CHAPTER 10: PARTNERSHIPS: FORMATION, OPERATION, AND BASIS

CHAPTER 10: PARTNERSHIPS: FORMATION, OPERATION, AND BASIS 1. A partnership is an association formed by two or more taxpayers (who may be any type of entity) to carry on a trade or business. a. True b. False ANSWER: ...

CHAPTER 10: PARTNERSHIPS: FORMATION, OPERATION, AND BASIS 1. A partnership is an association formed by two or more taxpayers (who may be any type of entity) to carry on a trade or business. a. True b. False ANSWER: True RATIONALE: A partnership can have partners who are individuals, corporations, Subchapter S corporations, trusts, associations or even other partnerships. 2. In a limited liability company, all members are protected from all debts of the partnership unless they personally guaranteed the debt. a. True b. False ANSWER: True RATIONALE: In a limited liability company, the members are not liable for entity debts unless they guarantee them. 3. A limited partnership offers all partners protection from claims by the LP’s creditors. a. True b. False ANSWER: False RATIONALE: A limited partnership must have at least one general partner that is liable for the entity’s debts; that general partner may be a corporation or other entity that is, itself, protected from liability. 4. The primary purpose of the partnership agreement is to document the various tax elections made by the partners regarding depreciation methods, treatment of research and experimental costs, calculation of the § 199 deduction, and the § 754 election. a. True b. False ANSWER: False RATIONALE: The partnership agreement documents the arrangement among the partners regarding formation, operation, and liquidation of the partnership; allocations of profits, losses, and distributions; and other matters. The elections described are not typically covered in the partnership agreement, and such elections are made by the partnership rather than the partners. 5. The taxable income of a partnership flows through to the partners, who report the income on their tax returns. a. True b. False ANSWER: True RATIONALE: The partners, not the partnership, pay tax on partnership income. 6. An example of the “aggregate concept” underlying partnership taxation is the fact that the partners (rather than the partnership) pay tax on partnership income. a. True b. False ANSWER: True RATIONALE: This is an example of the aggregate (or “conduit”) principle of taxation. 7. Each partner’s profitsharing, losssharing, and capitalsharing ownership percentages are always the same. a. True b. False ANSWER: False RATIONALE: Each partner’s profitsharing, losssharing, and capitalsharing ratios are reported on that partner’s Schedule K-1. In many cases, the three ratios are the same. However, if the partnership agreement provides for special allocations or if capital contributions or distributions differed at some point from the profit- or loss-sharing percent, these ratios may differ for a given partner. 8. The “inside basis” is defined as a partner’s basis in the partnership interest. a. True b. False ANSWER: False RATIONALE: The “outside basis” is defined as a partner’s basis in the partnership interest. 9. The partnership reports each partner’s share of income to the partner in a single amount on Form 1099. a. True b. False ANSWER: False RATIONALE: The partners will receive a Schedule K1 from the partnership that includes the partner’s share of ordinary partnership income and each separately stated item. 10. Section 721 provides that, in general, no gain or loss is recognized by the partnership or the partner on contribution of appreciated or depreciated property to a partnership in exchange for an interest in the partnership. a. True b. False ANSWER: True RATIONALE: Section 721 provides for nonrecognition of either gain or loss on a contribution of property to the partnership. 11. Ken and Lars formed the equal KL Partnership during the current year, with Ken contributing $100,000 in cash and Lars contributing land (basis of $60,000, fair market value of $40,000) and equipment (basis of $0, fair market value of $60,000). Lars recognizes a $40,000 gain on the contribution and his basis in his partnership interest is $100,000. a. True b. False ANSWER: False RATIONALE: Under § 721, neither the partnership nor a partner will generally recognize gain or loss on contribution of property to a partnership. Lar’s basis in his partnership interest is the $60,000 basis in the assets contributed ($60,000 basis in land plus $0 basis in equipment). 12. Morgan and Kristen formed an equal partnership on August 1 of the current year. Morgan contributed $60,000 cash and land with a basis of $18,000 and a fair market value of $40,000. Kristen contributed equipment with a basis of $42,000 and a value of $100,000. Kristen and Morgan each have a basis of $100,000 in their partnership interests. a. True b. False ANSWER: False RATIONALE: Morgan’s basis includes the $18,000 substituted basis for the contributed land plus $60,000 cash, for a total of $78,000. Kristen’s basis is $42,000, a substituted basis from the contributed equipment. 13. Section 721 provides that no gain or loss is recognized on a contribution of property to a partnership in exchange for an interest in the partnership. An exception might apply if the taxpayer receives a cash distribution from the partnership soon after the property contribution is made. a. True b. False ANSWER: True RATIONALE: A contribution of property to a partnership followed by a distribution soon thereafter may be recharacterized as a disguised sale of the property by the partner to the partnership. A disguised sale does not receive tax- deferred treatment under § 721. 14. George received a fully-vested 10% interest in partnership capital and a 20% interest in future partnership profits in exchange for services rendered to the GHP, LLC (not a publicly-traded partnership interest). The future profits of the partnership are subject to normal operating risks. George will report ordinary income equal to the fair market value of the profits interest, but the capital interest will not be currently taxed to him. a. True b. False ANSWER: False RATIONALE: George will recognize ordinary income equal to the fair market value of the capital interest (i.e., his share of the liquidation value of the partnership). The fair market value of the profits interest is not reasonably assured and is, therefore, indeterminable. The profits interest will be taxed to George as the partnership’s profits are earned. 15. Laura is a real estate developer and owns property that is treated as inventory (not a capital asset) in her business. She contributes a parcel of this land (basis of $15,000) to a partnership, also to be held as inventory. The fair market value of the property is $12,000 at the contribution date. After three years, the partnership sells the land for $10,000. The partnership will recognize a $5,000 ordinary loss on sale of the property. a. True b. False ANSWER: True RATIONALE: Because the property was not a capital asset in Laura’s hands, the partnership is not subject to the requirement that precontribution losses realized and recognized by the partnership within five years of contribution be treated as capital losses. 16. If the partnership properly makes an election for treatment of a specific tax item, the partner is bound by that treatment. a. True b. False ANSWER: True RATIONALE: The partnership makes elections regarding everything from the partnership’s taxable year to the depreciation method for partnership assets. Each partner is bound by the decisions made by the partnership relative to these partnership level elections. 17. JLK Partnership incurred $6,000 of organizational costs and $50,000 of startup costs in 2014. JKL may deduct $5,000 each of organizational and startup costs, and the remaining costs ($1,000 of organizational costs and $45,000 of startup costs) may be amortized over 60 months. a. True b. False ANSWER: False RATIONALE: For organizational and startup costs, the first $5,000 may be deducted ($10,000 of startup costs in some years), provided total expenses in that category do not exceed $50,000 ($60,000 for startup costs if the $10,000 deduction is available). If costs in the category exceed the base amount, the deduction is phased out, dollar-for-dollar. When costs exceed the phaseout amount in that category, no portion of the current deduction is permitted. Any amount that may not be deducted is amortized over 180 months. 18. Syndication costs arise when partnership interests are being marketed to investors. These costs cannot be amortized or deducted. a. True b. False ANSWER: True RATIONALE: Syndication costs include brokerage fees, legal fees, and registration fees incurred in connection with marketing interests in partnerships. Under § 709, these costs are neither amortizable nor deductible. 19. Seven years ago, Paul purchased residential rental estate that he has been depreciating as MACRS property over 27.5 years. This year, when his adjusted basis in the property was $250,000, Paul transferred the property to the newly formed PLA LLC in exchange for a one-third interest in the LLC. PLA incurred $10,000 of transfer taxes and fees related to the property. PLA must treat the $260,000 basis in the property, fees, and expenses, as new MACRS property depreciable over 27.5 years. a. True b. False ANSWER: False RATIONALE: PLA “steps into Paul’s shoes” with respect to the $250,000 basis in the original property and depreciates the property over the remaining (approximately) 20-year recovery period. It treats the $10,000 of fees and taxes as a new depreciable property with a 27.5 year recovery period. 20. A partnership cannot use the cash method of accounting if one of the partners is a C corporation. a. True b. False ANSWER: False RATIONALE: A partnership may be able to use the cash method of accounting if the partnership has never had “average annual gross receipts” in excess of $5 million in any prior 3year period, if the C corporation partner is a qualified personal service corporation, or if the partnership is engaged in the farming business. 21. ABC, LLC is equally-owned by three corporations. Two corporations have June 30 fiscal year ends, the third is a calendar-year taxpayer. ABC will use the least aggregate deferral method to determine its taxable year- end. a. True b. False ANSWER: False RATIONALE: The partnership year end is determined by reference to the first of three tests that is met by the partnership. The first test is the majority partners’ tax year test. If more than 50% of the partnership’s capital and profits interests are owned by partners with the same tax year, that year is required under the majority partner tax year rule. The June 30 year-end corporations, combined, own 66 2/3% of partnership capital and profits, so that year end is used. 22. PaulCo, DavidCo, and Sean form a partnership with cash contributions of $80,000, $50,000 and $30,000, respectively, and agree to share profits and losses in the ratio of their original cash contributions. PaulCo uses a January 31 fiscal year-end, while DavidCo and Sean use a November 30 and December 31 year-end, respectively. The partnership must use the least aggregate deferral method to determine its year end. a. True b. False ANSWER: True RATIONALE: The partnership has no majority partners, as PaulCo does not own more than 50%. Also, the three principal partners do not have the same year-end. Therefore, the least aggregate deferral method must be used to determine the partnership’s yearend. 23. A partnership must provide any information to the partners that the partners would need to calculate deductions not permitted at the partnership level, such as for oil and gas depletion or the corporate dividends received deduction. a. True b. False ANSWER: True RATIONALE: On Schedule K-1, the partnership reports to the partner any information the partner needs to prepare his/her/its tax return. Deductions such as oil and gas depletion and the dividends received deduction cannot be claimed at the partnership level, so the relevant information must be provided to the partners. 24. Items that are not required to be shown on the partners’ Schedules K1 include AMT adjustments and preferences and taxes paid to foreign countries, as AMT and the foreign tax credit are calculated by the partnership. a. True b. False ANSWER: False RATIONALE: Partnership income and loss items must be separately stated if they could differently affect the tax liabilities of two or more partners. This is true also for other partnership items and information (not necessarily income or loss amounts), such as AMT adjustments and preferences and the information a partner might need for calculating the foreign tax credit. These calculations are generally made at the partner rather than partnership level. 25. The JPM Partnership is a US-based manufacturing company. JPM calculates the domestic production activities deduction (§ 199) and deducts that amount on its Form 1065. a. True b. False ANSWER: False RATIONALE: The partnership typically calculates QPAI (qualified production activities income) and W-2 wages (or similar information under other methods permitted by the Regulations) and allocates those amounts to the partners. Each partner separately calculates the § 199 deduction. 26. The amount of a partnership’s income and loss from operating activities is combined with separately stated income and expenses to determine the partnership’s equivalent of “taxable income.” This amount is reconciled to book income on the partnership’s Schedule M1 or Schedule M3. a. True b. False ANSWER: True RATIONALE: A partnership combines its “ordinary business income (loss)” and “separately stated items” into a single amount on the Analysis of Net Income (loss); this amount is the partnership’s equivalent of a taxable income amount. This amount is reconciled to book income on Schedule M-1 or M-3. 27. Partners’ capital accounts should be determined using the same method on Form 1065 Schedule L, Form 1065 Schedule M-2, and the Schedules K-1 prepared for the partners. a. True b. False ANSWER: False RATIONALE: On Schedule L, partners’ capital should generally be determined using financial reporting methods. On Schedule M2 and the partners’ Schedules K1, the same methods should be used, and that method may differ from the method used for Schedule L. 28. A partnership’s allocations of income and deductions to the partners are required to be proportionate to the partners’ percentage ownership of partnership capital in order to meet the substantial economic effect tests. a. True b. False ANSWER: False RATIONALE: A partnership may allocate items of partnership income, gain, loss, deduction, or credit in any manner agreed upon by the partners, provided the allocation meets the three substantial economic effect tests or certain alternate tests for economic performance. 29. Tom and William are equal partners in the TW Partnership. Just before TW liquidated, Tom’s capital account balance was $50,000 and William’s capital account balance was $30,000. To meet the substantial economic effect requirements, any liquidating cash distribution must be allocated in proportion to those ending capital account balances. a. True b. False ANSWER: True RATIONALE: One of the three requirements of the economic effect test is that the partnership agreement must provide that liquidating distributions will be in proportion to the partners’ ending capital account balances. In addition to the “economic effect” test, all allocations must meet the “substantial” requirement. 30. Blaine contributes property valued at $50,000 (basis of $40,000) in exchange for a 25% interest in the BIKE Partnership. If the property is later sold for $70,000, gain of $15,000 will be allocated to Blaine. a. True b. False ANSWER: True RATIONALE: If appreciated property is contributed to a partnership, any recognized precontribution gain must be allocated to the partner that contributed the property. This only applies to the appreciation at the contribution date. Any appreciation after that date is allocated proportionately to the partners (or in accordance with the partnership agreement). In this case, the precontribution gain of $10,000 must be allocated to Blaine, plus $5,000 [25% × ($70,000 – $50,000)] of the gain arising since the property was contributed. 31. Nicholas, a 1/3 partner with a basis in the interest of $80,000 at the beginning of the year, received a guaranteed payment in the current year of $50,000. Partnership income before consideration of the guaranteed payment was $20,000. Nicholas reports a $10,000 ordinary loss from partnership operations, and the $50,000 guaranteed payment as ordinary income. a. True b. False ANSWER: True RATIONALE: The guaranteed payment is deductible in computing the ordinary income or loss of a partnership. Thus, the partnership ends the year with a $30,000 operating loss [$20,000 (income before deducting guaranteed payment) – $50,000 (guaranteed payment)]. Nicholas’s 1/3 share of the $30,000 partnership loss is $10,000 and its deductibility is not limited under § 704(d). In addition, Nicholas must report the guaranteed payment as ordinary income. 32. Emma’s basis in her BBDE LLC interest is $60,000 at the beginning of the tax year. Her allocable share of LLC items are as follows: $20,000 of ordinary income, $2,000 tax-exempt interest income, and a $6,000 long- term capital gain. In addition, the LLC distributed $12,000 of cash to Emma during the year. Assuming the LLC had no liabilities at the beginning or the end of the year, Emma’s ending basis in her LLC interest is $76,000. a. True b. False ANSWER: True RATIONALE: Emma’s initial basis is increased by her share of ordinary income, taxexempt income, and longterm capital gain. Her basis is decreased by the distribution. Her basis at the end of the year is $76,000 ($60,000 initial basis + $20,000 ordinary income + $2,000 tax-exempt interest income + $6,000 long-term capital gain – $12,000 distribution). 33. Ashley purchased her partnership interest from Lindsey on the first day of the current year for $40,000 cash. She received a $10,000 cash distribution from the partnership during the year, and her share of partnership income is $15,000. Her share of partnership liabilities on the last day of the partnership year is $20,000. Ashley’s outside basis for her partnership interest at the end of the year is $45,000. a. True b. False ANSWER: False RATIONALE: Ashley’s adjusted basis at the end of the year is $65,000, determined as follows: $40,000 cash (paid to acquire interest) + $15,000 (share of income) + $20,000 (share of partnership liabilities) – $10,000 (cash distribution). 34. Julie and Kate form an equal partnership during the current year. Julie contributes cash of $160,000, and Kate contributes property (adjusted basis of $90,000, fair market value of $260,000) subject to a nonrecourse liability of $100,000. As a result of these transactions, Kate has a basis in her partnership interest of $40,000. a. True b. False ANSWER: False RATIONALE: Kate is allocated the first $10,000 of debt ($100,000 debt – $90,000 basis), plus onehalf of the remaining debt. She has an adjusted basis for her partnership interest of $45,000, calculated as follows: Basis, property transferred $ 90,000 Less: liability assumed by partnership (100,000) Plus: § 704(c) allocation of debt 10,000 Basis before remaining allocation $ –0– Remaining allocation of debt ($90,000 × 50%) 45,000 Kate’s basis $ 45,000 35. Debt of a limited liability company is allocated among LLC members using the nonrecourse debt allocation rules unless an LLC member has personally guaranteed the debt. a. True b. False ANSWER: True RATIONALE: LLC members are protected from the LLC’s liabilities, so even if a liability is nominally recourse to the LLC, it is treated as a nonrecourse debt for purposes of allocations to the LLC members. 36. The sum of the partners’ ending basis amounts on all Schedules K1 equals the partners’ ending capital account balance shown on the partnership’s Schedule L. a. True b. False ANSWER: False RATIONALE: The partner’s basis is not shown on Schedule K1 or anywhere else on the tax return. The partner’s capital account is shown on Schedule K1, but it does not generally equal the partner’s basis. The amounts are not equal for various reasons, one being that the partner’s share of partnership debt is not included in the capital account. The method used to calculate the partners’ capital accounts is not necessarily the method used on Schedule L. 37. If a partnership allocates losses to the partners, the partners must first apply the passive loss limitations, then the basis limitation, and finally the at-risk limitations. If all three hurdles are met, the partner may deduct the loss. a. True b. False ANSWER: False RATIONALE: The overall limitation of § 704(d) must first be met. This means the allocated loss cannot exceed the partners’ basis in the partnership interest. Any loss that meets the overall limitation must be tested under the atrisk rules of § 465. Any losses that pass the atrisk rules are evaluated. If the loss is a passive loss under § 469, it is combined with passive income and losses from other sources to determine whether or not it may be deducted. 38. Harry’s basis in his partnership interest was $10,000 at the beginning of the tax year. For the year, his share of the partnership’s loss was $8,000, and he also received a distribution of $4,000. Harry can deduct an $8,000 loss, and he recognizes a gain of $2,000 on the distribution of cash in excess of his remaining basis. a. True b. False ANSWER: False RATIONALE: Harry’s basis is first adjusted for the distribution he received, so it is reduced to $6,000 ($10,000 – $4,000 distribution). The loss is limited under § 704(d) to his basis after the distribution, or $6,000, with the remaining $2,000 being deferred to a future year. 39. William is a general partner in the WST partnership. During the current year, he receives a guaranteed payment of $10,000 for services he provides to the partnership, and his distributive share of partnership income is $30,000. William is required to pay self-employment tax on the $10,000 guaranteed payment, but not on his distributive share of partnership income. a. True b. False ANSWER: False RATIONALE: As a general partner, William must report both the guaranteed payment for services and his distributive share of partnership income as self-employment income. 40. Maria owns a 60% interest in the KLM Partnership. Four years ago her father gave her a parcel of land. The gift basis of the land to Maria is $60,000. In the current year, Maria had still not figured out how to use the land for her own personal or business use; consequently, she sold the land to the partnership for $50,000. The partnership immediately started using the land as a parking lot for its employees. Maria may recognize her $10,000 loss on the sale. a. True b. False ANSWER: False RATIONALE: Because Maria owns more than a 50% interest in the partnership’s capital or profits, Maria may not deduct a loss on sale of property to the entity. 41. One of the disadvantages of the partnership form is that the partner’s share of the partnership’s taxable income is taxed to the partner, regardless of whether or not distributed. a. True b. False ANSWER: True RATIONALE: The partnership’s income (or loss) is allocated and reported to the partners each year on Schedule K1; the partners report this income (or loss) regardless of whether the partnership distributes any cash to the partners during the year. 42. Which of the following entity owners cannot participate in management of the entity? a. A general partner in a general partnership. b. A member of a limited liability company. c. A partner in a limited liability partnership. d. A limited partner in a limited liability limited partnership. e. None of the above. ANSWER: d RATIONALE: By definition, a limited partner cannot participate in management of the partnership. An LLLP is a limited partnership for which all partners (general and limited) have limited liability. As a type of limited partnership, those partners treated as limited partners would not be able to participate in management. General partners, LLC members, and LLP partners may participate in management if permitted by the partnership or operating agreement. 43. Which one of the following statements regarding partnership taxation is incorrect? a. A partnership is a taxable entity for Federal income tax purposes. b. Partnership income is comprised of ordinary partnership income or loss and separately stated items. c. A partnership is required to file a return with the IRS. d. A partner’s profitsharing percent may differ from the partner’s losssharing percent. e. All of these statements are correct. ANSWER: a RATIONALE: A partnership is not taxed but it must file a tax return (choice a. is correct). 44. Which of the following is a correct definition of a concept related to partnership taxation? a. The aggregate concept treats partners and partnerships as separate units and gives the partnership its own tax “personality.” b. A partner’s capital sharing ratio is defined as the percent of partnership assets (capital) that would be allocated to the partner upon liquidation of the partnership. c. The partnership’s outside basis is defined as the sum of each partner’s capital account balance. d. A special allocation is defined as an amount that could differently affect the tax liabilities of two or more partners. e. None of these statements is correct. ANSWER: b RATIONALE: For choice a., the entity concept treats the partnership as a distinct unit. Choice b. is the correct answer and is the definition of a capital-sharing ratio. For choice c., the partnership’s inside basis equals the partnership’s basis in its assets, as contrasted with the partners’ outside basis (not capital account) in the partnership interest. Choice d. is the definition of a separately stated item. 45. A partnership will take a carryover basis in an asset it acquires when: a. The partnership acquires the asset through a § 1031 likekind exchange. b. A partner owning 25% of partnership capital and profits sells the asset to the partnership. c. The partnership leases the asset from a partner on a one-year lease. d. The partnership acquires the asset from a partner as a contribution to partnership capital under § 721(a). e. None of the above. ANSWER: d RATIONALE: When a partner contributes an asset to a partnership in exchange for a partnership interest under § 721(a), the partnership takes a carryover basis for the asset under § 723. Under § 1031, a partnership takes a substituted basis for the asset received in the exchange, so choice a. is incorrect. The purchase of an asset from either a partner or an outside party will result in the asset taking a cost basis to the partnership, therefore choice b. is also incorrect. Choice c. is incorrect because, when a partnership leases an asset from a partner under a short- term lease, the asset is not a partnership asset and is not recorded on the partnership books. 46. On January 1 of the current year, Anna and Jason form an equal partnership. Anna contributes $50,000 cash and a parcel of land (adjusted basis of $100,000; fair market value of $150,000) in exchange for her interest in the partnership. Jason contributes property (adjusted basis of $180,000; fair market value of $200,000) in exchange for his partnership interest. Which of the following statements is true concerning the income tax results of this partnership formation? a. Jason recognizes a $20,000 gain on his property transfer. b. Jason has a $200,000 tax basis for his partnership interest. c. Anna has a $150,000 tax basis for her partnership interest. d. The partnership has a $150,000 adjusted basis in the land contributed by Anna. e. None of the statements is true. ANSWER: c RATIONALE: The contributions are taxfree and the carryover and substituted basis rules of §§ 722 and 723 apply. Jason’s basis for his partnership interest will be the same as his $180,000 basis for the property contributed. Anna will have a $150,000 tax basis for her partnership interest; the partnership will have a $100,000 adjusted basis for the land contributed by Anna; and neither Jason nor Anna will recognize a gain or loss on their property contributions. 47. Tim, Al, and Pat contributed assets to form the equal TAP Partnership. Tim contributed cash of $40,000 and land with a basis of $80,000 (fair market value of $60,000). Al contributed cash of $60,000 and land with a basis of $50,000 (fair market value of $40,000). Pat contributed cash of $60,000 and a fully depreciated property ($0 basis) valued at $40,000. Which of the following tax treatments is not correct? a. Tim’s basis in his partnership interest is $120,000. b. Al realizes and recognizes a loss of $10,000. c. Pat realizes a gain of $40,000 but recognizes $0 gain. d. TAP has a basis of $80,000, $50,000, and $0 in the land and property (excluding cash) contributed by Tim, Al, and Pat, respectively. e. All of these statement are correct. ANSWER: b RATIONALE: Al’s basis in the partnership interest equals the $60,000 cash plus his $50,000 basis in the property contributed. He cannot recognize his $10,000 realized loss. The other three statements are correct. Tim’s basis equals the cash contribution plus the $80,000 basis in the land. Pat’s basis equals the $60,000 cash contribution since he had no basis in the property he contributed; he does not recognize his $60,000 realized gain. The partnership takes a carryover basis in the three contributed properties. 48. When property is contributed to a partnership in exchange for a capital and profits interest, when does the partner’s holding period begin for the partnership interest? a. The day after the contribution date. b. The day the property was contributed. c. The day the contributed property was purchased. d. The day the partnership interest was acquired. e. Either (or both) c. and d. may be true, depending upon the types of property contributed. ANSWER: e RATIONALE: Generally, the holding period of a partner’s interest includes the holding period of any capital assets or § 1231 property contributed by the partner. The holding period related to other property starts on the day the partnership interest is acquired. 49. In which of the following independent situations would the transaction most likely be characterized as a disguised sale? a. Partner George contributes appreciated property to the GM Partnership, and three years later GM distributes $100,000 proportionately to the partners. b. Brianna contributes property with a basis of $20,000 and a fair market value of $50,000 to the BGB Partnership in exchange for a 20% interest therein. The partnership agrees to distribute $20,000 to Brianna in fifteen months, if partnership cash flows from operations exceed $100,000 at that time. The partnership does not expect to produce operating cash flows of over $100,000 for at least five years. c. Luis contributes appreciated property to the BLP Partnership. Thirty months later, he receives a distribution from the partnership of $15,000 cash. None of the other partners received a distribution. There was no agreement that BLP would make the distribution, and Luis would have made the contribution whether or not the partnership made the distribution. d. None of the above transactions will be treated as a disguised sale. e. a., b., and c. are all treated as disguised sales. ANSWER: d RATIONALE: Choice a. is not a disguised sale, because the partner is merely receiving his share of partnership cash flows. Choice b. is not a disguised sale because the distribution is subject to entrepreneurial risk. Choice c. is not a disguised sale because the contribution was not contingent on a future distribution being made. In addition, the distribution in c. meets the IRS’s twoyear time frame in which a distribution is generally not presumed to be part of a disguised sale. 50. Tara and Robert formed the TR Partnership four years ago. Because they decided the company needed some expertise in multimedia presentations, they offered Katie a 1/3 interest in partnership capital if she would come to work for the partnership. She will also receive a 25% interest in future partnership profits. On July 1 of the current year, the unrestricted partnership capital interest (fair market value of $25,000) was transferred to Katie. How should Katie treat the receipt of the partnership interest in the current year? a. Nontaxable. b. $25,000 ordinary income. c. $25,000 short-term capital gain. d. $25,000 long-term capital gain. e. None of the above. ANSWER: b RATIONALE: A person who receives an unrestricted partnership capital interest for services rendered recognizes ordinary income when the interest is received. The amount of income recognized is the fair market value of the partnership interest on the date it is received. 51. Which of the following would be currently taxable as ordinary income to the service partner if received in exchange for services performed for the partnership? (In all cases, assume the interest is not sold within two years after the time it is granted to the service partner.) a. A 10% interest in the capital of the partnership that will vest in 3 years. b. A 20% interest in the future profits of the partnership received in exchange for future services to be performed for the partnership. c. A 25% interest in the capital of the partnership where there are no restrictions on transferability of the interest. d. A 30% interest in ongoing profits of the partnership where the partnership is not a publicly-traded partnership and the income stream is not assured. e. All of the above. ANSWER: c RATIONALE: Receipt of an interest in partnership capital in exchange for services is taxable to the service partner if it is not subject to a substantial risk of forfeiture (choice c. is correct). An interest that will vest in 3 years is subject to a substantial risk of forfeiture and is not currently taxable (choice a. is incorrect). An interest requiring performance of future services is not currently taxable (choice b. is incorrect). Receipt of a profits interest cannot generally be valued and so is not taxable unless the partnership is a publicly-traded partnership or the partnership’s income stream is assured (choice d. is incorrect). 52. Which of the following is an election or calculation made by the partner rather than the partnership? a. Calculation of a § 199 deduction amount. b. Whether to capitalize, amortize, or expense research and experimental costs. c. The partnership’s overall accounting method. d. Whether to claim a § 179 deduction related to property acquired by the partnership. e. All of the above elections are made by the partnership. ANSWER: a RATIONALE: The partner determines the amount that can be deducted under § 199 based on information provided by the partnership. 53. TEC Partners was formed during the current tax year. It incurred $10,000 of organizational expenses, $80,000 of startup expenses, and $5,000 of transfer taxes to retitle property contributed by a partner. The property had been held as MACRS property for ten years by the contributing partner, and had an adjusted basis to the partner of $300,000 and fair market value of $400,000. Which of the following statements is correct regarding these items? a. TEC treats the contributed property as a new MACRS asset placed in service on the date the property title is transferred. b. TEC must amortize the $10,000 of organizational expenses over 180 months. c. TEC’s startup expenses are amortized over 60 months. d. TEC must capitalize the transfer tax and treat it as a new asset placed in service on the date the property is contributed. e. None of the above statements are true. ANSWER: d RATIONALE: Choice a. is incorrect because the partnership “steps into the partner’s shoes” with respect to depreciation of contributed property. Choice b. is incorrect because the first $5,000 of organizational costs may be deducted if total organizational costs are less than $50,000. Choice c. is incorrect because the portion of startup costs that cannot be currently deducted must be amortized over 180 months. 54. Which of the following statements is always correct regarding assets acquired by a newly formed partnership? If a partner contributes: a. Depreciable property: the partnership treats the property as newly acquired depreciable property, and may claim a § 179 deduction. b. Unrealized (cash-basis) receivables: the partnership will report a capital gain when the receivable is collected. c. Inventory (in the partner’s hands): the partnership reports ordinary income if the property is held as a capital asset and sold within five years of the contribution date. d. Land valued at less than its basis: the partnership reports a § 1231 loss if the property is sold at a loss. e. None of these statements is correct. ANSWER: c RATIONALE: If the partnership holds (as a capital asset) inventory contributed by the partner, it reports ordinary income if the inventory is sold within five years of the contribution date. If depreciable property is contributed to the partnership (choice a.), the partnership steps into the partner’s shoes in calculating depreciation and it may not claim a § 179 deduction. If a partner contributes cash basis accounts receivable (choice b.), the partnership reports ordinary income when the receivable is collected. If the partner contributes depreciated land held by the partner as a capital asset (choice d.), the partnership must report a capital loss if the land is sold within five years of the contribution. 55. Which of the following statements is always true regarding accounting methods available to a partnership? a. If a partnership is a tax shelter, it can use the cash method of accounting. b. If a nontaxshelter partnership had “average annual gross receipts” of less than $5 million in all prior years, it can use the cash method. c. If a partnership has a partner that is a personal service corporation, it cannot use the cash method. d. If a partnership has a partner that is a C corporation, it cannot use the cash method. e. All of the above statements are false. ANSWER: b RATIONALE: Choice a. is false because a partnership must use the accrual method if it is considered to be a tax shelter. A partnership must often use the accrual method if it has a partner that is a C corporation (choice d. is false). However, the partnership can use the cash method if 1) the C partner is a personal service corporation (choice c. is false), or 2) the partnership has average annual gross receipts of $5 million or less for all prior 3-year tax periods (choice b. is true). 56. Fern, Inc., Ivy, Inc., and Jeremy formed a general partnership. Fern owns a 50% interest and Ivy and Jeremy each own 25% interests. Fern, Inc. files its tax return on an October 31 year-end; Ivy, Inc., files with a July 31 year-end, and Jeremy is a calendar year taxpayer. Which of the following statements is true regarding the taxable year the partnership can choose? a. The partnership must choose the calendar year because it has no principal partners. b. The partnership must choose an October year-end because Fern, Inc., is a principal partner. c. The partnership can request permission from the IRS to use a March 31 fiscal year under § 444. d. The partnership must use the “least aggregate deferral” method to determine its taxable year. e. None of the above. ANSWER: d RATIONALE: Because the partnership does not have any majority partners and because the principal partners do not all have the same taxable year, the least aggregate deferral rule determines the partnership’s “required” taxable year. The partnership may be able to obtain IRS permission to adopt a different taxable year if it can demonstrate to the IRS that it has a substantial business purpose for choosing that year, such as having a “natural business year.” The partnership can also make an election under § 444, but a March 31 yearend would not be possible under § 444 because it would result in greater than 3 months deferral of income to all of the partners. 57. In the current year, the POD Partnership received revenues of $200,000 and paid the following amounts: $50,000 in rent and utilities, and $20,000 as a distribution to partner Olivia. In addition, the partnership earned $6,000 of long- term capital gains during the year. Partner Donald owns a 50% interest in the partnership. How much income must Donald report for the tax year? a. $68,000 ordinary income. b. $78,000 ordinary income. c. $65,000 ordinary income; $3,000 of long-term capital gains. d. $75,000 ordinary income; $3,000 of long-term capital gains. e. None of the above. ANSWER: d RATIONALE: The partnership’s ordinary income is calculated as follows: Revenues $200,000 Less: rent and utilities (50,000) Ordinary income $150,000 The distribution to Olivia is not deductible. Donald’s share of POD’s ordinary income is $75,000. The $6,000 of longterm capital gains is a separately stated item, of which Donald’s share is $3,000. 58. Kristie is a 30% partner in the KKM Partnership. During the current year, KKM reported gross receipts of $280,000 and a charitable contribution of $30,000. The partnership paid office expenses of $80,000. In addition, KKM distributed $20,000 each to partners Kaylyn and Megan, and the partnership paid partner Kaylyn $20,000 for administrative services. Kristie reports the following income from KKM during the current tax year: a. $54,000 ordinary income; $9,000 charitable contribution. b. $60,000 ordinary income; $9,000 charitable contribution. c. $36,000 ordinary income. d. $54,000 ordinary income. e. None of the above. ANSWER: a RATIONALE: KKM’s net ordinary income is $180,000 ($280,000 ordinary income – $80,000 of office expenses – $20,000 payment to Kaylyn). The cash distributions to Kaylyn and Megan are not deductible. Kristie’s share of this income is $54,000. In addition, Kristie reports her $9,000 share of the partnership’s charitable contribution. 59. Which one of the following is not shown on the partnership’s Schedule K on Page 4 of Form 1065? a. The partnership’s selfemployment income. b. The partnership’s separately stated income and deductions. c. The partnership’s tax preference and adjustment items. d. The partnership’s net operating loss carryforward. e. All of the above. ANSWER: d RATIONALE: Any partnership losses flow through to the partners in the year incurred. They are not carried back or forward at the partnership level. 60. On a partnership’s Form 1065, which of the following statements is not true? a. The partnership reconciles its net income (including separately stated items) to book income on Schedule M- 1 or M-3. b. The partnership balance sheet on Schedule L is generally presented on a financial (book) basis. c. All partnership income and expense items are reported on Form 1065, page 1. d. The partnership’s equivalent of taxable income is reported in the “Analysis of Income (Loss).” e. None of the above statements are true. ANSWER: c RATIONALE: The partnership reconciles the taxable income equivalent—Net Income (Loss) from the Analysis of Income (Loss) (which combines all ordinary and separately stated amounts)—to book income (choices a. and d. are true). The partnership’s balance sheet (on Schedule L) will typically be reported on a book basis (choice b. is true). The partnership reports ordinary income from operations on Form 1065, page 1, and it reports other types of income and expenses (separately stated items) on Form 1065, Schedule K (choice c. is not true). 61. ABC LLC reported the following items on the LLC’s Schedule K: ordinary income, $100,000; interest income, $3,000; long-term capital loss, ($4,000); charitable contributions, $1,000; post-1986 depreciation adjustment, $10,000; and cash distributions to partners, $50,000. How much will ABC show as net income (loss) on its Analysis of Income (Loss)? a. $68,000 b. $78,000 c. $95,000 d. $98,000 e. $102,000 ANSWER: d RATIONALE: The LLC’s net income per the Analysis of Income reconciliation equals the net amount of all the partnership’s separately stated income and deductions. ABC’s amount is $98,000 ($100,000 ordinary income + $3,000 interest income – $4,000 longterm capital loss – $1,000 charitable contribution). 62. Which of the following statements is not a requirement of the substantial economic effect test? a. Income, gains, losses, and deductions must be allocated to the partners in accordance with their capital contributions. b. An allocation of income must increase the partner’s capital account balance, and an allocation of deduction must decrease the partner’s capital account balance. c. A partner with a negative capital account balance must “restore” that capital account, generally by contributing cash to the partnership. d. On liquidation of the partner’s interest in the partnership, the partner must receive assets that have a fair market value equal to that partner’s (positive) capital account balance. e. All of the above statements are requirements of the substantial economic effect test. ANSWER: a RATIONALE: A partnership is not required to allocate items proportionately to the partners (choice a. is false), provided the reporting and recordkeeping requirements of the substantial economic effect requirements are met. 63. Brooke and John formed a partnership. Brooke received a 40% interest in partnership capital and profits in exchange for contributing land (basis of $30,000 and fair market value of $120,000). John received a 60% interest in partnership capital and profits in exchange for contributing $180,000 of cash. Three years after the contribution date, the land contributed by Brooke is sold by the partnership to a third party for $150,000. How much taxable gain will Brooke recognize from the sale? a. $102,000 b. $90,000 c. $48,000 d. $36,000 e. $0 ANSWER: a RATIONALE: Section 704(c)(1)(A) requires that any precontribution gain must be allocated entirely to Brooke. Therefore, Brooke is allocated the $90,000 precontribution (“builtin”) gain and 40% ($12,000) of the $30,000 post contribution gain. 64. Mark and Addison formed a partnership. Mark received a 25% interest in partnership capital and profits in exchange for land with a basis of $40,000 and a fair market value of $60,000. Addison received a 75% interest in partnership capital and profits in exchange for $180,000 of cash. Three years after the contribution date, the land contributed by Mark is sold by the partnership to a third party for $76,000. How much taxable gain will Mark recognize from the sale? a. $0 b. $9,000 c. $24,000 d. $36,000 e. None of the above ANSWER: c RATIONALE: Section 704(c)(1)(A) requires that any precontribution gain must be allocated entirely to Mark. Therefore, Mark is allocated the $20,000 precontribution (“builtin”) gain and 25% ($4,000) of the $16,000 postcontribution gain. 65. Molly is a 30% partner in the MAP Partnership. During the current tax year, the partnership reported ordinary income of $200,000 before payment of guaranteed payments and distributions to partners. The partnership made an ordinary cash distribution of $20,000 to Molly, and paid guaranteed payments to partners Molly, Amber, and Pat of $20,000 each ($60,000 total guaranteed payments). How much will Molly’s adjusted gross income increase as a result of the above items? a. $42,000 b. $60,000 c. $62,000 d. $80,000 e. None of the above ANSWER: c RATIONALE: MAP reports ordinary income of $140,000 ($200,000 less the $60,000 of guaranteed payments). The distribution to Molly is not deducted by the partnership and is not taxable to her. Molly’s share of partnership income is $42,000 (30% × $140,000). In addition, she will pay tax on the $20,000 guaranteed payment she received. 66. Stephanie is a calendar year cash basis taxpayer. She owns a 50% profit and loss interest in a cash basis partnership with a September 30 yearend. The partnership’s operating income (after deducting guaranteed payments) was $120,000 ($10,000 per month) and $144,000 ($12,000 per month), respectively, for the partnership tax years ended September 30, 2013 and 2014. The partnership paid guaranteed payments to Stephanie of $2,000 and $3,000 per month during the fiscal years ended September 30, 2013 and 2014. How much will Stephanie’s adjusted gross income be increased by these partnership items for her tax year ended December 31, 2013? a. $60,000 b. $72,000 c. $84,000 d. $90,000 e. $108,000 ANSWER: c RATIONALE: In her calendar year, 2013 tax return, Stephanie reports the guaranteed payment and the share of partnership income she received for the partnership’s yearend September 30, 2013. She reports the $24,000 of guaranteed payments she received plus her 50% share of the $120,000 of partnership operating income ($60,000), for a total of $84,000. 67. Ryan is a 25% partner in the ROCC Partnership. At the beginning of the tax year, Ryan’s basis in the partnership interest was $90,000, including his share of partnership liabilities. During the current year, ROCC reported net ordinary income of $100,000. In addition, ROCC distributed $10,000 to each of the partners ($40,000 total). At the end of the year, Ryan’s share of partnership liabilities increased by $10,000. Ryan’s basis in the partnership interest at the end of the year is: a. $90,000. b. $100,000. c. $115,000. d. $125,000. e. None of the above. ANSWER: c RATIONALE: Ryan’s $90,000 basis is increased by his $10,000 share of increased partnership liabilities and is decreased by the $10,000 distribution he received. His basis is also increased by his $25,000 share of partnership income ($100,000 × 25%). 68. Allison is a 40% partner in the BAM Partnership. At the beginning of the tax year, Allison’s basis in the partnership interest was $100,000, including her share of partnership liabilities. During the current year, BAM reported an ordinary loss of $60,000. In addition, BAM distributed $8,000 to Allison and paid partner Brian a $20,000 consulting fee (neither of these amounts was deducted in determining the $60,000 loss from operations). At the end of the year, Allison’s share of partnership liabilities decreased by $10,000. Assuming loss limitation rules do not apply, Allison’s basis in the partnership interest at the end of the year is: a. $2,000. b. $50,000. c. $70,000. d. $100,000. e. None of the above. ANSWER: b RATIONALE: BAM’s net loss from operations is $80,000 after deducting the $20,000 consulting fee paid to Brian. Allison’s share of this loss is $32,000. Her $100,000 basis is reduced by her $32,000 share of the loss, the $8,000 distribution she received, and the $10,000 decrease in her share of partnership liabilities, for an ending basis of $50,000. 69. Binita contributed property with a basis of $40,000 and a value of $50,000 to the BE Partnership in exchange for a 20% interest in partnership capital and profits. During the first year of partnership operations, BE had net taxable income of $30,000 and tax-exempt interest income of $10,000. The partnership distributed $10,000 cash to Binita. Binita’s adjusted basis (outside basis) for her partnership interest at yearend is: a. $36,000. b. $38,000. c. $60,000. d. $70,000. e. None of the above. ANSWER: b RATIONALE: Binita is a 20% partner and shares in 20% of the partnership’s taxable and taxexempt income, or $8,000. Her basis is reduced by the cash distribution during the year. Binita’s ending basis is calculated as follows: $40,000 beginning basis + $8,000 [20% × ($30,000 + $10,000)] – $10,000 distribution. 70. At the beginning of the year, Heather’s “tax basis” capital account balance in the HEP Partnership was $85,000. During the tax year, Heather contributed property with a basis of $6,000 and a fair market value of $10,000. Her share of the partnership’s ordinary income and separately stated income and deduction items was $40,000. At the end of the year, the partnership distributed $15,000 of cash to Heather. Also, the partnership allocated $12,000 of recourse debt and $10,000 of nonrecourse debt to Heather. What is Heather’s ending capital account balance determined using the “tax basis” method? a. $116,000 b. $120,000 c. $126,000 d. $128,000 e. $138,000 ANSWER: a RATIONALE: Heather’s beginning capital account balance of $85,000 is “rolled forward” by adding the basis of the property she contributed ($6,000) and her share of partnership income ($40,000), and subtracting the distribution to her ($15,000). Liabilities are not included in the partner’s capital account. 71. Misty and John formed the MJ Partnership. Misty contributed $50,000 of cash in exchange for her 50% interest in the partnership capital and profits. During the first year of partnership operations, the following events occurred: the partnership had a net taxable income of $20,000; Misty received a distribution of $12,000 cash from the partnership; and Misty had a 50% share in the partnership’s $60,000 of recourse liabilities on the last day of the partnership year. Misty’s adjusted basis for her partnership interest at year end is: a. $48,000. b. $60,000. c. $78,000. d. $88,000. e. $90,000. ANSWER: c RATIONALE: Misty’s adjusted basis consists of her $50,000 cash contribution, plus her $10,000 share of partnership income, minus the $12,000 cash distribution, plus her $30,000 share of partnership liabilities. 72. Which of the following statements is correct regarding the manner in which partnership liabilities are reflected in the partners’ bases in their partnership interests? a. Nonrecourse debt is allocated to the partners according to their loss-sharing ratios. b. Recourse debt is allocated to the partners to the extent of the partnership’s minimum gain in the property. c. An increase in partnership debts results in a decrease in the partners’ bases in the partnership interest. d. A decrease in partnership debt is treated as a distribution from the partnership to the partner and reduces the partner’s basis in the partnership interest. e. Partnership debt is not reflected in the partners’ bases in their partnership interests. ANSWER: d RATIONALE: Nonrecourse debt is allocated to the partners in a three-step process with the final allocation generally being in accordance with the partners’ profitsharing ratios (choice a. is incorrect). Recourse debt is allocated in accordance with the constructive liquidation scenario (choice b. is incorrect). An increase in partnership debt results in an increase in the partners’ bases in the partnership interest (choice c. is incorrect). Partnership debt is reflected in the partners’ bases (choice e. is incorrect): An increase in partnership debt is treated as a contribution to the partnership and a decrease in partnership debt is treated as a distribution from the partnership to the partners. 73. Alicia and Barry form the AB Partnership at the start of the current year with a land contribution by Barry and a cash contribution by Alicia. Barry’s contributed property is subject to a recourse mortgage assumed by the partnership. Barry has an 80% interest in AB’s profits and losses. The land has been held by Barry for the past 6 years as an investment. It will be used by AB as an operating asset in its parking lot business. Which of the following statements is correct? a. Immediately after formation, Alicia’s basis in the partnership equals the cash contributed by Alicia. b. Immediately after formation, Alicia’s basis in the partnership equals the cash she contributed plus her share of the recourse debt contributed by Barry. c. Because the debt is recourse, the constructive liquidation scenario is not applicable for determining the allocation of debt to the partners. d. AB’s basis in the land contributed by Barry equals Barry’s basis in the land immediately before the contribution date, less the amount of the recourse debt assumed by the partnership. e. None of the above. ANSWER: b RATIONALE: Choice a. is incorrect because the debt on the land contributed by Barry will increase Alicia’s interest in AB. Choice c. is incorrect because the constructive liquidation scenario is the method used to allocate debt to the partners. Choice d. is incorrect because the basis of the land to AB equals its basis to Barry immediately before the contribution date. 74. Sharon contributed property to the newly formed QRST Partnership. The property had a $100,000 adjusted basis to Sharon and a $160,000 fair market value on the contribution date. The property was also encumbered by a $120,000 nonrecourse debt, which was transferred to the partnership on that date. Another partner, Rochelle, shares 30% of the partnership income, gain, loss, deduction, and credit. Under IRS regulations, Rochelle’s share of the nonrecourse debt for basis purposes is: a. $20,000. b. $30,000. c. $36,000. d. $100,000. e. $120,000. ANSWER: b RATIONALE: The § 704(c) portion of the debt must first be allocated to the contributing partner, Sharon. The § 704(c) portion of the nonrecourse debt that is allocated to Sharon under this rule is $20,000 ($120,000 – $100,000 basis). The rest of the nonrecourse debt is allocated in the manner that the partners share in the deductions that relate to the debt. Therefore, Rochelle shares in $30,000 ($100,000 × 30%) of the remaining nonrecourse debt. 75. During the current tax year, Jordan and Whitney each contributed $50,000 to form the J&W LLC. Each member has a 50% interest in LLC capital, profits, and losses (including deemed losses in the “constructive liquidation scenario”), except that depreciation expense is allocated 40% to Jordan and 60% to Whitney. During the first year, the LLC reported income (before depreciation expense) of $20,000 and had depreciation expense of $10,000. The LLC incurred recourse debt (that was personally guaranteed by both of the LLC members) of $60,000. Partnership assets are $170,000 at the end of the year. Under the constructive liquidation scenario, how is the recourse debt allocated to Jordan and Whitney? a. The recourse debt is shared equally ($30,000 each) by Jordan and Whitney. b. The recourse debt is allocated $36,000 to Whitney and $24,000 to Jordan. c. The recourse debt is allocated $31,000 to Whitney and $29,000 to Jordan. d. The recourse debt is allocated $29,000 to Whitney and $31,000 to Jordan. e. The recourse debt is allocated $24,000 to Whitney and $36,000 to Jordan. ANSWER: c RATIONALE: Current year items must first be allocated to Jordan and Whitney. The operating income is allocated equally, and the depreciation expense is allocated $4,000 to Jordan and $6,000 to Whitney. After these allocations, Whitney’s capital account is $54,000 ($50,000 + $10,000 income – $6,000 depreciation). Jordan’s capital account is $56,000 ($50,000 + $10,000 income – $4,000 depreciation). Under the constructive liquidation scenario, the LLC’s assets are treated as if they became worthless. Total assets would have been $170,000 ($110,000 net capital plus $60,000 of assets purchased with debt). The $170,000 deemed loss on the assets is allocated equally ($85,000 each) between the partners, resulting in negative capital accounts of ($29,000) for Jordan and ($31,000) for Whitney. These are the amounts of recourse debt that are allocated to Jordan and Whitney, respectively, under the constructive liquidation scenario. 76. Which of the following is not a specific adjustment to the partners’ basis in the partnership interest? a. Increased by contributions the partner made to the partnership. b. Decreased by the amount of guaranteed payments shown on the partner’s Schedule K1. c. Increased by the partner’s share of taxexempt income. d. Decreased by any decrease in the partner’s share of partnership liabilities. e. Increased by the partner’s share of separately stated income items. ANSWER: b RATIONALE: The partner’s basis in the partnership interest is not affected by guaranteed payments that partner receives. The guaranteed payments are already factored into the partnership’s income or loss amounts; therefore, the partner’s proportionate share of the guaranteed payments will affect the partner’s basis. However, the basis is not again affected when the partner reports the (entire) guaranteed payment as income. 77. Rebecca is a limited partner in the RST Partnership, which is not publicly traded. Her allocable share of RST’s passive ordinary losses from a nonrealty activity for the current year is ($60,000). Rebecca has a $40,000 adjusted basis (outside basis) for her interest in RST (before deduction of any of the passive losses). Her amount “at risk” under § 465 is $30,000 (before deduction of any of the passive losses). She also has $25,000 of passive income from other sources. How much of her ($60,000) allocable loss can Rebecca deduct on her current year’s tax return? a. $25,000 b. $30,000 c. $40,000 d. $60,000 e. None of the above ANSWER: a RATIONALE: The $60,000 passive loss must be limited first by Rebecca’s $40,000 outside basis for her partnership interest. The “at risk” rules further limit her deduction to $30,000, the amount she is “at risk” in RST. She can deduct $25,000 of this loss because that is the amount she has of passive income from other sources. 78. At the beginning of the tax year, Zach’s basis for his partnership interest and his amount at risk in the partnership was $30,000. His share of partnership items for the year consisted of tax-exempt interest income of $2,000 and an ordinary loss of $44,000. He also received a distribution from the partnership of $20,000 cash during the year. For the tax year, Zach will report: a. A nontaxable distribution of $20,000, an ordinary loss of $10,000, and a suspended loss carryforward of $34,000. b. An ordinary loss of $32,000, a suspended loss carryforward of $12,000, and a taxable distribution of $20,000. c. A nontaxable distribution of $20,000, an ordinary loss of $12,000, and a suspended loss carryforward of $32,000. d. An ordinary loss of $44,000 and a nontaxable distribution of $20,000. ANSWER: c RATIONALE: The $20,000 distribution and the $2,000 share of partnership taxexempt income combine to reduce Zach’s basis for his partnership interest to $12,000 ($30,000 + $2,000 – $20,000). Zach will then be allocated the $44,000 partnership loss; $12,000 of which is deductible and $32,000 of which is suspended. 79. Paul sells one parcel of land (basis of $100,000) for its fair market value of $160,000 to a partnership in which he owns a 60% capital interest. Paul held the land for investment purposes. The partnership is in the real estate development business, and will build residential housing (for sale to customers) on the land. Paul will recognize: a. $0 gain or loss. b. $36,000 ordinary income. c. $36,000 capital gain. d. $60,000 ordinary income. e. $60,000 capital gain. ANSWER: d RATIONALE: If a partner owns more than a 50% interest in a partnership, any property sold to the partnership at a gain results in ordinary income to the selling partner, unless the property was a capital asset both to the partner and the partnership. In this case, the land was a capital asset to Paul, but it was inventory to the partnership, so the gain is treated as ordinary income. The gain on the sale is $60,000 ($160,000 – $100,000); as this is a sale of Paul’s asset, the entire gain is taxed to him. 80. Samuel is the managing general partner of STU, in which he owns a 25% interest. For the year, STU reported ordinary income of $400,000 (after deducting all guaranteed payments). In addition, the LLC reported interest income of $12,000. Samuel received a guaranteed payment of $120,000 for services he performed for STU. How much income from self-employment did Samuel earn from STU? a. $100,000 b. $120,000 c. $220,000 d. $223,000 e. None of the above ANSWER: c RATIONALE: Samuel’s income from self employment includes his distributive share of partnership income of $100,000 ($400,000 × 25%). In addition, his SE income includes the guaranteed payment he received for services ($120,000), for total SE income of $220,000. His share of the LLC’s interest income is not subject to SE tax. 81. Which of the following is not a correct statement regarding the advantage of the partnership entity form over the subchapter C corporate form? a. A partnership typically has easier administrative and filing requirements than does a C corporation. b. Partnership income is subject to a single level of taxation; corporate income is double taxed. c. Partnerships may specially allocate income and expenses among the partners, provided the substantial economic effect requirements are met; corporate dividends must be proportionate to shareholdings. d. Partners in a general partnership have less personal liability for entity claims than shareholders of a C corporation. e. All of the above are advantages of partnership taxation. ANSWER: d RATIONALE: Partners in a general partnership have unlimited liability for partnership debts, whereas shareholders of a corporation have no personal liability (generally) for entity debt. Other types of partnerships (e.g., LPs, LLCs) are used in many situations because they offer less personal liability for the partners. 82. George and James are forming the GJ Partnership. George contributes $600,000 cash and James contributes nondepreciable property with an adjusted basis of $400,000 and a fair market value of $750,000. The property is subject to a $150,000 liability, which is also transferred into the partnership and is shared equally by the partners for basis purposes. George and James share in all partnership profits equally except for any precontribution gain, which must be allocated according to the statutory rules for built-in gain allocations. a. What is James’s adjusted tax basis for his partnership interest immediately after the partnership is formed? b. What is the partnership’s adjusted basis for the property contributed by James? c. If the partnership sells the property contributed by James for $800,000, how is the tax gain allocated between the partners? ANSWER: a. James’s adjusted basis in the partnership interest is $325,000. Computation: Basis of property contributed $400,000 Plus: James’s share of partnership liability 75,000 Less: James’s liability transferred to partnership (150,000) $325,000 b. Partnership’s basis (carryover basis) is $400,000. c. James is allocated $375,000 of the gain and George is allocated gain of $25,000. Computation: Sales price $800,000 Less: Adjusted basis (400,000) Total gain on sale $400,000 Built-in (precontribution) gain James $350,000 George $ –0– Remaining gain 25,000 25,000 Gain allocated to partner $375,000 $25,000 83. Palmer contributes property with a fair market value of $4,000,000 and an adjusted basis of $3,000,000 to AP Partnership. Palmer shares in $1,000,000 of partnership debt under the liability sharing rules, giving him an initial adjusted basis for his partnership interest of $4,000,000. One month after the contribution, Palmer receives a cash distribution from the partnership of $2,000,000. Palmer would not have contributed the property if the partnership had not contractually obligated itself to make the distribution. Assume Palmer’s share of partnership liabilities will not change as a result of this distribution. a. Under the IRS’s likely treatment of this transaction, what is the amount of gain or loss that Palmer will recognize because of the $2,000,000 cash distribution? b. What is the partnership’s basis for the property after the distribution? c. If Palmer is unhappy with this result, can you suggest a possible alternative that may provide him with a better answer? ANSWER: a. Palmer will likely recognize a $500,000 [($4,000,000 – $3,000,000) × 50% ] gain on the transaction. Palmer received a cash payment equal to one-half the value of the property he contributed. The IRS would likely treat this as a disguised sale of the property. A disguised sale is presumed to occur when a contractual agreement requires a contribution by a partner to be followed within two years by a specified distribution by the partnership, and the distribution is made without regard to partnership profits. Both these issues occur in this scenario. While Palmer could argue that the intent of this transaction is not to create a disguised sale, it is doubtful that he would be successful. b. The partnership’s total basis for the property is $3,500,000. Its basis for the purchased property is the $2,000,000 cost of the property (the partnership is deemed to have paid for the property). In addition, the partnership has a $1,500,000 carryover basis for the portion of the property that was not “purchased.” c. If Palmer can wait for more than two years to receive the distribution and if the distribution is not contractually guaranteed, the contribution and distribution transactions will be presumed not to be a disguised sale. The distribution will be treated as a normal distribution that will not create capital gain for Palmer unless the distribution amount exceeds the adjusted basis for his partnership interest when the distribution is made. 84. During the current year, MAC Partnership reported the following items of receipts and expenditures: $600,000 sales, $80,000 utilities and rent, $200,000 salaries to employees, $20,000 guaranteed payment to partner Antonio, investment interest income of $4,000, a charitable contribution of $8,000, and a distribution of $30,000 to partner Carl. Antonio is a 25% general partner. Based on this information, what items will be reflected on Antonio’s Schedule K-1? ANSWER: The partnership’s ordinary taxable income is: Sales $600,000 Utilities and rent (80,000) Salaries (200,000) Guaranteed payment to Antonio (20,000) Partnership ordinary income $300,000 The partnership also reports the following information: Separately stated interest income $ 4,000 Guaranteed payment to partner $20,000 Separately stated charitable contribution $ 8,000 The distribution to Carl is not deductible by the partnership. Antonio’s share of the partnership’s ordinary income is $75,000 ($300,000 × 25%). Antonio also reports his separately stated share of interest income ($1,000, or $4,000 × 25%) and charitable contributions ($2,000, or $8,000 × 25%). Antonio’s K1 will also show his guaranteed payment of $20,000, his net earnings from self- employment ($95,000 = $75,000 ordinary income + $20,000 guaranteed payment), and other information he might need in order to prepare his return (e.g., AMT or investment income information). 85. The LN partnership reported the following items of income and deduction during the current tax year: revenues, $300,000; cost of goods sold, $180,000; tax-exempt interest income, $2,000; salaries to employees, $80,000; and long-term capital gain, $10,000. In addition, the partnership distributed $20,000 of cash to 50% partner Nina and $10,000 of cash to 50% partner Len. What is Nina’s share of ordinary partnership income and separately stated items? ANSWER: The partnership’s ordinary taxable income is: Revenues $300,000 Cost of goods sold (180,000) Salaries (80,000) Partnership ordinary income $ 40,000 Nina’s share ($40,000 × 50%) $ 20,000 Separately stated tax-exempt income (not reported) $ 1,000 Separately stated long-term capital gain (reported) $ 5,000 The distributions to the partners are not deductible. 86. Carli contributes land to the newly formed CD Partnership in exchange for a 30% interest. The land has an adjusted basis and fair market value of $300,000 and is subject to a liability of $100,000, which the partnership assumes. None of this liability is repaid at year-end. At the end of the year, the partnership has trade accounts payable of $20,000. Assume all liabilities are allocated proportionately to the partners. Total partnership income for the year is $400,000. What is Carli’s basis in her partnership interest at the end of the year? ANSWER: Carli’s basis in the partnership interest at the end of the year is determined as follows: Basis in land contributed to CD $300,000 Less: relief of liability assumed by partnership (100,000) Plus: share of liability related to land ($100,000 × 30%) 30,000 Plus: share of trade accounts payable ($20,000 × 30%) 6,000 Plus: share of partnership income 120,000 Ending basis in partnership interest $356,000 87. An examination of the RB Partnership’s tax books provides the following information for the current year: Operating (ordinary) income before guaranteed payments $300,000 Long-term capital gain 6,000 Guaranteed payment to Rachel for services 30,000 Cash distributions to each partner 20,000 Interest on Colorado state bonds (exempt interest income) 2,000 Charitable contributions made by partnership 10,000 Decrease in partnership liabilities from 1/1-12/31 (20,000) Rachel is a 30% general partner in partnership capital, profits, and losses. Assume the adjusted basis of her partnership interest is $60,000 at the beginning of the year, and she shares in 30% of the partnership’s liabilities for basis purposes. a. What is Rachel’s adjusted basis for the partnership interest at the end of the year? b. How much income must Rachel report on her tax return for the current year? What is the character of the income and what types of tax might apply to it? ANSWER: a. Rachel’s adjusted basis for her partnership interest is $114,400. Adjusted basis, beginning of year $ 60,000 Plus: Share of income after guaranteed payment $81,000 ($270,000 × 30%) Long-term capital gain 1,800 Share of interest on Colorado state bonds 600 83,400 Less: Decrease in share of partnership liabilities $ 6,000 Cash distributions 20,000 Share of partnership charitable contributions 3,000 (29,000) Adjusted basis, 12/31 $114,400 b. Rachel will report $81,000 of income from the partnership plus a long-term capital gain of $1,800. She may be able to deduct $3,000 of charitable contributions as an itemized deduction. In addition, Rachel must report the $30,000 guaranteed payment as income. The bond interest income is nontaxable and the related interest expense is nondeductible. Her guaranteed payment ($30,000) and her distributive share ($81,000) will both be subject to SE tax because she is a general partner. 88. Katherine invested $80,000 this year to purchase a 30% interest in the KLM Partnership. The partnership reported $200,000 of net income from operations, a $2,000 short-term capital loss, and a $10,000 charitable contribution. In addition, the partnership distributed $20,000 to Katherine and $10,000 each to partners Lauren and Missy. Assuming the partnership has no beginning or ending liabilities, what is Katherine’s basis in her partnership interest at the end of the year? ANSWER: $116,400. Katherine’s initial basis of $80,000 is increased by her 30% share of partnership income from operations ($60,000). Her basis is decreased by her 30% share of the partnership’s charitable contribution ($3,000) and the short-term capital loss ($600). It is also decreased by the $20,000 distribution she received. The distributions to Lauren and Missy do not affect Katherine’s basis. Katherine’s ending basis, then, is $116,400 ($80,000 + $60,000 – $600 – $3,000 – $20,000). 89. Sarah contributed fully depreciated ($0 basis) property valued at $50,000 to the RSTU Partnership in exchange for a 25% interest in partnership capital and profits. During the first year of partnership operations, RSTU had net taxable income of $200,000 and tax-exempt income of $4,000. The partnership distributed $10,000 cash to Sarah. Her share of partnership recourse liabilities on the last day of the partnership year was $20,000. What is Sarah’s adjusted basis (outside basis) for her partnership interest at the end of the tax year? ANSWER: $61,000. Sarah is a 25% partner and will share in 25% of the partnership’s taxable income and taxexempt income. In addition, her basis will include her allocable share of the partnership’s recourse liabilities. Her basis will be reduced by the cash distribution during the year. Sarah’s ending basis is calculated as follows: Beginning basis $ –0– Plus: Share of partnership ordinary income (25% × $200,000) 50,000 Plus: Share of tax-exempt income (25% × $4,000) 1,000 Plus: Share of partnership liabilities 20,000 Basis before losses and distributions $71,000 Less: Distribution (10,000) Ending basis $61,000 90. In the current year, the DOE LLC received revenues of $200,000 and paid the following amounts: $50,000 in rent and utilities, a $40,000 guaranteed payment to 50% member Dave, $10,000 to member Ethan for consulting services, and $10,000 as a distribution to member Olivia. In addition, the LLC earned $2,000 of tax-exempt interest income during the year. Dave is the managing member of the LLC. Dave’s basis in his LLC interest was $50,000 at the beginning of the year, and includes a $12,000 share of LLC liabilities. At the end of the year, his share of the LLC’s liabilities was $20,000. a. How much income must Dave report for the tax year and what is the character of the income? b. What is Dave’s basis in his LLC interest at the end of the tax year? c. On what income will Dave’s selfemployment tax be calculated? ANSWER: a. The LLC’s ordinary income is calculated as follows: Revenues $200,000 Less: rent and utilities (50,000) Less: guaranteed payment to Dave (40,000) Less: consulting expenses to Ethan (10,000) Ordinary income $100,000 The distribution to Olivia is not deductible. The payment to Ethan is a deductible business expense. Dave’s share of DOE’s ordinary income is $50,000. The $2,000 of tax-exempt interest income is a separately stated item, of which Dave’s share is $1,000. (It is not taxable to Dave but will increase his basis.) In addition, Dave must report the $40,000 guaranteed payment as income. b. Dave’s basis in his LLC interest is calculated as follows: Beginning basis $ 50,000 Plus: increase in share of the LLC’s liabilities 8,000 Plus: share of ordinary income 50,000 Plus: share of tax- exempt interest income 1,000 Ending basis $109,000 Dave’s guaranteed payment does not affect his basis. c. Dave’s distributive share of $50,000 and his $40,000 guaranteed payment are subject to SE tax. 91. Sharon and Sue are equal partners in the S&S Partnership. On January 1 of the current year, each partner’s adjusted basis in S&S was $80,000 (including each partner’s $20,000 share of the partnership’s $40,000 of liabilities). During the current year, S&S repaid $30,000 of the debt and borrowed $20,000 for which Sharon and Sue are equally liable. In the current year ended December 31, S&S also sustained a net operating loss of $40,000 and earned $10,000 of interest income from investments. If liabilities are shared equally by the partners, on January 1 of the next year how much is each partner’s basis in her interest in S&S? ANSWER: $60,000. Each partner’s initial basis in the partnership is $80,000. The basis is reduced by the $15,000 of repaid debt and increased by each partner’s $10,000 share of new liabilities. Each partner’s basis is then reduced by the $20,000 share of the net operating loss and increased by the $5,000 share of interest income, as follows: Beginning basis $80,000 Plus: share of interest income 5,000 Less: decrease in share of partnership debt (5,000) Less: share of S&S loss (20,000) Ending basis $60,000 92. In the current year, the CAR Partnership received revenues of $400,000 and paid the following amounts: $160,000 in rent, utilities, and salaries; a $40,000 guaranteed payment to partner Ryan; $20,000 to partner Amy for consulting services; and a $40,000 distribution to 25% partner Cameron. In addition, the partnership realized a $12,000 net longterm capital gain. Cameron’s basis in his partnership interest was $60,000 at the beginning of the year, and included his $25,000 share of partnership liabilities. At the end of the year, his share of partnership liabilities was $15,000. a. How much income must Cameron report for the tax year? b. What is Cameron’s basis in the partnership interest at the end of the year? ANSWER: a. $45,000 ordinary income and $3,000 LTCG. The partnership’s ordinary income is calculated as follows: Revenues $400,000 Less: rent, utilities, and salaries (160,000) Less: guaranteed payment to Ryan (40,000) Less: consulting expenses to Amy (20,000) Ordinary income $180,000 The distribution to Cameron is not deductible. The payment to Amy is a deductible business expense. Cameron’s share of CAR’s ordinary income is $45,000. The $12,000 net long-term capital gain is a separately stated item, of which Cameron’s share is $3,000. b. Cameron’s basis in his partnership interest is calculated as follows: Beginning basis $60,000 Plus: share of ordinary income 45,000 Plus: share of net long-term capital gain 3,000 Less: decrease in share of partnership liabilities (10,000) Less: cash distribution to Cameron (40,000) Ending basis $58,000 93. In the current year, Derek formed an equal partnership with Cody. Derek contributed land with an adjusted basis of $110,000 and a fair market value of $200,000. Derek also contributed $50,000 cash to the partnership. Cody contributed land with an adjusted basis of $80,000 and a fair market value of $230,000. The land contributed by Derek was encumbered by a $60,000 nonrecourse debt. The land contributed by Cody was encumbered by $40,000 of nonrecourse debt. Assume the partners share debt equally. Immediately after the formation, what is the basis of Cody’s partnership interest? ANSWER: $90,000. Cody’s basis is determined as follows: Basis of land $80,000 Deemed cash distribution (relief of Cody’s debt) (40,000) Share of Cody’s debt 20,000 Share of Derek’s debt 30,000 Cody’s basis $90,000 94. Morgan is a 50% managing member in the calendar year, cash basis MKK LLC. The LLC received $150,000 income from services and paid the following other amounts: Rent expense $10,000 Salary expense to employees 40,000 Payment to Morgan for services, per the operating agreement 30,000 Distributions to partners, Kristin and Katie 12,000 Payment to 30% cash basis partner Katie for tax and accounting 10,000 services How much will Morgan’s adjusted gross income increase as a result of the above items? What amount will be included in Morgan’s selfemployment tax calculation? ANSWER: $60,000 income and amount included in SE tax calculation. The $30,000 payment to Morgan is a guaranteed payment and is deductible by the partnership. The $10,000 payment to Katie is deductible under § 707(a), because it was paid during the year. The distributions to Kristen and Katie are not deductible by the partnership. The partnership’s ordinary income, then, is $60,000. Income from services $150,000 Less: Rent expense $10,000 Salaries to employees 40,000 Guaranteed payment to Morgan 30,000 Payment to Katie for services 10,000 (90,000) Partnership income $ 60,000 Of this $60,000 partnership income, 50%, or $30,000, is allocated to Morgan. She must also include the $30,000 guaranteed payment in her gross income this year, as she and the partnership use the same reporting period. This $60,000 is included in Morgan’s SE tax calculation. 95. The MOP Partnership is involved in construction activities. Patricia has an adjusted basis for her partnership interest on January 1 of the current year of $600,000, consisting of the following: Capital account $350,000 Share of partnership recourse debt 50,000 Share of partnership nonrecourse debt 200,000 $600,000 During the year, the partnership has an operating loss of $1.2 million and distributes $60,000 of cash to Patricia. Partnership liabilities were the same at the end of the tax year, and the nonrecourse debt is not “qualified nonrecourse debt.” If she owns a 60% share of partnership profits, capital, and losses, and is a material participant in the partnership, how much of her share of the operating loss can Patricia deduct? What Code provisions could cause a suspension of the loss? How would your answer change if MOP were an LLC and Patricia had not personally guaranteed any of the debt? ANSWER: Patricia can only deduct $340,000 of her $720,000 share of the partnership’s operating loss on her tax return. Patricia’s adjusted basis for her partnership interest immediately before the deduction of any portion of the loss is $540,000 ($600,000 – $60,000 distribution). The amount of the loss that can be deducted is first limited by the $540,000 adjusted basis. Then, the remaining loss is limited by the “at risk” amount of $340,000 ($600,000 – $60,000 distribution – $200,000 nonrecourse debt). (Patricia is not “at risk” for her $200,000 share of the nonrecourse debt.) The passive loss rules do not apply, since Patricia is a material participant in the partnership. Therefore, she can deduct a $340,000 loss on her return. Deductible Suspended Adjusted basis [§ 704(d)] $540,000 $180,000 At risk amount (§ 465) Passive loss rules (§ 469) 340,000 Not applicable 200,000 If MOP were an LLC, the nominally recourse debt of $50,000 would not be included in Patricia’s amount at risk because she did not personally guarantee the debt. Her deductible loss would be limited to $290,000 ($340,000 – $50,000). 96. Cassandra is a 10% limited partner in C&C, Ltd. Her basis in the interest is $60,000 before loss allocations, including her $30,000 share of the partnership’s nonrecourse debt. (This debt is not qualified nonrecourse financing.) Cassandra is also a 10% limited partner in MNOP, in which her basis is $30,000. Cassandra is allocated an $80,000 loss from C&C, and $20,000 of income from MNOP. How much of the loss from C&C may Cassandra deduct? Under what Code provisions are the remaining losses suspended? ANSWER: Cassandra’s $80,000 loss from C&C is first limited by the basis rules of § 704(d); $20,000 of the loss ($80,000 loss – $60,000 basis) is limited under this rule. The remaining $60,000 loss is tested under the atrisk rules. Cassandra’s amount at risk is $30,000 (her basis less the nonrecourse debt); $30,000 of the loss ($60,000 – $30,000) is suspended under the atrisk rules. As a limited partner, the remaining $30,000 loss is treated as a passive loss. That loss can be deducted to the extent of Cassandra’s passive income from MNOP, or $20,000. The remaining $10,000 of loss is suspended under the passive loss rules. Deductible Suspended Adjusted basis [§ 704(d)] $60,000 $20,000 At risk amount (§ 465) 30,000 30,000 Passive loss rules 20,000 10,000 97. Jeordie and Kendis created the JK Partnership by contributing $100,000 each. The $200,000 cash was used by the partnership to acquire a depreciable asset. The partnership agreement provides that the partners’ capital accounts will be maintained in accordance with Reg. § 1.7041(b) (the “economic effect” Regulations) and that any partner with a deficit capital account will be required to restore that capital account when the partner’s interest is liquidated. The partnership agreement provides that MACRS will be allocated 20% to Jeordie and 80% to Kendis. All other items of partnership income, gain, loss, deduction, and credit will be allocated equally between the partners. In the first year, MACRS is $40,000 and no other operating transactions occur. The property is sold at the end of the year for $160,000 and the partnership is liquidated immediately thereafter. To satisfy the economic effect test, how much of the $160,000 cash (from the sale) is allocated each to Jeordie and Kendis? ANSWER: Distributions upon liquidation must follow the capital accounts for each partner. After MACRS allocations, Jeordie will have a capital account balance of $92,000 ($100,000 – $8,000) and Kendis’s capital account balance will be $68,000 ($100,000 – $32,000). If the asset is sold for its $160,000 carrying value on the partnership books, no gain or loss will be recognized on the sale and, therefore, no further adjustment needs to be made to the partner’s capital accounts. Upon liquidation, the partners will receive the balances in their capital accounts. 98. Allison and Taylor form a partnership by each making contributions of $90,000 cash to partnership capital. The partnership purchases an asset for $600,000, using the cash and financing the rest with a $420,000 recourse note. The partners expect the partnership to have losses for the first three years of operations and profits thereafter. Allison is allocated 75% of partnership losses until the date when the total partnership profits exceed total partnership losses. After that date, the profits and losses are shared equally between the two partners. How will the recourse debt be shared between the partners for basis purposes immediately after the property is acquired? ANSWER: The recourse debt will be allocated $360,000 to Allison and $60,000 to Taylor. According to the constructive liquidation scenario, the $600,000 partnership asset is deemed worthless. The asset is deemed to be sold for the $0 value and the loss is allocated $450,000 to Allison and $150,000 to Taylor. This reduces Allison’s capital account to a deficit of ($360,000) and Taylor’s to a deficit of ($60,000). Each partner is then deemed to contribute cash to the partnership to eliminate this capital account deficit (Allison contributes $360,000; Taylor contributes $60,000). The partnership is deemed to use these cash contributions to pay the $420,000 partnership liability. Constructive liquidation scenario computations: Allison Taylor Original capital accounts $ 90,000 $ 90,000 Allocation of deemed loss (450,000) (150,000) Balance in capital accounts ($360,000) ($ 60,000) Deemed cash contributions (allocation of debt) 360,000 60,000 Ending capital $ –0– $ –0– 99. On the formation of a partnership, when might a “disguised sale” occur? How can this treatment be avoided? ANSWER: A disguised sale might occur when a partner contributes appreciated property to a partnership and soon thereafter receives a cash distribution from the partnership. Under §§ 721 and 731, the contribution and distribution transactions normally would not be taxable events if the partner has sufficient basis to cover the distribution. If the appearance of the transaction is that the contribution and distribution are related, the IRS may take the position that the partnership form was simply used to accommodate a transaction that was intended to be a sale. Disguised sale treatment can be avoided if the distribution is not abnormal (e.g., the other partners receive similar and proportionate distributions); the partnership is not obligated to make the distribution; at the contribution date, the partner’s rights to future distributions are clearly subject to entrepreneurial risk; or the distribution is more than two years after the contribution occurred. 100. Your client owns a parcel of land that has depreciated in value. He wants to know if there is a way he can contribute the property to his partnership, have the partnership sell the property, and convert the existing capital loss into an ordinary loss. He also wants to know if part of the loss would be allocated to his other partners. What is your reaction? ANSWER: In the short run, it would not be possible to convert the capital loss into an ordinary loss. If the client can wait more than five years for the partnership to sell the property, the character of the loss would be determined by reference to the partnership’s use of the land. The builtin (precontribution) loss would be allocated to the client and any loss arising after the contribution date would be allocated according to the provisions in the partnership agreement. Section 724 provides that when property is sold by a partnership at a loss within five years of the date the property is contributed, any built-in capital loss at the contribution date remains a capital loss, regardless of the partnership’s use of the property. For example, even if the land was considered inventory by the partnership rather than a capital asset, sale of that land within five years would result in a capital loss to the extent of the built-in loss at the contribution date. When a partner contributes property to a partnership, any built-in gain or loss must be tracked and allocated to the contributing partner under § 704(c). Therefore, the builtin loss would be allocated to the client when the property is eventually sold. 101. What are “syndication costs” and how are they treated for tax purposes? ANSWER: Syndication costs are costs incurred in bringing an investment partnership to market. These costs include brokerage commissions and fees; registration fees; legal and accounting fees for developing the offering document; and printing and distribution costs for the prospectus, placement memoranda, and related documents. Under § 709, syndication costs cannot be deducted and no amortization is permitted. Upon termination of the partnership, the partners’ basis will theoretically still include those costs, so the partner might have a lower gain or a greater loss at that time. (See Chapter 11 for treatment of liquidating distributions and limitations on when a loss can be recognized.) 102. Harry and Sally are considering forming a partnership. Both taxpayers use the calendar year and are cash basis taxpayers. The partnership will not be a tax shelter. The partners are uncertain as to whether the partnership should use the cash or accrual method of accounting. Also, the idea of a tax deferral in the first year of operations has led them to consider using a June 30 fiscal year-end for the partnership. As their tax adviser, identify the issues that must be considered in selecting an accounting method and tax year for the partnership. ANSWER: Because neither partner is a Subchapter C corporation and the partnership is not a tax shelter, the partnership may select any accounting method: cash, accrual, or a hybrid of the two methods. If the partnership uses the accrual method of accounting in determining its income, the partners will be taxed on partnership revenues from all “closed” transactions. In this regard, it does not matter whether cash has been received by the partnership and whether or not the partners use the accrual method on their individual tax returns. Thus, if the partnership adopts the accrual method for tax purposes, the partners may be faced with reporting and paying taxes on partnership income long before cash is available for distribution. Regarding the July 1 to June 30 fiscal year, the desired tax deferral has little chance of success. Under § 706(b), the partnership must use the calendar year unless Harry and Sally can convince the IRS that a business purposes exists for a tax year other than the calendar year. Nothing in the fact pattern indicates a valid business purpose exists for a fiscal year. The partnership may also elect to use a tax year other than the required tax year if the deferral period is three months or less (e.g., September, October or November year-end), and if the partnership agrees to deposit tax on the deferred income at a specified tax rate. This election cannot be used in this situation to obtain a July 1 to June 30 fiscal year. 103. The MOG Partnership reports ordinary income of $60,000, long-term capital gain of $12,000, and tax-exempt income of $12,000. The partnership agreement provides that Molly will receive all long-term capital gains and George will receive all tax-exempt interest income. Their allocation of ordinary income will be reduced accordingly, and Olivia will be allocated a proportionately greater share of ordinary income. (In other words, each partner will receive allocations totaling 1/3 of the total $84,000 of partnership income.) This allocation was agreed upon because Molly and George are in a high marginal tax bracket and Olivia is in a low marginal tax bracket. a. Describe the elements that must be included in a partnership agreement in order for an allocation to have “economic effect.” b. Discuss whether or not the MOG allocation would be permitted and provide your reasoning. ANSWER: a. For partnership allocations to meet the “economic effect” tests under the § 704(b) Regulations, a partnership agreement should provide that (1) capital accounts will be maintained, (2) liquidating proceeds will be distributed according to capital account balances, and (3) any partner with a deficit capital account balance will contribute cash to the partnership to eliminate the deficit. b. The MOG allocation will not be permitted. Though the partnership agreement may meet the “economic effect” tests under § 704, the allocation does not produce pretax economic consequences to Molly and George (i.e., the allocation does not meet the “substantial” requirement). Therefore, the allocations are not effective for tax purposes as they have no function other than the reduction of the partners’ combined tax liability. 104. On a corporate Form 1120, Schedule M-1 (or M-3) is used to reconcile book and tax income, and Schedule M-2 reconciles retained earnings to the amounts shown on Schedule L. How are these reconciliations accomplished on a partnership return? What additional information must be provided? ANSWER: A partnership is not a taxpaying entity and does not report taxable income, per se. On Form 1065, the Analysis of Income (Loss) schedule (page 5) accumulates the partnership’s equivalent of taxable income based on the various income and deductions reported on the partnership’s Schedule K (page 4). This taxable income equivalent is reconciled to book income on Schedules M-1 and M-3. On Schedule L, the partnership reports partners’ capital using a “book” method, such as GAAP, “§ 704(b) book,” or the tax basis, depending on the method the partnership uses for any financial reporting. On Schedule M2, the partnership reports partners’ capital using the same method it uses to prepare the partners’ capital accounts on the partners’ Schedules K1. If these methods differ, the partnership should provide a schedule reconciling the two methods of reporting partners’ capital. 105. If a partnership earns tax-exempt income, the income should not affect the partners’ bases in their partnership interests. Do you agree with this statement? Explain. ANSWER: Partnership income is intended to be subject to a single level of taxation. This is accomplished by: 1) flowing the partnership’s income, gains, losses, and deductions through to be taxed by the partners, and 2) adjusting the partners’ bases in their partnership interests upward and downward to account for those allocations. A partner’s basis is adjusted for nontaxable income and nondeductible expenses as well as taxable amounts. If the partners’ basis was not so adjusted, double taxation would arise. For example, if a partner’s share of taxexempt interest income was $5,000, the value of the partnership interest would theoretically increase by $5,000. Because the partners’ basis in the partnership interest is increased by $5,000, the partner can sell the interest without recognizing gain to the extent of that exempt income. If the basis were not so increased, the exempt income would be taxed upon sale of the partnership interest. 106. What is the difference between a partner’s basis in the partnership interest and a partner’s § 704(b) book capital account? What are the purposes of these two amounts? Why are these amounts typically different? ANSWER: The partner’s capital account balance is an accounting measure of the partner’s ownership interest in the entity. Capital accounts are referenced in determining the partnership’s allocations of income, gains, losses, deductions, and credits among the partners under § 704(b). In addition, liquidating distributions must be in accordance with ending capital account balances under the substantial economic effect rules. The capital account is reported on the partners’ Schedules K1 and may be determined under GAAP, the § 704(b) book method, or tax accounting rules. A partner’s basis is the tax measure by which the partner’s taxable gain or loss is determined upon sale of the interest or receipt of cash distributions from the partnership. Basis is also used as the measure for determining whether the partner’s share of partnership losses can be deducted. The partner’s initial basis (cost, gift, or inherited basis) is increased by the partner’s contributions to and decreased by distributions from the partnership (including changes in the partner’s share of partnership liabilities). In addition, basis is increased by the partner’s share of income and gains, and decreased by the partner’s share of deductions and losses. Capital accounts are similarly adjusted, except the adjustments might be based on fair market value determinations, and the partner’s share of partnership liabilities is not included. These two amounts could only be the same if the partner shares in none of the partnership’s liabilities. The partner’s basis includes the partner’s share of partnership liabilities. Partnership debts are not included in capital accounts. Other situations that could cause differences between the two amounts include sale of an interest, or death of a partner and transfer of the interest to a successor. Match each of the following statements with the terms below that provide the best definition. a. Organizational choice of many large accounting firms. b. Partner’s percentage allocation of current operating income. c. Might affect any two partners’ tax liabilities in different ways. d. Brokerage and registration fees incurred for promoting and marketing partnership interests. e. Transfer of asset to partnership followed by immediate distribution of cash to partner. f. Must have at least one general and one limited partner. g. All partners are jointly and severally liable for entity debts. h. Theory treating the partner and partnership as separate economic units. i. Partner’s basis in partnership interest after taxfree contribution of asset to partnership. j. Partnership’s basis in asset after taxfree contribution of asset to partnership. k. Owners are “members.” l. Theory treating the partnership as a collection of taxpayers joined in an agency relationship. m. Allows many unincorporated entities to select their Federal tax status. n. No correct match provided. 107. Limited partnership ANSWER: f 108. Check the box regulations ANSWER: m 109. Profits interest ANSWER: b 110. Limited liability partnership ANSWER: a 111. Aggregate concept ANSWER: l 112. Substituted ANSWER: i 113. Limited liability company ANSWER: k 114. Qualified nonrecourse debt ANSWER: n 115. Syndication costs ANSWER: d 116. Disguised sale ANSWER: e 117. Separately stated item ANSWER: c 118. Carryover ANSWER: j 119. Entity concept ANSWER: h 120. General partnership ANSWER: g Match each of the following statements with the terms below that provide the best definition. a. Adjusted basis of each partnership asset. b. Operating expenses incurred after entity is formed but before it begins doing business. c. Each partner’s basis in the partnership. d. Reconciles book income to “taxable income.” e. Tax accounting election made by partnership. f. Tax accounting calculation made by partner. g. Tax accounting election made by partner. h. Does not include liabilities. i. Designed to prevent excessive deferral of taxation of partnership income. j. Amount that may be received by partner for performance of services for the partnership. k. Computation that determines the way recourse debt is shared. l. Will eventually be allocated to partner making tax-free property contribution to partnership. m. Partner’s share of partnership items. n. Must generally be satisfied by any allocation to the partners. o. Justification for a tax year other than the required taxable year. p. No correct match is provided. 121. Organizational costs ANSWER: p 122. Required taxable year ANSWER: i 123. Foreign tax credit or deduction ANSWER: g 124. Schedule K-1 ANSWER: m 125. Inside basis ANSWER: a 126. Business purpose ANSWER: o 127. Startup costs ANSWER: b 128. Schedules M-1 or M-3 ANSWER: d 129. § 179 deduction ANSWER: e 130. Economic effect test ANSWER: n 131. Precontribution gain ANSWER: l 132. Partner’s capital account ANSWER: h 133. Domestic production activities deduction ANSWER: f 134. Outside basis ANSWER: c 135. Guaranteed payment ANSWER: j 136. Constructive liquidation scenario ANSWER: k