4-1 of gain or loss is the general rule for property...

Property Contributions to

Partnerships

Chapter 4

Nonrecognitionof gain or loss is the general rule

for property contributions to

partnership

4-1

Compare contributions of

services in which the

general rule is income (Ch 5)

4-1

A letter of intent may be

property

Stafford727 F.2d 1043 (CA11 1984)

4-3

“the absence of enforceability does not necessarily preclude a

finding that a document, substantially committing the parties to the major terms of a development

project, is property”:

4-3

Other Examples:

• Unpatented know-how

• Unpatented secret processes

4-3

Mark IV Pictures v. Comm’r, 969 F.2d 669

(8th Cir. 1992),

The facts showed that the payments were for

services, and not for film rights

7

4-3

Partnership Level Gain on Transfers of Equity Intersts

for Services 4-4

2005 Proposed Equity for Services

Regulations

The Treasury and IRS view is that

“partnerships should not be required to recognize gain on the transfer of a

compensatory partnership interest.”

McDougal required gain recognition to a race horse owner on the transfer of a

one-half interest in the appreciated race horse to a trainer who fixed the leg of the race horse, immediately prior to the contribution of the race horse to a newly

formed partnership.

Built-in Gain Property:

IRC sec. 704(c) Property

Example 4-1 4-5

• Dave and Donna form an equal partnership to operate an orchard

• Dave contributes $100,000.

12

Donna contributes:

FMV BasisLand $50,000 $10,000

Equip. $50,000 $25,000

13

• Donna does not recognize gain.

• The partnership’s tax basis in the land and equipment is $10,000 and $25,000 respectively.

• The partnership’s book basis in the land and equipment is $50,000 each (FMV)

14

If the land is sold for $50,000, then

the entire tax gain of $40,000 is

allocated to 50% partner Donna (Sec. 704(c))

15

Donna contributes:

FMV BasisLand $50,000 $10,000

Money $50,000 $50,000

16

ObservationWhat if:

As part of the deal she receives a distribution of $50,000 six months later

and the distribution reduces her partnership

interest from 50% to 33.33%

17

Book Capital Accts (In Thousands)

Donna(50%)

Dave(50%)

Beginning Bal. 100 100

Distribution -50


Donna(33%)

Dave(66.6%)

Beginning Bal. 100 100

Distribution -50

Ending Bal. 50 100

Tax free recovery of $60,000 of outside

basis?

• Likely disguised sale of land (Chap. 6) –Donna recognizes $40,000 of gain on the sale.

• Can use installment method if eligible. 20

Example 4-2A 4-7

Alice contributes land to a partnership in exchange for a 20% partnership interest:

$10,000 FMV$4,000 Adjusted Basis

Bill and Carol each contribute $20,000 for two 40% interests. 21

4-7

No gain recognition for Alice (Sec. 721)

Alice’s outside basis = $4,000 (Sec. 722)

Partnership’s inside basis = $4,000 (Sec. 723)

Alice’s beginning Sec. 704(b) “capital account” is $10,000.22

If the land were sold by the partnership for $10,000, how much of the $6,000 recognized tax gain would be allocated to Alice?23

4-7

$6,000 (Sec. 704(c))

24

If the land were sold by the partnership for $10,000, does the partnership have any Sec. 704(b) book gain?

25

No Book GainBook basis of contributed property is FMV (Sec. 704(b)).

26

If the land were sold by the

partnership for $20,000?

27

Book gain is now $10,000

($20,000 - $10,000) and

$2,000 (20%) of book gain is

allocated to Alice.28

The tax gain is $16,000

($20,000 - $4,000).

How much is allocated to Alice on her K-1?

29

$8,000 is Allocated to Alice:

$6,000 (first $6K)*

* Sec. 704(c) tax gain 6K

30

$8,000 is Allocated to Alice:

$6,000 (first $6K)*+ $2,000 (20% x $10K)**= $8,000

* Sec. 704(c) tax gain 6K** Sec. 704(b) tax & book

gain of 10K31

Alice’s beginning capital account:

Beg. EndBook $10,000

Tax $4,00032

Alice’s ending capital account:

Beg. EndBook $10,000 $12,000

Tax $4,000 $12,000 33

What if the partnership had total recourse debt of $10,000 of which $2,000 (20%) is allocated to Alice under sec. 752

34

Example 4-2B

Impact of Partnership Debt

A net increase in a partner’s share of debt is a deemed contribution of money by the partner.(Sec. 752)35

The impact of the net debt assumption $2,000 is that Alice’s outside basis is increased by the $2,000:

$4,000 basis of contrib. prop.+$2,000 deemed cash contrib.=$6,000 Alice’s outside basis.

36

The $2,000 debt share does not increase the

partnership’s $4,000 inside tax basis in

the contributed property

37

Subsequent Increases and Decreases in Outside Basis

Sec. 705

OrderingBeginning O.B.

+ Income (exempt also)

- Distributions- Losses= Ending O.B.

39

Example 4-2C

What if Alice in Example 4-2A received a liquidating distribution of $10,000 cash from the partnership when her pre-distribution outside basis is $4,000 (not a disguised sale)? 40

4-8

$6,000 of gain (Sec. 731(a)(1))

41

• Does not appear directly on the parter’s K-1

• Does not increase outside basis

• Does increase at-risk basis

If the partnership made a section 754 election, the section 734 adjustment of $6,000 eliminates the gain to the continuing partners—Bill and Carol 42

Without a Section 754

Election43

Absent a section 754 election, if the land were subsequently sold for $10,000, the tax gain of $6,000 would be allocated $3,000 to Bill and $3,000 to Carol (50-50 partners). 44

However, that gain would increase each continuing partner’s outside basis from $20,000 to $23,000.

45

If Bill and Carol were liquidated for $20,000,

then each would recognized a loss of

<$3,000> under section 731 (capital

loss). 46

Example 4-2D

What if Alice’s share of partnership debt is reduced by $10,000 when her pre-distribution outside basis is $4,000? 47

4-8

Impact of Partnership Debt

A net decrease in a partner’s share of partnership debt is a deemed distribution of money to the partner. (Sec. 752)48

$6,000 of gain (Sec. 731(a)(1)

Example 4-2E

What if Alice is properly allocated losses of <$10,000> when her post-distribution outside basis is $4,000? 50

4-9

<$4,000> deducted (IRC sec. 704(d))

<$6,000> suspended

51

Example 4-2F

$4,000 Beginning O.B.

Alice’s K-1:<$7,000> Losses

$3,000 Cash Distribution

52

4-9

OrderingBeginning O.B.

+ Income- Distributions- Losses= Ending O.B.

53

$3,000 distribution reduces her outside basis to $1,000 ($4,000 O.B. - $3,000 distribution).

<$1,000> loss is deductible

<$6,000> losses are suspended.

54

VisionMonitorSoftware, LLC, TC Memo 2014-182 (Sept. 3, 2014)

Partnership Had No Basis in Partner Notes

Contributed to Partnership Until Notes are Paid 55

4-9

Contributed Property with a Built-in Loss and

Prop. Regs.

REG-144468-05 (Feb. 3, 2014)

56

4-10

The prop. regs. require the tax

basis balance sheet to reflect the built-in loss contributed

property at FMV

What happens to the contributing partner’s built-in

loss?

The built-in loss becomes a special exclusive basis

adjustment of the contributing partner

(AKA: the “section 704(c)(1)(C) adjustment”)

Example 4-3AAdam contributes raw land (Blackacre):$50,000 FMV$90,000 Basis

Melvin contributes $50,000 cash.

4-11

ContributingPartner Adams

NoncontributingPartner Melvin

Tax Book Tax BookBeg. Bal. 50,000 50,000 50,000 50,000

The partnership would show a common balance sheet tax basis of $50,000 (FMV) in Blackacre

Adam has a section 704(c)(1)(C) basis

adjustment of $40,000

($90,000 - $50,000) in the Land

62

Similar to basis adjustments under section 743(b), a section 704(c)(1)(C) basis adjustment is unique to the contributing partner and does not affect the common balance sheet basis of partnership property

Blackacreappreciates and is subsequently sold for $70,000

65

Adam MelvinTax Book Tax Book

Beginning Capital 50,000 50,000 50,000 50,000Blackacre Sale for $70,000 10,000 10,000 10,000 10,000

Ending Capital 60,000 60,000 60,000 60,000

Book and Tax Gain is $20,000

(split 50/50)

Adam’s $40,000 IRC sec. 704(c)(1)(C)

adjustment would offset his $10,000 gain and produce a net loss of

($30,000) ($10,000 – 40,000)

Adam’s outside basis is reduced to $60,000

($90,000 (beg. O.B.) -$30,000 (net loss)

Matching Tax and Book capital accounts

If, prior to the Blackacre sale, Adam

gave his 50% partnership interest to his daughter, the section 704(c)(1)(C)

adjustment is eliminated68

If Blackacre is sold following the gift, then the daughter would report the $10,000 of gain

69

Example 4-3BWhat if Adam contributed:Blackacre:

$45,000 Adjusted Basis$5,000 FMV

andWhiteacre:

$5,000 Adjusted Basis$45,000 FMV

4-12

ContributingPartner Adams

NoncontributingPartner Melvin

Tax Book Tax BookBeg. Bal. 10,000 50,000 50,000 50,000

The partnership would show a common balance sheet tax basis of $5,000 (FMV) in Blackacre and $5,000 (A.B.) in Whiteacre

Adam has a section 704(c)(1)(C) basis

adjustment of $40,000

($45,000 (A.B.) -$5,000 (FMV)) in

Blackacre72

Blackacreappreciates and is subsequently sold for $25,000

74

Adam MelvinTax Book Tax Book

Beginning Capital 10,000 50,000 50,000 50,000Blackacre Sale for $25,000 10,000 10,000 10,000 10,000

Ending Capital 20,000 60,000 60,000 60,000

Book and Tax Gain is $20,000

(split 50/50)

Adam’s $40,000 IRC sec. 704(c)(1)(C)

adjustment would offset his $10,000 gain and produce a net loss of

($30,000) ($10,000 – 40,000)

Adam’s outside basis is reduced to $20,000

($50,000 (beg. O.B.) -$30,000 (net loss)

matching tax basis capital accounts

If Whiteacre were subsequently sold

for $45,000(tax gain of

$40,000)

Adam Capital Melvin Capital

Tax Book Tax Book

Beginning Balance 20,000 60,000 60,000 60,000

Whiteacre Sale for $45,000

40,000

Ending Capital 60,000 60,000 60,000 60,000

IRC sec. 704(c)(1)(C) is

Not Applicable to

Reverse Section 704(c) Allocations.

Prop. Reg. Example Involving

Depreciable Property

4-13

• A contributes depreciable Property on January 1:$12,000 adjusted basis

$5,000 fair market value

• B contributes $5,000 to PRS, a partnership.

• A’s property had a 10 Year MACRS life with 7.5 years remaining at the time of contribution.

4-13

• PRS's basis in Property is $5,000 (fair market value) and the depreciation is $667 per year ($5,000 divided by 7.5 years), which is shared equally between A and B.

A’s 704(c)(1)(C) basis adjustment is

$7,000 ($12,000 (A.B.) -

$5,000 (FMV) 83

A's $7,000 section 704(c)(1)(C) basis

adjustment is subject to depreciation of $933 per

year ($7,000 ÷ 7.5 years)

If a partner with a sec. 704(c)(1)(C) adjustment sells their partnership interst, then the

adjustment is eliminated.

The prop. regs. are effective when

finalized.“No inference is

intended … before the effective date of these

regulations”

Introduction To Partnership

Capital Accounts

87

4-21

88

Why maintain Sec. 704(b)book capital accounts?

89

Section 704(b) requires capital

account maintenance to use the safe harbors for

substantial economic effect

90

Helps establish capital and profit

percentage of contributing partner

+704(c) tracking and revaluations

91

Helps establish how much to distribute to a redeemed partner

+704(c) revaluations

92

Proposed section 751(b) regulations require

capital account revaluation if other

property is distributed and partnership has 751

property after the distribution

93

The recently proposed regulations governing the allocation of nonrecourse deductions rely upon book

capital accounts to allocate excess nonrecourse debt

under section 752.

94

Need not use book capital accounts

on Schedule L and K-1s

Ordering Matches O.B.

Beginning Cap.+ Income- Distributions- Losses= Ending Cap.

95

FMV of contributed property

FMV of distributed property

• a pre-distribution adjustment must be made to reflect unrealized appreciation or depreciation in the distributed property

Capital Accounts (“Book”)

96

1) Contribution of money or property in exchange for partnership interest.

2) Distribution of money or property in exchange for partnership interest.

Optional Adjustments to Book Capital Accounts

97

3) Grant of partnership interest for services

4) In connection with issuance of noncompensatory option

5) Under GAAP mark to market rules.

98

The Optional Adjustments Are Made for All Partnership

Property With Unrealized Appreciation or Depreciation

99

Example 4-4The ABC Partnership is a

dealer in real estate

Section 704(c) Basics

4-23

ABC Partnership

AliceBill

Blackacre FMV $1,000,000Adj. Basis: $100,000

30%50%

Carol$600,000

$400,000

20%

Assets:704(b)

Book BasisCash $1,000,000Blackacre $1,000,000

Total $2,000,000Capital:

Alice 50% $1,000,000Bill 30% $600,000Carol 20% $400,000

Debt + Capital $2,000,000

Balance Sheet After Formation

Assets: Tax Basis704(b)

Book BasisCash $1,000,000 $1,000,000Blackacre $100,000 $1,000,000

Total $1,100,000 $2,000,000Capital:

Alice 50% $100,000 $1,000,000Bill 30% $600,000 $600,000Carol 20% 400,000 400,000

Debt + Capital $1,100,000 $2,000,000


Blackacre (land)--held for sale --

is sold for $1,000,000 at the end of

Year 1

Ordinary Gain $900,000(1,000,000 – 100,000)

No other income or loss.

IRC sec. 704(c) forces all $900K of the tax gain

to Alice

Zero Book Gain


Book BasisCash $2,000,000 $2,000,000Capital:

Alice 50% $1,000,000 $1,000,000Bill 30% $600,000 $600,000Carol 20% 400,000 400,000

Debt + Capital $2,000,000 $2,000,000

Balance Sheet After Sale

Example 4-5ASecond 704(c) Layer

4-23

Same original facts as Example 4-4

above

ABC Partnership

AliceBill

Blackacre FMV $1,000,000Adj. Basis: $100,000

30%50%

Carol$600,000

$400,000

20%


Book BasisCash $1,000,000 $1,000,000Blackacre $100,000 $1,000,000

Total $1,100,000 $2,000,000Capital:

Alice 50% $100,000 $1,000,000Bill 30% $600,000 $600,000Carol 20% 400,000 400,000

Debt + Capital $1,100,000 $2,000,000


Later, Blackacre

appreciates by $1,000,000

Assets: Tax Book FMVCash 1,000 1,000 1,000Blackacre $100 1,000 2,000

Total $1,100 2,000 3,000Capital:

Alice 50% $100 1,000 1,500Bill 30% $600 600 900Carol 20% 400 400 600

Debt + Capital $1,100 2,000 3,000

Balance Sheet After Appreciation of Blackacre (in Thousands)

Donna contributes $3,000,000 for a 50% interest in

ABCD

Per the partnership agreement, book

capital accounts are adjusted to reflect current FMV at the

time Donna becomes a partner.

Reverse 704(c)

Assets: Tax Basis Book BasisCash $4,000,000Blackacre $2,000,000


Donna 50% $3,000,000Alice 25% $1,500,000Bill 15% $900,000Carol 10% 600,000


Revalued ABCD Balance Sheet After Donna Contributes $3 Mil.

Assets: Tax Basis Book BasisCash $4,000,000 $4,000,000Blackacre $100,000 $2,000,000

Total $4,100,000 $6,000,000Capital:

Donna 50% $3,000,000 $3,000,000Alice 25% $100,000 $1,500,000Bill 15% $600,000 $900,000Carol 10% 400,000 600,000

Debt + Capital $4,100,000 $6,000,000

Revalued ABCD Balance Sheet


is sold for $2,000,000.

Zero Book Gain


Alice Bill Carol

Beginning 1,000 600 400


Donna Alice Bill Carol

Beginning 1,000 600 400

Donna Admitted

3,000


Donna Alice Bill Carol

Beginning 1,000 600 400

Donna Admitted

3,000

Revaluation 500 300 200Blackacre Sale

0 0 0 0

Ending Cap. 3,000 1,500 900 600

Tax gain of $1,900,000

($2,000,000 -$100,000)

First $900,000(forward 704(c)):

All to Alice

Second $1,000,000(reverse 704(c)):

$500,000 to Alice$300,000 to Bill$200,000 to Carol

Tax Basis Capital Accts (In Thousands)Alice(25%)

Bill(15%)

Carol(10%)

Beginning 100 600 400

Tax Basis Capital Accts (In Thousands)

Donna(50%)

Alice(25%)

Bill(15%)

Carol(10%)


Donna Admitted

3,000

Revaluation


Donna(50%)

Alice(25%)

Bill(15%)

Carol(10%)


Donna Admitted

3,000

Revaluation

Blackacre Sale

0 1,400 300 200

Ending Cap. 3,000 1,500 900 600

Assets: Tax Basis Book BasisCash $6,000,000Capital:




Assets: Tax Basis Book BasisCash $6,000,000 $6,000,000Capital:

Donna 50% $3,000,000 $3,000,000Alice 25% $1,500,000 $1,500,000Bill 15% $900,000 $900,000Carol 10% 600,000 600,000

Debt + Capital $6,000,000 $6,000,000


If the cash is distributed in

liquidation per book capital accounts,

then zero tax gain or loss to

all partners on liquidation.

Variation on 4-5A(not in Text)

Strategy with Debt. The Entity is an LLC

What if Donna does not want to pay

$3,000,000 for her 50% interest?

Any win-win solutions?


Total $1,100 2,000 3,000Capital:

Alice 50% $100 1,000 1,500Bill 30% $600 600 900Carol 20% 400 400 600

Debt + Capital $1,100 2,000 3,000

ABC Balance SheetBefore Donna Joins (in Thousands)

The partnership could first borrow

$1,000,000 and distribute it to Alice

($500,000), Bill ($300,000) and Carol

($200,000)

Alice, Bill, and Carol would

proportionately guarantee the LLC

debt(Donna does not guarantee

the LLC debt)


Total $1,100 2,000 3,000Debt 1,000 1,000 1,000Capital:

Alice 50% -400 500 1,000Bill 30% 300 300 600Carol 20% 200 200 400

Debt + Capital $1,100 2,000 3,000

ABC Balance Sheet (in Thousands)

Does the Distribution trigger tax

gain for Alice?

NO!

100,000 Beg.+ 500,000 Debt Share- 500,000 Distribution

= 100,000 End.(no change when Donna joins)

Alice’s Outside Basis


Total $3,100 5,000 5,000Debt 1,000 1,000 1,000Capital:Alice 25% -400 1,000 1,000Bill 15% 300 600 600Carol 10% 200 400 400Donna 50% 2,000 2,000 2,000Debt + Cap. $3,100 5,000 5,000

ABCD Balance Sheet (in Thousands)

A big problem for Alice if Donna were

subsequently allocated 50% of the

debt reducing Alice’s share by

$250,000

100,000 Beg.- 250,000 Distribution= 0

Sec. 731(a) gain of $150,000

Alice’s Outside Basis

Example 4-5BContribution at a

Discount

4-25

Same facts as Example 4-4A except Donna negotiates a 25%

discount ($750,000 discount)

and contributes $2,250,000 for her 50%

interest.


Total $1,100 2,000 3,000Capital:

Alice 50% $100 1,000 1,500Bill 30% $600 600 900Carol 20% 400 400 600

Debt + Capital $1,100 2,000 3,000

Balance Sheet Before Donna’s Contribution (in Thousands)

The negotiated $2,250,000

contribution must be used to imply the post-

contribution book value of partnership

assets

“[T]he fair market value assigned to property … revalued by a partnership, will be regarded as correct, provided that

1) such value is reasonably agreed to among the partners in arm's-length negotiations, and

2) the partners have sufficiently adverse interests.”

Reg. 1.704-1(b)(2)(iv)(h)

So the implied FMV of partnership assets, after Donna’s contribution, is

$4,500,000

.50 x X = 2,250,000

X = 4,500,000

The implied value of Blackacre is $1,250,000:

4,500,000 -- Total Asset Value- 3,250,000 -- Cash

= 1,250,000 -- Blackacre FMV

Assets: Tax Basis Book BasisCash $3,250,000Blackacre $1,250,000




Revalued ABCD Balance SheetAfter Donna Contributes $2.25 Mil.

Assets: Tax Basis Book BasisCash $3,250,000 $3,250,000Blackacre $100,000 $1,250,000

Total $3,350,000 $4,500,000Capital:

Donna 50% $2,250,000 $2,250,000Alice 25% $100,000 $1,125,000Bill 15% $600,000 $675,000Carol 10% 400,000 450,000

Debt + Capital $3,350,000 $4,500,000

Revalued ABCD Balance SheetAfter Donna Contributes $2.25 Mil.


is sold for $2,000,000 for a

book gain of $750,000

($2,000,000 -$1,250,000)

Allocation of Book Gain of 750,000:

$375,000 to Donna (50%)$187,500 to Alice (25%)$112,500 to Bill (15%)

$75,000 to Carol (10%)


Donna(50%)

Alice(25%)

Bill(15%)

Carol(10%)

Beginning 1,000 600 400

Donna Admitted

2,250


Donna(50%)

Alice(25%)

Bill(15%)

Carol(10%)

Beginning 1,000 600 400

Donna Admitted

2,250

Revaluation 125 75 50


Donna(50%)

Alice(25%)

Bill(15%)

Carol(10%)

Beginning 1,000 600 400

Donna Admitted

2,250

Revaluation 125 75 50

Blackacre Sale

375 187.5 112.5 75

Ending Cap. 2,625 1,312.5 787.5 525

Tax gain of $1,900,000

($2,000,000 $100,000)

First $900,000(forward 704(c):

All to Alice

Second $250,000(reverse 704(c)):

$125,000 to Alice$75,000 to Bill$50,000 to Carol

Third $750,000(matches book gain (704(b)):

$375,000 to Donna (50%)

$187,500 to Alice (25%)

$112,500 to Bill (15%)

$75,000 to Carol (10%)


Donna(50%)

Alice(25%)

Bill(15%)

Carol(10%)


Donna Admitted

2,250

Revaluation


Donna(50%)

Alice(25%)

Bill(15%)

Carol(10%)


Donna Admitted

2,250

Revaluation

Blackacre Sale

375 1,212.5 187.5 125

Ending Cap. 2,625 1,312.5 787.5 525

Assets: Tax BookCash 5,250 5,250Capital:

Donna 50% 2,625 2,625 Alice 25% 1,312.5 1,312.5Bill 15% 787.5 787.5Carol 10% 525 525

Total Capital 5,250 5,250

Balance Sheet After Sale (in Thousands)

If the cash is distributed in

liquidation per book capital accounts,

then zero tax gain or loss to

all partners on liquidation.

704(c)Allocation Methods

(Examples moved to Chapter 8)

Contribution of Property Subject to Recourse Debt

Reg. 1.752-1

4-29

Alice contributes land to a corporation for 20% of the stock (assume Sec. 351 applies):

$10,000 FMV$4,000 Adjusted Basis$6,000 Recourse Debt

165

S (or C) Corporation Example

Although she is protected by Sec. 351, she must recognize $2,000 of gain under Sec. 357(c)—debt relief in excess of her total basis in total contributed property ($6,000 - $4,000).

166

Example 4-7

Alice contributes land to partnership for 20% interest:

$10,000 FMV$4,000 Adjusted Basis$6,000 Recourse Debt

167

4-27

Alice’s remaining outside basis (O.B.):

$4,000 A.B. of Land-$4,800 Debt (80%) Allocated to other Ps$ 0 Ending O.B.

Gain of $800 (Cash in excess of O.B.)

168

Contribution of Property Subject to Nonrecourse

Debt

Reg. 1.752-3

4-30

Example 4-8

Alice contributes land to partnership for 20% interest:

$10,000 FMV$4,000 Adjusted Basis$6,000 Non-Recourse Debt

170

4-29

Alice’s share of the $6,000 nonrecourse debt is $2,800:

Tier One: Zero (no minimum gain)

Tier Two: $2,000 ($6,000 (debt) -$4,000 (land adjusted basis))

Tier Three: $800 (($6,000 (debt) -$2,000 (tier two allocation)) x 20%)171

Alice’s remaining outside basis (O.B.):

$4,000 A.B. of Land-$3,200 Debt Allocated to other Ps$ 800 Alice’s O.B.

Zero Gain Recognized

172

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