing in a real estate activity ONLY.

Question 3

Limitations of Tax Benefits

Essentially, the only difference between the amount at risk and the basis in a partnership is the treatment of…

(5-3, 14)

Answer 3

non-recourse financing.

A partner’s share of non-recourse financing established basis in the partnership, but is not treated as an amount at risk. Remember that non recourse financing is debt that is secured by the property, but for which no individual has personal liability. In the event of default, the lender may seize the property, but that is the lender’s only recourse. Recourse financing is typically secured by the property as well; however, in the case of default, the lender will still pursue the borrower for repayment.

Question 4

Limitations of Tax Benefits

Qualified non-recourse financing is financing…

(5-3, 14)

Answer 4

1. that is secured by real property,
2. for which no one is personally liable,
3. that is not convertible into an equity interest, and
4. that is provided either by
   (a) an unrelated person or entity regularly engaged in the business of lending money (a bank, savings and loan, credit union, insurance company, pension fund, or government unit), or
   (b) a “related” person on commercially reasonable terms.

Given the recent credit crisis, it seems counter-intuitive that lenders would still offer non-recourse financing, but it is indeed still being used in real estate activities today.

Question 5

Limitations of Tax Benefits

The alternative minimum tax on individuals imposes upon a taxpayer a tax computed at a lower rate, but upon a much broader base, than the regular income
tax. A taxpayer must pay the greater of the or the _____ alternative minimum tax (AMT). The AMT is significant in tax shelter analysis since many of the benefits provided by tax shelters are preference items, or adjustments, upon which the AMT is imposed.

(5-3, 14)

Answer 5

regular income tax

Question 6

Limitations of Tax Benefits

A problem with tax shelters is that they often “burn out.” That is, the tax advantages get used up in earlier years, and in later years they generate taxable income without any positive cash flow. This is known as…

(5-3, 15)

Answer 6

phantom income.

Phantom income often occurs when the “crossover point” is passed. This is when the nondeductible principal portion of a payment on a mortgage exceeds the deductible interest portion of the payment.

Question 7

Limitations of Tax Benefits

The Tax Reform Act of _____ imposed strict limits on the deductibility of losses and credits from passive activities. Although the rules were generally designed to kill the tax shelter industry, the rules were broadly written to include all passive activities.

(5-3, 15)

Answer 7

Tax Reform Act of 1986

Question 8

Limitations of Tax Benefits

A _____ is generally defined as any trade or business activity in which the taxpayer does not materially participate.

(5-3, 15)

Answer 8

passive activity

In addition, most rental activities, by their very nature, are treated as passive activities.

Question 9

Limitations of Tax Benefits

Passive losses may only be used to offset passive income and may not be used to reduce _____ (wages, salaries, etc.) or _____ (interest, dividends, royalties, etc.). Unused passive losses carry forward and are subject to differing rules, depending upon the origin of the losses and the type of disposition of the passive activity. There are, of course, certain exceptions to the passive activity loss rules.

(5-3, 16)

Answer 9

active income, portfolio income

Question 10

Limitations of Tax Benefits

Assume that Mary and her neighbor Bill formed an S corporation. Bill will manage the corporation, and Mary shows up only occasionally to check up on Bill. It is highly likely that Mary does not materially participate in this trade or business activity. Thus, any income or losses from the activity would be _____ income or losses for Mary.

(5-3, 16)

Answer 10

passive

If the activity generated a net loss during the year, that loss would only be deductible against passive income from another passive activity. If Mary has no passive income during the year, the losses from the S corporation would be held in suspense (carried forward) and may be used against future passive income. Since he is managing the activity, it is likely that Bill does not have a passive activity, and he may deduct the losses against his other income.

Question 11

Limitations of Tax Benefits

Discuss how each of the following factors may limit the effectiveness of a tax-advantaged investment.

passive activity loss rules

(5-3, 51)

Answer 11

These rules limit a taxpayer’s ability to use losses or credits from passive activities to reduce the tax due on active or portfolio income. A passive activity is a trade or business activity in which the taxpayer does not materially participate. Also, most rental activities are deemed to be passive activities. However, if the average period of customer use of the rented tangible property is seven days or less, the activity is not automatically deemed to be passive.

Question 12

Limitations of Tax Benefits

Discuss how each of the following factors may limit the effectiveness of a tax-advantaged investment.

substantial economic effect

(5-3, 51)

Answer 12

This doctrine limits the use of special allocations. To have substantial economic effect, a partnership must

(1) keep capital accounts that reflect the allocation;
(2) provide that, upon liquidation, partners with negative capital account balances must restore the balance to zero; and
(3) upon liquidation, make distributions based upon the capital account balance. In addition, there must be substantial non-tax economic consequences for the partner receiving the special allocation.

Question 13

Limitations of Tax Benefits

Discuss how each of the following factors may limit the effectiveness of a tax-advantaged investment.

at-risk rules

(5-3, 51)

Answer 13

These rules limit the deductibility of losses to the amount considered to be at risk. The amount at risk equals the sum of the money invested (except to the extent the money invested was borrowed and was secured only by the investment), the adjusted basis of other property contributed to the partnership, amounts borrowed for use in the activity (but only to the extent that the partners are personally liable for repayment of the debt—recourse indebtedness), the partner’s share of income less the partner’s share of losses or withdrawals from the partnership, and the partner’s share of qualified nonrecourse financing in a real estate activity ONLY.

Generally, the at-risk rules are discussed in terms of limiting the use of leverage. Generally, nonrecourse financing does not constitute an amount at risk unless the nonrecourse financing is qualified nonrecourse financing in a real estate activity, only.

Question 14

Limitations of Tax Benefits

Discuss how each of the following factors may limit the effectiveness of a tax-advantaged investment.

alternative minimum tax

(5-3, 51)

Answer 14

The AMT limits a taxpayer’s ability to reduce overall tax liability by imposing a tax on alternative minimum taxable income, which includes preference items and adjustments that may flow through from direct participation programs.

Question 15

Module Check

3. Which one of the following typically is not an item used in determining the amount a partner has at risk?
   a. The adjusted basis of property contributed to the partnership
   b. Amounts borrowed for use in the activity for which the partner is personally liable for repayment
   c. Amounts borrowed for use in the activity that were secured only by the investment

(LO 5-3)

Answer 15

c. Amounts borrowed for use in the activity that were secured only by the investment

A borrowed amount that is secured only by the investment (nonrecourse financing) is not treated as an amount at risk, unless the borrowing is qualified nonrecourse financing in a real estate activity.

a. is incorrect because “The adjusted basis of property contributed to a partnership is considered to be an amount for which the taxpayer is at risk.”
b. is incorrect because “Borrowed amounts for which the taxpayer is personally liable are considered to be amounts for which the taxpayer is at risk.”

Question 16

Module Check

5. The passive activity loss rules apply to
   a. personal service corporations only.
   b. closely held C corporations only.
   c. individuals only.
   d. personal service corporations, closely held C corporations, and individuals.

(LO 5-3)

Answer 16

d. personal service corporations, closely held C corporations, and individuals.

The passive activity loss rules apply to personal service corporations, closely held C corporations, and individuals, as well as estates and trusts.

Question 17

16. Which one of the following best describes the role of the “at-risk” rules?
    a. They allow the IRS to tax certain partnerships as if they were corporations.
    b. They limit the ability to use special allocations.
    c. They limit the advantage gained through leverage.
    d. They require the substantial economic effect doctrine to be satisfied.

(LO 5-3)

Answer 17

c. They limit the advantage gained through leverage.

The at-risk rule limits the deductibility of losses to the amount at-risk. Only certain debt establishes an amount at-risk. Specifically, recourse financing and qualified nonrecourse financing (in a real estate activity only) establish amounts at-risk.

Question 18

71. Which of the following rules or doctrines may limit the availability of income tax benefits from a particular investment?

I. tax conduit

II. the substantial economic effect doctrine

III. the at-risk rule

IV. the passive activity loss rule

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

(LO 5–3)

Answer 18

II, III, and IV only

The substantial economic effect doctrine limits the ability to use special allocations in a partnership. The at-risk rule limits the ability to use leverage by attacking the use of nonrecourse financing. The passive activity loss rule limits the ability to deduct losses from activities in which the taxpayer does not materially participate.

Question 19

72. To which of the following do the passive activity loss rules apply?

I. individuals

II. C corporations that are not closely held

III. closely held C corporations

IV. estates

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

(LO 5–3)

Answer 19

d. I, III, and IV only

Of the listed choices, option II is the only one to which the passive activity loss rules do not apply. The passive activity loss rules specifically do not apply to C corporations that are not closely held.