Vol 02 chapter 11 2012

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Corporations, Partnerships,Estates & Trusts

1

Chapter 11

Partnerships: Distributions, Transfer of Interests, and Terminations

The Big Picture (slide 1 of 4)

• In the previous chapter, Josh, Kyle, and Maria created Beachside Properties, LLC, to own and operate the Beachsider Cafe´ and to own, manage, and lease the remaining properties in the Shorefront Center.

• Several years have passed since the LLC was formed. – The LLC interests and the net underlying assets are

currently valued at approximately $10 million (including $1 million of goodwill for the Beachsider Cafe´).

– During this period, the LLC has made significant distributions of cash and property to its members.


• The area has grown substantially, and it appears to be a good time to develop the remaining 7 acres of property.– The cost of development is estimated at $10 million.

• Josh wants to manage the expansion.– Kyle and Maria are nearing retirement age.– They would prefer to dispose of their interests (valued at

$9.5 million, or 95% of the net LLC value).• Josh has been approached by a group of developers

who are willing to invest the $19.5 million necessary to make the improvements and to purchase Kyle’s and Maria’s interests.


• The transfer of Kyle’s and Maria’s interests and the admission of the new LLC members can be accomplished in two ways. – First, the LLC could admit the new members for $19.5

million of cash• Use $9.5 million to redeem the interests of Kyle and Maria.

– Second, Kyle and Maria could sell their LLC interests directly to the new members for $9.5 million.

• The new members would also contribute $10 million of cash to the LLC for the expansion.


• Although the two alternatives have identical economic effects, the tax results could differ substantially.– How are the distributions of cash and property to the LLC

members treated over the years? – What are the tax consequences of admitting the new

members to the LLC and redeeming the interests of Kyle and Maria?

– What are the results if the new members acquire the interests directly from Kyle and Maria and contribute the cash for expansion to the LLC?

• Read the chapter and formulate your response.

Distributions from a Partnership(slide 1 of 4)

• A payment from a partnership to a partner is not necessarily treated as a distribution– e.g., Partnership may pay interest or rent to a partner, make

a guaranteed payment, or purchase property from a partner

• If a payment is treated as a distribution, it will fall into one of two categories:– Liquidating distributions

– Nonliquidating distributions

• Depends on whether the partner remains a partner in the partnership after the distribution

Distributions from a Partnership (slide 2 of 4)

• A liquidating distribution occurs when either:– Partnership itself liquidates and distributes all its

property to the partners, or– Ongoing partnership redeems interest of one of its

partners• e.g., Partner retires

Distributions from a Partnership (slide 3 of 4)

• A nonliquidating distribution is any distribution from a continuing partnership to a continuing partner– Two types of nonliquidating distributions

• Draw– Distribution of partner’s share of current or accumulated

profits

• Partial liquidation– Reduces partner’s interest in partnership capital but does not

liquidate partner’s interest

Distributions from a Partnership(slide 4 of 4)

• Distributions from a partnership may be either:– Proportionate—Partner receives his or her share of

certain ordinary income-producing assets– Disproportionate—Partner’s share of certain

ordinary income-producing assets increases or decreases

The Big Picture – Example 1Distributions From A Partnership

• Return to the facts of The Big Picture on p. 11-2. • Assume that Josh’s basis in his interest in Beachside

Properties, LLC, is $300,000. • The LLC distributes $50,000 cash to Josh at the end

of the year. – Josh does not recognize any gain on the distribution and

reduces his basis by $50,000 (the amount of the distribution) to $250,000.

– Josh’s basis in the cash he received is $50,000,and the LLC’s inside basis for his assets is reduced by the $50,000 cash distributed.

Proportionate Nonliquidating Distributions (slide 1 of 3)

• In general, neither partner nor partnership recognizes gain or loss on proportionate nonliquidating distributions– Partner usually takes a carryover basis in assets

distributed– Basis in partnership interest is reduced by amount

of cash and basis of property distributed


– Partner recognizes gain to extent cash received exceeds partner’s adjusted basis (outside basis) in partnership interest

• Reduction in partner’s share of partnership debt is treated as a distribution of cash

– First reduces partner’s basis in partnership

– Any reduction in excess of partner’s basis in partnership results in taxable gain to the partner

– Partner cannot recognize loss on a proportionate nonliquidating distribution


• Property distributions– In general, no gain recognized on a property

distribution• If inside basis of property distributed exceeds partner’s

outside basis in partnership interest, distributed asset takes substituted basis

• Assets are deemed distributed and basis applied in a certain order

Ordering Rules

• 1. Cash

• 2. Unrealized receivables and inventory

• 3. All other assets

• Basis is allocated to assets within a category based on adjusted basis to partnership

Proportionate Nonliquidating Distribution Examples (slide 1 of 6)

Bill’s basis in partnership interest: $30,000 Proportionate nonliquidating distributions (independent fact situations): Assets Distributed A B C .Cash $15,000 $15,000 $ 5,000Land—basis N/A $ 6,000 N/A

(Fair mkt value) N/A $10,000 N/A Accts rec—basis N/A N/A -0- (Fair mkt value) N/A N/A $16,000


A B C .

Basis in interest $30,000 $30,000 $30,000

Cash distributed ( 15,000) (15,000) (5,000)

Basis after cash 15,000 15,000 25,000

Acct. rec. distrib. N/A N/A (-0-)

Basis after A.R. 15,000 15,000 25,000

Land Distrib. N/A ( 6,000) N/A

Basis after all dist. $15,000 $ 9,000 $25,000


A B C .

Basis in p’ship int. $15,000 $9,000 $25,000Basis in cash 15,000 15,000 5,000Basis in land N/A 6,000 N/ABasis in A/R N/A N/A -0-Total basis $30,000 $30,000 $30,000

Sale of non-cash assetsat FMV: Selling price N/A $10,000 $16,000Basis N/A (6,000) (-0-)Gain N/A $4,000 $16,000


Bill’s basis in partnership interest: $30,000 Proportionate nonliquidating distributions (independent fact situations): Assets Distributed D E F .Cash $40,000 N/A $20,000Relief of liabilities N/A 40,000 N/ALand-basis N/A N/A $30,000(Fair mkt value) N/A N/A $50,000


D E F .

Basis in interest $30,000 $30,000 $30,000

Cash distributed (40,000) N/A (20,000)

Relief of liabilities N/A (40,000) N/A

Gain recognized 10,000 10,000 N/A .

Basis after cash (and

deemed cash) dist. -0- -0- 10,000

Land distrib. N/A N/A (10,000)

Basis after all distrib. -0- -0- -0-


D E F .Basis in p'ship int. -0- -0- -0-Basis in cash 40,000 N/A 20,000Liabilities relieved N/A 40,000 N/ABasis in land N/A N/A 10,000Gain recognized (10,000) (10,000) N/A .Original basis 30,000 30,000 30,000

Sale of non-cash assetsat FMV: Selling price N/A N/A $50,000Basis N/A N/A (10,000)Gain N/A N/A $40,000

Effect of Liquidating Distribution

• In general:– No gain or loss is recognized by partnership– Partner reduces basis in partnership interest by

basis in property received at each level using Ordering Rules

– Partner’s entire basis in interest will be absorbed by distributed assets

Exceptions to Liquidating Distribution Rules (slide 1 of 2)

• Gain is recognized if:– Cash distributed exceeds partner’s basis– Precontribution gain exceptions– Disproportionate distribution

Exceptions to Liquidating Distribution Rules (slide 2 of 2)

• Loss is recognized only if:– Assets received include only cash, unrealized

receivables and inventory, and– Outside basis exceeds partnership’s inside basis in

distributed property

Proportionate Liquidating Distribution Examples (slide 1 of 4)

Bill’s basis in partnership interest: $30,000

Proportionate liquidating distributions (partnership also liquidates) (independent fact situations):

G H I .

Cash $50,000 $10,000 $10,000

Unrealized rec. N/A -0- -0-

(Fair mkt value) N/A $16,000 $16,000

Filing cabinet (1231) N/A N/A 300

(Fair mkt value) N/A N/A 300


G H I .

Basis in interest $30,000 $30,000 $30,000Cash distribution (50,000) (10,000) (10,000)

Gain recognized 20,000 N/A N/ABasis after cash -0- 20,000 20,000A/R distrib. N/A -0- -0-

Loss recognized N/A(20,000) N/ABasis after A/R -0- -0- 20,000Filing cabinet N/A N/A (20,000)Ending basis $ -0- $ -0- $ -0-


G H I .

Basis in p’ship int. $ -0- $ -0- $ -0-

Basis in cash 50,000 10,000 10,000

Basis in A/R N/A -0- -0-

Basis in filing cabinet N/A N/A 20,000

Capital (Gain)/loss (20,000) 20,000 N/A .

Original basis $30,000 $30,000 $30,000


Sale of non-cash assets at FMV:Example H: A/R Fil.Cab. Total

. Selling price $16,000 N/A $16,000 Basis -0- N/A -0- . Gain/(loss) $16,000 N/A $16,000

(Ordinary)Example I: Selling price $16,000 $ 300 $16,300 Basis -0- 20,000 20,000 Gain/(loss) $16,000 ($19,700) ($3,700)

(Ordinary) (May be ord)

Property Distributions with Special Tax Treatment (slide 1 of 4)

• Disguised sales– Contribution of appreciated property to partnership

followed by a cash distribution to the contributing party may be treated as a disguised sale

– Treated as a sale of property resulting in gain recognition

• Partnership’s basis in the asset is cost


• Marketable securities– FMV of marketable securities distributed to a

partner is treated as a cash distribution• Some or all of excess of FMV of securities distributed

over partner’s outside basis is taxable gain

– Marketable securities include most actively traded debt or equity interests, options, futures, and derivatives

– Exceptions apply


• Precontribution gain property– Contributing partner recognizes gain on

distribution of precontribution gain property in two situations:

• 1. If property is distributed to another partner within 7 years of contribution date, contributing partner recognizes remaining precontribution gain

– Partner’s basis in partnership and basis of distributed property is increased by gain recognized


• Precontribution gain property– Contributing partner recognizes gain on

distribution of precontribution gain property in two situations (cont’d):

• 2. If partnership distributes any property other than cash to a partner within 7 years after that partner contributes appreciated property, the partner recognizes the lesser of:

– Remaining net precontribution gain– Excess of FMV of distributed property over partner’s basis in

partnership interest

Disproportionate Distributions(slide 1 of 3)

• Occurs when partnership distributes cash or property to a partner which increases or decreases the partner’s share of ordinary income-producing assets (hot assets)


• If partner receives less than proportionate share of hot assets, then treated as if:– Partnership distributed some of the assets, and – Partner sold these hot assets back to partnership– Partner recognizes ordinary income on sale of the

hot assets; Partnership’s basis in hot assets is cost


• Hot assets include:– Substantially appreciated inventory

• Inventory includes all assets other than cash, capital and §1231 assets

• Substantially appreciated means FMV > 120% of partnership’s adjusted basis in inventory

– Unrealized receivables• Rights to receive future amounts that will result in

ordinary income recognition

§736: Liquidating Distribution Where P’ship Does Not Liquidate (slide 1 of 3)

• §736(a) income payment:– Treated as distributive share of partnership income or

guaranteed payment to partner– Certain items if partnership is service-provider and retiring

partner is a general partner:• Unrealized receivables (except depreciation recapture)• Goodwill (unless provided for in partnership agreement)

• §736(b) property payment:– Payments made for liquidated partner’s share of

partnership’s assets


• §736(a) income payment:– Partner has:

• Ordinary income (guaranteed payment), or

• Distributive share of income

– Partnership has:• Guaranteed payment (deductible) if determined without

regard to partnership profits

• Distributive share if based on profits


• §736(b) property payment:– Disproportionate distribution to extent of partner’s

share of hot assets– Return of basis (and capital gain (loss) for

remainder)

The Big Picture – Example 27

§ 736(b) Property Payments (slide 1 of 4)

• Return to the facts of The Big Picture on p. 11-2. • Recall that the members of Beachside Properties,

LLC, are considering two alternatives for its future expansion.

• Assume that they decide to admit new partners for $19.5 million and use $9.5 million of the cash to redeem the interests of Kyle and Maria.

• Because the LLC itself is not liquidating, the distribution to Kyle and Maria is classified under § 736.



The current balance sheet for Beachside Properties, LLC, is as follows:



• Capital is a ‘‘material income-producing factor’’ for Beachside Properties, LLC. – The entire $9.5 million distribution from the LLC

to Kyle and Maria is a § 736(b) payment for their interests in the partnership’s property.

– Kyle and Maria will recognize gain to the extent that this cash distribution (including forgiveness of their shares of the LLC’s debt) exceeds their bases in the LLC interests.



• Because Kyle and Maria receive cash in lieu of their shares of the LLC’s unrealized receivables and inventory, this is a disproportionate distribution. – They will recognize ordinary income to the extent that their

gain relates to these receivables and inventory.

• The remaining gain will be a capital gain.• As there are no § 736(a) payments, the LLC cannot

claim any deductions. – Absent a § 754 election (discussed later), the basis of the

LLC’s property will not be affected

Sale of Partnership Interest (slide 1 of 4)

• Generally, results in gain or loss recognition by selling partner– Gain (loss) = amount realized less partner’s basis

in partnership interest– Partnership liabilities assumed by purchasing

partner are treated as part of consideration paid for the partnership interest


• Partnership tax year closes for selling partner on sale date– Partner’s share of income through sale date is

calculated• Can prorate annual income or use interim closing of the

books

– Taxed to selling partner and increases basis in partnership interest


• Effect of hot assets– Hot assets include:

• Unrealized receivables (same as for disproportionate distributions)

• Inventory– Includes all partnership property except money, capital assets,

and §1231 assets


• Effect of hot assets (cont’d)– Must allocate sales price of partnership interest

between “hot” (ordinary income) assets and “nonhot” (capital gain) components

– Selling partner’s gain is classified as a capital gain or loss portion and an ordinary income or loss amount related to the hot assets


Effect Of Hot Assets (slide 1 of 2)

• Return to the facts of The Big Picture on p. 11-2

• Recall that the second restructuring option for Beachside Properties, LLC, is for Kyle and Maria to sell their interests directly to the new members of the LLC. – The new members will contribute $10 million of

cash to Beachside Properties and pay $4.75 million each to Kyle and Maria in exchange for their interests in the LLC.


Effect Of Hot Assets (slide 2 of 2)

• Refer back to the balance sheet in Example 27. – Kyle and Maria will receive cash of $9.5 million (total)

plus relief of their shares of the LLC’s debt. – Their bases in the LLC interests equal their capital account

balances plus their shares of the LLC’s liabilities.• The difference must be recognized as a gain.

– The gain is ordinary income to the extent that it relates to Kyle’s and Maria’s shares of the LLC’s accounts receivable, inventory, and depreciation recapture.

– The remaining gain is a capital gain. • Absent a § 754 election (discussed later), the basis of

the LLC’s property will not be affected.

Other Dispositions of Partnership Interests (slide 1 of 8)

• Transfer of a partnership interest to a controlled corporation– Tax free if §351 requirements are met– If 50% or more of the total interest in capital and

profits of the partnership are transferred, the partnership terminates


• Incorporating a partnership– At least three methods available:

• 1. Transfer each partner’s interest to the corp in exchange for stock

– Partnership terminates

– Corp becomes owner of all partnership assets

– Corp has substituted basis in assets; Old partners have substituted basis in stock


• Incorporating a partnership (cont’d)• 2. Transfer partnership assets to corp in exchange for

stock and assumption of partnership liabilities– Partnership distributes stock to partners in liquidating

distribution

– Corp has carryover basis in assets; Old partners have substituted basis in stock


• Incorporating a partnership (cont’d)• 3. Partnership distributes all assets and liabilities pro

rata to partners in complete liquidation of partnership

– Partners transfer assets and liabilities to corp in exchange for stock under §351

– Corp has substituted basis for assets; Partners have substituted basis for stock


• Incorporating a partnership (cont’d)– All three methods of incorporating a partnership

are tax-free• Exception: if liabilities of partnership exceed basis of

transferred assets


• Nontaxable like-kind exchange rules do not apply to the exchange of interests in different partnerships


• Generally, the gift of a partnership interest is tax-free– Partnership income, loss, etc. is prorated between

donor and donee


• Death of a partner– Taxable year of partnership closes with respect to

that partner on date of death– Compute deceased partner’s share of partnership

income or loss to that date and report on partner’s final Form 1040

§754 Election

• Adjusts partnership’s basis in assets to reflect:– The difference in the amount paid by the purchasing

partner and his share of the inside basis of partnership assets

• The adjustment can be positive or negative

• The adjustment affects the basis of partnership property with respect to the transferee partner only

– Gain or loss recognized by partner receiving distribution from partnership

• Once made, election remains in effect for all future years unless election revoked with IRS consent


§ 754 Election (slide 1 of 2)

• Return to the facts of The Big Picture on p. 11-2. • For either restructuring option, Beachside Properties could

make a § 754 election and reflect an adjustment to the basis of the LLC’s property.

• Step-up related to sale of interests– On a sale of the interests to the new LLC members, the step-up would

equal the difference between the $9.5 million paid and Kyle’s and Maria’s share of the inside basis of the LLC’s property.

– This step-up of approximately $7.6 million [$9.5 million - (95% X $2 million net assets)] would be allocated to the various partnership properties under the rules of § 755 (not discussed in this chapter).

– Deductions related to the stepup, such as depreciation, would be allocated to the new developer group.


§ 754 Election (slide 2 of 2)

• Step-up related to distribution in liquidation of the partners’ interests. – If the LLC redeems the interests of Kyle and Maria, the LLC can step

up the bases of its remaining assets by the amount of gain recognized by Kyle and Maria.

– This step-up is approximately $7.8 million [$9.5million distribution - $1.7 million total basis in partnership interests (Kyle’s basis of $400,000 + Maria’s basis of $1.3 million)], and benefits all the remaining partners in the partnership.

• Note that the step-up differs depending on whether there is a sale or redemption, because Kyle’s and Maria’s share of the basis of the assets differs from their basis in the LLC interests

Termination of Partnership(slide 1 of 3)

• Partnership terminates when either of the following events occur:– No part of the business continues to be carried on

by any partners – Within a 12-month period, 50% or more of the

partnership’s capital and profits interests are sold or exchanged

Termination of Partnership (slide 2 of 3)

• Partnership terminates and its tax year closes when:– The partnership incorporates– One partner in a two-party partnership buys out the

other partner

• A termination also occurs when the partnership ceases operations and liquidates

Termination of Partnership (slide 3 of 3)

• Partnership tax year usually does not close:– Upon the death of a partner– Entry of a new partner– Liquidation of a partner’s interest in other than a

two-party partnership– Sale or exchange of a less than 50% partnership

interest


Termination Of A Partnership (slide 1 of 2)

• Return to the facts of The Big Picture on p. 11-2. • Before the sale or redemption, Kyle’s and Maria’s

combined interests equal – 95% of the LLC’s capital, and

– 80% of the LLC’s profits interests.

• If they both sell their interests within a 12-month period, they will cause a technical termination of the existing LLC, and a new LLC will be deemed to be formed.


Termination Of A Partnership (slide 2 of 2)

• A technical termination would require redetermination of the LLC’s basis in its assets and reestablishing the (new) LLC as an entity.– Note: The partners could structure the sale so that the

termination did not occur.– For example, have Kyle and Maria sell less than a 50%

interest in the LLC in one year and the remaining interest more than 12 months later.

• If the LLC redeems the interests, there is no sale or exchange transaction, and no technical termination of the LLC.

Family Partnerships (slide 1 of 3)

• Owned and controlled primarily by members of the same family– Often formed to save taxes by funneling some of

parent’s income to the children

• Often difficult to establish for tax purposes


• Family member will be recognized as a partner if:– Capital is a material income-producing factor and

partnership interest is acquired in a bona fide transaction where ownership and control are received

• Can be acquired by gift or purchase from another family member

– Capital is not a material income-producing factor, but family member contributes substantial or vital services


• Kiddy tax may apply to child partner under age 19 (or a student under age 24) and claimed as a dependent by parent-partner

• Family member whose interest is acquired by gift from another family member may only have a portion of partnership income allocated to them– Donor partner must be allocated income representing

reasonable compensation for services rendered to the partnership

Limited Liability Companies

• A LLC with 2 or more owners is taxed as a partnership– LLC members are not personally liable for debts of

the entity• Effectively treated as a limited partnership with no

general partners

– LLCs are relatively new so there is no established body of case law available

• Makes planning difficult

Limited Liability Partnerships

• Partners are not personally liable for the malpractice and torts of their partners

• Taxable as a partnership

• Conversion of a general partnership into a LLP is not taxable if all of the general partners become LLP partners and hold the same proportionate interest

Refocus On The Big Picture (slide 1 of 3)

• Two things are happening when the new developers become members of Beachside Properties, LLC. – The developers are buying out the interests of two existing

LLC members, and – They are providing cash with which to expand the LLC’s

operations.• The expansion itself raises no specific tax problems.

– An LLC can admit new members with no immediate tax consequences.

• In addition to the issues addressed earlier in the chapter, the LLC’s operating agreement should be modified to ensure that there is no shift in ownership rights between Josh and the new LLC members.


What If?

• Changing the facts, assume the developers have only $2 million in cash, with good prospects for receiving an additional $2 million over the next two years, and $1 million more in the third year. – The LLC has found a bridge loan and temporary

financing to cover costs during this interim period.


What If?• This loan, though, is not large enough to also completely buy

out Kyle’s and Maria’s interests. – Thus, they have agreed to accept installment payments for the sale or

redemption of their interests.

• Now the buyout of Kyle and Maria can be treated either as an installment sale or as a redemption under § 736 requiring a series of payments.

• While the specific results of these arrangements are beyond the scope of this chapter, different tax consequences might arise as to the timing and character of Kyle’s and Maria’s gain recognition.

72© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, [email protected]

SUNY Oneonta

Technology

Vol 02 chapter 11 2012