Chapter 6 – Allocation of Partnership Income Among the Partners: The Substantial Economic Effect Requirement
What requirements must be met in order for an allocation of income or loss to have economic effect?
(a) Capital accounts must be properly maintained
(b) Liquidating distributions must be made according to capital accounts
(c) Partners must be required to restore deficit capital accounts upon liquidation
1. A, B, and C form the equal ABC partnership. Capital accounts are properly maintained. Depreciation is allocated completely to C, but any distributions in liquidation will be made equally to each partner, although partners are required to restore deficit capital accounts upon liquidation. Does the allocation of depreciation have economic effect?
No. Liquidating distributions must be made according to capital accounts
2. A, B, and C form the equal ABC partnership. Capital accounts are properly maintained. Depreciation is allocated completely to C, and any distributions in liquidation will be made according to the capital accounts of each partner. However, under local law any excess of liabilities over assets at the time of liquidation must be made up equally by each partner. Does the allocation of depreciation have economic effect?
No. Partners must be required to restore deficit capital accounts upon liquidation, although it can be local law, rather than the partnership agreement, that requires the restoration.
3. A, B, and C form the equal ABC partnership by contributing $100,000 each, and purchasing some equipment for $300,000. The equipment has a depreciable life of six years, and all depreciation (straight line) is allocated to A. Capital accounts are properly maintained. Any distributions in liquidation will be made according to the capital accounts of each partner. Partners are required to restore deficit capital accounts upon liquidation. Income aside from depreciation is $60,000 each year. If the partnership were liquidated at the end of year three, how much would each partner get?
A / B / CContribution / $100,000 / $100,000 / $100,000
Income (3 yrs) / $60,000 / $60,000 / $60,000
Depreciation (3 yrs) / - $150,000
Liquidation Amount / $10,000 / $160,000 / $160,000
What would your answer be if the liquidation occurred at the end of year four?
A / B / CContribution / $100,000 / $100,000 / $100,000
Income (4 yrs) / $80,000 / $80,000 / $80,000
Depreciation (4 yrs) / - $200,000
Capital Account Balance / -$20,000 / $180,000 / $180,000
Liquidation amount / $0 / $180,000 / $180,000
Note that the only way B and C will actually receive $180,000 each is if A contributes $20,000 to the partnership. Otherwise the partnership assets will only total $300,000 + $240,000 - $200,000 = $340,000 (assuming the equipment is sold for its adjusted basis at the time of liquidation). If this were the case then B and C, not A, would be bearing the economic burden of the last $20,000 of depreciation deduction allocated to A.
4. Partner A of the AB partnership has $100,000 of NOLs, and partner B has $100,000 of long term capital losses. The partnership is expected to earn $100,000 of ordinary income and $100,000 of long term capital gains during the year. The partnership agreement is amended to allocate this year’s ordinary income to A and long term capital gain to B. Assume that the three tests for economic effect are met. Is this allocation substantial? Why or why not? What type of allocation is it, a shifting allocation or a transitory allocation? Would the allocation be substantial if A did not have a net operating loss carryforward?
This allocation is not substantial, because there is at least one partner (in this case both of them) who benefits, on a present value basis, from the allocation, and there is a strong likelihood that none of the partners will be hurt by the allocation, again on a present value basis. This is an example of a shifting allocation, because it occurs in one year. Transitory allocations are allocations that occur in one or more current years and are offset by other allocations in future years. If A did not have a net operating loss carryforward, then the allocation would be substantial. This is because the allocation of all of the ordinary income to A would not result in a strong likelihood that the after-tax consequences of no partner would be diminished, since A’s consequences would almost certainly be diminished. This is due to the fact that without the special allocation A would have $50,000 of ordinary income and $50,000 of long term capital gain, which would be subject to a maximum tax rate of 15%. With the special allocation, A instead has $100,000 of ordinary income, all subject to regular tax rates.
5. The ABCD Partnership owns an office building. In a special allocation that has economic effect, partner D is allocated all of the depreciation from the building, and all of the gain from any sale of the building, up to the amount of depreciation taken. Any gain in excess of depreciation taken is to be split equally among the partners. The building is expected to be sold for a substantial gain within four years. Is this allocation substantial? Why or why not?
Yes, this allocation is substantial, because the fair market value of the building in the future when it is sold is presumed to be equal to its book value. This would mean that there is a nonrebuttable presumption that there will be no gain on the sale, and D’s decrease in her capital account from the extra depreciation is not expected to be made up by the gain, at least according to the tax rules. Her potential hypothetical liquidation proceeds from the partnership would therefore be reduced by the additional depreciation, by an amount that exceeds the tax savings from her additional depreciation deductions. In short, there would not be a strong likelihood that no partner would be hurt by the allocation, so the allocation would be substantial.
Paragraph 607.
1. Suppose that a partner’s capital account balance and tax basis in her partnership interest is $200, and the FMV of her partnership interest is $300. In liquidation of her interest she gets distributed property with a FMV of $300 and a book value of $200. She had a 25% interest, so this leaves her with a capital account of $200 + $25 - $300 = -$75. She is no longer a partner, so what can the partnership do to make this deficit capital account go away?
It can revalue all partnership assets, and the book gain on the remaining assets should zero out her capital account.
2. If a partner contributes encumbered property to a partnership, what are the effects on his capital account for book purposes? How is this different from the effects on his basis when he contributes encumbered property?
The capital account is increased by FMV – liability.
His basis will be increased by basis of the property – liability + his share of the liability (through the partnership).
3. If a partnership distributes encumbered property to a partner, what are the effects on her capital account? How is this different from the effects on her basis when she is distributed encumbered property?
The capital account is increased/reduced by her share of the book gain/loss, and the capital account is then reduced by FMV – liability assumed.
Her basis will be decreased by the basis of the property, increased by the liability assumed, and is decreased by her reduction in her share of the partnership’s liabilities.
4. Partner A is a 25% partner, and has a basis in her interest and capital account balance of $200,000. She contributes some land (FMV = $100,000, basis = $60,000, liability attached = $40,000) to the partnership. How much are her book capital account and basis afterward?
Book capital account: $200,000 + $100,000 - $40,000 = $260,000.
Basis = $200,000 + $60,000 -$40,000 + $10,000 (share of liability) = $230,000.
Chapter 7 – Allocation of Income and Losses from Contributed Property: Code Sec. 704(c)
Reading:
Paragraphs 701-702.
1. T and K formed new partnership TK to operate a charter boat service in Florida. T contributed a boat with a tax basis of $210,000 and a fair market value of $350,000. K contributed $350,000 cash. The partnership agreement allocates profits, losses, and capital 50% to each partner. The agreement satisfies the requirements of Code Sec. 704(b).
a. Assume the fishing boat is depreciated using the straight-line method over 7 years. Further assume that the partnership deducts a half-year of depreciation expense in its first year of operations. How will year 1 book and tax depreciation be allocated between the partners?
Under Code Sec. 704(b), book depreciation will be allocated equally in accordance with the partnership agreement. The allocation of tax depreciation, however, must be allocated under Code Sec. 704(c) in a manner that reflects the difference between the book and tax basis of the boat. Sec. 704(c) requires that tax depreciation be allocated to the non-contributing partner in the same amount as she is allocated for book if possible. The remainder, if any, will be allocated to the contributing partner:
T / K / ∑Book depreciation ($350,000 ÷ 7 x ½) / $12,500 / $12,500 / $25,000
Tax depreciation ($210,000 ÷ 7 x ½) / 2,500 / 12,500 / 15,000
b. Assume the partners agreed to dissolve the partnership at the end of year 1. The partnership sold the boat for $400,000 and liquidated. How much gain will it recognize on sale of the boat for book and tax? How will this gain be allocated between the partners?
As with depreciation expense, K (the non-contributing partner) is allocated tax gain in an amount equal to her book allocation. Under Code Sec. 704(c), the remainder is allocated to T (the contributing partner):
T / K / ∑Book gain ($400,000 –[325,000]) / $37,500 / $37,500 / $75,000
Tax gain ($400,000 –[210,000-15,000]) / 167,500 / 37,500 / 205,000
2. Assume the same facts as above, except that the tax basis of the fishing boat was only $140,000, rather than $210,000. If the partnership uses the traditional method under Code Sec. 704(c), how will year 1 tax depreciation be allocated between the partners?
Under Code Sec. 704(b), book depreciation will be allocated equally in accordance with the partnership agreement. The allocation of tax depreciation, however, must be allocated under Code Sec. 704(c) in a manner that reflects the difference between the book and tax basis of the boat. Sec. 704(c) requires that tax depreciation be allocated to the non-contributing partner in the same amount as she is allocated for book if possible. The remainder, if any, will be allocated to the contributing partner:
T / K / ∑Book depreciation ($350,000 ÷ 7 x ½) / $12,500 / $12,500 / $25,000
Tax depreciation ($140,000 ÷ 7 x ½) / 0 / 10,000 / 10,000
3. Assume the tax basis of the fishing boat was $140,000 as above. Further assume that the partnership used the traditional method to allocate tax depreciation in year 1, and that at the end of year 1, it sold the boat for $400,000 and liquidated. How will it allocate book and tax gain between the partners? Will this allocation offset the distortion caused by the ceiling rule in allocating year 1 depreciation between the partners?
As with depreciation expense, K (the non-contributing partner) is allocated tax gain in an amount equal to her book allocation. Under Code Sec. 704(c), the remainder is allocated to T (the contributing partner):
T / K / ∑Book gain ($400,000 –[350,000-25,000]) / $37,500 / $37,500 / $75,000
Tax gain ($400,000 –[140,000-10,000]) / 232,500 / 37,500 / 270,000
4. A and B form the equal AB partnership. A contributes property (FMV = $100,000, basis = $60,000) and B contributes $100,000 cash. The property is depreciated straight line over a 10 year life for both book and tax purposes. Using the traditional method under Code Sec. 704(c), how much of the tax depreciation in the first year will A get? How much will B be allocated? How much of the gain would be allocated to A if the asset is sold for $110,000 at the beginning of year 2?
Book depreciation for the asset is $10,000, and tax depreciation is $6,000. The noncontributing partner (B) will be allocated tax depreciation up to her book depreciation, or $5,000. A will be allocated the rest, $1,000. Each year for 10 years A will get $4,000 less in depreciation than B, which is somewhat equivalent to having to recognize the $40,000 gain.
The total gain would be $110,000 - $54,000 = $56,000. After year 1, the remaining book/tax differential (built-in gain) for the property is $90,000 - $54,000 = $36,000. A would have to recognize all of this $36,000 plus 50% of the remaining gain of $20,000, for a total of $46,000.
Reading:
Paragraph 703.
1. Daisy Tree Partnership owns and operates two apartment complexes in the metropolitan area. The first complex was contributed to the partnership by partner L. The other two partners (M and N) contributed cash which, together with borrowed funds, was used to purchase the second complex. The three partners share partnership income, loss, gain and deduction equally. The tax basis and book value of the partnership’s assets at the end of the current year are as follows:
Tax / BookCash and equivalents / $60,000 / $60,000
Receivables / 0 / 45,000
Apartment Complex 1 / 600,000 / 1,500,000
Accumulated depreciation, complex 1 / (120,000) / (300,000)
Apartment Complex 2 / 2,475,000 / 2,475,000
Accumulated depreciation, complex 2 / (180,000) / (180,000)
Land and other assets / 200,000 / 200,000
Total assets / $2,035,000 / $4,070,000
a. Assume that the partnership uses the traditional method with curative allocations to make allocations under Code Sec. 704(c). Further assume that complex 1 has a remaining useful life of 8 years for book and tax. Complex 2 has a remaining useful life of 25.5 years. Both are depreciated using the straight line method for both book and tax. Show how book and tax depreciation will be allocated among the partners.