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CCH Federal Taxation Comprehensive Topics Chapter 20 Partnerships—Distributions, Sales, and Exchanges. ©2006 , CCH, a Wolters Kluwer business 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 www.CCHGroup.com. Distributions—General Effect on Partners. Chapter 20, Exhibit 1a.

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cch federal taxation comprehensive topics chapter 20 partnerships distributions sales and exchanges

CCH Federal TaxationComprehensive TopicsChapter 20Partnerships—Distributions, Sales, and Exchanges

©2006, CCH, a Wolters Kluwer business

4025 W. Peterson Ave.

Chicago, IL 60646-6085

800 248 3248

www.CCHGroup.com

distributions general effect on partners
Distributions—GeneralEffect on Partners

Chapter 20, Exhibit 1a

CCH Federal Taxation Comprehensive Topics

distributions general effect on partners1
Distributions—GeneralEffect on Partners

Chapter 20, Exhibit 1b

CCH Federal Taxation Comprehensive Topics

distributions general rules code sections 731 to 733
Distributions—General Rules Code Sections 731 to 733

The rules indicated below assume that the partnership DOES NOT make a disproportionate distribution of the Code Sec. 751 “hot” assets.

What is a distribution?

A distribution is a transfer of value from the P/S to a partner in reference to his interest in the partnership. A distribution may be in the form of money, debt relief, or other property. Any decrease in a partner’s allocable share of P/S debt is treated as a distribution of money. This can result from payment of principal by the P/S on its debt. Also, a draw against a partner’s share of partnership income is a distribution.

Chapter 20, Exhibit 3a

CCH Federal Taxation Comprehensive Topics

distributions general rules code sections 731 to 7331
Distributions—General Rules Code Sections 731 to 733

Will the partnership recognize either a gain or loss on the distribution of property to a partner?

Generally no. Even distributions of Code Sec. 1245 or Code Sec. 1250 property do not trigger recognition unless Code Sec. 751(b) applies.

Exception: Disproportionate distributions.

Chapter 20, Exhibit 3b

CCH Federal Taxation Comprehensive Topics

distributions general rules code sections 731 to 7332
Distributions—General Rules Code Sections 731 to 733

Will the partner recognize either a gain or loss on the distribution?Capital gain is recognized only if cash or debt relief received is greater than her outside basis. Loss is never recognized. Code Sec. 731(a); Reg. 1.731-1(a)(1). If the cash received is a draw against profits and the amount received is greater than outside basis, gain is NOT recognized. The reason: A distribution reduces outside basis as shown below. However, the profits implied in a draw against profits increases basis by an equal amount. Thus, a cash draw would have a zero effect on outside basis.

What effect does the distribution have on the partner’s outside basis?Her outside basis is reduced by the amount of cash plus the partnership’s inside basis in the distributed asset(s). However, her outside basis cannot be reduced below zero

Chapter 20, Exhibit 3c

CCH Federal Taxation Comprehensive Topics

distributions general rules code sections 731 to 7333
Distributions—General Rules Code Sections 731 to 733

What is the basis of the transferred asset(s) to the partner?

Follow this step-by-step formula:

(1) Reduce her outside basis by the amount of cash received.

(2)(a) If her remaining outside basis is sufficient, she will take a basis equal to the partnership’s inside basis in the distributed asset.

(2)(b) If her remaining outside basis is NOT sufficient, she will allocate the “step-down” in basis first to assets with a basis in excess of FMV.

(2)(c) Any excess of the “step-down” over the amount in (2)(b) is allocated among remaining assets in accordance with their remaining bases.

Chapter 20, Exhibit 3d

CCH Federal Taxation Comprehensive Topics

distributions general rules code sections 731 to 7334
Distributions—General Rules Code Sections 731 to 733

What is the holding period and character of assets distributed from a partnership to a partner?

The holding period begins on the day after the date that the partnership acquired the asset. The character is determined by the use that the partner makes of the asset.

CCH Federal Taxation Comprehensive Topics

proportionate distributions example
Proportionate Distributions—Example

FACTS:

  • On July 1, Y1, ABC Partnership distributes to each of its equal partners $10,000 cash and land with a fair market value (FMV) of $10,000 and basis (AB) of $5,000.
  • The three parcels of land were acquired by ABC on 12/31/80.
  • A, B and C have outside bases of $20,000, $10,000, and $5,000 respectively.
  • The partnership has the following tax/book balance sheet prior to the distribution.

Chapter 20, Exhibit 4a

CCH Federal Taxation Comprehensive Topics

proportionate distributions example1
Proportionate Distributions—Example

Chapter 20, Exhibit 4b

CCH Federal Taxation Comprehensive Topics

proportionate distributions example2
Proportionate Distributions—Example

QUESTION 1: What are the tax consequences of the distribution to A, B and C?

QUESTION 2: What result to C if he receives the land first and the cash in a subsequent separate distribution on October 1?

QUESTION 3: What result to C in QUESTION 2, if the cash distribution on October 1 is a draw against his share of partnership income, which is $20,000 for the year?

Chapter 20, Exhibit 4c

CCH Federal Taxation Comprehensive Topics

proportionate distributions example3
Proportionate Distributions—Example

Chapter 20, Exhibit 4d

CCH Federal Taxation Comprehensive Topics

proportionate distributions example4
Proportionate Distributions—Example

Chapter 20, Exhibit 4e

CCH Federal Taxation Comprehensive Topics

proportionate distributions example5
Proportionate Distributions—Example

Chapter 20, Exhibit 4f

CCH Federal Taxation Comprehensive Topics

selling a partnership interest effect on selling partner
Selling a Partnership Interest—Effect on Selling Partner

How is a partner’s initial outside basis in a partnership (P/S) interest

determined if purchased from a partner?A partner buying into a P/S takes an outside basis that is the sum of:

(a) Purchase price (Code Sec. 742);

(b)  Partner’s share of partnership liabilities (Code Sec. 752(d)).

Chapter 20, Exhibit 5a

CCH Federal Taxation Comprehensive Topics

selling a partnership interest effect on selling partner1
Selling a Partnership Interest—Effect on Selling Partner

What is the character of any gain or loss recognized by the selling partner on the sale of a P/S interest?

Code Sec. 741 provides that a sale of a partnership interest generally results in capital gains or losses. However, Code Sec. 741 yields to Code Sec. 751 and gain or loss is ordinary if amounts received by the selling partner are attributable to “hot assets.” Code Sec. 751 defines “hot” assets as the following items:

  • Unrealized receivables in which no taxable income resulted from the credit sale. Generally cash basis but not accrual basis P/S’s would have unrealized receivables. However in determining the character of gain on sale of a partnership interest, unrealized receivables must include any Code Sec. 1245 or 1250 depreciation recapture potential from Code Sec. 1231 assets!

Chapter 20, Exhibit 5b

CCH Federal Taxation Comprehensive Topics

selling a partnership interest effect on selling partner2
Selling a Partnership Interest—Effect on Selling Partner
  • Appreciated inventory, where aggregate FMV exceeds aggregate basis. For purposes of determining aggregate amounts under Code Sec. 751, inventory includes all partnership property except cash, capital assets and Code Sec. 1231 assets. Thus, for purposes of the “aggregate” computation, inventory includes unrealized receivables! In determining the character of gain on sales of partnership interests the minimum 20% substantial appreciation requirement has been repealed effective August 5, 20x1. However, this 20% substantial appreciation requirement has been retained for inventory distributions (or deemed distribution) by partnerships.
  • Code Sec. 1245 and 1250 business assets (i.e., long-term business assets with depreciation recapture potential.)

A selling partner’s distributive share of any built-in gain on sale of “hot” assets is recognized as ordinary income, even when there is a realized loss on the sale. In such a case, the recognized capital loss would be increased by the ordinary income amount. The combined effect of Code Sec. 741 & 751 may yield surprising results when a partner sells a partnership interest—an ordinary gain under Code Sec. 751 and a capital loss under Code Sec. 741.

Chapter 20, Exhibit 5c

CCH Federal Taxation Comprehensive Topics

selling a partnership interest effect on partnership
Selling a Partnership Interest—Effect on Partnership

What is the tax effect on a partnership’s (P/S’s) inside basis of assets when a partner sells her interest?

Without Code Sec. 754 election.

Code Sec. 743(a) provides that “the basis of partnership property shall not be adjusted as the result of a transfer of an interest in a partnership by sale ...” However, if the partnership carries “hot assets,” the tax effect is initially quite alarming. Consider the following example.

Chapter 20, Exhibit 6

CCH Federal Taxation Comprehensive Topics

selling a partnership interest example
Selling a Partnership Interest—Example

FACTS:

12/31/x1: Buyer pays $40,000 cash to Seller for a 1/3 interest in a cash method partnership that has as its primary asset $90,000 of accounts receivable with a zero basis and land with a $30,000 fair market value (FMV) and basis. Comments: As indicated earlier, Buyer’s outside basis is cost, or $40,000. In effect, he has paid $30,000 for his 1/3 interest in receivables (1/3 x $90m = $30m) and $10,000 for his 1/3 interest in the land (1/3 x $30m = $10m)]

1/1/x2: $90,000 cash is received by the P/S on the receivables.

Chapter 20, Exhibit 7a

CCH Federal Taxation Comprehensive Topics

selling a partnership interest example1
Selling a Partnership Interest—Example

QUESTION 1:

Does Seller have ordinary income of $30,000?

ANSWER 1:

Yes, Seller is taxed under Code Sec. 751 on the $30,000 of ordinary income attributable to the receivables when she sells her partnership interest to Buyer.

Chapter 20, Exhibit 7b

CCH Federal Taxation Comprehensive Topics

selling a partnership interest example2
Selling a Partnership Interest—Example

QUESTION 2:

Does the Buyer have ordinary income of $30,000? (i.e., a 1/3 share in the partnership’s income from collections—1/3 x [90m cash – 0 inside basis of P/S] = 30m)

ANSWER 2:

Yes! Buyer is taxed on his 1/3 share, or $30,000 ordinary income. This result occurs even though (1) Seller already recognizes $30,000 as ordinary income and (2) Buyer pays $30,000 for his share of the receivables and has no real gain on their collection. Comments: Of course, Buyer’s outside basis will increase by his $30,000 share of P/S ordinary income. When he eventually sells his P/S interest, the increased outside basis will reduce capital gain (or increase capital loss) by $30,000. Not much consolation, given the timing (i.e., 20x2) and character (i.e., ordinary) of his taxable income.

Chapter 20, Exhibit 7c

CCH Federal Taxation Comprehensive Topics

selling a partnership interest example3
Selling a Partnership Interest—Example

QUESTION 3:

Is there a way to prevent the Buyer’s dilemma?

ANSWER 3:

Yes! Read on.

With Code Sec. 754 election.

To avoid taxing Buyer on the appreciation of his proportionate share of partnership assets prior to the date of purchase, the P/S may elect under Code Sec. 754 to adjust its inside basis of the receivables. In the example above, a Code Sec. 754 election by the P/S gives Buyer a $30,000 inside “cost” basis in his “share” of the receivables.

When the receivables are collected, the other partners each will be taxed just as they would be with the Code Sec. 754 election. However, Buyer realizes no income because of the upward adjustment of his “personal” inside basis.

Chapter 20, Exhibit 7d

CCH Federal Taxation Comprehensive Topics

selling a partnership interest example4
Selling a Partnership Interest—Example

COMMENTS: Code Sec. 754 cuts both ways. If partnership assets had declined in value as of the time of the sale of the partnership interest, a Code Sec. 754 election would create a downward adjustment to the Buyer’s personal inside basis in the partnership assets. Obviously, such an election would be disadvantageous to Buyer.

Chapter 20, Exhibit 7e

CCH Federal Taxation Comprehensive Topics

selling a partnership interest with hot assets example
Selling a Partnership Interest with Hot Assets—Example

FACTS:

1. S sells his 1/3 capital interest to B for $150,000 cash.

2.  The tax/book balance sheet of the partnership (P/S) immediately before the sale is as follows:

Chapter 20, Exhibit 8a

CCH Federal Taxation Comprehensive Topics

selling a partnership interest with hot assets example1

P/S Balance Sheet Immediately Before the Sale

Inside Basis

FMV

Outside Basis

FMV

Cash

$ 30,000

$ 30,000

Capital- S (1/3)

$ 30,000

$150,000

Accounts receivable

0

240,000

Capital- S (2/3)

120,000

300,000

Land

150,000

180,000

Total Assets

$180,000

$450,000

Total Capital

$180,000

$450,000

Selling a Partnership Interest with Hot Assets—Example

Chapter 20, Exhibit 8b

CCH Federal Taxation Comprehensive Topics

selling a partnership interest with hot assets example2
Selling a Partnership Interest with Hot Assets—Example

QUESTIONS:

What is the amount and character of the gain to S?

Indicate how the partnership tax/book balance sheet will appear assuming that a Code Sec. 754 election is NOT in place.

Indicate how the partnership tax/book balance sheet will appear assuming that a Code Sec. 754 election IS in place.

Chapter 20, Exhibit 8c

CCH Federal Taxation Comprehensive Topics

selling a partnership interest with hot assets example3

SOLUTION:

Amount and character of the gain to S

(a)

(b)

(c) = (a) – (b)

(d) = 1/3 x [240m – 0]

(e) = (c) – (d)

Sales Price

Outside Basis of Seller

Realized gain

OI

Capital

$150,000

$60,000

$90,000

$80,000

$10,000

Selling a Partnership Interest with Hot Assets—Example

Chapter 20, Exhibit 8d

CCH Federal Taxation Comprehensive Topics

selling a partnership interest with hot assets example4

SOLUTION:

Partnership Tax/Book Balance Sheet assuming that a Code Sec. 754 election is NOT in place.

P/S Tax/Book Balance Sheet - Without Code Sec. 754 Election:

Inside Basis

FMV

Outside

FMV

Cash

$ 30,000

$ 30,000

Capital-B (1/3)

$150,000

$150,000

Accounts receivable

0

240,000

Capital-Z (2/3)

120,000

300,000

Land

150,000

180,000

Total Assets

$180,000

$450,000

Total Capital

$270,000

$450,000

Selling a Partnership Interest with Hot Assets—Example

Chapter 20, Exhibit 8e

CCH Federal Taxation Comprehensive Topics

selling a partnership interest with hot assets example5

SOLUTION:

Partnership Tax/Book Balance Sheet assuming that a Code Sec. 754 election IS in place.

P/S Tax/Book Balance Sheet - With Code Sec. 754 Election:

Inside Basis

FMV

Outside

FMV

$ 30,000

Cash

$ 30,000

Capital-B (1/3)

$150,000

$150,000

A/R

[Inside Basis: 0 + 80m]

80,000

240,000

Capital-Z (2/3)

120,000

300,000

Land

[Inside Basis: 150+10]

160,000

180,000

$450,000

Total Assets

$270,000

Total Capital

$270,000

$450,000

Selling a Partnership Interest with Hot Assets—Example

Chapter 20, Exhibit 8f

CCH Federal Taxation Comprehensive Topics

slide30

Selling a Partnership Interest with Hot Assets—Example

Note on the $80,000 step-up of A/R:

The $80,000 step-up in P/S’s inside basis of receivables benefits only B, not the other partners. In effect, B gets a “personal inside basis” in P/S’s receivables, which will reduce his share of P/S income when the receivables are collected.

Chapter 20, Exhibit 8g

CCH Federal Taxation Comprehensive Topics

basic partnership tax accounting outside basis inside basis and capital account
Basic Partnership Tax Accounting—Outside Basis, Inside Basis and Capital Account

Code Sec. 704(d) Outside Basis

Definition.This is a partner’s adjusted basis (AB) in the partnership (P/S) capital interest.

Purpose.Outside basis is used mainly in computing gain or loss on the sale of a P/S interest, and for determining the deductibility of Code Sec. 702(a)(8) operating losses under the at-risk rules.

Chapter 20, Exhibit 10a

CCH Federal Taxation Comprehensive Topics

basic partnership tax accounting outside basis inside basis and capital account1
Basic Partnership Tax Accounting—Outside Basis, Inside Basis and Capital Account

Inside Basis

Definition.This is the P/S’s basis in assets.

Purpose.Inside basis is used by the P/S to compute depreciation, or its gain or loss on disposition of the property.

Computation.If the assets are acquired through a partner’s contribution, inside basis is generally the partner’s AB at date of contribution. If obtained from a non-partner, inside basis is cost.

Chapter 20, Exhibit 10b

CCH Federal Taxation Comprehensive Topics

basic partnership tax accounting outside basis inside basis and capital account2
Basic Partnership Tax Accounting—Outside Basis, Inside Basis and Capital Account

Capital Account

Definition.A capital account is maintained for each partner at the partnership level. It represents a partner’s equity in the P/S.

Purpose. At any point in time during the life of a P/S, the capital account generally identifies what each partner would be entitled to receive upon liquidation of her outside basis.

Computation.A partner’s initial capital account balance is the FMV (net of debt relief) of the contributed property. It is increased by the partner’s share of P/S profits. It is decreased by the partner’s share of losses, and the amount of cash and the FMV of any property distributed to the partner.

Comparison with outside basis.It is different from the partner’s outside basis in that (1) capital arising from property contributions are stated at FMV, not contributing partner’s AB; and (2) it does not include the partner’s share of P/S liabilities as does the outside basis.

Chapter 20, Exhibit 10c

CCH Federal Taxation Comprehensive Topics

basic partnership tax accounting example 1 formation
Basic Partnership Tax Accounting—Example 1 (Formation)

Chapter 20, Exhibit 12a

CCH Federal Taxation Comprehensive Topics

basic partnership tax accounting example 1 formation1
Basic Partnership Tax Accounting—Example 1 (Formation)

Chapter 20, Exhibit 12b

CCH Federal Taxation Comprehensive Topics

basic partnership tax accounting example 1 formation2
Basic Partnership Tax Accounting—Example 1 (Formation)

COMMENTS:

“Tax/book” balance sheet means a financial statement that shows

(1) the partnership’s inside basis in its assets,

(2) the partners’ outside basis in their capital interest, and

(3) the partners’ capital accounts as reported on the partnership books.

Chapter 20, Exhibit 12c

CCH Federal Taxation Comprehensive Topics

basic partnership tax accounting example 2 profit allocation
Basic Partnership Tax Accounting—Example 2 (Profit Allocation)

FACTS:

[Use the balance sheet at Example1 as the starting point]

Same as above, except that during 20x1, ABC reports $10,000 Code Sec. 702(a)(8) income from cash sales, and sold the land for $40,000 cash. Profits are allocated according to the partners’ capital account balances.

Allocate 20x1 Income, reconstruct the P/S Balance Sheet, and identify: (1) Outside Bases

(2) Inside Bases and

(3) Capital Account Balances

Chapter 20, Exhibit 13a

CCH Federal Taxation Comprehensive Topics

slide38

Basic Partnership Tax Accounting—Example 2 (Profit Allocation)

Chapter 20, Exhibit 13b

CCH Federal Taxation Comprehensive Topics

slide39

Basic Partnership Tax Accounting—Example 2 (Profit Allocation)

Chapter 20, Exhibit 13c

CCH Federal Taxation Comprehensive Topics

slide40

Basic Partnership Tax Accounting—Example 2 (Profit Allocation)

COMMENTS:

Each partner’s outside basis is increased by the partner’s share of partnership liabilities on the theory that the partners ultimately will be responsible for paying that debt. Code Sec. 752(a). The result is that the borrowed funds become an asset ($30,000 cash) having an inside basis of $30,000 to the partnership, and the resulting liability to repay that cash increases the partners’ outside bases by that same amount in a ratio of 1:6:3, or $3,000 to A, $18,000 to B and $9,000 to C. Note that a partner’s share of partnership liabilities does not increase his or her capital account.

Chapter 20, Exhibit 13d

CCH Federal Taxation Comprehensive Topics

basis adjustments attributable to partnership distributions sec 734 b
Basis Adjustments Attributable to Partnership Distributions – Sec. 734(b)
  • Certain distributions cause differences between inside and outside basis:
    • Distributions that trigger recognition of gain or loss to recipient partner
    • Distributions where partner takes different basis in property than partnership had
        • Current distribution where p/s basis exceeded basis of p/s interest
        • Liquidating distribution where basis of p/s interest exceeded p/s basis in distributed property

CCH Federal Taxation Comprehensive Topics

basis adjustments attributable to partnership distributions sec 734 b1
Basis Adjustments Attributable to Partnership Distributions – Sec. 734(b)
  • Unlike Adjustments under Sec. 743(b), basis adjustments under Sec. 734(b) are made for benefit of all remaining partners
  • Basis adjustment is made to same class of property as that resulting in imbalance between inside and outside basis
  • Adjustments attributable to excess distributions of cash are made to capital assets

CCH Federal Taxation Comprehensive Topics

death or retirement of a partner
Death or Retirement of a Partner
  • Code Sec. 736 – Consequences depend on nature of payments to retiree or deceased partner’s successor in interest
    • Payments for partner’s share of partnership “property” are treated as distributions and subject to same rules as other distributions
    • Payments in excess of partner’s share of p/s property treated as guaranteed payments or distributive shares of partnership income (and thus deductible by partnership or allocated away from existing partners)

CCH Federal Taxation Comprehensive Topics

death or retirement of a partner1
Death or Retirement of a Partner
  • What constitutes partnership “property” under Code Sec. 736?
    • Is capital a material income-producing factor for partnership?
      • Yes – property is everything except unrealized receivables
      • No – property is everything except unrealized receivables and goodwill
    • Exception – goodwill is treated as property if required in partnership agreement

CCH Federal Taxation Comprehensive Topics

income in respect of a decedent
Income in Respect of a Decedent
  • Code Sec. 736(b) payments received by deceased partner’s beneficiary will generally be nontaxable to recipient due to Code Sec. 1014 stepped-up basis rules.
  • Code Sec. 736(a) payments, in contrast, are generally treated as income in respect of a decedent and will be fully taxable to recipient.

CCH Federal Taxation Comprehensive Topics