South western federal taxation 2019 corporations partnerships estates and trusts 42nd edition raabe

South-Western Federal Taxation 2019 Corporations Partnerships Estates and Trusts 42nd Edition Raabe Solutions Manual Visit to download the full and correct content document: https://testbankdeal.com/dow nload/south-western-federal-taxation-2019-corporations-partnerships-estates-and-tru sts-42nd-edition-raabe-solutions-manual/

SWFT 2019 Corporations, Partnerships, Estates and Trusts Chapter 10: Partnerships: Formation, Operation, and Basis End-of-Chapter Question, Exercise, and Problem Correlations Corporations, Corporations, Partnerships, Partnerships, Estates & Estates & Trusts 41e Trusts 42e (2018) (2019) Discussion Questions (DQ) DQ.10.01 DQ.10.01 DQ.10.02 DQ.10.02 DQ.10.03 DQ.10.03 DQ.10.04 DQ.10.04 DQ.10.05 DQ.10.05 DQ.10.06 DQ.10.06 DQ.10.07 DQ.10.07 DQ.10.08 DQ.10.08 DQ.10.09 DQ.10.09 DQ.10.10 DQ.10.10 DQ.10.11 DQ.10.11 DQ.10.12 DQ.10.12 DQ.10.13 DQ.10.13 DQ.10.14 DQ.10.14 DQ.10.15 Computational Exercises (EX) EX.10.15 EX.10.16 EX.10.16 EX.10.17 EX.10.17 EX.10.18 EX.10.18 EX.10.19 EX.10.19 EX.10.20 EX.10.20 EX.10.21 EX.10.21 EX.10.22 EX.10.22 EX.10.23 EX.10.23 EX.10.24 EX.10.24 EX.10.25 EX.10.25 EX.10.26 EX.10.26 EX.10.27 EX.10.27 EX.10.28

Corporations, Partnerships, Estates & Trusts 42e (2019) Learning Objectives

Exact Same

LO1 LO1 LO2, 4, 7, 8 LO3 LO3, 4 LO4 LO5 LO7, 8 LO7, 8 LO8 LO9, 10 LO11 LO12 LO13 LO10, 12, 14

x

LO2 LO3 LO3 LO3 LO4 LO7 LO7 LO8 LO9 LO10 LO10 LO12 LO13

x x x x x

Revised

Brand New

x x x x x x x x x x x x x x

x x x x x x x x

EOC 10-1

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South-Western Federal Taxation 2019 Edition Series End-of-Chapter Question, Exercise, and Problem Correlations: Corporations, Partnerships, Estates and Trusts

Corporations, Partnerships, Estates & Trusts 41e (2018) Problems (PR) PR.10.28 PR.10.29 PR.10.30 PR.10.31 PR.10.32 PR.10.33 PR.10.34 PR.10.35 PR.10.36 PR.10.37 PR.10.38 PR.10.39 PR.10.40 PR.10.41 PR.10.42 PR.10.43 PR.10.44 PR.10.45 PR.10.46 PR.10.47 PR.10.48 PR.10.49 PR.10.50 PR.10.51 PR.10.52 PR.10.53 PR.10.54 PR.10.55 PR.10.56 PR.10.57 PR.10.58 PR.10.59

Corporations, Partnerships, Estates & Trusts 42e (2019)

Corporations, Partnerships, Estates & Trusts 42e (2019) Learning Objectives

PR.10.29 PR.10.30 PR.10.31 PR.10.32 PR.10.33 PR.10.34 PR.10.35 PR.10.36 PR.10.37 PR.10.38 PR.10.39 PR.10.40 PR.10.41 PR.10.42 PR.10.43 PR.10.44 PR.10.45 PR.10.46 PR.10.47 PR.10.48 PR.10.49 PR.10.50 PR.10.51 PR.10.52 PR.10.53 PR.10.54 PR.10.55 PR.10.56 PR.10.57 PR.10.58 PR.10.59 PR.10.60 PR.10.61 PR.10.62

LO3 LO3, 14 LO3 LO3 LO3, 9 LO3, 9, 14 LO3, 14 LO3, 14 LO3 LO4 LO4 LO5 LO3, 4, 5 LO6 LO7 LO3, 7, 8 LO7, 8, 11 LO7, 9, 10 LO7, 8 LO11 LO8, 10, 11 LO7, 8, 9, 11 LO7, 8, 9 LO7, 8, 9, 12 LO3, 7, 9, 10 LO11 LO3, 7, 9, 10 LO7 LO7 LO3, 7, 9, 12 LO7, 9, 12 LO10 LO3, 9, 10 LO9, 10, 12, 14

Exact Same

EOC 10-2

Revised

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© 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

South-Western Federal Taxation 2019 Edition Series End-of-Chapter Question, Exercise, and Problem Correlations: Corporations, Partnerships, Estates and Trusts

Corporations, Corporations, Corporations, Partnerships, Partnerships, Partnerships, Estates & Estates & Estates & Trusts Trusts 41e Trusts 42e 42e (2019) (2018) (2019) Learning Objectives PR.10.60 PR.10.63 LO10, 12 PR.10.61 PR.10.64 LO13 Cumulative (Tax Return) Problems (CP) CP.10.01 CP.10.01 Research Problems (RP) RP.10.01 RP.10.01 RP.10.02 RP.10.02 RP.10.03 RP.10.03 RP.10.04 RP.10.04 RP.10.05 RP.10.05 RP.10.06 RP.10.06 Becker CPA Review Questions (BCPA) RCPA BCPA.10.01 RCPA BCPA.10.02 RCPA BCPA.10.03 RCPA BCPA.10.04 RCPA BCPA.10.05 RCPA BCPA.10.06 RCPA BCPA.10.07

Exact Same

EOC 10-3

Revised x

Brand New

x x x x x x x x x x x x x x x

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CHAPTER 10 PARTNERSHIPS: FORMATION, OPERATION, AND BASIS SOLUTIONS TO PROBLEM MATERIALS

DISCUSSION QUESTIONS 1.

(LO 1) A partnership agreement (or an operating agreement for an LLC) is an agreement among the partners regarding the rights and obligations of the partners, the allocation of partnership income and deductions, allocation and distribution of partnership cash flows, requirements for current and future capital contributions, conditions under which the partnership is terminated, and other matters.

2.

(LO 1) In a general partnership (GP), each owner is a general partner and may participate in managing the entity; however, these partners also have unlimited liability for the entity’s debts.

In a limited liability company (LLC), each member may also participate in management; however, absent a personal guarantee, the members have no liability for the entity’s debts. Because the owners of both a GP and an LLC may run the business, there are few situations in which a general partnership provides an equivalent benefit to an LLC. GPs are usually used only for arrangements such as corporate joint ventures where the corporate partners are established with limited assets, or where the general partner itself is an LLC. LLCs, on the other hand, should be the entity form of choice for an operating partnership.

3.

(LO 2, 4, 7, 8) A partnership is not a taxpaying entity; however, it must still file a tax return. The partnership reports its income and expenses on Form 1065. Partnership income consists of income from operations and separately stated income and expenses. The income and expenses from operating activities are reported on page 1 of Form 1065. A separately stated item is any item (income or expense) that could differently affect the tax liabilities of different partners. Separately stated items are reported in the partnership return on Schedule K. Under the “entity” theory, the partnership files a return and makes most elections regarding the treatment of partnership items. However, under the “aggregate” theory, the partnership does not generally calculate or pay any tax with the return.

The partnership allocates its interest expense to its various activities. For business interest expense, the partnership determines whether the 30% deduction limitation under § 163(j) applies, and then it allocates any excess business expense carryover to the partners. In years in which there is no deduction limitation, the partnership calculates and allocates its excess taxable income to the partners so they can deduct some or all of any carryover. Applying the deduction limitation at the partnership level is consistent with the entity theory, in that the partnership is better equipped to make the initial calculation. Treatment of the carryover at the partner level is consistent with the aggregate theory, in that this treatment ensures the partners in the partnership at the time the carryover arose are the partners who are able to claim the deduction.

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2019 Corporations Volume/Solutions Manual In contrast, the partner calculates the § 199A qualified business income deduction. The partnership calculates and reports the information the partners need to calculate any limitation on the deduction (e.g., W–2 wages and property basis), but the partner makes the actual calculation. This treatment is consistent with the aggregate theory, because each partner might have QBI from other sources that should be taken into account in determining the allowable deduction.

4.

(LO 3) As a general rule, both §§ 721 and 351 provide that no gain or loss is recognized when property is transferred on the formation of a partnership or corporation. However, § 351 applies only if those persons transferring property to a corporation are in control of the corporation immediately after the exchange, whereas § 721 does not include a control requirement. Section 721 defers gain or loss recognition whether the transfer is to form the partnership or on a later contribution to capital.

Under § 721, the contributor must receive an interest in the partnership, while under § 351, the transferor must receive stock in the corporation. Under both §§ 721 and 351, if the transfer of property involves the receipt of money or other consideration, the transaction may be deemed a sale or exchange rather than a tax-free transfer.

5.

(LO 3, 4) For property contributed by a partner to a partnership, the partnership “steps into the shoes” of the contributing partner and continues to use the depreciation schedule used by the partner.

For example, say that at the midpoint of year 4, a calendar year partner contributes nonresidential real property that was purchased in August of year 1. The current year’s cost recovery will be calculated using the 39-year MACRS table for the “eighth month,” fourth recovery year. One-half of the cost recovery would be allocated to the partner, and the remainder would be allocated to the partnership. The following year would be the fifth recovery year, and the cost recovery would be allocated completely to the partnership.

If newly capitalized costs arise on a contribution of assets to the partnership (e.g., transfer taxes or legal fees), the partnership treats these costs as newly acquired MACRS property and commences depreciation at the date the partnership places the property in service.

6.

(LO 4) Expenditures might include the following and would be treated as indicated.

Type of Expenditure

Treatment

Reference

Acquisition of property

Capitalized and depreciated; potential bonus depreciation or § 179 deduction

§ 167, § 168, § 179

Startup expenses

$5,000 expensed (subject to phaseout); remainder capitalized and amortized over 180 months

§ 195

Organization costs

$5,000 expensed (subject to phaseout); remainder capitalized and amortized over 180 months

§ 709

Syndication costs

Capitalized; no amortization permitted

§ 709

Section 197 intangible

Amortized over 15 years

§ 197

Other intangibles

Amortized over useful life if it is determinable; no amortization if life is not determinable

Reg. § 1.167–3

Ordinary and necessary postoperating business expense

Deductible currently

§ 162

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Partnerships: Formation, Operation, and Basis

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7.

(LO 5) A partnership can generally use the cash method if it is engaged in the business of farming, or if it does not have any partners that are C corporations (other than personal service corporations). In addition, if the partnership has a partner that is a C corporation, it can still use the cash method if the partnership has not had more than $25 million of average annual gross receipts in any threeyear period prior to the current tax year. If the partnership is classified as a tax shelter, it cannot use the cash method regardless of whether it is eligible under one of the other provisions.

8.

(LO 7, 8) A guaranteed payment is an amount paid to a partner for the performance of services or for the partnership’s use of the partner’s capital. These payments are conceptually similar to the salary or interest payments made by other entities. Guaranteed payments generally are deductible by the partnership and can result in a loss to the entity. (Note that guaranteed payments for services are not subject to tax withholding requirements.)

Guaranteed payments are deducted on Form 1065, page 1. These amounts are also shown on Schedule K as an item that must be allocated to the partners for them to report as ordinary income. On the partnership’s Analysis of Income (Loss) on page 5, guaranteed payments have effectively been deducted and restored. Therefore, in the partnership’s “book-tax reconciliation” on Schedules M–1 or M–3, the guaranteed payments are added to book income so the two measures of the partnership’s income can be equal.

The amount received by a partner as a guaranteed payment is shown on that partner’s Schedule K–1 and is reported by the partner as ordinary income. A guaranteed payment the partner receives for services rendered to the partnership (i.e., the equivalent of wages) is treated as self-employment income by the recipient partner and also might be subject to the additional Medicare tax; it is not eligible for the § 199A QBI deduction and it is not subject to the net investment income tax. A guaranteed payment the partner receives for contributing capital to the partnership (i.e., the equivalent of interest income) is eligible for the § 199A deduction, and is potentially subject to the net investment income tax, but generally it is not subject to self-employment tax.

9.

(LO 7, 8) The qualified business income (QBI) deduction under § 199A is designed to yield a lower effective tax rate on QBI to taxpayers in certain pass-through operating businesses (i.e., businesses other than professional service businesses). The deduction does not require a corresponding cash payment.

The partner calculates the QBI amount for each trade or business. This amount is 20% of qualified income (generally operating or rental income, plus guaranteed payments a partner receives for capital provided to the partnership) from qualified businesses (as described above). This amount is limited to the greater of (1) 50% of W–2 wages paid by the business, or (2) 25% of W–2 wages plus 2.5% of the unadjusted basis of the partnership’s depreciable property.

The partner’s deduction is the “combined QBI amount” which is the sum of the QBI amounts from each trade or business. The deduction is limited, in general, to 20% of the partner’s taxable income excluding capital gains.

A partnership must report information the partner needs to calculate the deduction limitation, including W–2 wages and the unadjusted (e.g., cost) basis of the partnership’s depreciable property.

10.

(LO 8) The three rules of the economic effect test are designed to ensure that a partner bears the economic burden of a loss or deduction allocation and receives the economic benefit of an income or gain allocation. By increasing the partner’s capital account by the gain or income allocated to the partner, the rule ensures that a positive capital account partner will receive an allocation of assets equal to the balance in the partner’s capital account when the partner’s interest is eventually liquidated. If the partner has a negative capital account, an allocation of gain or income to the partner reduces the amount of the negative capital account and, therefore, the

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2019 Corporations Volume/Solutions Manual amount of the deficit capital contribution that is required from the partner upon liquidation.

In short, a dollar of income or gain increases the partner’s capital account by a dollar and, everything being equal, the partner should receive a dollar more upon liquidation (or contribute a dollar less to restore a deficit in the capital account).

Allocations of losses and deductions affect the partner in the opposite manner as income or gain.

Therefore, the allocation of a dollar of loss or deduction reduces the partner’s capital account by a dollar and, everything being equal, reduces the amount the partner will receive upon liquidation (or increases by a dollar the partner’s deficit capital restoration requirement).

11.

(LO 9, 10) Under § 722, a partner’s initial basis is determined by reference to the amount of money and the basis of other property contributed to the partnership. This basis is increased by any gain recognized under § 721(b) and the partner’s share of any partnership liabilities. Basis is decreased by any partner liabilities assumed by the partnership.

Basis is also adjusted to reflect the effect of partnership operations: it is increased by the partner’s share of taxable and nontaxable income and is decreased by the partner’s share of separately stated deductions (including the partnership’s basis of property contributed to charity), foreign taxes, losses, and nondeductible/noncapitalizable expenses. Certain adjustments for depletion are also made.

Finally, a partner’s basis is increased by additional contributions to the partnership and by increases in the partner’s share of partnership debt. Basis is decreased by distributions from the partnership and decreases in the partner’s share of partnership debt.

A partner’s basis is adjusted any time it may be necessary to determine the basis for the partnership interest (e.g., when a distribution was made during the taxable year or at the end of a year in which a loss arises). A partner’s basis may never be reduced below zero (i.e., no negative basis). Ordering rules (Exhibit 10.2) detail the sequence of basis adjustments for purposes of determining whether loss allocations can be deducted.

Basis adjustments preserve the partnership’s single level of taxation: if basis is increased by partnership income, that income would not be taxed again when the partner sells the partnership interest at its fair market value.

12.

(LO 11) A partner’s capital account is a mechanical determination of the partner’s financial interest in the partnership, as determined using one of several possible accounting methods, including tax basis, GAAP, § 704(b) book basis, or some other method defined by the partnership.

The capital account reflects contributions and distributions of cash or other property to or from the partner. In addition, it accumulates the partner’s share of increases and decreases from operations, including amounts that are otherwise tax-exempt or nondeductible. Even if capital accounts are determined on a tax basis, a partner’s capital account usually will differ from the partner’s basis in the partnership interest because (among other reasons) the capital account does not include the partner’s share of partnership liabilities.

13.

(LO 12) Losses may be limited by the partner’s basis in the partnership [§ 704(d)], the at-risk limitations (§ 465), the passive activity loss limitations (§ 469), or the excess business loss limitation [§ 461(l)], in that order. The basis limitations prevent a partner from claiming a loss for amounts in excess of the investment in the partnership (including obligations for partnership liabilities). The atrisk limitations further limit the losses to the amounts the partner could actually (theoretically) lose if the partnership were to liquidate in bankruptcy. (The major exception to this premise is the inclusion of “qualified nonrecourse financing” in the amount at risk.) The passive activity loss rules limit deduction of losses in a passive activity. Passive losses from an activity are only deductible

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Partnerships: Formation, Operation, and Basis

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to the extent of passive activity income from the taxpayer’s other activities. The excess business loss rule applies to any losses allowed to a noncorporate taxpayer under the first three sets of rules. Any business loss that exceeds $250,000 (or $500,000 for married taxpayers filing jointly) is carried forward as part of the taxpayer’s net operating loss.

The loss limitation rules exist to provide some assurance that a partner cannot claim a loss or deduction for which the partner bears no economic risk of loss.

14.

(LO 13) An individual partner who is a general partner must pay self-employment tax on his or her distributive share of partnership income. Any partner (general or limited) must also pay selfemployment tax on any guaranteed payments for services. Proposed Regulations outline situations in which a partner will be treated as a general partner.

The net investment income tax could apply to investment-related income from the entity (e.g., interest, dividends, gains) or to guaranteed payments for use of an individual partner’s capital.

15.

(LO 10, 12, 14) A sample e-mail follows: To: Liang Industries From: Shelly Nunez Date: February 1, 2019 Subject: Advantages and disadvantages of a partnership compared to a C corporation You have asked when a partnership might be more or less advantageous than a C corporation.

Partnership advantages. A partnership might be more advantageous than a C corporation under any of the following conditions.

•

The entity plans to distribute its excess cash flow to the owners on a regular basis. In such a case, if the entity operates as a C corporation, its taxable income could be subject to a total tax of 39.8% of its income. [Say the C corporation has $100 of taxable income and cash flow. It pays $21 of tax and distributes the remaining $79 to shareholders. Assuming this is a qualified dividend, individual shareholders in the highest bracket would pay tax of 23.8% (including the 3.8% net investment income tax) on the $79 distribution, or $18.80. The shareholder receives a net of $60.20 ($79 – $18.80), and the combined tax burden is $39.80 ($21 + $18.80, or $100 – $60.20), or 39.8%.] If the entity operates as a partnership, the highest individual tax rate would be 37%, with lower rates on qualified business income, capital gains, or qualified dividends passed through from the entity. (The net investment income tax might apply to some income, but would not apply to operating income.) The partnership advantage is even more pronounced if the owners are in lower tax brackets. Note: If cash flow is substantially different from taxable income, or if cash-flow distributions are delayed, more detailed analysis or time value of money calculations should be made.

•

The entity owners are individuals and the income will be eligible for the qualified business income deduction under § 199A.

•

The entity owners want to be able to make special allocations of income, expenses, cash flows, etc.

•

The entity has taxable losses the owners can utilize on their individual tax returns.

•

The entity owners are limited owners who would not be subject to self-employment tax on their distributive shares of income, or they have wages from other sources and SE tax would be minimized. The partnership generates net passive activity income that offsets passive activity losses of the owners.

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2019 Corporations Volume/Solutions Manual •

The entity will exist for only a short period of time, and if a corporation, its liquidation would result in a large tax due to the appreciation in its assets.

Partnership disadvantages. A partnership might be less advantageous than a Subchapter C corporation when: •

The entity currently operates as a C corporation and has substantial built-in gains on its assets. In such a case, the cost of converting to a partnership (i.e., the cost of liquidating the C corporation and re-forming as a partnership) could be prohibitive.

•

The entity will retain its income for expansion and the income will be taxed at lower corporate rates than if it flowed through to owners in higher tax brackets.

•

The entity can reduce or eliminate its income by paying salaries to the owners (although the cost of employment taxes should be considered), leasing property from the owners (rent expense would be deducted), or loaning funds to the entity (assuming the business interest expense limitation would not be triggered).

•

The entity is in a high-risk business, and the owners require protection from personal liability for claims against the entity or the other partners. An LLC or LLP may be useful in such situations.

Several other advantages and disadvantages may exist. If you have further questions or if you have a specific scenario in mind, please let me know.

COMPUTATIONAL EXERCISES 16.

(LO 2) Enercio is allocated 40% of the $80,000 of partnership income, or $32,000. This is the income on which tax will be paid. In this situation, the distribution is not separately taxed.

17.

(LO 3) a.

Henrietta has a realized gain of $15,000 [$100,000 value of interest − $85,000 basis in contributed property ($75,000 cash + $10,000 equipment basis)]. None of this gain is recognized.

18.

b.

Henrietta takes a substituted basis of $85,000 in the partnership interest.

c.

The partnership takes a carryover basis of $10,000 in the equipment.

(LO 3) a.

Wozniacki recognizes ordinary compensation income equal to the $50,000 value of the interest. b.

19.

The $50,000 becomes the amount of his basis in the partnership interest. The LLC will deduct this amount if it relates to ordinary and necessary tax planning services or the LLC will capitalize/expense/amortize it (most likely) if it would be classified as an organizational or startup expenditure.

(LO 3) FM recognizes $90,000 of ordinary income upon collection of the cash basis accounts receivable and $35,000 of ordinary income upon sale of the inventory. This rule exists to ensure that a partner and partnership cannot transfer property between themselves and alter the inherent character of the underlying deferred income, gain, loss, or deduction.

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Partnerships: Formation, Operation, and Basis 20.

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(LO 4) Candlewood may deduct $5,100 of organizational costs and $1,700 of startup expenditures.

The first $5,000 of the $9,500 organizational costs is deducted and the remaining $4,500 is amortized over 180 months, with 4 months of amortization in the current year ($4,500 × 4/180 = $100), for a total of $5,100 ($5,000 current expense + $100 amortization).

The first $500 of the $54,500 startup costs is deducted [$5,000 maximum – ($54,500 – $50,000) excess over $50,000]. The remaining $54,000 ($54,500 – $500) is amortized over 180 months, with 4 months of amortization in the current year ($54,000 × 4/180 = $1,200), for a total of $1,700 ($500 current expense + $1,200 amortization).

21.

22.

(LO 7) On its Schedule K, Penguin would report some or all of the following.

•

Ordinary business income (line 1).

•

Guaranteed payments to the LLC members (line 4).

•

If the business interest expense limitation applies, the partnership will report any excess interest expense so the partners can carry it over to future years; otherwise, the partnership will report excess taxable income to the partners. (Floor plan financing interest expense is not discussed in this chapter but might allow the interest expense to be excluded from the business interest expense limitation.)

•

Various types of investment income, such as dividends and taxable and tax-exempt interest (lines 5, 6, and 18, Code A).

•

Possibly gains or losses (line 8 or 9) if there are any security sales or capital gains distributions during the year.

•

Net earnings (loss) from self-employment (line 14, Code A).

•

Possibly information related to foreign tax credit (line 16, Codes A to N).

•

Information related to alternative minimum tax (line 17a).

•

Investment income and expenses for purposes of the investment interest expense limitation (line 20, Codes A and B).

•

Information the LLC members need to calculate their qualified business income deduction under § 199A, including W–2 wages and the unadjusted basis of the partnership’s depreciable property.

•

If any items of net investment income are not otherwise apparent from the Schedule K–1, Penguin would also report those items so the LLC members can calculate their net investment income tax (line 20, Code Y).

(LO 7) a.

Tastee paid $72,000 of guaranteed payments for services ($6,000 × 12). These are the payments to Stella. b.

Tastee deducts the $72,000 to arrive at ordinary income of $20,000 ($92,000 − $72,000 guaranteed payments).

c.

Stella will report $90,000 of ordinary income, including her guaranteed payment ($72,000) and 90% of the partnership’s $20,000 ordinary income.

d.

Euclid will report only 10% of the partnership’s ordinary income, or $2,000 ($20,000 × 10%). The $10,000 payment to Euclid did not exceed his basis and is neither deductible by the partnership nor taxable to Euclid.

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10-8 23.

2019 Corporations Volume/Solutions Manual (LO 8) a.

Padgett records the land at its $200,000 value for § 704(b) book capital account purposes. b.

Padgett takes a carryover tax basis of $50,000.

c.

If the land is sold for $300,000, Nova reports a $200,000 gain and Oscar’s gain is $50,000.

The precontribution gain of $150,000 ($200,000 value at the contribution date − $50,000 basis) is allocated to Nova. The $100,000 postcontribution gain is allocated equally between the partners according to their 50/50% profit sharing ratios.

24.

(LO 9) Barnaby’s basis in the partnership was $62,000 at the end of the tax year. Barnaby’s initial $50,000 basis was increased by the $3,000 increase in his share of partnership debt ($8,000 ending − $5,000 beginning), his $20,000 share of partnership income, and his $1,000 share of the partnership’s tax-exempt income. His basis was reduced by the $12,000 cash distribution he received.

25.

(LO 10) Both Elisha’s and Ezra’s bases in the partnership interests are $299,100 at the end of the year.

Elisha’s initial basis of $200,000 (cash contribution) is increased by a $70,000 share of the liability on the contributed land, a $10,000 share of the construction debt, and a $4,100 share of the accounts payable debt. In addition, Elisha’s basis is increased by the $15,000 share of the partnership’s taxable income.

Ezra’s initial basis of $340,000 (building and land basis) is reduced by the $140,000 debt assumed by the partnership, and then increased by a $70,000 share of the liability on the contributed land, a $10,000 share of the construction debt, and a $4,100 share of the accounts payable debt. In addition, Ezra’s basis is also increased by the $15,000 share of the partnership’s taxable income. The bases are the same because the fair market value of Ezra’s contributed property was the same as its tax basis.

26.

(LO 10) Jokan has a $10,000 share of the debt and a $30,000 basis in the LLC interest following the contribution. Jokan’s $60,000 basis is first reduced by the $40,000 of debt assumed by the LLC. Then Jokan is allocated 25%, or $10,000 of the debt, resulting in a $30,000 basis in the LLC interest.

27.

(LO 12) Tobias may deduct $90,000 of losses from Solomon LLC. Tobias is limited to a $130,000 loss under the basis limitation [$20,000 is suspended under § 704(d)], but only a $105,000 loss under the at-risk limitation ($25,000 suspended under § 465). Because the loss from Solomon is passive (and not a real estate loss), Tobias’s loss is further limited to his $90,000 of passive activity income from other sources ($15,000 suspended under § 469). Because the loss is less than $250,000 (the threshold for a single taxpayer), it is not further limited by the excess business loss limitation.

28.

(LO 13) a.

Heather incurs no deductible loss. At the original sale date, Heather has a realized loss of $25,000 ($75,000 basis − $50,000 selling price), but because the sale is to a related partnership, none of the loss is deductible. b.

The partnership later has a $5,000 taxable gain. When the partnership sells the land to an unrelated party for $80,000, it reports a gain of $30,000 ($80,000 selling price − $50,000 cost basis). At that time, the partnership can offset the gain by the $25,000 loss that Heather was not permitted to deduct. This results in a net taxable gain to the partnership of $5,000 ($30,000 − $25,000).

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Partnerships: Formation, Operation, and Basis

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PROBLEMS 29.

30.

31.

(LO 3) a.

Under § 721, neither the partnership nor the partners recognizes any gain on formation of the entity. b.

Emma will take a cash basis of $100,000 in her partnership interest.

c.

Laine will take a substituted basis of $40,000 in her partnership interest ($40,000 basis in the property contributed to the entity).

d.

The partnership will take a carryover basis in the assets it receives ($100,000 basis in cash and $40,000 basis in property).

(LO 3, 14) a.

Shawna has a realized loss of $20,000. However, § 721 contains the general rule that no gain or loss is recognized to a partnership (LLC) or any of its partners (members) upon the contribution of money or other property in exchange for a capital interest. Because Shawna is subject to this rule, she does not recognize the loss. b.

$360,000. Section 722 provides that the basis of a partner’s (member’s) interest acquired by a contribution of property, including money, is the amount of such money plus the adjusted basis of such property to the contributing partner (member) at the time of the contribution.

c.

$380,000. The adjusted basis of the contributed property (§ 722).

d.

$380,000. Under § 723, the basis of property to the entity is the adjusted basis of such property to the contributing partner (member) at the time of the contribution, increased by any § 721(b) gain recognized by such member. Because no such gain (and no loss) was recognized

by Shawna on the contribution, the LLC takes a carryover basis in the property.

e.

A more efficient tax result may arise if Shawna sells the property to an unrelated party for $360,000, recognizes the $20,000 loss on the property, and contributes $360,000 cash to the LLC. The LLC could then use the $360,000 to acquire similar property, in which it would take a $360,000 basis. Transaction costs would need to be considered.

(LO 3) a.

Liz realizes a gain of $15,000 on contribution of the land. John realizes a gain of $150,000 on contribution of the equipment. The partnership realizes a gain equal to the value of the property it receives (it has a $0 basis in the partnership interests it issues). b.

Under § 721, neither the partnership nor either of the partners recognizes any gain on formation of the entity.

c.

Liz will take a substituted basis of $155,000 in her partnership interest ($80,000 cash plus $75,000 basis in land). John will take a substituted basis of $20,000 in his partnership interest ($20,000 basis in the equipment).

d.

The partnership will take a carryover basis in all the assets it receives ($80,000 basis in cash, $75,000 basis in land, and $20,000 basis in equipment).

© 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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32.

2019 Corporations Volume/Solutions Manual e.

The partners’ outside bases in their partnership interests total $175,000: Liz’s basis of $155,000 plus John’s basis of $20,000. This is the same as the partnership’s inside basis in assets of $175,000 ($80,000 cash plus $75,000 land plus $20,000 equipment).

f.

The partnership will “step into John’s shoes” in determining its depreciation expense. It will use the remaining depreciable life and the same depreciation rates John would have used.

(LO 3) Both partners are contributing assets valued at $140,000. One property has a built-in gain; the other has a built-in loss. Mike and Melissa recognize no gain or loss on contribution of their respective properties to the partnership. Mike takes a substituted basis of $176,000 in his partnership interest ($40,000 cash plus $136,000 basis in land). However, the partnership interest is only valued at $140,000. The partnership takes a $136,000 carryover basis in the contributed land.

Melissa takes a $115,000 basis in a partnership interest worth $140,000. Similarly, the partnership will have a $115,000 basis in assets valued at $140,000. The partnership will “step into Melissa’s shoes” in determining depreciation deductions. The assets contributed by Melissa have a built-in gain that must be tracked and allocated to Melissa if the property is ever sold at a gain.

The land contributed by Mike has a built-in loss that must be tracked and allocated to Mike if the property is ever sold at a loss [§ 704(c)].

33.

(LO 3, 9) a.

In Alternative 1, MM would recognize the $36,000 loss in year 6. Because the LLC will have held the property for more than five years, the LLC’s use of the property determines the character of the loss. The loss is treated as a § 1231 loss (currently deductible as an ordinary loss). Because this is a precontribution loss, the loss is allocated to Mike. Therefore, Mike would deduct a $36,000 § 1231 loss in year 6.

In Alternative 2, the $36,000 loss would be recognized immediately by Mike as a long-term capital loss. Because the deduction for an individual taxpayer’s long-term capital losses is limited, Mike would deduct $3,000 of the loss each year for the next 12 years. b.

In Alternative 1, Mike would have tax savings in year 6 of $12,600 ($36,000 loss deducted against ordinary income × 35% tax savings). This is a tax savings in a single year, six years down the road. Using the Present Value of $1 table, a six-year horizon, and a 3% annual discount rate, the present value of the tax savings is $10,553 (PV factor of 0.8375 × $12,600 tax savings).

In Alternative 2, Mike would have tax savings of $1,050 each year for 12 years ($3,000 capital loss deducted against ordinary income × 35% tax savings each year until the $36,000 loss is fully utilized). This is a 12-year annuity of $1,050. Using the Present Value of an Annuity table and a 3% annual discount rate, the present value of the tax savings is $10,452 (PV factor of 9.9540 × $1,050 per year).

As Mike’s tax adviser, considering only the tax savings, Alternative 1 is preferred because the present value of the tax savings is slightly higher than under Alternative 2. However, in both situations, there is substantial uncertainty. In Alternative 1, the actual future selling price cannot be known until the property is sold. In both situations, the tax rules could change in the future, which could change the potential tax benefits and timing.

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Partnerships: Formation, Operation, and Basis

10-11

[Note: In Microsoft Excel, net present value (NPV) calculations yield the same present values of the “income” (tax savings) streams. The student would create a chart with 2 columns (Alternatives 1 and 2) and 12 rows (one for each year). The annual tax savings is shown in each cell, and the formula for the NPV calculation for each alternative is NPV(discount rate, tax savings period 1… tax savings period 12).] c.

If MM planned, instead, to sell the property in year 4, Alternative 2 would be preferable for Mike. On sale of the property in year 4, the loss would be treated as a long-term capital loss, because the loss would have been a long-term capital loss in Mike’s hands. MM must use the land as a § 1231 asset for five years before its use of the land (rather than Mike’s) governs the treatment of the precontribution loss.

On a sale in year 4, Alternative 1 yields a $36,000 long-term capital loss, except Mike’s $3,000 annual loss deduction would begin in year 4 (Alternative 1) instead of year 1 (Alternative 2). In present value terms, earlier is better than later, so Alternative 2 would be preferred, with its immediate annual $3,000 long-term capital loss deductions.

34.

35.

(LO 3, 9, 14) a.

None. Under § 721, neither the LLC nor any of the members recognize gain on contribution of property to an LLC in exchange for an interest in the LLC. b.

$100,000. Sam’s basis in his LLC interest will equal the basis he held in the property he inherited from his uncle. The basis a beneficiary takes in property received from an estate generally equals the fair market value of the asset at the date of death or at the alternate valuation date (six months later) if available and elected.

c.

Drew will recognize $50,000 of ordinary income. The fair market value of Drew’s 50% LLC interest is $200,000. Because Drew will contribute only $150,000 of property, the difference between the amount contributed and the value of the interest will be treated as being for services rendered to the LLC. Services do not constitute “property” for purposes of § 721 nonrecognition treatment. Drew does not have a carried interest because (1) it is a capital interest, and (2) Drew “paid” for the interest by recognizing income equal to the value of the interest.

d.

Drew’s basis in his LLC interest will be $200,000 [$150,000 (cash contributed) + $50,000 (the amount of ordinary income recognized for services rendered to the partnership)].

(LO 3, 14) SD’s balance sheet is as follows immediately after formation. (The column totals are calculated using the “sum” command.) a.

Assets Cash Land Land improvements Total assets

Basis $150,000 100,000 50,000 $300,000

FMV $150,000 200,000 50,000 $400,000

Partnersʼ capital Sam’s capital Drew’s capital Total capital

$100,000 200,000 $300,000

$200,000 200,000 $400,000

© 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10-12

2019 Corporations Volume/Solutions Manual SD LLC will capitalize the $50,000 deemed payment for Drew’s services, because the services relate to a capitalizable expenditure. The LLC will reflect this $50,000 in “cost of lots sold” as the development lots are sold. b.

36.

Drew could prepare a development plan and secure zoning permits before the LLC is formed.

He could then contribute these plans and permits to SD in addition to the $150,000 cash.

Because a completed plan would be considered “property,” no portion of his LLC interest would be received in exchange for services if this were done. The entire transaction would be considered under § 721.

(LO 3, 14) a.

Under general guidelines, the $100,000 would be treated as a distribution, which, as it does not exceed Sam’s basis in his interest, would not be taxable. The distribution would reduce Sam’s basis in his LLC interest by $100,000. b.

None.

c.

The LLC would take a basis of $100,000 in the land, Sam’s basis in the property at the time of the contribution.

d.

The IRS might assert that the contribution and distribution transactions were in effect a disguised sale of one-half ($100,000 distribution ÷ $200,000 fair market value) of the property contributed by Sam to the LLC.

e.

$50,000. Under disguised sale treatment, Sam will recognize gain on a sale of one-half of his interest in the land. He will be deemed to have received $100,000 in exchange for one-half of the land, with a basis of $50,000 ($100,000 basis × ½). Total gain recognized, then, is $50,000.

f.

$150,000. The LLC will be deemed to have paid $100,000 for one-half of the land. The remaining one-half is deemed to be contributed to the LLC, and the LLC will take a carryover basis of $50,000 in this parcel. The LLC’s total basis is $150,000 ($100,000 + $50,000).

g.

The distribution is less likely to be treated as a disguised sale if (1) Sam is subject to “entrepreneurial risk” with respect to the distribution (e.g., the amount will not be paid unless the LLC achieves a specified earnings level) and/or (2) there is an extended amount of time between the date of the formation and the distribution.

Regulations have adopted a two-year rebuttable presumption that a distribution made after that time period is not part of a disguised sale transaction.

37.

(LO 3) a.

The partners’ initial bases in their partnership interests are the same amounts as their bases in the contributed property (§ 722).

Jessica’s basis Matt’s basis b.

$420,000 720,000

The 2019 sale results in ordinary income of $200,000 to the partnership.

Selling price Basis Gain

$620,000 (420,000) $200,000

The gain is ordinary income because the land is held as inventory by the partnership. The land was a capital asset to Jessica, but no Code provision allows treatment of the gain based on Jessica’s use rather than the partnership’s use. © 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Partnerships: Formation, Operation, and Basis c.

10-13

The 2020 sale results in a $140,000 loss (including a $120,000 capital loss and a $20,000 ordinary loss).

Selling price Basis Loss

$580,000 (720,000) ($140,000)

As a sale of inventory (determined at the partnership level), the sale in 2020 of the land contributed by Matt would normally result in an ordinary loss. However, § 724 overrides the usual treatment. The character of the precontribution loss, instead, is determined based on the character of the property in Matt’s hands. This sale was within five years of the capital contribution date, so the loss is capital in nature to the extent of the built-in loss at the contribution date, which is: FMV at contribution Basis Capital loss

$600,000 (720,000) ($120,000)

The remaining $20,000 loss in 2020 is an ordinary loss because the character of the postcontribution loss is based on the partnership’s ownership and use of the property as inventory. d.

38.

If the property Matt contributed was sold by the partnership in 2025, the entire $140,000 loss would be treated as an ordinary loss. A sale in 2025 would not be within five years of the contribution date, so the character of the loss would be determined solely by reference to the character of the asset to the partnership. Because the land is inventory to the partnership, the loss in 2025 would be ordinary.

(LO 4) TM Partnership, Ltd., has incurred costs for organizing ($30,000), starting the business ($60,000), transferring property ($5,000), and securing investors ($600,000) for the partnership.

The organizational costs are treated under § 709. Under this section, the first $5,000 of such expenses are deducted (provided the total is less than $50,000); the remainder is amortized over 180 months.

The startup costs are treated under § 195. Under this section, also, the first $5,000 of such expenses are deducted, provided the total is less than $50,000. If costs exceed $50,000, the $5,000 deduction is phased out, dollar for dollar, by the amount of costs in excess of $50,000. When total costs equal or exceed $55,000, no portion of the expense is currently deductible. Instead, the full amount is amortized over 180 months. Under these rules, TM deducts $5,278 [$5,000 + ($25,000 × 2/180)] of organizational costs and $667 ($60,000 × 2/180) of startup expenses.

The $5,000 transfer tax is treated as a cost of acquiring the land and is added to the partnership’s basis in the land. The $600,000 of brokerage commissions is treated as a syndication cost of the partnership.

Under § 709, these costs cannot be deducted.

39.

(LO 4) a.

The legal and accounting fees totaling $8,000 are organizational costs. The $10,000 to secure limited partnership investments are nonamortizable, nondeductible syndication costs. The $51,500 for advertising and the preopening event are startup expenses. b.

The partnership may deduct $5,000 of the organizational costs plus $50 amortization [($8,000 total – $5,000 deducted) × 3/180], for a total of $5,050. None of the syndication costs is deductible. The partnership may deduct $3,500 of the startup costs [$5,000 maximum permitted – ($51,500 total – $50,000 phaseout)] plus $800 amortization [($51,500 total – $3,500 deducted) × 3/180], for a total deduction in its initial year of operation of $4,300.

© 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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2019 Corporations Volume/Solutions Manual c.

40.

The organizational and startup costs that are not deducted currently are amortized and deducted over 180 months, beginning with the month in which the partnership begins business. The syndication costs are not deductible.

(LO 5) In 2018, 2019, and 2020, BR can use its choice of the cash, accrual, or a hybrid method of accounting. BR has at least one Subchapter C corporation as a partner, but BR’s average annual gross receipts did not exceed $25 million in either 2018 or 2019. (BR’s average annual gross receipts were $22 million for 2018 and $23.5 million for 2019.)

In 2021, BR must change to the accrual method of accounting. BR has at least one C corporation as a partner during that year, and BR’s average annual gross receipts for the preceding year exceeded $25 million. (Average annual gross receipts for the period ending in 2020 were $26 million.) [Test average annual gross receipts for the three-year period ending before the current tax year (e.g., three-year period ending in 2020 for the 2021 tax year).]

41.

(LO 3, 4, 5) Section 709 organizational cost; immediate deduction ($5,000) and amortization over ≥ 180 months beginning with the month the trade or business begins ($3,000 × 3/180 = $50); total initial year deduction = $5,050: Legal fees to form partnership.

$8,000

Section 195 “startup cost” immediate deduction ($5,000) and amortization over ≥ 180 months beginning with the month the trade or business begins ($39,000 × 3/180 = $650); total initial year deduction = $5,650: Advertising for “Grand Opening” Consulting fees to establish accounting system Preopening rent (2 months @ $2,000) Preopening utilities (2 months @ $1,000) Total startup costs

$18,000 20,000 4,000 2,000 $44,000

Section 162 ordinary and necessary business expense: Advertising after opening Rent after opening (3 months @ $2,000) Utilities (3 months @ $1,000) Salaries to clerks (after opening) Tax return preparation expense Total § 162 expenses

$ 30,000 6,000 3,000 50,000 12,000 $101,000

Section 197 intangible asset, 15-year amortization beginning with the month in which the intangible was acquired: Trade name and logo of Granny Newcombs, Inc. amortization: $200,000 ÷ 15 yrs. × 3/12 = $3,333 Deductible guaranteed payment for services:

$36,000

Payments to Morlan and Merriman ($6,000/month each for three months). (Note that this amount would be capitalized if the expenses were for services during the preopening period or for capitalizable services such as architectural consulting.)

© 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Partnerships: Formation, Operation, and Basis 42.

10-15

(LO 6) A partnership’s required taxable year is determined based on the first of three rules to apply.

Three Cs cannot use the “majority partner” rule because there are no partner interests with the same tax year-end that can be combined for more than 50% ownership of the entity. Cerulean owns exactly 50% (not more than 50%), and neither of the other partners has the same year-end as Cerulean.

Similarly, the “principal partner” test can only be used if all partners who own more than a 5% interest have the same year-end. In this case, all three partners own more than 5%, but all three year-ends are different.

Therefore, the required taxable year is based on the least aggregate deferral calculation outlined in Regulations. While the calculation is not required, it yields a taxable year-end of October 31.

If the partners do not want to use the required taxable year, they can appeal to the IRS to use a natural business year or they can select July, August, or September under § 444 because those three years would result in less than a three-month deferral of income relative to the required taxable year.

(Under § 444, a tax deposit would be required to “prepay” the IRS for the tax on the deferred income.)

In addition, Three Cs might have business reasons for wanting to use a 52- to 53-week year that ends on or near October 31.

43.

44.

(LO 7) a.

CL can deduct $12 million of its business interest expense on Form 1065, page 1 ($40 million tax EBITDA × 30%). The remaining $2 million is allocated to the LLC members and carried forward. b.

On its Schedule K, CL reports the $1 million of portfolio interest expense as a separately stated deduction. In addition, it reports the $2 million of excess business interest as a separately stated item so the LLC members can claim a deduction in future years.

c.

In the current year, the LLC members will deduct their distributive shares of the $1 million investment interest expense to the extent permitted. In future years, the LLC members can deduct their distributive shares of the $2 million excess business interest carryover against excess taxable income the LLC allocates to the members in those future years.

d.

If average annual gross receipts is less than $25 million for all prior tax years, the business interest expense limitation does not apply, so all business interest expense is currently deductible by the LLC on Form 1065, page 1. The $100,000 of portfolio interest expense is still treated as a separately stated item.

(LO 3, 7, 8) a.

Reece’s basis is $75,000. Under § 722, the basis of an LLC member’s interest equals the adjusted basis of contributed property at the time of contribution. Because Reece paid $75,000 for the property, her basis in her LLC interest is $75,000. b.

The LLC’s holding period includes the period during which Reece owned the investment property; thus, Phoenix’s holding period began five years ago.

c.

$15,000 gain. Under § 704(c), all unrealized gain or loss at the contribution date (i.e., precontribution gain or loss) on property contributed for an LLC interest is allocated to the contributing LLC member. On the land sale, the LLC realized a gain of $15,000 ($90,000 selling price minus $75,000 adjusted basis). This gain is allocated entirely to Reece, because this was the amount of the unrealized gain on the land at the contribution date.

© 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10-16

2019 Corporations Volume/Solutions Manual d.

The balance sheet for Phoenix Investors LLC is as follows immediately after sale of the property contributed by Reece. (In Excel, the column totals are calculated using the “sum” command.)

Assets Cash Land

Basis $ 90,000 30,000

FMV $ 90,000 180,000

$120,000

$270,000

Partnersʼ Capital Basis Interest, Phoebe $ 15,000 Interest, Parker 15,000 Interest, Reece 90,000* $120,000*

FMV $ 90,000 90,000 90,000 $270,000

*$75,000 LLC interest plus $15,000 gain.

45.

(LO 7, 8, 11) a. $36,000 loss. Under § 704(c), all unrealized gain or loss at the contribution date (i.e., precontribution gain or loss) on property contributed for an LLC interest belongs to the contributing LLC member.

Gain or loss in excess of that amount on the subsequent sale or exchange of the property is divided among the LLC members according to their profit and loss sharing ratios. On the land sale, the LLC has a loss of $36,000 ($120,000 adjusted basis minus $84,000 selling price), $30,000 of which is allocated to Reece under § 704(c) (Reece’s basis of $120,000 in the land at the contribution date minus the land’s FMV of $90,000 at that date). The remaining loss of $6,000 is allocated equally among the LLC members. b.

c.

Assets Cash Land

Basis $ 84,000 30,000

FMV $ 84,000 180,000

$114,000

$264,000

Partnersʼ Capital Interest, Phoebe Interest, Parker Interest, Reece

Basis $ 13,000 13,000 88,000 $114,000

FMV $ 88,000 88,000 88,000 $264,000

Each memberʼs tax-basis capital account is rolled forward from before the sale to after the sale as follows.

Total Phoebe Parker Reece $15,000 $15,000 $120,000 Before sale $150,000 Built-in loss on land (30,000) (30,000) Loss on land after contribution date (6,000) (2,000) (2,000) (2,000) After sale $114,000 $13,000 $13,000 $ 88,000 Each memberʼs § “704(b) book” capital account (FMV) is rolled forward from before the sale to after the sale as follows.

Before sale Loss on land after contribution date After sale

Total $270,000*

Phoebe $90,000

Parker $90,000

Reece $90,000

(6,000) $264,000

(2,000) $88,000

(2,000) $88,000

(2,000) $88,000

*$180,000 FMV of existing land plus $90,000 FMV of Reeceʼs contribution.

46.

(LO 7, 9, 10) Because AM Products is an LLC and the LLC members have not guaranteed the debt, it is a. treated as nonrecourse debt. Amyʼs share of that debt is included in her basis in the LLC interest. Assuming that Amyʼs capital account (given) reflects an accurate number for basis purposes, her beginning basis is determined as follows.

© 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Partnerships: Formation, Operation, and Basis Capital account balance, beginning of year Share of AM’s debt ($200,000 × 1/2) Amy’s basis, beginning of year b.

10-17 $300,000 100,000 $400,000

Using the ordering rules shown in Exhibit 10.2, Amy’s basis at the end of the year is determined as follows. (Students should prepare a Microsoft Excel spreadsheet for these calculations.)

Capital account balance, beginning of year

$300,000

Plus Amy’s share of AM’s debt at the end of the year ($140,000 × 1/2) Add Amy’s share of: $200,000 Ordinary business income (see calculation below) Interest income 2,000 Net long-term capital gain [1/2 × ($12,000 − $6,000)] 3,000 Less

Charitable contribution Cash distribution to Amy

$

2,000 20,000

70,000

205,000 $575,000

Amy’s basis, end of year

(22,000) $553,000

Amy’s share of the LLC’s ordinary income is calculated as follows.

Income Less: W–2 wages Less: Depreciation AM LLC’s ordinary business income (Schedule K, line 1)

$900,000 (200,000) (300,000) $400,000*

Amy’s 50% share of AM’s ordinary business income

$200,000*

Amy’s 50% share of AM’s W–2 wages is $100,000. Amy’s 50% share of AM’s unadjusted basis of partnership depreciable property is $800,000. These amounts do not affect her basis or capital account, and they are not amounts Amy reports on her tax return. This information is needed to help Amy calculate her qualified business income deduction under § 199A. 47.

(LO 7, 8) Amy will report her $200,000 share of the LLC’s ordinary income, her $2,000 share of the LLC’s interest income, and her $3,000 share of the LLC’s net long-term capital gain. She may deduct her $2,000 share of the LLC’s charitable contribution on her Schedule A if she itemizes deductions. The cash distribution Amy received would not be taxable, nor would the decrease in Amy’s share of the LLC liabilities.

Amy may be eligible to deduct up to 20% of the ordinary income as qualified business income under § 199A, and will make that calculation on her return. This deduction does not require a cash outflow

by Amy or the LLC, and it does not affect her basis or capital account. As someone treated as a general partner, Amy’s distributive share of the LLC’s ordinary business income is subject to selfemployment tax and possibly the additional Medicare tax (.9%). Her net investment income from the LLC (e.g., interest and gains) may be subject to the net investment income tax (3.8%) under § 1411.

48.

(LO 11) Although this will not always be the case, Amy’s tax-basis capital account differs from her basis only by the amount of her share of the LLC’s liabilities. Amy’s beginning capital account balance of $300,000 is increased and decreased by Amy’s 50% share of LLC items as follows, to arrive at an ending capital account of $483,000.

© 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10-18

2019 Corporations Volume/Solutions Manual Capital account balance, beginning year Ordinary income (see calculation in solution for Problem 46) Interest income Net long-term capital gain Less:

Charitable contribution Cash distribution to Amy

Capital account balance, end of year

$200,000 2,000 3,000

$ 2,000 20,000

$300,000

205,000 $505,000

(22,000) $483,000

Amy’s capital account appropriately does not include her $70,000 share of the LLC’s debt ($140,000 × 50%). This amount is, however, included in Amy’s basis in her LLC interest.

Instructor note: Situations where this result would not hold true might be where, for example, Amy purchased or inherited the LLC interest and the value (excluding liabilities) differed from the capital account balance or when capital accounts are not determined on the tax basis.

49.

(LO 8, 10, 11) Amy’s Schedule K–1 follows. Part II indicates that Amy is an individual taxpayer and a domestic LLC member-manager. Beginning and ending profit, loss, and capital shares are each 50%.

Amy’s liability share is nonrecourse, as she is an LLC member who did not guarantee the debt.

Her capital account analysis is shown as described in Problem 48, except that most of the items are combined into the “current year increase (decrease)” line. The analysis is prepared on a tax basis, and she did not contribute any built-in gain or loss property.

In Part III, her ordinary income and interest income are reported on lines 1 and 5. The capital gains and losses are netted at the partnership level and reported as a net long-term amount on line 9a. The charitable contribution is reported on line 13. We use the Codes on Schedule K–1, page 2, to determine that this cash contribution should be marked with Code A. Amy is a managing member of the LLC, so her income is shown as self-employment earnings on line 14, Code A. The $20,000 cash distribution reduces her basis and capital account and is shown on line 19, Code A. Her interest income is investment income for purposes of the investment interest expense deduction limitation and is shown on line 20, Code A. We do not show an amount on line 20, Code Y (net investment income), because all investment income amounts can be determined from the information provided in lines 1 to 12. Nevertheless, Amy might be subject to net investment income on her interest income and long-term capital gain.

At this writing, the Schedule K–1 for 2018 has not been released, so it is not known where the information should be reported related to Amy’s qualified business income § 199A deduction. For our purposes, this information is shown in the sample Schedule K–1 as additional information on line 20.

The IRS, however, might decide it should be reported elsewhere on the K–1. Amy’s 50% share of AM’s W–2 wages is $100,000. Amy’s 50% share of AM’s unadjusted basis of partnership depreciable property is $800,000.

© 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Partnerships: Formation, Operation, and Basis

© 2019 Cengage®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10-19

10-20 50.

2019 Corporations Volume/Solutions Manual (LO 7, 8, 9, 11) a.

Amy’s QBI deduction is $40,000. Amy has qualified income from the AM LLC trade or business of $200,000. Amy’s tentative qualified business income (QBI) from this business is 20% of this amount, or $40,000.

The tentative QBI for this trade or business is subject to the greater of two limitations. The first limitation is 50% of Amy’s share of the LLC’s W–2 wages, or $50,000 ($100,000 allocable share × 50%). The second limitation is 25% of Amy’s share of the LLC’s W–2 wages ($25,000, or $100,000 × 25%) plus 2.5% of Amy’s share of the LLC’s unadjusted basis of partnership property, or $20,000 ($800,000 × 2.5%), for a total limitation of $45,000.

The 50% of wages limitation of $50,000 is the higher amount, so this is the maximum QBI for this business. The tentative QBI is only $40,000, so the deduction for this business is not limited.

This $40,000 also is Amy’s combined QBI amount because she has no QBI from other trades or businesses, REITs, or publicly traded partnerships. The combined QBI amount is limited to 20% of Amy’s taxable income excluding capital gains, or $100,000 ($500,000 × 20%).

Therefore, Amy can deduct the full $40,000 combined QBI amount.

b.

51.

The QBI deduction does not require a corresponding outflow of cash. The deduction does not affect Amy’s basis or capital account.

(LO 7, 8, 9) a. to c. The following illustration shows a sample spreadsheet for KL Partnership.

a.

As shown in cells D20 to D22, the partnershipʼs ordinary taxable income is $18,000. KL has a separately stated long-term capital gain of $6,000 and distributions that total $27,000 (Schedule K, line 20). The distribution to Lisa is not deductible by the partnership. The payment to Mercy Hospital for Kayla’s medical expenses is treated as a distribution to Kayla in the amount of $12,000. Kayla may be able to claim a deduction for medical expenses on her personal tax return.

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Partnerships: Formation, Operation, and Basis

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b.

Form 1065, pages 1 and 4, are shown beginning on the next page and include all the information in the KL Partnership column (Column D) of the spreadsheet. In addition, because each partnerʼs distributive share of the partnershipʼs income is subject to selfemployment tax, the amount on Schedule K, line 1 (18,000) is also shown on line 14a.

c.

Kayla’s and Lisa’s Schedules K–1 will each show a $9,000 share of partnership income (line 1) and a $3,000 share of the partnership’s long-term capital gain (line 9a). In addition, Kayla’s K–1 will show a $12,000 distribution and Lisaʼs K–1 will show a $15,000 distribution (both on line 20). (See spreadsheet cells E20–E22 and F20–F22.)

Kayla and Lisa will each report $9,000 of ordinary income on their Schedule E, page 2. They will also report a $3,000 long-term capital gain on their personal Schedule D. As determined in part d., the distribution does not exceed their basis, so it is not taxable.

d.

Kayla’s basis in her partnership interest at the end of the tax year is $20,000. As calculated on the spreadsheet, her beginning basis of $20,000 is increased by her $9,000 income allocation and $3,000 long-term capital gain distribution. It is decreased by the $12,000 payment for medical expenses treated as a distribution. Her ending basis is $20,000.

Lisa’s basis in her partnership interest at the end of the tax year is $13,000. As calculated on the spreadsheet, her beginning basis of $16,000 is increased by her $9,000 income allocation and $3,000 long-term capital gain distribution. It is decreased by the $15,000 distribution.

Her ending basis is $13,000.

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2019 Corporations Volume/Solutions Manual

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Partnerships: Formation, Operation, and Basis

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52.

2019 Corporations Volume/Solutions Manual

(LO 7, 8, 9, 12) The following illustration shows the updated sample spreadsheet for KL Partnership.

a.

The spreadsheet shows correct amounts for information reported by the partnership: Form 1065, Schedule K, and Schedules K–1. At the partner level, though, limitations arise. The spreadsheet indicates that partners would have a negative basis, which is not permitted.

As shown on the spreadsheet, the partnership would report an ordinary loss from operations of $32,000 rather than income of $18,000. (Originally reported receipts were $150,000; revised receipts were $100,000, for a net profit/(loss) reduction of $50,000, from $18,000 of income to a $32,000 loss.) Each partner’s share of the loss is $16,000. The separately stated long-term capital gain remains $6,000, with $3,000 being allocated to each partner.

At the partner level, it is not possible to start with the beginning basis and add and subtract amounts from Schedule K–1. The basis ordering rules (Exhibit 10.2) and the loss limitation rules must be considered.

b.

Kayla’s basis in her partnership interest at the end of the tax year is determined as follows, using the ordering rules in Exhibit 10.2.

Beginning basis Share of separately stated income items: Long-term capital gain Basis before loss allocation and distribution Less: Distribution (partnership payment of medical expenses) Basis before loss allocation Less: Ordinary loss allowed under § 704(d) Ending basis in interest

$20,000 3,000 * $23,000 (12,000) $11,000 (11,000)* $ –0–

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Partnerships: Formation, Operation, and Basis

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* As in Problem 51, Kayla reports the long-term capital gain. Per the ordering rules of Exhibit 10.2, the distribution is considered before the loss. The distribution from the partnership is not taxable as it is less than her basis after current income items. Her ordinary loss from the partnership is limited under § 704(d) to $11,000. The remaining $5,000 ordinary loss is carried forward (as a suspended loss) until such time as Kayla has sufficient basis in her partnership interest to utilize the loss. c.

Lisa’s basis in her partnership interest at the end of the tax year is determined as follows.

Beginning basis Share of separately stated income items: Long-term capital gain Basis before loss allocation and distribution Less: Distribution Basis before loss allocation Less: Ordinary loss allowed under § 704(d) Ending basis in interest

$16,000 3,000 $19,000 (15,000) $ 4,000 (4,000) $ –0–

Lisa reports the long-term capital gain. The distribution is again considered before determining the allowable loss. Lisa’s basis is $4,000 lower than Kayla’s, and the distribution Lisa received is $3,000 higher than the distribution to Kayla, so Lisa’s deductible loss is $7,000 less than Kayla’s. Lisa may only deduct $4,000 of the loss. The remaining $12,000 loss is carried forward. d.

53.

The amounts calculated on the spreadsheet are not the same as shown in Exhibit 10.2, because of the aforementioned basis limitations. You can use this spreadsheet to determine amounts at the partnership level. The file also can be used to calculate allocations to the partner. The partnerʼs basis can be calculated on the spreadsheet as long as the loss is not suspended.

(LO 3, 7, 9, 10) a.

Suzy’s beginning basis in her partnership interest is $240,000, calculated as follows.

Basis in contributed business-related assets Share of partnership nonrecourse debt assumed from Anna Total beginning basis

$200,000 40,000 $240,000

Anna’s beginning basis in her partnership interest is $340,000, calculated as follows.

Basis in contributed business-related assets Relief of debt assumed by the partnership Share of partnership nonrecourse debt assumed from Anna Total beginning basis b.

$380,000 (100,000) 60,000 $340,000

The partnership reports ordinary business income of $200,000. Separately stated items include the short-term capital gain ($10,000), tax-exempt interest income ($4,000), and charitable contributions ($8,000). Suzy’s Schedule K–1 shows the following items.

Ordinary income Short-term capital gain Tax-exempt interest income Charitable contributions Distribution received by Suzy

$80,000 4,000 1,600 3,200 10,000

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2019 Corporations Volume/Solutions Manual On her tax return, Suzy reports the $80,000 of ordinary income on Schedule E. She reports the short-term capital gain ($4,000) with her capital transactions on Form 8949 and Schedule D. She reports the charitable contributions ($3,200) on Schedule A with her personal charitable contributions. The tax-exempt interest income and the distribution she receives are not taxable, although they affect her basis (as shown below). (Although not taxable, the taxexempt interest income is reported as an information item on Suzy’s Schedule B and line 8b of her Form 1040.)

Suzy might also be eligible for the qualified business income deduction; the partnership needs to provide additional information (i.e., W–2 wages and the unadjusted basis of partnership depreciable property) so Suzy can calculate the deduction.

Suzy also calculates self-employment tax (and potentially additional Medicare tax) on her distributive share of partnership income. She might also be subject to net investment income tax on her share of the partnership’s short-term capital gain. c.

At the end of the tax year, Suzy’s basis in her partnership interest is $392,400 (including an $80,000 share of partnership nonrecourse debt and a $40,000 share of partnership recourse debt), calculated as follows.

Beginning basis (including $40,000 share of debt) Increase in Suzy’s share of recourse debt (40% × $100,000) Increase in Suzy’s share of qualified nonrecourse financing [40% × ($200,000 – $100,000)] Partnership ordinary income Short-term capital gain Tax-exempt interest income Charitable contributions Distribution to Suzy Ending basis

$240,000 40,000 40,000 80,000 4,000 1,600 (3,200) (10,000) $392,400

Suzy’s amount at risk is the same as her basis in the partnership interest, because the nonrecourse debt is qualified nonrecourse financing.

54.

(LO 11) a.

Suzy’s beginning capital account balance equals her basis in the property she contributed to the partnership, or $200,000. The capital account does not include the partner’s share of liabilities. b.

Suzy’s capital account is increased and decreased by her share of Suz-Anna’s income and deductions, and it is decreased by the distribution she received. Her ending capital account is $272,400, calculated as follows.

Beginning capital account Partnership ordinary income Short-term capital gain Tax-exempt interest income Charitable contributions Distribution to Suzy Ending capital account

c.

$200,000 80,000 4,000 1,600 (3,200) (10,000) $272,400

In this situation, Suzy’s ending capital account differs from her ending tax basis, because her $120,000 share of partnership liabilities ($40,000 of recourse debt and $80,000 of nonrecourse debt) is not included in her ending capital account.

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Partnerships: Formation, Operation, and Basis 55.

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(LO 3, 7, 9, 10) a.

Recourse debts are debts for which at least one partner (or LLC member) has an economic risk of loss. Nonrecourse debts are debts for which no partner (or LLC member) has an economic risk of loss. Because an LLC limits owner liability to the assets of the entity itself, none of the LLC members are personally liable for the accounts payable of the LLC. As such, the accounts payable are treated as nonrecourse debt. They are included in the members’ bases in their LLC interests (shown as nonrecourse debt on their Schedules K–1), but they are not included in the amounts at risk.

Similarly, none of the LLC members are personally liable for the nonrecourse debt of the LLC. It is included in the LLC members’ bases (under § 705) as a nonrecourse debt. Because the LLC debt is considered qualified nonrecourse financing, it is included in the amount at risk for purposes of the § 465 limitation. b.

Suzy’s basis in her LLC interest is the same as calculated in 53.c. above—$392,400. This amount includes the same share of LLC liabilities, even though $40,000 of those liabilities are now classified as nonrecourse rather than recourse debt.

Suzy’s amount at risk in her LLC interest is $352,400. This is $40,000 less than her basis, because her share of ending partnership accounts payable is $40,000. These liabilities are nonrecourse debt to the LLC member and are not qualified nonrecourse financing. Therefore, they cannot be included in the amount at risk.

56.

(LO 7) a.

In its April 30, 2019 tax return, Burgundy, Inc., must report income from BV LLC of $140,000. This includes Burgundy’s $100,000 guaranteed payment and its 50% distributive share of the partnership’s $80,000 of taxable income for the tax year ended December 31, 2018. b.

In her December 31, 2019 tax return, Violet must report income from BV of $45,000. This is her 50% share of the partnership’s $90,000 of taxable income for the tax year ended December 31, 2019. Violet does not receive a guaranteed payment.

57.

(LO 7) If Burgundy’s guaranteed payment increases to $120,000 on January 1, 2019, Burgundy’s income for the April 30, 2019 tax year still is $140,000 [as in 56.a. above]. The increase is reflected as a guaranteed payment on the Schedule K–1 issued for Burgundy for the partnership year ended December 31, 2019, and Burgundy reports this amount in the April 30, 2020 tax return.

58.

(LO 3, 7, 9, 12) a.

The partners’ bases at the end of the first year are determined as follows.

Capital contribution Loss allocation Depreciation allocation Basis at end of year 1

Bryan $120,000 (40,000) (28,800) $ 51,200

Cody $120,000 (40,000) (7,200) $ 72,800

The partners’ bases at the end of the second year are determined as follows.

Basis at end of year 1 Income allocation Depreciation allocation Basis at end of year 2

Bryan $51,200 20,000 (46,080) $25,120

Cody $72,800 20,000 (11,520) $81,280

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2019 Corporations Volume/Solutions Manual None of the losses are suspended for either partner, because the initial capital contribution exceeds cumulative profit and loss allocations. b.

59.

These allocations have economic effect because (1) gains, income, loss, etc., allocations are reflected in capital account balances, (2) liquidating distributions are in accordance with ending capital account balances, and (3) deficit capital account balances must be restored.

(LO 7, 9, 12) Gain must be recognized on sale of the equipment. a.

Selling price Less: Adjusted basis Original basis Less: Year 1 depreciation Less: Year 2 depreciation Gain

$150,000 $200,000 (36,000) (57,600)

(106,400) $ 43,600

This gain is reflected in basis as follows.

Basis at end of year 2 Plus: Gain on equipment Basis before final distribution

Bryan $25,120 21,800 $46,920

Cody $ 81,280 21,800 $103,080

Note that part a. in the text says to disregard depreciation in year 3.

60.

b.

Each partner will receive cash from the $150,000 sale proceeds in the amount of the capital account balance reflected above. (Bryan gets $46,920 and Cody gets $103,080, for a total of $150,000.)

c.

Bryan has directly reduced his right to cash flows on liquidation in favor of current deductions from taxable income. Absent the special allocation of depreciation, the parties would each have received $75,000 on the distribution of sale proceeds. The economic effect rules ensure that a deduction reflects a true economic consequence to the partner. The partners must decide which is more valuable: the value of a current deduction or the present value of $1 of cash distributed on termination of the partnership.

(LO 10) The debt assumed by the LLC is treated as a nonrecourse debt to the LLC members because they are protected from entity liabilities and neither LLC member was required to personally guarantee the debt. (The LLC members are treated as limited partners for purposes of liability allocations.) Nonrecourse debts are allocated, in general, according to the LLC membersʼ profit sharing ratios, so the debt is allocated 40% to Callie ($60,000) and 60% to Neil ($90,000). Neil’s and Callie’s bases in their LLC interests are determined as follows.

Callie Neil Substituted basis of contributed property or cash $300,000 $200,000 Less: Liability assumed by LLC –0– (150,000) Plus: Allocation of nonrecourse debt 60,000 90,000 Basis in LLC interest $360,000 $140,000

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Partnerships: Formation, Operation, and Basis 61.

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(LO 3, 9, 10) TAX FILE MEMORANDUM DATE

December 11, 2018

FROM

Jane Student

SUBJECT

PA LLC debt allocation

Facts The PA LLC will be formed before the end of the current year to manufacture specialty athletic apparel. The LLC will be equally owned by Paul and Anna, and both parties will be managing members. It will purchase equipment and pay other expenses for $600,000, with $160,000 paid in cash. The remaining $440,000 will be borrowed from First State Bank. The loan will be personally guaranteed by Anna. By the end of the tax year, the LLC will also have $40,000 of accounts payable (not guaranteed by either LLC member).

The operating agreement provides that all LLC items will be allocated equally. Capital accounts will be appropriately maintained under the § 704(b) Regulations. Any member with a deficit capital account balance upon liquidation of the LLC will be required to contribute cash in the amount of the deficit at that time. (See Instructor Note below.)

The LLC expects to produce a loss of about $580,000 for its first taxable year (allocated $290,000 each to Paul and Anna), and the LLC members would both like to be able to deduct their share of the loss.

Issues Paul and Anna would like to know whether the loss limitation rules will affect their ability to deduct the $580,000 loss (allocated $290,000 to each LLC member). If limitations arise, can any adjustments be made to ensure the losses can be deducted?

Conclusion and recommendations Under the existing scenario, Paul’s § 704(d) loss limitation will be $100,000 and Annaʼs will be $340,000. Both amounts are reduced by an additional $20,000 under the at-risk limitations to $80,000 and $320,000, respectively.

Paul’s basis and at-risk amounts will only allow him to deduct $80,000 of his expected $290,000 share of LLC losses.

Both Paul and Anna are active LLC members, so the passive activity loss limitations will not apply.

The excess business loss limitation would apply to Anna and limit her allowable loss to $250,000 instead of $290,000.

Instead, if both Paul and Anna were to guarantee one-half of the recourse debt, each member would have an amount at risk of $300,000. However, both Paul and Anna are single taxpayers, so, under the excess business loss rules, their loss would be limited to $250,000 each, with the additional $40,000 loss carried forward as part of each taxpayer’s net operating loss. However, this is a better result than the original allocation. (See Instructor Note below.)

Law and analysis Losses only can be deducted under § 704(d), to the extent of the LLC membersʼ basis in the LLC interest. Paul and Anna each contributed $80,000 of cash. In addition, their basis includes their share of the LLCʼs liabilities.

Recourse debt is allocated to the partners/members who have an economic risk of loss with respect to the debt. Anna has guaranteed the $440,000 equipment loan, so she bears the entire economic risk of loss with respect to that debt. The entire amount is allocated to her.

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2019 Corporations Volume/Solutions Manual The accounts payable are recourse to the LLC, but neither LLC member has guaranteed the debt, so it is nonrecourse with respect to the two LLC members. It is allocated according to the profit sharing ratios, $20,000 to each LLC member.

Losses also must be evaluated under the at-risk limitations. Because PA is an LLC, neither partner is liable for the accounts payable, so those liabilities cannot be included in their amounts at risk.

Absent other arrangements, Paul and Annaʼs losses for the year are limited as follows.

Cash contribution Recourse debt share Nonrecourse debt share § 704(d) loss limitation Less: Nonrecourse debt § 465 limitation

Paul $ 80,000 –0– 20,000 $100,000 (20,000) $ 80,000

Anna $ 80,000 440,000 20,000 $540,000 (20,000) $520,000

As mentioned, the passive activity loss limitation would not arise because both LLC members are active in the business. However, the members must also consider whether the excess business loss limitation would apply. Under this rule, a single individual taxpayer’s business losses are limited to $250,000 in a given tax year. Neither Paul nor Anna has business income (or losses) from other sources, so the $80,000 and $520,000 amounts calculated above are the amounts considered under this limitation. Unfortunately, Anna’s allocated loss would exceed the threshold amount, so she could only deduct $250,000 and the remaining $270,000 loss would be carried forward as part of her net operating loss carryover.

If, instead, Paul and Anna each agreed to guarantee one-half of the recourse debt, the $440,000 would be allocated $220,000 to each person. Paul and Annaʼs bases [§ 704(d) loss limitation] would be $320,000 each, and their amounts at risk would be $300,000 each.

The passive activity loss limitation would not apply, but the excess business loss limitation would. As single taxpayers, both Paul and Anna would be limited to a $250,000 loss. Therefore, of the total $290,000 loss allocated to each partner, a $250,000 deduction would be permitted. The excess $40,000 loss would be carried over as part of each LLC member’s net operating loss.

Instructor note The assumption that the LLC’s operating agreement contains a deficit capital restoration provision is for simplification only. Many LLCs utilize other provisions of the § 704(b) Regulations to ensure profit allocations will be respected and do not include the restoration provision in the operating agreement.

Some students might suggest that both Paul and Anna guarantee the full amount of the debt. Final and Proposed Regulations address situations where there are overlapping guarantees and allocate debt in proportion to the amount guaranteed. Under those rules (beyond the scope of this text), if each LLC member guaranteed the full amount of the debt (doubly guaranteed), half the debt would be allocated to each member. This is the same tax result that would arise if each member were to guarantee half the debt, as suggested above.

62.

(LO 9, 10, 12, 14) a.

A partner’s basis in the partnership interest must be adjusted in the order shown in Exhibit 10.2: income items and contributions first increase basis, then basis is reduced by distributions from the partnership. Finally, losses may be deducted under § 704(d) to the extent of any remaining basis. However, this allowed loss may be further limited under the at-risk, passive activity loss, and excess business loss rules.

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Partnerships: Formation, Operation, and Basis

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b.

In Brad’s case, the $20,000 distribution reduces his basis in the partnership interest to $0 and Brad must recognize a $5,000 gain (probably a capital gain) in the amount of the distribution that exceeds his $15,000 basis. (Instructor note: Distribution rules and gain recognition are introduced in Example 2 and discussed in detail in Chapter 11.)

c.

Because his basis is reduced to $0, none of the loss can be deducted. The full $10,000 is suspended under § 704(d) and must be carried forward until Brad has adequate basis to absorb the loss.

d.

If the partnership can make the distribution at the beginning of the following tax year, Brad could deduct his $10,000 share of the loss in the current year. The partnership expects to report earnings in future years, so Brad’s share of that income would increase his basis before the cash is distributed, and he will probably not be required to report a capital gain on the distribution.

Alternatively, the partnership could incur additional (short-term) debt at the end of the year.

Brad’s share of the debt would be treated as a contribution of capital that increases Brad’s basis in his partnership interest. With adequate basis, the cash could be distributed without gain recognition, and the losses would be fully deductible (subject to other loss limitations). Clearly, the partnership would need to consider the economic consequences of additional debt, even on a short-term basis.

63.

(LO 10, 12) TAX FILE MEMORANDUM DATE

January 28, 2019

FROM

Beth Mullins

SUBJECT

Deductibility of loss from LLC

Facts Jasmine Gregory reports the following allocations and bases in her LLC interests for the current year.

Income (loss) allocation Basis excluding liabilities Recourse liability allocation Nonrecourse liability allocation

Sparrow ($100,000) 50,000 10,000 30,000*

Starling $36,000 N/A N/A N/A

*This debt cannot be treated as qualified nonrecourse financing.

Jasmine spends significant time working for each LLC during the year. Her modified AGI is $300,000 before considering the LLCs’ activities. She has no other business losses.

Issues How much of the $100,000 loss from Sparrow Properties LLC can Jasmine deduct in the current year?

Under what Code provision are any disallowed losses suspended?

Conclusion Jasmine can deduct $36,000 of the $100,000 loss. Of the disallowed loss, $10,000 is suspended under § 704(d). An additional $30,000 is suspended under the at-risk limitations. The remaining suspended loss of $24,000 is suspended under the passive activity loss rules of § 469. The special $25,000 deduction for active participation in a passive real estate activity is not available because Jasmine’s modified AGI is too high. None of the loss is suspended under the excess business loss limitation.

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2019 Corporations Volume/Solutions Manual Law and analysis Under § 704(d), Jasmine may deduct a portion of the Sparrow loss equal to her basis in her LLC interest, including recourse and nonrecourse liabilities. The basis is $90,000 ($50,000 + $10,000 + $30,000), and the excess $10,000 loss is suspended.

The $30,000 of nonrecourse debt cannot be included in the amount at risk, because it is not qualified nonrecourse indebtedness. Therefore, an additional $30,000 is suspended under the at-risk limitation rules of § 465. (After this limitation, $60,000 of the loss is still available for testing under the passive loss limitation rules.)

The activities of both LLCs are treated as rental activities, which, by definition, are passive for purposes of § 469. The Sparrow loss is deductible to the extent of the $36,000 of income from Starling. Also, because Sparrow conducts rental real estate activities and Jasmine is an active participant owning more than 10%, this loss is eligible for an additional $25,000 deduction.

However, none of this additional $25,000 deduction is available to Jasmine, because her modified AGI exceeds $150,000 (the top of the phaseout range for the additional deduction allowance).

The $36,000 loss allowed under the passive activity loss rules exactly equals the passive income from Starling, so the net deductible loss from all activities is $0. Therefore, the excess business loss limitation does not apply.

64.

(LO 13) a. $50,000 loss. As a 40% owner, Lacy’s loss on the sale to the partnership is not disallowed. b.

$60,000 gain. The partnership has a cost basis in the property of $200,000.

c.

Lacy would claim no loss. Section 707(b)(1)(A) applies, and Lacy’s $50,000 realized loss is not deductible.

On the partnership’s later sale of the property, it would recognize a gain of $10,000. Section 267(d) permits the partnership to offset any subsequent gain by the loss previously disallowed ($60,000 gain less $50,000 previously disallowed loss).

d.

$80,000 gain. Lacy’s $80,000 gain would be ordinary under § 707(b)(2) if the investment property immediately after the transfer is not a capital asset of the Four GRRLs Partnership.

RESEARCH PROBLEMS 1.

a.

Either June 30 or December 31 would be an acceptable year-end. Under § 706(b)(1), the LLC’s (partnership’s) required taxable year is the first of the following that applies: (1)

the majority interest taxable year.

(2)

the same taxable year as all the principal (5% or greater interest) partners.

(3)

the year determined under the “least aggregate deferral” rules, as explained in the Regulations.

The majority interest taxable year does not apply because neither of the LLC members has a majority interest (>50%) in the profits and capital of the LLC [§ 706(b)(4)(A)].

Both Barney and Aldrin, Inc., are principal partners (5% or greater interests) in BA LLC. However, as both members do not have the same taxable year, the principal partner rule does not apply.

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Partnerships: Formation, Operation, and Basis

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Therefore, BA LLC must choose the taxable year that provides for the least aggregate deferral of income. To determine the required tax year of an LLC (partnership) under this method, perform the following steps: •

Select one partner’s tax year as a test year.

•

Calculate the number of months from the end of the test year to the next year-end for each partner (i.e., determine the number of deferral months for each partner).

•

Multiply the number of income deferral months for each partner by each partner’s profit percent.

•

Add the products to determine the aggregate number of deferral months for the test year.

•

Repeat the process until each partner’s tax year has been used as a test year.

•

Compare the aggregate number of deferral months for each test year.

•

The test year that has the smallest number of aggregate deferral months is the required tax year.

TEST FOR 12/31 YEAR-END (Barney’s year-end) Profit Partner Year Ends Interest Barney 12/31 1/2 Aldrin, Inc. 6/30 1/2 Aggregate number of deferral months

× ×

Months of Deferral 0 6

= =

Product 0.00 3.00 3.00

= =

Product 3.00 0.00 3.00

TEST FOR 6/30 YEAR-END (Aldrin, Inc.’s year-end) Profit Partner Year Ends Interest Barney 12/31 1/2 Aldrin, Inc. 6/30 1/2 Aggregate number of deferral months

× ×

Months of Deferral 6 0

Under the least aggregate deferral rule, both a June 30 and December 31 year-end provide for the same amount of deferral. Under Regulations, if this calculation results in two taxable years with the same least aggregate deferral, the partnership may select either one of these taxable years as its taxable year [Reg. § 1.706–1(b)(3)(i)]. b.

If the partnership originally selected a June 30 taxable year, the year-end of the LLC will remain June 30. The majority interest rule will now apply, and Aldrin, Inc., a June 30 fiscal year taxpayer, will own a majority (75%) interest in the LLC. If the partnership originally selected a December 31 taxable year, the taxable year of the LLC must change to June 30. Under Reg. § 1.706–1(b)(8)(i)(A), a partnership has automatic approval from the IRS to make this change.

Under Reg. § 1.706–1(b)(9), the December 31 partnership taxable year could be retained only if the LLC could get approval from the IRS for a “natural business year” or by making a § 444 election. The problem states that BA does not have a natural business year. A § 444 election is not available because the six-month deferral from the required taxable year is greater than the maximum three-month deferral permitted under § 444 [§ 444(b)(2)].

The change from a December 31 taxable year to a June 30 taxable year will be made under the provisions of Rev.Proc. 2006–46, 2006–2 C.B. 859.

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10-34 2.

2019 Corporations Volume/Solutions Manual This question is designed to focus on the liability-sharing Regulations. Specifically, item a. stresses the requirement that time value of money considerations must be taken into account in determining an allocation of liabilities. Item b. addresses Final and Proposed Regulations that clarify that a liability can only be included in basis one time and that provide guidelines for allocating liabilities where there is an overlapping economic risk of loss. a.

The allocation of recourse liabilities to the partners depends on the extent to which a partner bears the economic risk of loss for any amount [Reg. § 1.752–2(a)]. The extent to which a partner bears the economic risk of loss for a liability is determined under the constructive liquidation scenario of Reg. § 1.752–2(b)(1). Under this scenario, assets are deemed to be sold for $0, and losses on disposal are allocated to the partners. Partners with negative capital account balances would then be required to contribute cash to make up any deficits. Under Reg. § 1.752–2(g), any restoration must be discounted to reflect the present value of the restoration obligation.

For the Realty partnership, both partners are required to restore deficit balances in their capital accounts. Fredstone’s restoration is within the 90-day safe harbor allowed [Reg. § 1.752–2(g)], so his restoration is treated at the face amount. Gradison is not required to restore the deficit in its capital account until three years following liquidation of the partnership, and the deferred obligation does not bear interest. Therefore, Gradison’s economic risk of loss is limited to the present value of the future obligation.

During the three-year deferral period, Fredstone is presumed to cover any shortfalls and bear further risk of loss to the extent of the difference between the present and future amount of the obligation. See the example in Reg. § 1.752–2(g)(4).

The discount rate is assumed to be 2%, compounded semiannually for three years. This translates to six discount periods at 1% each. Using the Present Value of $1 table in Appendix F, the actual allocation of the liability would be determined as follows.

(1)

Under the constructive liquidation scenario, the $100,000 partnership liability becomes due in full.

(2)

The partnership assets (basis $130,000) become worthless and are sold for $0, resulting in a loss of $130,000.

(3)

The loss is allocated equally to the partners under the partnership agreement, resulting in capital account deficits of $50,000 each, as follows.

Initial contribution Loss allocation Capital account balance

(4)

Fredstone $15,000 65,000 ($50,000)

Gradison $15,000 65,000 ($50,000)

Gradison’s deficit restoration obligation is discounted to the “fair market value” of the obligation at the date of the constructive liquidation. Because the obligation does not bear interest, the fair market value is equal to the imputed principal amount under § 1274(b) (i.e., the present value of the restoration payment obligation). Per the Appendix F, Present Value of $1 table, the factor for six discount periods at 1% per period is .9420. Therefore, Gradisonʼs restoration obligation would be $47,100 ($50,000 × .9420). Gradison’s remaining obligation of $2,900 is deemed not to exist.

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Partnerships: Formation, Operation, and Basis

10-35

(5)

Fredstone would be required to contribute $50,000 to restore the deficit in its capital account. In addition, as general partner, Fredstone would be required to make up the shortfall in Gradison’s restoration, or $2,900. Fredstone’s total restoration, then, is $52,900.

(6)

The partners’ cash contributions under the constructive liquidation scenario totals $100,000 ($52,900 + $47,100). This amount would be used by the partnership to repay the $100,000 liability, and the partnership would liquidate.

The restoration obligations of both partners would be used exclusively to repay partnership liabilities. Therefore, the deficit restoration obligations ($52,900 for Fredstone and $47,100 for Gradison) will be the amount of liabilities allocated to the partners under § 752. b.

In the revised scenario, the entity is an LLC, and the debt, therefore, is nominally nonrecourse. However, Fredstone is required to guarantee the full debt and Gradison is required to guarantee a portion of the debt that corresponds to Gradison’s ownership interest.

Therefore, not only is the debt recourse to the LLC members, but the members have guaranteed 150% of the debt rather than just 100% of the debt.

Proposed Reg. § 1.752–2 provides guidance for allocating recourse debt when there is an overlapping risk of loss. Example 1 in this Regulation illustrates that the debt is allocated based on the proportionate risk of loss that would arise if all partners were required to bear a proportionate share of their maximum debt guarantee.

3.

(1)

Fredstone would have a risk of loss of $100,000 and Gradison would have a risk of loss of $50,000 for a total guarantee of $150,000 toward a maximum debt of $100,000.

(2)

Fredstone’s allocated risk of loss is 2/3 of the total debt ($100,000/$150,000 = 66.67%), or $66,667.

(3)

Gradison’s allocated risk of loss is 1/3 of the total debt ($50,000/$150,000 = 33.33%), or $33,333.

(4)

The recourse debt allocation to the LLC members then is $66,667 to Fredstone and $33,333 to Gradison.

Section 179(b)(1) limits the amount of qualifying property that may be immediately expensed by a taxpayer to $1 million annually. Section 179(b)(2) reduces that limit by the amount the cost of qualifying property placed in service exceeds $2.5 million.

Section 179(d)(8) states that the limitations on § 179 expense contained in § 179(b) apply at both the partnership and partner levels. This is reiterated in Reg. § 1.179–2(b)(3). Reg. § 1.179–2(b)(3)(i) provides that the § 179 expense allocated to each partner can be added to any nonpartnership expense the partner may have. This Regulation also provides that for purposes of determining whether excess property has been placed in service, the amount of § 179 property placed in service by a partnership is not attributed to any partner.

The Attic’s total § 179 expense is limited to $600,000 [$1,000,000 − ($2,900,000 − $2,500,000)], with $540,000 allocable to Andy. Neither the property additions placed in service by The Attic ($2.9 million) nor the excess property additions ($400,000) are attributable to Andy or any other partner.

Andy’s qualifying additions, then, are considered to only be the $700,000 of property purchased by his proprietorship, MoveOn. Therefore, Andy’s § 179 allowance is not reduced by the dollar limitations of § 179(b)(2).

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10-36

2019 Corporations Volume/Solutions Manual In deciding the amount to elect to expense under § 179 from his proprietorship, Andy should consider the amount passed through from the LLC. There is no carryforward permitted under § 179 (unless the taxpayerʼs deduction is limited under the taxable income limitation). Therefore, Andy’s § 179 deduction related to his proprietorship expenses should be the amount that maximizes his deduction, or $460,000 ($1,000,000 maximum − $540,000 from the LLC). His remaining MoveOn expenditures, $240,000, should be depreciated as usual.

Andy’s total § 179 expense for the year is $1,000,000 ($460,000 from the proprietorship and $540,000 from The Attic).

Research Problems 4 to 6 These research problems require that students utilize online resources to research and answer the questions.

As a result, solutions may vary among students and courses. You should determine the skill and experience levels of the students before assigning these problems, coaching where necessary. Encourage students to use reliable websites and blogs of the IRS and other government agencies, media outlets, businesses, tax professionals, academics, think tanks, and political outlets to research their answers.

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Partnerships: Formation, Operation, and Basis

10-37

CHECK FIGURES 16.

17.a.

17.b.

17.c.

18.a.

18.b.

19.

20.

21.

22.a.

22.b.

22.c.

22.d.

23.a.

23.b.

23.c.

24.

25.

26.

27.

28.a.

28.b.

29.a.

29.b.

29.c.

29.d.

30.a.

$32,000 income taxed; $10,000 distribution not taxed. $15,000 realized; $0 recognized.

Henrietta’s basis is $85,000.

Partnership’s equipment basis is $10,000. $50,000 ordinary compensation income. $50,000 basis in partnership interest; $50,000 probable organizational or startup cost for LLC. $90,000 ordinary income on collection of accounts receivable; $35,000 ordinary income on sale of inventory. $5,100 organizational costs; $1,700 startup costs.

Schedule K includes some or all: Ordinary income; Guaranteed payments; Business interest expense information; Various types of investment income; Gains/losses on asset sales; SE income; Foreign tax credit information; AMT information; Investment interest income; Net investment income (if not stated elsewhere); Information for calculating the qualified business income deduction. $72,000 guaranteed payment deducted. $20,000 partnership income.

Stella reports $90,000.

Euclid reports $2,000. $200,000 § 704(b) book basis. $50,000 tax basis. $200,000 gain allocated to Nova; $50,000 gain allocated to Oscar. $62,000 basis.

Elisha’s and Ezra’s bases are each $299,100. $10,000 debt share; $30,000 basis.

Tobias deducts $90,000; $20,000 suspended under § 704(d); $25,000 suspended under § 465; $15,000 suspended under § 469; $0 suspended under excess business loss limitation of § 461(l).

Heather’s loss = $0.

Partnership’s later gain = $5,000. $0; $0. $100,000. $40,000. $40,000 basis in property. ($20,000) realized; $0 recognized.

30.b.

30.c.

30.d.

30.e.

31.a.

31.b.

31.c.

31.d.

31.e.

31.f.

32.

33.a.

33.b.

33.c.

34.a.

34.b.

34.c.

34.d.

35.a.

35.b.

36.a.

36.b.

36.c.

36.d.

36.e.

36.f.

36.g.

37.a.

37.b.

$360,000. $380,000. $380,000.

Sell and contribute cash. $15,000 realized on land; $150,000 realized on equipment.

No gain recognized under § 721.

Liz $155,000; John $20,000. $75,000 basis in land; $20,000 basis in equipment.

Inside = Outside = $175,000.

Partnership continues John’s depreciation schedule.

No gain or loss to Mike, Melissa, or partnership; Mike’s basis $176,000; Melissa’s basis $115,000; partnership’s basis in land $136,000; partnership steps into Melissa’s shoes for depreciation; consider precontribution gain and loss rules.

Alt. 1 year 6 $36,000 § 1231 loss to Mike.

Alt. 2 $36,000 year 1 long-term capital loss to Mike deductible at $3,000/year years 1 to 12.

Present value (PV) of Alt. 1 tax savings ($10,553) > PV of Alt. 2 tax savings ($10,452).

If sold in year 4, MM has long-term capital loss allocated to Mike. $0. $100,000. $50,000 ordinary income. No carried interest. $200,000 basis.

Capitalize $50,000 value of services.

Contribute “property” of “permits” and “development plan” completed before contribution.

Distribution. $0 gain or loss. $100,000.

Disguised sale. $50,000 gain. $150,000 basis.

Less likely to be disguised sale if (1) entrepreneurial risk and/or (2) extended time between formation date and distribution.

Jessica $420,000; Matt $720,000. $200,000 ordinary income.

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10-38 37.c.

37.d.

38.

39.a.

39.b.

39.c.

40.

41.

42.

43.a.

43.b.

43.c.

43.d.

44.a.

44.b.

44.c.

45.a.

46.a.

46.b.

2019 Corporations Volume/Solutions Manual $120,000 capital loss and $20,000 ordinary loss.

All ordinary (>5 years after contribution).

Organization costs $30,000 ($5,000 deducted, remainder amortized over 180 months); startup costs $60,000 amortized over 180 months; property acquisition costs $5,000 (added to property basis; depreciated as newly acquired asset); syndication costs $600,000 (nondeductible).

Organizational costs: $8,000; syndication costs $10,000; startup costs: $51,500. $5,000 deduction plus $50 amortization of organization costs. $3,500 deduction plus $800 amortization of startup costs. $0 syndication costs.

180-month amortization (organization and startup costs). No amortization of syndication costs.

BR can use cash, accrual, or hybrid method in 2018, 2019, and 2020. In 2021 and later years, BR may no longer use cash method. § 197 intangibles $200,000; § 709 organization cost $8,000; § 195 startup costs $44,000; § 162 expenses $101,000; guaranteed payment $36,000.

Required taxable year determined under Regulations; Natural business year; § 444 year of July, August, or September; 52- to 53-week year.

Partnership deducts $12 million business interest expense.

Allocate $2 million excess interest expense to partners for carryover; separately state $1 million of investment interest expense.

Partners deduct investment interest expense now; deduct business interest expense later against future partnership excess taxable income.

Small business exception; partnership deducts all business interest expense now. $75,000.

Five years. $15,000 gain. $36,000 loss; $30,000 to Reece and remaining $6,000 allocated equally among members. $400,000. $553,000.

47.

48.

49.

50.a.

50.b.

51.a.

51.b.

51.c.

51.d.

52.a.

52.b.

52.c.

52.d.

53.a.

53.b.

53.c.

54.a.

54.b.

54.c.

55.a.

55.b.

56.a.

56.b.

57.

58.a.

58.b.

59.a.

59.b.

59.c.

$200,000 ordinary income; $2,000 interest income; $3,000 net long-term capital gain; $2,000 charitable contribution. Selfemployment and Medicare taxes.

Amy’s capital account = Basis – Liabilities = $483,000.

See Schedule K–1 for AM Partnership. $40,000 QBI deduction (all deductible because < (1) $50,000 W–2 wage limit, (2) $45,000 W–2 wage plus property limit, and (3) $100,000 taxable income limit).

No cash paid; no basis or capital account effect. $18,000 ordinary income; long-term capital gain $6,000.

See Form 1065, pages 1 and 4. $9,000 ordinary income; $3,000 long-term capital gain for each partner. $20,000 basis for Kayla; $13,000 basis for Lisa. ($32,000); long-term capital gain $6,000. $0 basis; $11,000 loss allowed, $5,000 suspended. $0 basis; $4,000 loss allowed; $12,000 suspended.

If a ceiling comes into play, the spreadsheet wonʼt always work. $240,000 (Suzy); $340,000 (Anna).

Ordinary income $80,000; short-term capital gain $4,000; tax-exempt interest $1,600; charitable contribution $3,200; distribution to Suzy $10,000. $392,400 basis and at-risk amount. $200,000 beginning capital. $272,400 ending capital.

Liabilities not included.

Accounts payable are nonrecourse for LLC. $392,400 basis; $352,400 amount at risk. $140,000, incl. guaranteed payment. $45,000. $140,000.

Year 1—Bryan $51,200; Cody $72,800.

Year 2—Bryan $25,120; Cody $81,280.

Yes, has economic effect.

Gain $43,600 allocated equally. Basis— Bryan $46,920; Cody $103,080.

Bryan’s cash $46,920; Cody’s cash $103,080.

Tax savings now or cash later; not both.

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Partnerships: Formation, Operation, and Basis 60.

61.

62.a.

Debt is nonrecourse to LLC members.

Allocated using profit sharing ratios.

Callie $360,000; Neil $140,000.

Original: § 704(d) and § 465 loss limitations apply; Paul limited to $80,000; Anna limited to $320,000.

Alternative: Both guarantee half so debt is allocated equally. Both limited to $250,000 with $40,000 treated as NOL carryover.

Basis adjustment rules per Concept Summary 10.2; then loss limitation rules [§ 704(d), § 465, then § 469; § 461(l) NA.].

62.b.

62.c.

62.d.

63.

64.a.

64.b.

64.c.

64.d.

10-39

$5,000 gain, $0 basis.

No loss deduction.

Make distribution next year so Brad can deduct loss this year. Partnership can incur additional debt. $36,000 deducted; $64,000 suspended [$10,000 under § 704(d); $30,000 under § 465; $24,000 under § 469; no further limit under § 441(l)]. $50,000 loss. $60,000 gain. $0 loss now; $10,000 gain later. $80,000 gain; may be ordinary.

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