Pope Phft2017 Corp SM 09

Chapter C:9
Partnership Formation and Operation

Discussion Questions
C:9-1 Advantages of a partnership for Yvonne and Larry include:
1.
The partnership itself is not subject to tax, thereby eliminating the problem of
double taxation that exists for C corporations. p. C:9-4.
2.
Partners may divide the partnerships profit or loss among themselves without
regard to their proportionate capital interests (as long as the allocation has substantial economic
effect).
pp. C:9-17 through C:9-20.
3.
Partnerships are popular because of the relative simplicity and informality inherent
in creating and operating such entities. No legal agreement is required to form a partnership but a
written agreement is advisable. p. C:9-2.
4.
Under the conduit principle of taxation, partnership losses and other items
receiving special tax treatment flow through to the partners. p. C:9-4.
C:9-2 Lack of limited liability. A corporation provides limited liability protection for the business
owners while a general partnership does not. The purchase of the inn is likely to be financed with
debt and additional debt is likely to be incurred during the renovations. The construction
required during the renovation and the day-to-day operation of the inn provides significant
exposure for liability from lawsuits. The partnership form would not protect the owners of the
business from possibly losing their individual assets. If the owners want the advantages of a
partnership and still have limited liability, they may want to consider a limited liability company
(LLC) or a limited liability limited partnership (LLLP) if available in the taxpayers state. pp. C:23 through C:2-6 and C:9-2 through C:9-4.
C:9-3 General partnership. Because Sam will be providing business advice, this partnership
should be arranged as a general partnership. Both brothers will be actively managing the business
and therefore limited liability protection would not be available to Sam if the partnership is created
as a limited partnership with Sam as the limited partner. The brothers, however, also may want to
consider an LLC instead of a partnership. pp. C:9-2 through C:9-4.
C:9-4 Whether Doug receives a profits interest or a capital and profits interest; he theoretically
should report the value of the property he receives for services as ordinary income. In this case,
the initial basis for his partnership interest equals the amount he reports as income. If the profits
interests cannot be valued, however, Doug recognizes no income and has a zero basis in his
partnership interest. Also, under Rev. Proc. 93-27, 1993-2 C.B. 343, the IRS will not treat
receipt of a profits interest as a taxable event unless one of the following events occurs: (1) the
profits interest relates to a substantially certain and predicable income stream, (2) the partner
disposes of the interest within two years of receipt, or (3) the interest is a publicly traded
partnership. (Note: The IRS is in the process of revising its rules concerning service partners.
See Notice 2005-43, 2005-24 C.B. 1221.) pp. C:9-10 through C:9-12.
Copyright 2017 Pearson Education, Inc.
C:9-1
C:9-5 a.
Probably not. The existing partner could contribute the property tax-free to the
partnership, but Sec. 704(c) requires that the tax attributes from contributed property be allocated
to the partner that contributes the property. Under Sec. 704(c), the partners must specially
allocate among themselves the income, gain, loss, and deductions attributable to contributed
property in a manner that reflects the difference between the propertys FMV and its tax basis at
the time of the contribution. In addition, the partnership will have the property with a carryover
basis, which is below its FMV. For depreciable assets, the partnership will get smaller
depreciation deductions and the special allocation of depreciation among the partners may not
totally compensate the other partners. pp. C:9-5 through C:9-12 and C:9-18 through C:9-20.
b.
Sell or lease the property to the partnership or sell the property to a third party
who then contributes the property to the partnership. pp. C:9-27 and C:9-28.
c.
Ordinary income recognition is required on a partners sale of property to the
partnership where the seller owns more than 50% of the capital or profits interests if the property
is either depreciable, or is not a capital asset, in the hands of a partnership. If the partner leases
property to a partnership, the partner retains the depreciation and other deductions with respect to
the property. The leasing partner also avoids the depreciation recapture provisions. Rentals
received from the partnership are taxed as ordinary income. A sale of the property to a third party
is taxed as any other sale would be with no special tax consequences. pp. C:9-27 and C:9-28.
C:9-6 a.
The partner recognizes gain on the contribution of property and assumption of a
liability if the amount of the liability assumed by the other partners exceeds the contributing
partners basis in the contributed property plus her share of existing partnership liabilities. pp.
C:9-5 through C:9-8.
b.
Net decrease. The basis in the partnership interest will be decreased by the amount
of the liability assumed by the other partners. Viewed another way, her basis will increase by her
share of the increase in partnership liabilities and decrease by her liability assumed by the
partnership, for a net decrease. pp. C:9-6 through C:9-8.
C:9-7 a, b, and d. p. C:9-12.
C:9-8 No. Partnership ordinary income is the total of partnership income and deduction items
that do not have to be separately stated. This partnership has $100,000 of ordinary income.
Partnership taxable income, however, is the sum of all taxable items that are either separately
stated or included in ordinary income. BWs partnership taxable income is $150,000 ($100,000
ordinary income + $50,000 long-term capital gain). p. C:9-17.
C:9-9 The partners distributive share will equal the sum of the partners earnings for one-half of
his or her beginning-of-the-year interest for the entire year and the partners earnings for the other
one-half of his or her beginning-of-the-year interest for nine months (calculated on a daily basis).
pp. C:9-18 and C:9-19.
C:9-10 Usually no because a limited partner normally has no economic risk for recourse debt.
However, a limited partners basis is increased by recourse liabilities to the extent the limited
partner is liable to incur an economic loss, for example, to the extent he or she is obligated to
repay a
C:9-2
general partner should the general partner have to pay the debt or to the extent the limited partner
has guaranteed the debt. pp. C:9-21 through C:9-24.
C:9-11 Qualified nonrecourse real estate financing is included in the at-risk basis of both general
and limited partners. This financing meets the requirements for qualified nonrecourse real estate
financing. p. C:9-26.
C:9-12 Less restrictive. Section 704(d) limits the loss to the adjusted basis (before reduction by
current years losses) of a partners interest in the partnership at the end of the partnership tax
year in which the loss occurs. This basis includes recourse debt (to the extent of a partners
economic risk
of loss) and includes nonrecourse debt. The at-risk basis does not include nonrecourse debt
(other than qualified nonrecourse real estate financing). Thus, the at-risk rules are more
restrictive than the Sec. 704(d) rule. p. C:9-26.
C:9-13 No. As a limited partner in the JRS Partnership, Jeff is almost certainly subject to the
passive loss limitation rules on losses from this partnership. Accordingly, income from a general
partnership in which Jeff materially participates (and thus earns active income) cannot be used to
offset the passive losses. Jeff can use losses from the JRS Partnership only to offset passive
income, or he can claim the losses when he sells his entire interest in the JRS Partnership or when
the partnership terminates. pp. C:9-26 and C:9-27.
C:9-14 Contribute the property. ABC Partnership will hold the land as inventory for resale to
customers and not as a capital asset. Because Helen owns more than a 50% interest in the ABC
Partnership, the sale of the land to the partnership will generate ordinary income instead of capital
gain for Helen. If Helen instead contributes the land to the partnership, it will recognize no gain
until it sells the lots. Then, as the partnership sells each lot, Helen will recognize the precontribution
gain as well as her share of any postcontribution appreciation, and all the gain will be ordinary
income taxable at a marginal rate of up to 39.6%. In total, the ordinary income under this
alternative will be the same as if Helen had sold the land to the partnership. A contribution,
however, will allow her to delay the gain recognition. Even better results occur if Helen can dispose
of 5% or more of her partnership interest so that she owns, directly and indirectly, 50% or less of
the ABC Partnership. If she owns 50% or less, she can recognize capital gain on the sale of the land
to the partnership and use these gains to offset any capital losses she already may have recognized
or that she may desire to recognize. Capital gains are taxed at rates between 0% and 23.8%
(including the 3.8% rate on net investment income) depending on the taxpayers ordinary tax
bracket. These rates are below the rate applicable to ordinary income. Alternatively, she could sell
the land to a third party who would then contribute the land to the ABC Partnership, assuming the
partnership desires a new partner. Her gain on the sale of the land would be capital gain, and the
contributing partner would recognize no gain when he or she transferred the land to the partnership.
pp. C:9-27 and C:9-28.
C:9-15 Yes. Regulation Sec. 1.707-1(c) provides that a partner reports guaranteed payments as
ordinary income in the partners tax year that includes the last day of the partnerships tax year in
which the partnership deducted the payments under its method of accounting. A partner reports
his or her distributive share of partnership items (determined under Sec. 702(a)) in the tax year
that includes the last day of the partnerships tax year. Thus, from a timing perspective, the two
payments schemes are the same to Tracy. pp. C:9-28 and C:9-29.
C:9-3
C:9-16 The Sec. 704(e) rules apply only to a capital interest in a partnership, where capital is a
material income producing factor and where the family member is the true owner of the interest. If
capital is a material income-producing factor for the partnership, the family partnership rules
apply. p. C:9-30.
C:9-17 The distributive shares allocated to Andrew and Steve will be combined and then a
reasonable salary for Andrews personal services will be allocated to him. The remaining portion
of the distributive share (after a reasonable salary to Andrew) will be allocated 30/50ths to
Andrew and 20/50ths to Steve. p. C:9-30.
Issue Identification Questions
C:9-18
Does Bob recognize any gain on the formation? When will he recognize
the precontribution gain?
What is Bobs basis and holding period for his partnership interest?
Does Kate recognize any loss on the contribution of property in exchange for her
partnership interest? When will she recognize the precontribution loss? What will
the character of the loss be?
What is Kates basis and holding period for the partnership interest she received in
exchange for property?
What basis and holding period does the partnership have in the property received?
What are the Sec. 1250 ramifications for the building?
What type of gain will the partnership and partners recognize on the sale of the
building?
Did Kate receive any of her partnership interest for services?
If so, what gain, loss, or deductions must the partnership recognize?
What income must Kate recognize?
Bob must determine his basis in the partnership interest ($65,000 = $95,000 - $60,000 +
$30,000 share of liabilities) and his holding period for his interest in the partnership (begins with
his ownership of the office building). Because Bob recognizes no gain or loss, he does not have
to be concerned with any recapture potential under Sec. 1250. Also, Sec. 1250 depreciation
recapture will not be a concern if the parties have depreciated the property under straight-line
MACRS rules. Bob, however, will have to recognize precontribution gain on the office building
at a future date. This gain will be part unrecaptured Sec. 1250 gain subject to the 25% (and
possibly an additional 3.8%) capital gains tax rate under Sec. 1(h)(l)(D) (and possibly Sec. 1411)
and part Sec. 1231 gain subject to the applicable capital gains tax rate.
Kate must determine her basis in the partnership interest ($105,000 = $75,000 + $30,000
share of liabilities) and her holding period for her interest in the partnership (begins with her
ownership of the land). (Also see discussion of services in the last paragraph of this solution.)
Kate recognizes no loss at the time of the partnership formation. If the land was a capital asset to
Kate and the partnership sells the land within five years of Kates contribution, the loss will be a
capital loss up to $25,000, and that capital loss will be allocated to Kate as a precontribution loss.
After five
C:9-4
years, the character of the loss will be determined by the character of the land to the partnership,
but Kate still will have to report any precontribution loss recognized. Guaranteed payments will
be reported as ordinary income.
The partnership must be concerned with the basis and holding period of the assets it
receives (carryover for both basis and holding period). The partnership can deduct from ordinary
income the guaranteed payments made to Kate.
An additional tax issue must be addressed. Bob contributed property with a net value
of $70,000 for a one-half interest in the partnership while Kate contributed property with a net value
of only $50,000 for a one-half interest in the same partnership. The total partnership has a net value
of $120,000 ($130,000 + $50,000 - $60,000 liability). One possibility is that Bob has made a
$10,000 gift to Kate. If so, both partners bases must be adjusted to reflect the gift. Alternatively,
the facts suggest that Kate may be receiving some of her partnership interest in exchange for her
services in managing the business for the first year while receiving no guaranteed payment. If so,
Kate must recognize ordinary income and increase her basis for the value of the partnership interest
she received in exchange for services. If Kate is receiving some of her partnership interest for
services, the partnership must recognize gain or loss on the partnership assets she is deemed to
receive and must adjust the basis of the assets for her deemed recontribution. The partnership also
must deduct the guaranteed payment. (Note: The IRS is in the process of revising its rules
concerning partners who contribute services. See Notice 2005-43, 2005-24 C.B. 1221.) pp. C:9-5
through C:9-12, C:9-28, and C:9-29.
C:9-19
What items qualify as organizational expenditures, which are start-up

expenditures, and what items can be deducted currently?
Does the partnership want to deduct (up to $5,000) and then amortize
organizational expenditures and/or start-up expenditures? If so, over what time
period does the amortization occur (if applicable)?
When does the partnership business begin?
The partnership first must characterize each expenditure as an organizational expenditure,

a start-up expenditure (Chapter C:3), another expenditure to be capitalized, or a current period
expense. The costs of drawing up the partnership agreement and of establishing the accounting
system are organizational expenditures (totaling $3,200). The cost of searching for a retail outlet
is a start-up expenditure ($1,600), and the cost of having an income statement prepared is a
current period expense ($500).
The partnership then must decide how it wants to handle the organizational and start-up
expenditures. Because each of these items is less than $5,000, the partnership can elect to deduct
the expenditures currently under Sec. 195 for the start-up expenditures and under Sec. 709 for the
organizational expenditures. If the expenditures had exceeded $5,000 each, the partnership would
amortize the balances over 180 months.
Another issue the partnership must face is when is the partnership is considered to begin
business. Regulation Sec. 1.709-2(c) states that business begins when the partnership starts the
business operation for which it was organized. Had the expenditures exceeded $5,000,
amortization of both the excess organizational expenditures and the excess start-up expenditures
would begin with the month in which business begins. p. C:9-12.
C:9-5
C:9-20
Is the receipt of a profits interest in the ABC Partnership in exchange for

Caras services a taxable event?
If it is a taxable event, what is the amount and character of the income
recognized?
What is Caras basis and holding period for her partnership interest?
The receipt of the partnership interest is not a taxable event. Under Rev. Proc. 93-27,
1993-2 C.B. 343, the receipt of a profits interest is taxable only under circumstances where the
FMV of the interest can be readily determined. This situation does not fit into one of the three
exceptions contained in the revenue procedure guidelines as being a taxable event. (Note: The
IRS is in the process of revising its rules concerning partners who contributed services. See
Notice 2005-43, 2005-24 C.B. 1221.) pp. C:9-10 through C:9-12.
C:9-21
What is Georges basis in his partnership interest?

Does the repayment of the partnership liability cause an adjustment to Georges
basis in his partnership interest?
Is the repayment of the nonrecourse liability a taxable event for George? If so,
what is the amount and character of the income reported?
Repayments of partnership liabilities are treated as distributions to the partners.

A distribution made to a partner that exceeds his or her basis for the partnership interest produces
a taxable gain. The gain can be calculated as follows:
Basis at the beginning of the year
Plus: Georges share of income
(0.20 x $20,000)
Georges basis before the distribution
Minus: Georges deemed distribution from
repayment of partnership liability
(0.20 x $100,000)
Georges recognized gain
$15,000
4,000
$19,000
(20,000)
$ 1,000
After these adjustments, Georges basis in the partnership interest is zero. Also, the gain is a
capital gain if the distribution is deemed proportionate (see Chapter C:10).
C:9-22
What is Katies deductible loss from her partnership investment?

What is Katies Sec. 704(d) basis in her partnership interest?
What is Katies at-risk basis in her partnership interest?
Is the loss from the JKL Partnership a passive loss?
Does Katie have passive income from this investment or other investments?
If so, can she deduct her losses?
If not, do the losses carryover to later years?
C:9-6
As a limited partner, Katie is presumed not to materially participate in the partnership.

Therefore, because the loss is from a passive activity, she cannot deduct it unless she has passive
income from other investments, or she terminates her interest in the limited partnership. If no
such income exists, the losses carry over to later years. pp. C:9-26 and C:9-27.
C:9-23
Do the family partnership rules apply when no family relationship exists?

Does reasonable compensation need to be paid to Daniel for his services?
If so, what is reasonable compensation for Daniels services?
Does David need to be recognized as a partner in the CD Partnership?
If so, what is Davids allocable share of the partnership income?
What is Daniels allocable share of the partnership income?
The family partnership rules under Sec. 704(e) are written in terms of the donor-donee
relationship. Accordingly, they apply in this situation. Both Daniel and David would be allocated
a reasonable compensation amount. Then, the remainder of the income originally allocated to
Daniel and David would be reallocated to them based on their relative capital interests. p. C:9-30.
Problems
C:9-24 a.
Neither partner recognizes gain or loss (Sec. 721).
b.
Basis of contributed property
Plus: Share of partnership liabilities
Minus: Partnership assumption
of individual liabilities
Basis in partnership
Suzanne
$59,000
40,000
Bob
$95,000
40,000*
$99,000
(80,000)*
$55,000
*Alternatively, Bob reduces his basis by $40,000 ($40,000 - $80,000), which is the
amount of his liability assumed by the other partner.
c.
The partnership takes a carryover basis in each asset: inventory (securities),
$14,000; land, $45,000; and building, $50,000; plus $45,000 of cash.
d.
The partnerships initial book value is each assets FMV at the time of contribution:
inventory, $15,000; land, $40,000; and building, $100,000; plus $45,000 of cash.
e.
Amount realized
$20,000
Minus: Adjusted basis
( 14,000)
Realized gain
$ 6,000
Precontribution gain of $1,000 ($15,000 FMV at contribution - $14,000 basis) is allocated
to Suzanne. Bob and Suzanne share the remaining $5,000 gain equally. Thus, Suzanne reports
$3,500 of gain, and Bob reports $2,500 of gain. The gain is ordinary (and not capital) because
the property was inventory to Suzanne and because the partnership sold the inventory within five
years of its contribution. pp. C:9-5 through C:9-10, C:9-19, and C:9-21 through C:9-24.
C:9-7
C:9-25 a.
The partnership recognizes no gain or loss under Sec. 731(b), and neither partner
recognizes gain or loss under Sec. 731(a).
b.
$51,000 ending partnership basis for Able; $71,000 ending partnership basis for
Baker, determined under Secs. 705 and 752 as follows:
Basis in partnership interest:
Initial contribution
Plus: Share of bank liability
Share of assumed liability
Able
Baker
$30,000
$40,000
14,000
14,000
5,000*
Partnership ordinary income

Minus: Assumption of Ables liability
Ending basis
5,000
12,000
12,000
(10,000)*
$51,000
-0$71,000
*Alternatively, Able reduces his basis by $5,000 ($5,000 - $10,000), which is the amount
of his liability assumed by the other partner.
c.
Ending balance sheets:

Tax
$ 68,000
Book
$ 68,000
Contributed property
30,000
50,000
New property
24,000
24,000
Total assets
$122,000
$142,000
Liabilities ($10,000 + $28,000)
$ 38,000
$ 38,000
Cash ($40,000 + $28,000)
Capital accounts:
Able
Baker
Total liabilities and capital accounts
32,000a
52,000b
52,000c
52,000
$122,000
$142,000
$30,000 adjusted basis contributed - $10,000 liability + $12,000 share of partnership

ordinary income.
b
$50,000 FMV contributed - $10,000 liability + $12,000 share of partnership ordinary
income.
c
$40,000 cash contributed + $12,000 share of partnership ordinary income.
a
d.
The corporation recognizes no gain or loss under Sec. 1032(a), and neither
shareholder recognizes gain or loss under Sec. 351(a). Ables ending stock basis is $51,000, and
C:9-8
Bakers ending stock basis is $71,000, determined under Sec. 358(a)(1) as follows:
Basis in corporate stock:
Able
Baker
Initial contribution
$30,000
$40,000
Liability assumed by the corporation
(10,000)
Ending basis
$20,000
-0$40,000
The liability assumed by the corporation is treated as boot received for the stock basis calculation,
but it is not treated as boot for purposes of gain recognition if the liability assumption has a valid
business purpose and no tax avoidance purpose (Secs. 357(a) and 358(d)). The corporations
ordinary income does not affect the stock basis.
pp. C:9-5 through C:9-9, C:9-18, C:9-21 through C:9-24, and C:2-16 through C:2-20.
C:9-26 a.
Fred recognizes ordinary income (compensation) of $15,000. Ed recognizes
$89,000 (calculated in Part c below) of Sec. 1231 gain. The other partners recognize no gain or
income.
b.
The partnership recognizes no gain, loss, or income on the transfers.
c.
Al:
Cash contribution
Mortgage allocated to partner
Basis of partnership interest
$ 15,000
19,500
$ 34,500
Bob:
Accounts receivable basis to Bob

Clay:
Equipment basis to Clay

$ 13,000
19,500
$ 32,500
Dave:
Land basis to Dave

$ 50,000
19,500
$ 69,500
Ed:
Building basis to Ed
Mortgage contributed to partnership
$ 15,000
-026,000
$ 26,000
(130,000)*
Tentative basis (and amount of gain recognized)
26,000*
$
89,000
Actual basis (basis cannot be less than zero)
-0-
*Or minus $104,000 ($130,000 - $26,000) mortgage assumed

by other partners
Fred:
Services contributed by Fred

C:9-9
$ 15,000

19,500
$ 34,500
d.
Bases: cash, $15,000; accounts receivable, $0; equipment, $13,000; land, $50,000;
building, $15,000; and organizational expenditures, $15,000.
e.
Book values: cash, $15,000; accounts receivable, $20,000; equipment, $15,000;
land, $15,000; building, $150,000; and organizational expenditures, $15,000.
f.
The building has no depreciation recapture potential because straight-line MACRS
depreciation has been used. However, part or all of a subsequent gain will be classified as
unrecaptured Sec. 1250 gain subject, at the partner level, to the 25% (and possibly an additional
3.8%) capital gains tax rate under Sec. 1(h)(l)(D) (and possibly Sec. 1411). The depreciation
recapture potential for the office equipment carries over to the partnership. The partnership will
recognize the recapture when it sells or exchanges the property in a taxable transaction.
g.
If Freds profits interest had an ascertainable value, the result is unchanged. If the
profits interest has no ascertainable value at the time of the transaction, Fred recognizes no
income, and the partnership has no organizational expenditure for which an amortization
deduction can be
claimed. Also, under Rev. Proc. 93-27, 1993-2 C.B. 343, the IRS will not treat receipt of a
profits interest as a taxable event unless one of the following events occurs: (1) the profits
interest relates to a substantially certain and predicable income stream, (2) the partner disposes of
the interest within two years of receipt, or (3) the interest is in a publicly traded partnership.
(Note: The IRS is in the process of revising its rules concerning partners who contributed
services. See Notice 2005-43, 2005-24 C.B. 1221.)
h. Partnership:
Amount realized on sale
$ 9,000
( 50,000)
Recognized loss
($41,000)
Dave:
Fair market value when contributed

Precontribution loss
Total loss
Minus: Precontribution loss
Postcontribution loss
Precontribution loss
Plus: Share of postcontribution
loss (0.15 x $6,000)
Daves distributive share of loss
Other Partners:
Postcontribution loss allocated

to other partners ($6,000 - $900)
$15,000
50,000
($35,000)
$41,000
( 35,000)
$ 6,000
$35,000
900
$35,900
$ 5,100
Each partner can claim his share of the $5,100 loss only when he has sufficient basis in his
partnership interest. pp. C:9-5 through C:9-12, C:9-18, C:9-24, and C:9-25.
C:9-27 a.
Julie and Kay recognize no income on the partnership formation. Susan recognizes
ordinary income equal to the value of the partnership interest received, or $20,000. (Note: The
C:9-10
IRS is in the process of revising its rules concerning partners who contributed services. See
Notice 2005-43, 2005-24 C.B. 1221.)
b.
Julie
$
-016,200
Basis of property contributed

Plus: Share of liabilities
Minus: Liabilities assumed by partnership
Plus: Income recognized (for services)
Basis in partnership
$16,200
Kay
$75,000
32,400*
(54,000)*
_______
$53,400
Susan
N/A
$ 5,400
20,000
$25,400
*Or minus $21,600 ($54,000 - $32,400) liabilities assumed by other partners.

Basis
c. and d.
e.
Book Value
Accounts receivable
$
-0$ 60,000
Land
30,000
58,000
Building
45,000
116,000
Organizational expenditure
20,000
20,000
All of Kays precontribution gain is allocated to her, and no postcontribution gain
remains to be allocated to other partners.
Kays gains are analyzed as follows:

Cash received
Plus: Liability assumed by buyer
Amount realized
Gain realized and recognized
Character of gains:
Unrecaptured Sec. 1250 gain*
Sec. 1231 gain
Total
Land
Building
$40,000
18,000
$58,000
( 30,000)
$28,000
$ 80,000
36,000
$116,000
( 45,000)
$ 71,000
$ 15,000
56,000
$ 71,000
-028,000
$ 28,000
*The Sec. 1250 property is not subject to depreciation recapture because of straight-line
depreciation, but to the extent of depreciation taken, the gain is unrecaptured Sec. 1250 gain
subject to the 25% capital gains tax rate under Sec. 1(h)(l)(D) (and possibly an additional at
3.8% under Sec. 1411).
pp. C:9-5 through C:9-12, and C:9-19.
C:9-28 a.
Sean reports $75,000 of ordinary income and has a $75,000 basis in his partnership
interest. The partnership deducts $75,000 as compensation, allocating the deduction to the old
partners (none to Sean). The partnership (and the remaining partners) also recognize gains and
losses as if 20% of each asset had been sold at its FMV to pay for Seans services. The basis in
C:9-11
each asset having a gain (or loss) related to it will be adjusted upward (or downward) by the
amount of the gain (or loss) recognized. Also, any gains allocated to the old partners will increase
the basis in their partnership interests, and any deduction or losses will decrease their basis. In
addition, the $100,000 of current year ordinary income is allocated as follows under the varying
interest rule and also will increase the basis in their partnership interests:
Old partners: (100% x 335/365 x $100,000) + (80% x 30/365 x $100,000) = $98,356
Sean: 20% x 30/365 x $100,000 = $1,644
C:9-12
b.
Under Sol Diamond, 33 AFTR 2d 74-852, 74-1 USTC 9306 (7th Cir., 1974), if
an ascertainable FMV exists for the interest, such value must be reported as income by Sean and
is deductible by the XYZ Partnership. However, if the 20% interest has no ascertainable FMV,
neither Sean nor the XYZ Partnership has any current tax consequences except that the $100,000
ordinary income is allocated as in Part a. In addition, under Rev. Proc. 93-27, 1993-2 C.B. 343,
the IRS will not treat receipt of a profits interest as a taxable event unless one of the following
events
occurs:
(1) the profits interest relates to a substantially certain and predicable income stream, (2) the
partner disposes of the interest within two years of receipt, or (3) the interest is in a publicly
traded partnership. (Note: The IRS is in the process of revising its rules concerning partners who
contributed services. See Notice 2005-43, 2005-24 C.B. 1221.) pp. C:9-10 through C:9-12 and
C:9-18.
C:9-29
Marjorie:
Income: $15,000 ($20,000 FMV of interest - $5,000 cash)
Basis in partnership interest: $15,000 income recognized + $5,000 cash
contributed + Marjories share of partnership liabilities (not given in
problem).
Eldorado:
Capitalizes the $15,000. This amount is a syndication fee and cannot be

deducted now nor amortized in the future as an organizational expenditure.
The $5,000 cash contribution increases the partnerships assets. Marjories
capital account includes $15,000 + $5,000, or $20,000. In addition, the
partnership would recognize gain or loss on the deemed exchange of
property for Marjories services, and this gain or loss would be allocated to
the other partners. The partnership also would adjust the basis of its assets
for the recognized gain or loss.
(Note: The IRS is in the process of revising its rules concerning partners who contributed
services. See Notice 2005-43, 2005-24 I.R.B. 1221.)
C:9-30 a.
Possible Tax Year-Ends
6/30
Partner
Name
Beta
Chi
Delta
Partnership
Interest
Tax
Year
Months
Deferred
1/3
1/3
1/3
6/30
9/30
10/31
0
3
4
9/30
Total
.00
1.00
1.33
2.33
Months
Deferred
9
0
1
10/31
Total
3.00
.00
.33
3.33
Months
Deferred
8
11
0
Total
2.67
3.67
.00
6.34
The partnership must use a June 30 year-end, or with a Sec. 444 election, a tax year that
ends on March 31, April 30, or May 31.
C:9-13
b.
The natural business year that ends on January 31.
c.
The partnership would be required to use an October 31 year-end, or the tax year
of the majority partner. Alternatively, with IRS permission, the partnership could use a natural
business year-end (January 31), or with a Sec. 444 election, the partnership could use a tax year
that did not exceed a three-month deferral of income. pp. C:9-12 through C:9-15.
C:9-31 a.
December 31. The tax year-end of majority partners Boris and Damien is December
31, making this the required year-end for the partnership.
b.
Yes. Possible year-ends are those that allow for no more than a three-month
deferral from the required December 31 year-end. These year-ends include September 30, October
31, and November 30. pp. C:9-12 through C:9-15.
C:9-32 Solution appears on next page.
C:9-14
C:9-32 a. and b.
Total
Partnership ordinary income items:
Sales
Minus: Cost of goods sold
Gross profit
Plus: Sec. 1245 gain
Minus: Ordinary expenses:
Depreciation
Mark
Pamela
$ 84,100
$ 84,100
$450,000
(210,000)
$240,000
33,000
$27,00
0
Guaranteed payment
30,00
0
Business interest
42,00
0
Meals and entertainment
5,80
(50%)
0
Separately stated items:
Dividend income
T-E interest income
Sec. 1231 gain
Net long-term capital gain ($12,000 - $10,000)
Short-term capital loss
Investment interest expense
Charitable contributions
Nondeductible M&E expense
Nondeductible interest on loan for T-E interest
Guaranteed payment
(104,800)
$168,200
$ 15,000
4,000
18,000
2,000
(9,000)
(9,200)
(5,000)
(5,800)
(2,800)
30,000
c.
Beginning basis in partnership interest
Plus: Partnership ordinary income
Dividend income
T-E interest income
Sec. 1231 gain
Net long-term capital gain
Minus: Distributions
Reduction in partnership liabilities
Investment interest expense
Charitable contributions
Nondeductible M&E expense
Nondeductible interest on loan for T-E interest
Ending basis in partnership interest
C:9-15
7,500
2,000
9,000
1,000
(4,500)
(4,600)
(2,500)
(2,900)
(1,400)
7,500
2,000
9,000
1,000
(4,500)
(4,600)
(2,500)
(2,900)
(1,400)
30,000
Mark
Pamela*
$150,000
84,100
7,500
2,000
9,000
1,000
(40,000)
(7,000)
(4,500)
(4,600)
(2,500)
(2,900)
__(1,400)
$190,700
$150,000
84,100
7,500
2,000
9,000
1,000
(40,000)
(7,000)
(4,500)
(4,600)
(2,500)
(2,900)
__(1,400)
$190,700
*Note: Pamelas basis calculation does not reflect the guaranteed payment because the increase
for recognition and the decrease for payment net to zero. pp. C:9-16 through C:9-25.
C:9-33
Transaction
Income
Operating profit
Rental income
Interest on municipal bonds
Interest on corporate bonds
Dividend
Gain on investment land
LTCG
STCL
Sec. 1231 gain
Unrecaptured Sec. 1250 gain
Expenses
Depreciation
Interest:
Mortgage
Mun. bond loan
Guaranteed payment
Total
(a)
Financial
Income
(b)
Taxable
Income
(c)
Ordinary
Income
$ 94,000
30,000
15,000
3,000
20,000
60,000
10,000
( 7,000)
9,000
44,000
$ 94,000
31,000a
$ 94,000
( 39,000)
( 41,000)d
( 18,000)
( 5,000)
( 30,000)
$186,000
( 18,000)
3,000
20,000
66,000b
10,000
( 7,000)
9,000
44,000
-0-e
$ 211,000
(d)
Separately
Stated Items
$ 31,000
15,000
3,000
20,000
66,000c
10,000
( 7,000)
9,000
44,000
(12,000)
( 29,000)
( 30,000)
$35,000
( 18,000)
( 5,000)
30,000
Prepaid rental income is reported for tax purposes when it is received.

For financial accounting purposes, the book value of the land was $15,000 and generated a book
gain of $60,000. The tax basis was $6,000 smaller, so the tax gain is $6,000 larger.
c
The precontribution gain of $6,000 ($15,000 - $9,000) must be specially allocated to Jim while
the postcontribution gain of $60,000 ($66,000 total gain - $6,000 precontribution gain) is
allocated ratably to all three partners.
d
MACRS depreciation is used for tax purposes.
e
The guaranteed payment has no net effect on taxable income. The guaranteed payment both
reduces ordinary income and increases separately stated income items that are taxable.
a
Each partner will be notified of his share of low-income housing expenditures qualifying for the
credit. pp. C:9-16 through C:9-21.
C:9-16
C:9-34 a.
Partner
Items
Total
Ordinary income
Long-term capital gain
Charitable contribution deduction
$120,000
18,000
6,000
20,000
Becky
Chuck
Dawn
$24,000
3,600
1,200
4,000
$36,000
5,400
1,800
6,000
$60,000
9,000
3,000
10,000
b.
Partnership
Total
Beckys
%
Beckys
Amount
Chucks
%
Chucks
Amount
1/1 through 6/30a

Ordinary income
LTCG
STCL
Charitable contribution
$59,507
8,926
2,975
9,918
20%
20%
20%
20%
$11,901
1,785
595
1,984
30%
30%
30%
30%
$17,852
2,678
893
2,975
7/1 through 12/31b

Ordinary income
LTCG
STCL
Charitable contribution
$60,493
9,074
3,025
10,082
25%
25%
25%
25%
$15,123
2,269
756
2,521
25%
25%
25%
25%
$15,123
2,269
756
2,521
1/1 through 6/30 is 181 days in a non-leap year.

7/1 through 12/31 is 184 days in a non-leap year.
pp. C:9-18 and C:9-19.

C:9-35 Patty:
Ordinary income:
Long-term capital gain:
Precontribution
Postcontribution
Total income/gain
$ 3,200 (0.40 x $8,000)

6,000 ($10,000 - $4,000)
1,600 [0.40 x ($14,000 - $10,000)]
$10,800
Dave reports $4,800 ($8,000 x 0.60) of ordinary income and $2,400 ($4,000 x 0.60) of long-term
capital gain. p. C:9-19.
C:9-36 As stated in text Example C:9-25, the allocation meets the first test of shifting because the
partners capital accounts increase by $10,000 whether with the special allocation or with an equal
allocation. The following calculations show the tax effects of the two allocations:
C:9-17
Special allocation:
Andy
Becky
Total
Taxable interest income

Tax-exempt interest income
Total allocation
-010,000
$10,000
$10,000
-0$10,000
Taxable income
Times: Tax rate
Tax liability
$10,000
0.15
$ 1,500
$1,500
Becky
Total
Equal allocation:
-00.33
-0Andy
Taxable interest income

Total allocation
$ 5,000
5,000
$10,000
$ 5,000
5,000
$10,000
Taxable income
Times: Tax rate
Tax liability
$ 5,000
0.33
$ 1,650
$ 5,000
0.15
$ 750
$2,400
Thus, shifting occurs because the special allocation does not alter the partners capital accounts
and because the special allocation reduces the partners total tax liability. Therefore, the special
allocation lacks substantiality. pp. C:9-19 through C:9-21.
C:9-37 a.
No. This special allocation does not meet the test of having substantial economic
effect and will not be acceptable to the IRS. In particular, shifting occurs because the special
allocation does not alter the partners capital accounts, and the special allocation reduces the
partners total tax liability by shifting enough short-term capital gain to Clark to offset his entire
short-term capital loss.
b.
The special allocation affects only the partners tax consequences and not the
economic consequences. Each partners distributive share is still $100,000. Accordingly, the
special allocation will not be accepted, and the income must be allocated according to the
partners 50/50 interest in the partnership. The partners must report the following:
Total
Short-term capital gain
Ordinary income
Clark
$ 60,000
140,000
Lois
$30,000
70,000
C:9-18
$30,000
70,000
C:9-38 a.
The special allocation could have substantial economic effect in Year 1 but not in
Year 2 or Year 3 because Diane does not have an obligation to repay negative capital account
balances.
b.
The special allocation will have substantial economic effect in all three years.
c.
As in Part a, the special allocation will not have substantial economic effect in Year
2 or Year 3 because Diane will have a negative capital account balance in each year. The liability
increases basis but does not increase her capital account. pp. C:9-19 through C:9-21.
C:9-39 a.
b.
Carryover basis of contributed property

Minus: Debt assumed by other partners (0.80 x $10,000)
Partnership interest basis
$14,000
( 8,000)
$ 6,000
Carryover basis from friend

Partnership interest basis
$34,000
20,000
$54,000
c.
The interests FMV used in valuing the estate ($120,000) is Kellys basis. pp. C:921 through C:9-24.
C:9-40 a.
The FMV of the partnership interest, or $25,000.

(Note: The IRS is in the process of revising its rules concerning partners who
contributed services. See Notice 2005-43, 2005-24 C.B. 1221.)
b.
Land basis
$ 6,000
Car basis
15,000
Cash contributed
2,000
Share of recourse liabilities (0.40 x $100,000)
40,000
Basis in partnership interest
$63,000
C:9-19
C:9-41 a.
Purchase price
Plus: Share of liabilities (0.40 x $200,000)
Distributive share of taxable items ($30,000 +
$10,000 - $1,000)
Distributive share of tax-exempt items ($8,000 - $2,000)
Minus: Change in liabilities (0.40 x $20,000)
Basis on December 31
$ 50,000
80,000
39,000
6,000
( 8,000)
$167,000
b.
Purchase price
Plus: Share of recourse liabilities (0.30 x $200,000)
Distributive share of taxable items
Distributive share of tax-exempt items
Increase in nonrecourse liabilities (0.40 x $80,000)
Minus: Reduction in recourse liabilities (0.30 x $100,000)
$ 50,000
60,000
39,000
6,000
32,000
( 30,000)
$157,000
c.
Purchase price
Plus: Distributive share of taxable items
Distributive share of tax-exempt items
Increase in nonrecourse liabilities (0.40 x $80,000)*
*Tina has no economic risk of loss for the recourse liabilities
and therefore receives no basis for these liabilities.
$ 50,000
39,000
6,000
32,000
$127,000

C:9-42 a. and b.
Analysis of Outside Basis and At-Risk Basis:
Kerry
Outside basis at January 1
Plus: Short-term capital gain
Partnership nonrecourse liability
Outside basis before losses
Minus: Reduction for losses (see below)
Outside basis after losses
$200,000
150,000
50,000
$400,000
( 400,000)a
$
-0-
At-risk basis before losses

Minus: Reduction for losses
At-risk basis after losses
$350,000
(350,000)
$
-0-
C:9-20
City Corporation
$200,000
150,000
50,000
$400,000
( 400,000)
$
-0N/A
Treatment of Losses:
Kerry
City Corporation
Losses:
Ordinary loss
Long-term capital loss
Total
$450,000
50,000
$500,000
$450,000
50,000
$500,000
Loss allowed
$350,000a
$400,000b
Character of losses allowed:

Ordinary loss (450/500 x loss allowed)
Long-term capital loss (50/500 x loss allowed)
Total
$315,000
35,000
$350,000
$360,000
40,000
$400,000
Kerrys loss is limited under Sec. 465 to his at-risk basis. Nevertheless, his outside basis is
reduced by $400,000.
b
City Corporation is not subject to the at-risk rules because it is not closely held. Thus, the
corporations loss is limited to its outside basis.
a
c.
The qualified nonrecourse liability is considered to be at-risk. Therefore, both
partners can deduct a $400,000 loss and have a zero outside basis for their partnership interest
after the years operations. Thus, City Corporations results are the same as in Parts a and b, and
Kerrys results are now the same as Citys. p. C:9-26.
C:9-43
Gary (General Partner-60%)
Tax Basis
At-Risk Basis
Beginning basis without debt
Recourse debt (accts. pay.)
Nonrecourse debt
Basis before losses
Operating loss*
Ending basis
$ 42,000
18,000
60,000
$120,000
(120,000)
$
-0-
Mary (General Partner-40%)

Tax Basis
At-Risk Basis
$42,000
18,000
-0$60,000
(60,000)
$
-0-
$28,000
12,000
40,000
$80,000
(80,000)
$
-0-
$28,000
12,000
-0$40,000
(40,000)
$
-0-
*Gary recognizes a $60,000 loss, and Mary recognizes a $40,000 loss, both limited by the
at-risk rules. Nevertheless, Gary and Mary reduce their partnership bases by the full amount of
the losses. They can deduct the disallowed losses in future years if they increase their at-risk
bases.
p. C:9-26.
C:9-21
C:9-44 a.
Eve
Tom
Beginning basis
Plus: Share of LTCG
Basis before loss
$46,000
8,000
$54,000
$75,000
12,000
$87,000
Share of loss
$56,000
$84,000
Limitations on loss
Sec. 704(d) limit
At-risk limit
Passive activity limit
$54,000
54,000
N/A
$87,000
87,000a
12,000b
Deductible loss
$54,000
$12,000
Because the partnership has no nonrecourse liabilities, the at-risk basis equals the
partnership basis for both partners. Thus, the at-risk rules under Sec. 465 do not limit the
losses the partners can deduct.
b
Eve materially participates in the partnership business, so the partnerships ordinary loss is
an active loss for her. Tom is a limited partner and does not materially participate, so his
deduction for losses is limited under Sec. 469 to the passive income he earns from this
(and all other) passive activities during this year. Because the problem states that he has
no other income except his salary, Tom can deduct the loss only to the extent of his share
of income from this partnership. This result assumes that the long-term capital gain relates
to the partnerships operations and is not portfolio income. These rules determine the
amount of loss Tom can deduct. The character (and the treatment of Toms income on the
tax return) remains $12,000 ordinary loss and $12,000 long-term capital gain.
a
b.
The additional $100,000 recourse debt would increase both the Sec. 704(d) basis
and the at-risk basis for Eve, who has the economic risk of loss. This increase would give her
enough at-risk basis to deduct her full $56,000 distributive share of partnership losses. As a
limited partner, Tom would have a basis increase only if he had some agreement to assume an
economic risk of loss related to the recourse borrowings. Even if he had a basis increase (which is
unlikely), Tom could not deduct any additional loss because the passive activity loss rules still
limit passive losses to passive income.
pp. C:9-26 and C:9-27.
C:9-22
C:9-45 a.
Kate
Chad
Stan
Basis before gain and loss

Plus: Capital gain
Basis before loss
At-risk basis before lossa
$100,000
20,000
$120,000
$ 70,000
$100,000
20,000
$120,000
$ 70,000
$50,000
10,000
$60,000
$35,000
Distributive share of loss

Character of loss
Deductible loss
$ 80,000
Active
$ 70,000
$ 80,000
Passive
$ 20,000b
$40,000
Passive
$10,000b
Basis before loss minus nonrecourse liability.

Passive losses are deductible to the extent of passive income earned during the year, the capital
gain in this case. This result assumes the partners have no passive income from other sources that
can be offset by the passive loss and that the capital gain is not portfolio income.
b.
Rental activities are passive activities, so Kate and Chad are limited to a $25,000
loss deduction, $20,000 because of the capital gain plus $25,000 because their AGIs do not
exceed $100,000. The $25,000 portion of the deduction, however, would have to be reduced if
Kates and Chads AGIs were to exceed $100,000. Stan does not actively participate in the rental
activity, so he has the same deductible loss as in Part a. pp. C:9-26 and C:9-27.
a
C:9-46 a. & b. Analysis without the at-risk and passive activity loss (PAL) rules:
The following analysis shows the partnerships gain or loss for the Years 1 through 5 and
the beginning of Year 6. The $82,000 gain at the beginning of year six is all ordinary income
because of Sec. 1245 depreciation recapture. The total tax savings without discounting are zero.
However, with discounting, the total tax savings are $4,302. Thus, without the at-risk and PAL
rules, the
partners obtain a deferral advantage.
Year
Lease income
Minus: Depreciation
Interest expense
1
$ 10,000
( 40,000)
( 7,000)
2
$ 10,000
( 25,000)
( 6,500)
3
$ 10,000
( 15,000)
( 6,500)
4
$ 10,000
( 8,000)
( 6,000)
5
$ 10,000
( 8,000)
( 6,000)
Beg. 6
$82,000
( 4,000)
-0-
Gain (loss)
($37,000)
($21,500)
($11,500)
($ 4,000)
($ 4,000)
$78,000
Total
Tax (tax savings) (33%)

Present value (7%)
($12,210)
(11,411)
($ 7,095)
(6,197)
($ 3,795)
(3,098)
($ 1,320)
(1,007)
($ 1,320)
(941)
$ 25,740
18,352
-0(4,302)
c. Analysis with Sec. 465 at-risk and Sec. 469 passive activity loss rules:
With the at-risk and PAL rules in effect, the deferral advantage disappears, and the partners
achieve no tax savings. The following table shows this result.
Year
C:9-23
Beg. 6
Lease income
Minus: Depreciation
Interest expense
Gain (loss)
At-risk disallowance
PAL disallowance
Net gain (loss)
$ 10,000
( 40,000)
( 7,000)
($37,000)
35,000
2,000
$
-0-
$10,000
( 25,000)
( 6,500)
($21,500)
21,500
-0$
-0-
$ 10,000
( 15,000)
( 6,500)
($11,500)
11,500
-0$
-0-
$10,000
( 8,000)
( 6,000)
($ 4,000)
4,000
-0$
-0-
$10,000
( 8,000)
( 6,000)
($ 4,000)
4,000
-0$ -0-
$82,000
( 4,000)
-0$78,000
(76,000)*
( 2,000)*
$
-0-
*The partners can deduct these amounts in Year 6 because, after the sale, they have at-risk basis and
are allowed to deduct the deferred passive active loss.
d. The following table shows the combined basis of both partners interests in the
partnership. Each partner will have half the amounts shown in this table. Note that the
partners bases are always positive, so the Sec. 704(d) loss limitation does not apply.
Year
Beginning basis
Contributions
Debt
Gain (loss)
Basis before distributions
Final distribution
Ending basis
1
$
-02,000
95,000
(37,000)
$60,000
2
$60,000
-0( 3,500)
( 21,500)
$35,000
3
$35,000
-0( 3,500)
( 11,500)
$20,000
4
$20,000
-0( 4,000)
( 4,000)
$12,000
5
$12,000
-0( 4,000)
( 4,000)
$ 4,000
Beg. 6
$ 4,000
-0(80,000)
78,000
$ 2,000
( 2,000)
$
-0-
pp. C:9-26 and C:9-27.

C:9-47 a.
Amount realized
$ 40,000
( 60,000)
Realized loss
($20,000)
Susan cannot recognize the loss because she is deemed to own 100% of the partnership. The
partnership has a $40,000 cost basis in the securities.
b.
Amount realized
$ 40,000
( 50,000)
Realized loss
($ 10,000)
Susan recognizes the entire $10,000 loss because she owns only 15% of the partnership.
c.
Amount realized
$ 40,000
( 30,000)
Realized gain
$ 10,000
Susan recognizes the entire $10,000 as a capital gain, even though she owns directly and
indirectly 65% of the partnership, because the property is a capital asset to the partnership.
C:9-24
d.
The partnership reduces its gain realized by any previously disallowed loss
(Sec. 707(b)(1) and Sec. 267(d)). The reduction, however, cannot create or increase a loss.
Thus, the partnerships results are as follows:
Case 1
Selling price
$70,000
Minus: Partnerships basis
( 40,000)
Gain (loss) realized
$30,000
Reduction of gain for previously disallowed ( 20,000)
loss
Gain (loss) recognized
$10,000
Case 2
$55,000
( 40,000)
$15,000
( 15,000)
Case 3
$35,000
( 40,000)
($ 5,000)
-0-
($ 5,000)
-0-
pp. C:9-27 and C:9-28.

C:9-48
Other unrelated partners
37%
45%
Maura
KTV
KLM
15%
35%
Kara
(Mauras Mother)
45%
20%
3%
Lynn
Mauras interest in KTV is counted as indirectly owned by Kara. Therefore, KLM and KTV are
partnerships in which the same persons own directly or indirectly more than 50% of the capital or
profits interests.
a.
Amount realized
Realized loss
The KTV Partnership does not recognize the $ 30,000 loss.
b.
Amount realized
Realized gain
The KTV Partnership recognizes a $27,000 capital gain.
C:9-25
$50,000
( 80,000)
($30,000)
$50,000
( 23,000)
$27,000
c.
Amount realized
Realized gain
The KTV Partnership recognizes $15,000 of ordinary income.
C:9-26
$50,000
( 35,000)
$15,000
d. The KLM Partnership reduces its gain realized by any previously disallowed loss (Sec.
707(b)(1) and Sec. 267(d)). The reduction, however, cannot create or increase a loss. Thus, KLM
Partnerships results are as follows:
Case 1
$130,000
( 50,000)
Selling price
Minus: Partnerships basis in stock
Case 2
Case 3
$70,000 $ 40,000
( 50,000 ( 50,000)
)
Gain (loss) realized
$ 80,000
$20,000 ($10,000)
Reduction of gain for previously disallowed ( 30,000
( 20,000 (
-0-)
loss
)
)
Gain (loss) recognized
$ 50,000
$
-0- ($10,000)
pp. C:9-27 and C:9-28.
C:9-49
SD
Partnership
Ordinary income before guaranteed payments
Minus: Guaranteed payments
Capital gain
OI = Ordinary income
$23,000
(10,000)
$13,000
$14,000
Allocation to Partner:
Scott
Dave
$5,000 OI
$6,500 OI
$7,000 LTCG
$5,000 OI
$6,500 OI
$7,000 LTCG
LTCG = long-term capital gain
pp. C:9-28 and C:9-29.

C:9-50 a.
AB
Partnership
Ordinary income before guaranteed payment
Minus: Guaranteed payment
Total to partners
$160,000
( 90,000)
70,000
$160,000
C:9-27
Allen
Bob
$35,000
$35,000
$ 90,000
35,000
$125,000
b.
AB
Partnership
Ordinary income before
guaranteed payments
Minus: Adjustment for
guaranteed payment*
Income allocation
*Guaranteed minimum
Minus: Bobs distributive share
Guaranteed payment
Allen
Bob
$160,000
$80,000
$ 80,000
-0$160,000
( 10,000)
$70,000
10,000
$ 90,000
$90,000
(80,000)
$10,000
c.
LTCG
Guaranteed payment
Minus: Ordinary loss allocated*
Total to partners
AB
Partnership
Allen
Bob
$140,000
80,000
( 80,000)
$140,000
$70,000
(40,000)
$30,000
$ 70,000
80,000
( 40,000)
$110,000
*$0 ordinary income before guaranteed payment - $80,000 guaranteed payment =

($80,000) ordinary loss.
pp. C:9-28 and C:9-29.
C:9-51 a.
PS
Partnership
LTCG
Guaranteed payment
Minus: Ordinary loss allocated
Total to partners
$ 10,000
40,000
(40,000)*
$ 10,000
Pam
Susan
$ 3,000
40,000
(12,000)
$31,000
7,000
( 28,000)
($ 21,000)
*$0 ordinary income before guaranteed payments - $40,000 guaranteed payment =

($40,000) ordinary loss.
C:9-28
b.
PS
Partnership
Guaranteed payment
Ordinary income allocated
Sec. 1231 gain
Total to partners
$ 35,000
45,000*
60,000
$140,000
Pam
Susan
$35,000
9,000
12,000
$56,000
$36,000
48,000
$84,000
*$80,000 ordinary income before guaranteed payment - $35,000 guaranteed payment

= $45,000
c.
Ordinary income before guaranteed payment

Times: Pams distributive share of partnership income
Pams distributive share
Plus: Pams guaranteed payment ($60,000 - $48,000)
Pams total payment (guaranteed minimum)
PS
Partnership
Guaranteed payment
Ordinary income allocated
Total received
$ 12,000
108,000a
$120,000
$120,000
0.40
$ 48,000
12,000
$ 60,000
Pam
Susan
$12,000
48,000
$60,000
$60,000b
$60,000
$120,000 ordinary income before guaranteed payment - $12,000 guaranteed payment

= $108,000
b
The $60,000 allocation to Susan can be viewed two ways: $108,000 partnership
allocation minus $48,000 allocation to Pam, or $72,000 ($120,000 0.60) Susans share minus
$12,000 guaranteed payment to Pam.
a
pp. C:9-28 and C:9-29.
C:9-29
C:9-52 Assuming Son passes the tests for ownership of the partnership interest, Son is a partner
since capital is a material income producing factor. Allocation of the income would occur as
follows:
Dad (0.70 x $100,000)
Fred (0.10 x $100,000)
Son (0.20 x $100,000)
Total distributive shares
$ 70,000
10,000
20,000
$100,000
pp. C:9-30 and C:9-31.

C:9-53 Partnership income before guaranteed payment
Minus: Reasonable compensation for Steve
$160,000
( 70,000)
$ 90,000
Distributive shares:
Steve (60%)
Tracy (20%)
Vicki (20%)
Total
$ 54,000
18,000
18,000
$ 90,000
In addition to his distributive share, Steve receives $70,000 of ordinary income from the
guaranteed payment, for a total of $124,000. pp. C:9-30 and C:9-31.
Comprehensive Problems
C:9-54 a.
Ricks distributive share of income is his 40% loss share because the partnership
has an overall loss. Specifically, Ricks distributive share is:
Ordinary loss
Sec. 1231 gain
($176,000)
40,000
60,000
b.
What Rick can report on his tax return is restricted by loss limitation rules. In all
cases, he must report the $40,000 long-term capital gain and the $60,000 Sec. 1231 gain.
Beginning basis
Income (LTCG + Sec. 1231 gain)
Loss limitation
Allowed loss
Ending basis
Sec. 704(d) Limit
At-Risk Limit
$ 50,000
100,000
$150,000
(150,000)
$
-0-
$ 20,000
100,000
$ 120,000
( 120,000)
$
- 0-
Although the Sec. 704(d) limit would allow Rick to deduct $150,000, the at-risk rules
under Sec. 465 limit his loss to $120,000. (The $20,000 beginning at-risk amount is Ricks
beginning $50,000 basis in the partnership less the $30,000 portion of the basis attributable to his
share of the nonrecourse debt, for which he is not at risk.) Further, the passive activity loss rules
C:9-30
under Sec. 469 apply because Rick does no work in this partnership. The passive activity loss
rules limit his loss deduction to passive activity income. He has $100,000 income from this
activity (and no other investments). As long as the $100,000 is passive (and not portfolio
income), he can deduct $100,000 on this tax return.
c.
Ricks basis is zero as calculated above. Even though he can deduct only
$100,000, his partnership basis is reduced by the full $150,000.
pp. C:9-17, C:9-18, and C:9-24 through C:9-27.
C:9-55 a.
Partnership ordinary income:

Total
SalesInventory A
Minus: COGSInventory A
Gross profitInventory A
Minus: Precontribution profit
Postcontribution profit
$60,000
( 35,000)
$25,000
( 15,000)
SalesInventory B
Minus: COGSInventory B
Gross profitInventory B
$58,000
( 40,000)
18,000
(20,000)
( 500)
( 7,000)
$ 500
Separately stated items:

Total

Precontribution profit
c.
Mary
(60%)
$10,000
Minus: Operating expenses

Interest expense
Depreciation
b.
Charles
(40%)
$ 1,000
15,000
200
Charles
(40%)
$
400
15,000
300
Mary
(60%)
600
Partners basis in partnership:
Charles
(40%)
Mary
(60%)
Beginning basis (adjusted basis of original contributions)

Precontribution profit
Share of ending liabilities ($5,000 - $1,000)
Ending basis
$ 70,000
200
400
15,000
1,600
( 2,000)
$ 85,200
$150,000
300
600
C:9-31
2,400
( 3,000)
$150,300
d.
Partners book capital accounts:
Charles
(40%)
Beginning balance (FMV of original contributions)

Ending balance
e.
$150,000
300
600
( 3,000)
$147,900
Analysis of cash:
Increases:
Marys contribution
Original loan amount
Cash from sales ($60,000 + $58,000)
Sale of ST Corporation stock (proceeds)
Total increase
Decreases:
Purchase of equipment
Purchase of Inventory B
Purchase of ST stock
Loan principal repayment
Operating expenses
Interest expense
Distributions
Total decrease
Ending cash balance
f.
$100,000
200
400
( 2,000)
$ 98,600
Mary
(60%)
$150,000
5,000
118,000
6,000
$279,000
$ 50,000
80,000
5,000
1,000
20,000
500
5,000
( 161,500)
$117,500
Tax balance sheet:
Beginning
Assets:
Cash
Stock
Inventory
Equipment (ending: $50,000 - $7,000)
Total
Post-Purchase
Ending
$117,500a
70,000
_______
$220,000
$ 20,000
5,000
150,000
50,000
$225,000
75,000b
43,000
$235,500
$150,000
Liabilities and Capital Accounts:

Liabilities
Charles tax capital account
Marys tax capital account
Total
-070,000
150,000
$220,000
5,000
70,000
150,000
$225,000
4,000
83,600c
147,900c
$235,500
See Part e.
Analysis of inventory:
Contribution of Inventory A (carryover basis)
C:9-32
$ 70,000
Sale of inventory ($35,000 + $40,000)
Ending balance
80,000
( 75,000)
$ 75,000
See Part c. Same as ending basis minus each partners share of partnership liabilities.
g.
Book balance sheet:
Beginning
Assets:
Cash
Stock
Inventory
Equipment (ending: $50,000 - $7,000)
Total
Post-Purchase
Ending
$117,500a
100,000
_______
$250,000
$ 20,000
5,000
180,000
50,000
$225,000
90,000b
43,000
$250,500
$150,000
Liabilities and Capital Accounts:

Liability
Charles book capital account
Marys book capital account
Total
-0100,000
150,000
$250,000
5,000
100,000
150,000
$255,000
4,000
98,600c
147,900c
$250,500
See Part e.
Analysis of Inventory:
Contribution of Inventory A (FMV)
Sale of inventory ($50,000 + $40,000)
Ending balance
b
$100,000
80,000
( 90,000)
$ 90,000
See Part d.
C:9-33
Tax Strategy Problem

C:9-56 a. (1) Corporations taxable income and tax liability:
Sales
Beginning inventory
Plus: Purchases
Minus: Ending inventory
Cost of goods sold
$3,000,000
$1,770,000
2,100,000
(1,650,000)
(2,220,000
)
$ 780,000
Gross profit
Plus: Long-term capital gain
Dividends received
Total other income
Deductible interest expense
Dividends-received deduction ($4,000 x 0.70)
Total deductions
20,000
4,000
24,000
$ 500,000
30,000
2,800
Taxable income
532,800
)
$ 271,200
Income tax liability [$22,250 + (0.39 x $171,200)]
the
schedules):
89,018
(2) Sarahs and Rexs AGI, taxable income, and tax liability (both are
same, so only one computation follows based on 2016
Dividend income (AGI)

Minus: Standard deduction
Personal exemption
Taxable income (all dividend income subject to reduced tax rates)
Income tax liability [(0.00 x $37,650) + (0.15 x $2,000)]
Times: Number of taxpayers
Total income tax liability for Sarah and Rex
(3) Total tax liability for the corporation and its owners
b. (1) Partnership ordinary income:
Gross profit (same as Part a(1))
Deductible business interest expense
Total
$780,000
( 500,000)
( 30,000)
$250,000
C:9-34
(
(
$ 50,000
6,300)
4,050)
$ 39,650
$ 300
2
600
$ 89,618
Sarah
$125,000
Rex
$125,000
(2) Separately stated items:
Total

Dividend income
$ 20,000
4,000
2,200
Sarah
Rex
$ 10,000 $ 10,000
2,000
2,000
1,100
1,100
(3) Sarahs and Rexs AGI, taxable income, and tax liability
(Both are the same, so only one computation follows):
Plus: Long-term capital gain
Dividend income
Minus: One-half self-employment tax
Adjusted gross income (AGI)
Minus: Standard deduction
Personal exemption
Taxable income
Minus: Long-term capital gain and dividend income
Ordinary taxable income
Income tax liability on ordinary taxable income
{$18,558.75 + [0.28 x ($105,820 - $91,150)]}
Plus: Tax on long-term cap. gain and dividend income ($12,000 x
0.15)
Total income tax
Plus: Self-employment tax
Total tax liability
Total tax liability for Sarah and Rex
$125,000
10,000
2,000
( 8,830)
$128,170
( 6,300)
( 4,050)
$117,820
( 12,000)
$105,820
$ 22,666
1,800
$ 24,466
17,660
$ 42,126
2
$ 84,252
(4) Partners basis in their partnership interest

(both are the same, so only one computation follows):
Initial contribution to partnership
Partnership
ordinary
income
Dividend income
Minus: Distribution
Ending basis for each partner
$ 800,000
200,000
125,000
10,000
2,000
1,100
( 50,000)
$1,088,100
C:9-35
c.
Based on the analyses in Parts a and b, the partnership gives the better result in
terms of total tax liabilities, primarily because it avoids double taxation. However, the low tax
rate on dividend income lessens the impact of double taxation. A one-year analysis has two main
shortcomings, however. First, it does not take into account future operations, distributions, and
tax rates. Second, it does not factor in the shareholders taxes upon a final disposition or
liquidation of the corporation.
d.
The corporation could reduce the overall tax liability by paying out the $50,000
amounts to each shareholder as salary rather than dividends. Assuming the $50,000 amounts are
reasonable, the salaries would be deductible. However, they would trigger payroll taxes and tax
at ordinary rates. The following calculation shows the total additional tax savings assuming the
corporation pays and deducts a 7.65% payroll tax on the salaries and that the shareholderemployees also pay a 7.65% payroll tax via a reduction of their paychecks. The revised total tax
is $73,702 ($89,618 from Part a - $15,916 net tax savings as calculated below), which now is
better than the partnership arrangement.
Deductible salary expense ($50,000 x 2)
Deductible payroll tax ($100,000 x 0.0765)
Total corporate deduction
Times: Corporate marginal tax rate
Corporate tax savings
Minus: Corporate payroll tax paid
Employees payroll taxes ($50,000 x 0.0765 x 2)
Additional individual tax*
Net tax savings
$100,000
7,650
$107,650
0.39
$ 41,984
( 7,650)
( 7,650)
( 10,768)
$ 15,916
*Tax on $39,650 of ordinary salary income

Total
Minus: Tax on $39,650 of dividend income for two taxpayers
Additional individual tax
pp. C:9-16 through C:9-25 and Chapter C:3.

Tax Form/Return Preparation Problems
C:9-57 (See Instructors Resource Manual)
C:9-58 (See Instructors Resource Manual)
C:9-36
5,684
2
$ 11,368
(
600)
$ 10,768
Case Study Problems

C:9-59 The points listed below are the major ones that should be covered in the presentation to be
made. Students should incorporate these points into a properly structured presentation and should
be encouraged to create the audio-visual aids needed to make an effective presentation.
The bases for Abe and Brendas partnership interests on December 31 are as follows:
Abe
12/31 basis before income and liabilities
Plus: Current income items
Basis before losses
$81,000
12,000
$93,000
Brenda
$104,000
12,000
$116,000
The tax year is a loss year (because losses exceed income), so the 50% - 50% loss interest
ratios are used to allocate both income and loss items. Income items of $24,000 ($10,000 Sec.
1231 gain and $14,000 municipal bond income) are evenly allocated to the two partners and
reflected in the above bases numbers.
Each partner is allocated one-half of each item of loss or deduction for a total of $125,000
each. The partners cannot reduce their basis below zero, so a pro rata portion of each loss item is
used to reduce basis.
Ordinary loss
LTCL
STCL
Total
Abe
Brenda
$37,200*
5,208*
50,592*
$93,000
$ 46,400**
6,496**
63,104**
$116,000
*93/250 x Loss item amount

**116/250 x Loss item amount
Abe, who is an active partner, reports the following amounts: $5,000 Sec. 1231 gain,
$37,200 ordinary loss, $5,208 LTCL, and $50,592 STCL. His losses are not limited further by
the Sec. 469 passive activity rules. His $7,000 share of municipal bond income increases his basis
in his partnership interest but is not recognized as income. His basis at year-end is zero. He has
losses of $32,000 ($125,000 - $93,000), which he can deduct in future years when he again has
basis in his partnership interest.
Brenda is a passive partner, so she can deduct losses from this passive activity (her only
passive activity) up to the amount of income from this activity, the $5,000 Sec. 1231 gain. All
other losses will be suspended until she has passive income (from this or some other passive
investment) or until she disposes of her entire interest in the partnership. Her allocated share of
losses reduces her basis to zero even though she can deduct only $5,000.
C:9-37
The need to borrow money next year gives Abe (but not Brenda) the opportunity to
deduct some of the suspended loss from this years operations. If the borrowings are recourse or
qualified real estate nonrecourse financing, they will increase both partners partnership and at-risk
bases. Note that recourse loans will be allocated between the partners based on their economic
risk of loss while the nonrecourse debt would be divided on their 40% - 60% profit ratios. Abe
will be able to deduct his losses from the current year along with any losses from next years
operations up to the extent of his basis at the end of next year.
Brendas partnership and at-risk bases also will be increased by the borrowings, but her
passive losses will remain suspended until she has passive income. If the partnership earns money
next year, she will have passive income and can recognize some of her suspended passive losses.
If this partnership does not soon earn passive income, Brenda should consider adding investments
to her portfolio that will generate passive income.
C:9-60 Relevant facts:
Mr. Jones made an error last year in allowing the partnership return to be filed. Mr. Jones
is no longer with the firm, and the client already is unhappy about adjusting to a new accountant.
Filing as a partnership reduces the clients tax bill. The client is very important to the firm.
Some ethical issues:
1.
2.
3.
4.
5.
Should Wise and Johnson prepare the Andres Partnerships tax return?
Should Wise and Johnson prepare an amended return for Dr. Andres for the prior year
including all the Andres Partnerships income in his personal return?
How should John respond to Ms. Watsons question about whether he is positive that the
arrangement does not qualify as a partnership?
If the firm decides to prepare the return and Ms. Watson tells John to prepare it, should he
prepare it?
How should the firm (and Ms. Watson and John) balance loyalty to the retired partner
against misgivings about compromising integrity?
Some possible alternatives:
For John:
1.
2.
3.
4.
5.
Tell Ms. Watson he is not sure about his conclusion, and prepare the return if she wants to
give the client a partnership return.
Tell Ms. Watson he is sure about his conclusion, but prepare the return if she still wants to
give the client a partnership return.
Tell Ms. Watson he is sure about his conclusion, and ask to be taken off the assignment if
she still wants to give the client a partnership return.
Tell Ms. Watson he is sure about his conclusion, and talk to another partner in the firm if
she still wants to give the client a partnership return.
Resign, and let the firm work out its problem.
For Wise and Johnson:
C:9-38
1.
2.
3.
Prepare the current partnership return, and say nothing to the client.
Refuse to prepare the current partnership return, but do nothing about correcting last
years error.
Refuse to prepare the current partnership return, and tell the client that an amended return
must be filed for last year.
Examples of questions to be asked in discussing the ethics of the alternatives:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
How much value should be placed on (a) maintaining the firms reputation for quality
work, (b) keeping the client, (c) Johns professional integrity, (d) Ms. Watsons
professional integrity, and (e) Mr. Joness professional reputation?
What are the likely consequences of each alternative?
Which alternative would provide the greatest benefit to the greatest number of the people
involved?
Does John have the right to refuse to prepare the partnership return?
Does Ms. Watson have the right to insist that John prepare the partnership return?
Which alternative distributes the benefits and burdens of this situation most fairly?
What impact (if any) does the AICPAs Statements on Standards for Tax Services have on
the issues at hand (see Appendix E)?
Does the firm or an individual tax return preparer have any liability for penalties under the
tax return preparer rules (see Chapter C:15)?
Does the firm face any sanctions under Treasury Department Circular 230?
Does the firm have a responsibility for notifying the IRS about the error?
Do Dr. Andres and his sons have any penalty exposure under the substantial underpayment
provisions?
C:9-39
Tax Research Problems

C:9-61 Basis at Time of Contribution
Wallys basis in the property at the time of contribution:
Office furniture:
Cost
Minus: MACRS 7-year property ($60,000 x .1429 x 8/12)
Basis at contribution (September 20, 2016)
$60,000
( 5,716)
$54,284
Sources: Sec. 168(e)(1), Sec. 168(k), and Rev. Proc. 87-57, 1987-2 C.B. 687, Table 1.
(Also see Table 1 in Appendix C of the text.)
Building:
Cost
Prior years depreciation (MACRS 39year straight-line depreciation):
2012 (0.01391 x $100,000)
2013 (0.02564 x $100,000)
2014 (0.02564 x $100,000)
2015 (0.02564 x $100,000)
2016 (0.02564 x $100,000 x 8/12)
( 10,792)
Basis at contribution (September 20, 2016)
89,208
$100,000
$1,391
2,564
2,564
2,564
1,709
$
Sources: Sec. 168(c)(1) and IRS Publication 946, Table A-7a. (also see Table 9 in Appendix
C of the text.)
Land: Cost basis
8,000
Partnership Depreciation
The partnership continues the depreciation method used by the related party prior to the
contribution (Sec. 168(i)(7)). The partnership is assumed to have held the property for the entire
month in which the property is transferred (Prop. Reg. Secs. 1.168-5(b)(4)(i) and 1.168-5(b)(2)(i)
(B)). Accordingly, the current year depreciation is:
Office furniture ($60,000 x 0.1429 x 4/12)
$ 2,858
Building (0.02564 x $100,000 x 4/12)
C:9-40
855
Allocation of Depreciation to the Partners

Section 704(c)(1) requires that depreciation on contributed property be allocated to take into
account the difference between the basis and FMV amounts at the time of contribution. Treasury
Regulations describe three alternatives for allocating depreciation between the partners.
Regulation Sec. 1.704-3(b), and especially Reg. Sec. 1.704-3(b)(2) Example 1, illustrates the
traditional method of allocation between the partners.
For book purposes, the partnership records contributed property at its FMV at the time of
contribution (Reg. Sec. 1.704-1(b)(2)(iv)(d)). Caitlin is treated as though she purchased a onehalf interest in this book value. Consequently, she has an allocable right to tax depreciation in an
amount that equals one-half the book depreciation. According to Reg. Sec. 1.704-1(b)(2)(iv)(g)
(3), book depreciation is based on the following ratio:
Book depreciation = Tax depreciation x (Book value / Adjusted basis)
Thus, for the year of transfer, book depreciation is calculated as follows:
Office furniture: $2,858 x ($66,000 / $54,284) = $3,475
Building: $855 x ($120,000 / $89,208) = $1,150
The $66,000 and $120,000 book values in the above calculations are the FMVs at the time of
contribution. Caitlin, then, is allocated tax depreciation equal to one-half these book amounts,
and Wally receives any remaining tax depreciation. The following table summarizes the allocation
of tax depreciation.
Partnership
Office Furniture:
($3,475 x 0.5)
($2,858 - $1,738)
$2,858
Building:
($1,150 x 0.5)
($855 - $575)
Caitlin
Wally
$1,738
$1,120
855
$
575
$ 280
Treasury Regulations provide two other methods of allocating depreciation on contributed

property among the partners: the traditional method with curative allocations and the remedial
method. These elective methods are used only if the traditional method cannot give the
noncontributing partner (in our case, Caitlin) tax depreciation equal to her share of book
depreciation because the partnerships tax depreciation on the contributed asset is less than the
book value depreciation to be allocated to the noncontributing partner. One of these two methods
would be used if partnership tax depreciation on the office furniture was less than $1,738 or if the
partnership depreciation on the building was less than $575. Neither of these methods applies to
our situation because the traditional method already gives Caitlin tax depreciation equal to her
share of book depreciation.
C:9-41
Depreciation Recapture and Unrecaptured Sec. 1250 Gain

Both the office furniture and the building are Sec. 1231 property at the time of the contribution.
The building is technically subject to Sec. 1250 recapture but only to the extent that accelerated
depreciation claimed exceeds straight-line depreciation (Sec. 1250(a)). Because MACRS
mandates straight-line depreciation, no Sec. 1250 depreciation recapture potential exists for the
building. However, the building is subject to the unrecaptured Sec. 1250 gain rules of Secs. 1(h)
(1)(D) and 1(h)(7), which tax such gain at a 25% rate (and possibly an additional 3.8%).
At the time of the contribution, the office furniture is subject to Sec. 1245 recapture for
the full $5,716 depreciation that Wally has claimed (Sec. 1245(a)). However, the contribution of
the office furniture to the partnership triggers recapture only if gain must be recognized
(Sec. 1245(b)(3)), and Wally recognizes no gain on this contribution. The recapture potential
carries over to the partnership (Reg. Sec. 1.1245-2(c)(2)).
At the time of contribution, the building has potential unrecaptured Sec. 1250 gain of
$10,792, the amount of depreciation that Wally has claimed. However, because the contribution
triggers no gain recognition, the unrecaptured Sec. 1250 gain potential carries over to the
partnership.
Note for instructors: The problem did not request the allocation of recapture upon sale of the
furniture by the partnership. However, students may ask, and the answer is not the expected one.
The allocation of Sec. 1245 recapture at the time of the sale of the office furniture by the
partnership will not necessarily allocate all the precontribution recapture amounts to Wally.
Regulation Sec. 1.1245-1(e)(2) specifies that the recapture is to be allocated to the partners in
the same proportion as the total gain is allocated if the partnership agreement does not
specifically allocate the Sec. 1245 recapture. This pro rata allocation may or may not allocate the
full precontribution recapture to the contributing partner depending on the amount and allocation
of postcontribution gain. Similar treatment probably also applies to unrecaptured Sec. 1250 gain.
C:9-62 For financial accounting purposes, the asset transfer will be reported in the same manner
as the corporate formation transaction described in Tax Research Problem C2-64. Lisa will
recognize no gain on the transfer of the $50,000 in cash to the Lima General Partnership.
Matthew will report a $15,000 gain for financial accounting purposes on the land transfer to the
partnership. Again, as mentioned in the solution to Tax Research Problem C2-64, the actual
financial accounting reporting for the two transferors may be immaterial because neither of the
two individuals may maintain financial accounting records for their personal transactions.
However, Lima will report the cash at its $50,000 face amount and will report a $50,000 carrying
value for the land.
For tax purposes, Lisa will report no gain or loss on the cash contribution (Sec. 721(a)).
Lisas basis for her partnership interest is $50,000 (Sec. 722). The holding period for the
partnership interest begins on the day after the contribution. The partnerships basis for the cash
is $50,000 (Sec. 723(a)). The partnerships holding period for the cash is irrelevant. For tax
purposes, Matthew will report no gain or loss on the land contribution (Sec. 721(a)). Matthews
basis for his partnership interest is $35,000 (Sec. 722). The holding period for the partnership
interest includes Matthews holding period for the land (Sec. 1223(1)). The partnerships basis for
C:9-42
the land is $35,000 (Sec. 723(a)). The partnerships holding period for the land includes the
Matthews holding period for the land (Sec. 1223(2)).
C:9-63 Under prior law, partnerships with large losses could admit a new partner near the end of
the partnerships tax year and allocate a substantial portion of the entire years losses to that new
partner. Congress then enacted Sec. 706(d)(1), which requires that a partnership allocate losses
and income based on the partners varying interest during the year, seemed to close this loophole.
Soon, however, creative taxpayers decided to use a cash method partnership, which could
incur expenses during the tax year while deferring their payment as late in the year as feasible. A
new partner was admitted near the end of the tax year, and the unpaid items were then paid and
expensed. The Tax Courts decision in Cecil R. Richardson, 76 T.C. 12, affd. 51 AFTR 2d 83418, 83-1 USTC 9109 (5th Cir., 1982), established the precedent that allowed this technique to
be used and essentially permitted a retroactive allocation of losses. Subsequently, however,
Congress closed off much of this technique by adding Sec. 706(d)(2), which requires that a
partnership using the cash method of accounting accrue four types of expenses (interest, taxes,
payments for services or for the use of property, and any other appropriate item specified by
Treasury Regulations) for purposes of determining distributive shares. (The Treasury Department
has not yet issued related regulations.) Thus, the current Sec. 706 rules prevent the retroactive
allocation of certain partnership losses.
Using the Sec. 706 rules, Raj can gain no benefit from the use of the cash method of
accounting for the interest or the utilities. It is not clear whether the partnership would be allowed
to use the cash method of accounting for the maintenance that has been pushed into December,
but current law contains no prohibition against it. Under these rules, Raj would be allocated 25%
of the December loss from the partnership of:
($12,000) = 0.25 x [$33,000 revenue - ($20,000 interest + $1,000 utilities + $60,000
maintenance)]
In the Tax Court decision in Mary K.S. Odgen, 84 T.C. 871 (1985), revd. 57 AFTR 2d
86-1333, 86-1 USTC 9368 (5th Cir., 1986), a partner who was admitted late in the tax year
received a one-time special allocation of the partnerships loss that accrued during the period of
time after her admission to the partnership. The Tax Court accepted the special allocation as
meeting the tests for substantial economic effect and, in effect, allowed this method of achieving a
disproportionate allocation of loss to a new partner. On appeal, the Fifth Circuit Court of Appeals
ruled that the allocation lacked substantial economic effect because, by agreement, partners with
deficit accounts did not have to restore the deficit nor receive smaller distributions on termination
of the partnership. Even though the Ogden allocation was not valid, the technique still may be
valid if (1) partnership agreements are drawn so that the requirements for special allocations are
met and (2) the loss that is being specially allocated accrued after the new partner joined the
partnership.
With a carefully drawn partnership agreement, Raj might be allocated the entire $48,000
loss that the partnership sustains in December. The technique, however, remains controversial.
C:9-43
C:9-64 Upon forming the partnership, neither the partners nor the partnership recognized any gain
or loss under Sec. 721(a). Under Sec. 722, Alice and Beth each took a $100,000 basis in their
partnership interests, and Carl took a $160,000 basis in his partnership interest. Under Sec. 723,
the partnership took a $160,000 adjusted basis in the land. However, see discussion below
concerning Sec. 704(c)(1)(C).
Under Sec. 704(c)(1)(A) and Reg. Sec. 1.704-3(a)(1), the partnership must take into
account the difference between the lands FMV and adjusted basis at the time of contribution.
Thus, if Carl had remained a partner when the partnership sold the land, the partnership would
have allocated the $60,000 precontribution loss to him. Regulation Sec. 1.704-3(a)(7) states that,
if a contributing partner sells his or her partnership interest, any precontribution gains and losses
must be allocated to the incoming partner as they would have been allocated to the selling
partners. This rule, however, opens the possibility of transferring losses from one partner to
another and possibly doubling losses. For example, if this regulation applies as stated, Carl
recognizes a $60,000 capital loss on the sale of his partnership interest, and Dan recognizes a
$60,000 capital loss when the partnership sells the land. (Note, however, that Dans partnership
basis decreases to $40,000 so that he would recognize a $60,000 capital gain should the
partnership subsequently liquidate and distribute $100,000 to him. Thus, the loss recognition by
Dan is a timing issue.) Nevertheless, to prevent transferring a loss to the new partner, Congress
enacted Sec. 704(c)(1)(C). This section states that any built-in loss on contributed property can
be allocated only to the contributing partner. Furthermore, for purposes of allocating items to
other partners, the partnership must treat the built-in loss property as if its adjusted basis equals
the propertys FMV at the time of contribution. Accordingly, no built-in precontribution loss from
the property contributed by Carl can be allocated to Dan. Therefore, Dan recognizes no loss
when the partnership sells the property, and his basis in the partnership remains at $100,000.
What Would You Do In This Situation? Solution
Ch. C:9, p. C:9-14. A Contribution to a Partnership In a Different Form?
The IRS almost certainly will consider this transaction a part-sale, part-contribution. The
IRS is likely to say that Bob sold land with a FMV of $150,000 (basis of $15,000) to the
partnership and contributed land with a FMV of $150,000 (basis of $15,000) to the partnership.
Their position is buttressed by the fact that Tom contributed $150,000 cash for his 50% interest
while Bob is trying to claim a contribution of land worth $300,000 for an identical 50% interest.
The payment to Bob was not made out of partnership profits, so it would be difficult to argue that
Bobs receipt of the payment was contingent on partnership performance. Accordingly, you
should advise Bob to report this as a part-sale, part-contribution.
C:9-44

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Chapter C:9

Partnership Formation and Operation

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If so, what gain, loss, or deductions must the partnership recognize?

What income must Kate recognize?

What items qualify as organizational expenditures, which are start-up

The partnership first must characterize each expenditure as an organizational expenditure,

Is the receipt of a profits interest in the ABC Partnership in exchange for

What is Georges basis in his partnership interest?

Repayments of partnership liabilities are treated as distributions to the partners.

What is Katies deductible loss from her partnership investment?

If so, can she deduct her losses?

If not, do the losses carryover to later years?

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As a limited partner, Katie is presumed not to materially participate in the partnership.

Do the family partnership rules apply when no family relationship exists?

Neither partner recognizes gain or loss (Sec. 721).

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Partnership ordinary income

Ending balance sheets:

Liabilities ($10,000 + $28,000)

Cash ($40,000 + $28,000)

$30,000 adjusted basis contributed - $10,000 liability + $12,000 share of partnership

Liability assumed by the corporation

Accounts receivable basis to Bob

Equipment basis to Clay

Land basis to Dave

*Or minus $104,000 ($130,000 - $26,000) mortgage assumed

Services contributed by Fred

Mortgage allocated to partner

Fair market value when contributed

Postcontribution loss allocated

Basis of property contributed

*Or minus $21,600 ($54,000 - $32,400) liabilities assumed by other partners.

Kays gains are analyzed as follows:

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Capitalizes the $15,000. This amount is a syndication fee and cannot be

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Prepaid rental income is reported for tax purposes when it is received.

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1/1 through 6/30a

7/1 through 12/31b

1/1 through 6/30 is 181 days in a non-leap year.

pp. C:9-18 and C:9-19.

$ 3,200 (0.40 x $8,000)

Taxable interest income

Taxable interest income

pp. C:9-19 through C:9-21.

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Carryover basis of contributed property

Carryover basis from friend

The FMV of the partnership interest, or $25,000.

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pp. C:9-21 through C:9-24.

At-risk basis before losses

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Character of losses allowed:

Mary (General Partner-40%)

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Basis before gain and loss

Distributive share of loss

Basis before loss minus nonrecourse liability.