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Chapter C10

Special Partnership Issues


Discussion Questions
C10-1 A liquidating distribution. A current distribution is a distribution that does not terminate
the partner's interest in the partnership, nor is the payment one of a series of payments intended to
terminate the partner's interest in the partnership. A liquidating distribution is made with the
intention of terminating the partner's entire interest in the partnership either with this payment or
with a planned series of payments including this one. The January distribution to Javier is the first
in a series of distributions that will terminate his interest in the partnership and, therefore, is a
liquidating distribution. p. C10-2.
C10-2 The basis of property in the hands of the distributee partner generally is a carryover of the
property's adjusted basis in the partnership's hands immediately before the distribution. However,
the basis of all property distributed to a partner cannot exceed the distributee partner's basis in his
or her partnership interest immediately before the distribution, reduced by any cash or deemed
cash payments (liability reduction) that she received as part of the distribution. Lia's basis will be
$40,000 if the partnership's basis in the land prior to the distribution was $40,000 or more. Lia
will take a carryover basis from the partnership if the partnership's basis for the parcel of land
prior to the distribution was less than $40,000. pp. C10-4 through C10-7.
C10-3 The basis of a single asset received in a liquidating distribution is determined by two
factors: the basis of the distributed property in the partnership's hands and the distributee partner's
basis in his or her partnership interest prior to the distribution. However, the total basis to the
distributee partner of the assets received generally will equal the partner's basis in the partnership
interest immediately prior to the distribution. Because Mariel received a single asset that was not
money, accounts receivable, or inventory, her basis will be $60,000 in the land regardless of what
the partnership's basis in the land was prior to its distribution. pp. C10-12 through C10-14.
C10-4 Cindy's basis for the property she receives will be reduced to $4,000 from its $4,500 basis
to the CDE Partnership because it is limited to Cindy's basis in her partnership interest before the
distribution. Even though Cindy will hold the property as an investment, the sale of the inventory
would generate ordinary income for five years from the date of the distribution. The sale of the
capital asset would generate long-term capital gain that to most individual taxpayers is taxed at a
maximum 15% marginal tax rate. pp. C10-4 through C10-7.
C10-5 The partnership's accounts receivable probably are not unrealized receivables because the
partnership uses the accrual method of accounting. However, depreciation recapture potential
under Secs. 1245 is treated as an unrealized receivable. The partnership has Sec. 1245 recapture
potential on the machines used to produce the inventory (and presumably also from other
machinery, furniture, and equipment the partnership owns). The building has no Sec. 1250
recapture potential, and therefore does not produce an additional unrealized receivable because it
was depreciated under MACRS, which requires straight-line depreciation. The building, however,
does have Sec. 1250 gain potential, but Sec. 1250 gain is not an unrealized receivable. p. C10-8.
C10-1

C10-6 a, b, c, e. p. C10-8.
C10-7 For Sec. 751 to come into play in a current distribution, the distributing partnership must
have both Sec. 751 assets (unrealized receivables and/or substantially appreciated inventory) and
non-Sec. 751 assets. In addition, the distributee partner must have given up some of his or her
interest in one of the two classes of assets in exchange for an increased interest in the other class
of assets. In other words, the distribution must be disproportionate. p. C10-9.
C10-8 A partner can recognize a loss on a distribution only if the distribution is a liquidating
distribution that consists only of money, unrealized receivables, and/or inventory. The partner
recognizes a loss if the amount of money and the carryover basis of the receivables and inventory
are less than the partner's predistribution basis in his or her partnership interest. p. C10-12.
C10-9 No. The basis of unrealized receivables and inventory received by a distributee partner in
a nonliquidating or liquidating distribution cannot be greater to the partner than to the partnership.
If the partner receives only money, unrealized receivables, and inventory as part of a liquidating
distribution, and the carryover basis of the receivables and inventory is less than the partner's
predistribution basis in the partnership interest (reduced by money received or deemed to have
been received in the distribution), the partner cannot step-up the basis in the receivables or
inventory but instead must recognize a loss.
Yes. If the partner's predistribution basis in the partnership interest is smaller than the sum of
money received and the carryover basis for the receivables and inventory, the basis of the
receivables and inventory to the distributee partner is reduced. The basis to be allocated between
the unrealized receivables and inventory equals the predistribution basis for the partnership
interest reduced by any money or deemed money received in the distribution. pp. C10-12 through
C10-14.
C10-10 Yes. In determining the character of gain and/or loss on the sale of a partnership interest,
the partnership is deemed to sell all its assets in a hypothetical sale for their FMV. The selling
partner is then allocated his or her share of the ordinary income or loss from the sale of Sec. 751
assets. The partners residual gain or loss on the sale is capital gain or loss. If the partnership
owns loss assets in addition to Sec. 751 assets, the allocable ordinary income could exceed the
partners total gain, in which case the residual amount would be a capital loss. This result occurs
in Example C10-20 in the text. pp. C10-16 through C10-19.
C10-11 a.
When Tyra's interest in the partnership terminates, she will be deemed to have
received a money distribution in the amount of her interest in partnership liabilities. Because she
has a zero basis, she must report gain equal to the money distribution. Any other property she
receives in the distribution will have a zero basis.
b.
The amount realized will equal the sum of the money received and any liabilities
assumed by the purchaser. Because her basis is zero she will report a large gain. pp. C10-12 and
C10-16 through C10-18.
C10-12 If the entire partnership terminates, the Sec. 736 provisions do not apply at all. Rather
each partner is taxed under the liquidating distribution rules. Section 736 applies if one or more
C10-2

partners (but fewer than all the partners) dies or retires. Accordingly, Sec. 736 applies to the
payments to Tom. pp. C10-19 and C10-20.
C10-13 Section 736 divides payments into two categories. Section 736(b) payments are for a
partner's interest in partnership property, and these payments are taxed under the rules for
liquidating distributions. The partner recognizes capital gain if she receives money exceeding
basis in her partnership interest, so Lucia will report a capital gain of $3,000 ($23,000 - $20,000)
on the payment she receives for partnership assets.
Section 736(a) payments will be taxed as a guaranteed payment (ordinary income) if the
distribution is not based on partnership income. If the payment is based on partnership income,
the partner will be taxed on a distributive share of partnership income with the character of the
income determined at the partnership level. Accordingly, Lucia will report her share of
partnership income as a distributive share. pp. C10-19 and C10-20.
C10-14 The advantages of terminating a partnership include the termination of tax accounting
elections, which also may be disadvantageous, and the possibility of an accelerated loss flow
through when the terminated partnerships year closes. The disadvantages of a termination may
include loss of a favorable tax year and the bunching of income for the partners. The advantage
or disadvantage of changed asset bases no longer exists under current Treasury Regulations. See
Reg. Sec. 1.708-1(b)(1)(iv). pp. C10-22 through C10-24.
C10-15 A publicly traded partnership (PTP) is defined as a partnership whose interests are either
traded on an established securities exchange or are traded in a secondary market or the equivalent
thereof. Two groups of PTPs are not taxed as corporations. A PTP that existed on December 17,
1987, and which has not added a substantial new line of business, was not taxed as a corporation
until tax years beginning after December 31, 1997. These partnerships, which were grandfathered
under the 1987 law for ten years, were granted a new election in the Taxpayer Relief Act of 1997
(TRA of 1997). The TRA of 1997 allows these PTPs to continue to be taxed as partnerships if
they elect to do so and agree to pay an annual tax of 3.5% of gross income from the partnerships
trade or business. Partnerships that have 90% or more of their gross income being "qualifying
income" (interest, dividends, real property rents, etc.) continue to be taxed as partnerships. pp.
C10-28 and C10-29.
C10-16 From a legal standpoint, all the owners of a limited liability company (LLC) have limited
liability for the firms debts. In a limited partnership, all general partners have significant liability
for firm debts. Under the check-the-box regulations, an LLC can choose whether to be treated as
a partnership or taxed as a corporation. If the LLC chooses partnership treatment, the LLC and
the limited partnership are treated similarly except the limited partnership must have at least one
general partner. p. C10-29.
C10-17 An electing large partnership is a partnership that is not a service partnership, is not
engaged in commodity trading, has at least 100 partners, and files an election to be taxed as an
electing large partnership. The primary advantage to the partnership of electing to be an electing
large partnership is that the reporting of income to the large number of partners is simplified.
Relatively few items are separately stated so that the reporting process is more difficult than for a
corporation but easier than for a non-electing partnership. pp. C10-30 through C10-33.
C10-3

Issue Identification Questions


C10-18

Does Kayla recognize a gain or loss on the current distribution?


What is Kayla's basis in the office equipment?
When does Kayla's holding period begin for the property?
Does any depreciation recapture carryover to Kayla from the partnership?
What is Kayla's basis in her partnership interest following the distribution?

Kayla recognizes no gain or loss on the distribution. Her basis for the equipment would
be a carryover basis from the partnership ($35,000) if that were possible, but it is limited to her
basis in her partnership interest prior to the distribution ($30,000). Kayla's holding period for the
office equipment includes the holding period the partnership had for the property. Her basis in the
partnership interest is zero following the distribution. The depreciation recapture potential is an
unrealized receivable that will generate ordinary income under Sec. 735 (a)(1) when Kayla sells
the property. pp. C10-2 through C10-7.
C10-19

How much is Joels distribution?


Does the partnership have Sec. 751 assets?
If the partnership has Sec. 751 assets, did Joel exchange any interest in Sec. 751
assets for cash?
How much ordinary income must Joel recognize if he exchanges Sec. 751 assets
for cash?
How must Joel treat any cash distribution received that exceeds the amount
deemed to be part of the Sec. 751 exchange?

The amount of the distribution includes both the cash and the relief from liabilities that
he received when his interest in the partnership changed from one-third to one-fourth. The
partnership probably has Sec. 751 assets because the partnership inventory is substantially
appreciated. Furthermore, the cash basis partnership probably has unrealized accounts receivable,
and the partnership may have recapture potential if it has any depreciable personality. Again, an
exchange of Sec. 751 assets for cash probably occurred because Joel received only cash and
probably gave up a portion of his interest (from one-third to one-fourth) in each Sec. 751 asset.
The amount of ordinary income is the difference between the amount of cash Joel is deemed to
have received for the Sec. 751 assets and the adjusted basis that Joel would have had in the Sec.
751 assets had the Sec. 751 assets been distributed to Joel immediately before the deemed Sec.
751 sale (usually a carryover from the partnership's basis in these Sec. 751 assets). Any cash or
deemed cash exceeding the amount deemed to be part of the Sec. 751 exchange is treated as a
current distribution. The current distribution will reduce his basis in his partnership interest. If
the current distribution is greater than his basis in the partnership interest, Joel will recognize gain
because he receives cash exceeding his basis. pp. C10-7 through C10-11.
C10-20

Does the partnership have Sec. 751 assets?


What is the amount and character of the gain on the sale of Scott's partnership
interest?
Should the partnership make a Sec. 754 election so Sally can obtain an optional
basis adjustment?
C10-4

The partnership has no unrealized receivables, but the partnership does have inventory.
The results of the sale are determined as follows:
Application of step 1 yields the following gain on Scotts sale of his partnership interest:
Amount realized on sale
$43,000
Minus: Adjusted basis of partnership interest ( 33,000)
Total gain realized
$10,000
Application of step 2 yields the following allocation to Sec. 751 property:
Deemed Sale of
Assets

Partnership
Gain

Scotts Share
(1/3)

Inventory
$9,000
$3,000
Building
15,000a
5,000b
Land
6,000
2,000
a
$5,400 of which is Sec. 1250 gain.
b
$1,800 of which is Sec. 1250 gain.
Thus, on the sale of his partnership interest, Scott recognizes $3,000 of ordinary income
and $1,800 of Sec. 1250 gain.
Application of step 3 yields the following residual allocation to capital gain:
Total gain realized
Minus: Allocation to ordinary income and Sec. 1250 gain
Capital gain recognized

$10,000
( 4,800)
$ 5,200

In summary, on the sale of his partnership interest, Scott recognizes $3,000 of ordinary income,
$1,800 of Sec. 1250 gain, and a $5,200 capital gain.
If the partnership made a Sec. 754 election, Sallys optional basis adjustment would be calculated
as follows:
Cash purchase price
Minus: Sallys share of partnerships
basis in assets (1/3 x $99,000)
Optional basis adjustment

$43,000
( 33,000)
$10,000

The optional basis adjustment would be allocated $3,000 to the inventory, $5,000 to the building,
and $2,000 to the land.
pp. C10-16 through C10-18 and C10-26 through C10-29.
C10-21 Drew and Dana should consider the following:
C10-5

The sale as contemplated will terminate the partnership. Is termination of the


partnership desirable for Drew and Dana?

Will either individual have to recognize gain? The recognition of gain is


unlikely unless Drew and Dana have a small basis relative to the cash held
by the partnership and deemed distributed in the liquidating distribution.

What will be the basis for each of the assets? Under current Treasury
Regulations, the termination will be deemed to result in the old partnership
contributing the property directly to the new partnership so that no
adjustment to asset bases is likely to occur.

Will income be bunched into a single tax year if the partnership terminates?
Termination of the partnership closes a tax year. If the partnership has the
same tax year-end as Drew and Dana, no bunching of income will occur. If
their tax years differ, however, some bunching will occur.

When the partnership terminates, all elections are lost. Are there
advantages or disadvantages from losing all existing elections? A few
advantageous tax year-ends for old partnerships were grand fathered when
Congress enacted the rules imposing required partnership tax year-ends.
The loss of this tax benefit would be a significant disadvantage.
Would liquidation by the partnership be more advantageous than a sale to the other
partners? Liquidation by the partnership does not terminate the partnership.

David should consider:

How much of his gain from the sale would be considered sale from his interest in
Sec. 751 assets and, therefore, taxed as ordinary income? His sale will result in
ordinary income to the extent of his share of ordinary income upon the
hypothetical sale of underlying Sec. 751 assets.

Will the sale cause a bunching of income from the partnership for David?
Because the sale of the entire partnership interest closes the partnership tax
year for the selling partner, the sale will cause bunching of income if David's tax
year-end is different from DDD's tax year-end.

Could the transaction be structured in such a way that a liquidation by the


partnership would be more beneficial to David? Possibly. If Drew and Dana really
do not want the partnership to terminate, they may be willing to pay David more in
a liquidating distribution than they were willing to pay for an outright purchase.
pp. C10-16 through C10-18, C10-22 through C10-25.
C10-22

Does the partnership terminate for tax purposes?


If so, when does the termination occur?

The partnership terminates because only one partner remains. The partnership terminates
when the final Sec. 736 payment occurs. pp. C10-22 through C10-25.
C10-23

Is this gift going to make Haley a partner in the HotWheels LLC for tax purposes?

If Alex restructures the gift so that Haley has true control over the interest, how
will the LLC's income be allocated between Alex and Haley?
C10-6

Haley probably will not be a partner. For Haley to be considered a partner, she
must have control of the interest. For a minor, control includes the situation where the
interest is placed in trust for the benefit of the minor but only if the trustee is someone
who will act in the best interest of the trust beneficiary. It is not clear that Alex is giving
up any control over this interest since he will continue to control the 15% share he placed
into Haley's trust. Thus, Haley is unlikely to be considered a partner. A two-step
allocation process will be used to allocate partnership income. First, Alex must be
allocated a FMV salary. His current salary is described as small, and it may be too small
to be considered equal to the FMV of his services. Once Alex is allocated a FMV salary,
all other income allocated to Alex and Haley must be divided on a pro rata basis. Alex
must receive three-fourths and Haley must receive one-fourth. In effect, the family
partnership income allocation rules override the special allocation to Alex. pp. C9-30,
C9-31, and C10-29.
C10-24

Should Krypton choose to be taxed as a partnership or as a corporation?

How much will be kept in the business for growth, and how much will be
distributed to the owners each year? The larger the percentage of earnings
that will be distributed, the more advantageous a flow-through entity such
as a partnership can be.

What is the marginal tax rate for Jeff, Susan, and Richard? If Jeff, Susan,
and Richard have lower marginal tax rates than does Krypton, partnership
status has advantages.

How should Jeff's pay for operating the business be structured? If the business is
taxed as a corporation, a generous but reasonable salary will decrease the amount
of income subject to double taxation. However, given the 15% tax rate on
dividend income, double taxation is not as detrimental as when dividends were
taxed as ordinary income. If the business is structured as a partnership, the
partners need to decide whether to structure the payment as distributive share, as
an outright guaranteed payment, or whether to establish a guaranteed minimum
that may be some combination of the two. pp. C2-3 through C2-8 and C10-30.

C10-25 What method should XYZ Limited Partnership choose to use to operate under the
publicly traded partnership rules?

Pay the annual 3.5% of gross income tax and continue to be taxed as a publicly
traded partnership?
Buy back enough interests (or restrict opportunities for trading) so the partnership
is no longer publicly traded?
Incorporate the entity and be taxed as a regular C corporation?
If the XYZ Limited Partnership chooses to continue as a partnership, should it
elect to come under the electing large partnership rules?

The best alternative will be a function of the amount of gross income, amount of taxable
income, tax rates of the partners, amount of profits the firm wants to retain, and costs of buying
back partnership interests, and/or restricting trading, or incorporating.
C10-7

The election reduces the partnerships annual cost of providing information to partners
but will require some start-up cost to make the change. The election also has the advantage of
making it more difficult to accidentally terminate the partnership because of trades. However, the
election significantly reduces the partners reporting and audit options.
pp. C10-29 and C10-30.

Problems
C10-26 a.

Partnership interest basis:


Beginning basis
Minus: Cash received
Land basis
Ending basis

$ 25,000
( 4,000)
( 14,000)
$ 7,000

Lisa recognizes no gain. Her basis in the land is $14,000.

C10-8

b.

Partnership interest basis:


Beginning basis
Minus: Cash received
Basis before distribution of land
Minus: Basis of land to Lisa
Ending basis

$ 25,000
( 4,000)
$ 21,000
( 21,000)
$
-0-

Lisa recognizes no gain. Her basis in the land is limited to $21,000, which is the basis of
her partnership interest reduced by the cash distributed.
c.

Partnership interest basis:


Beginning basis
$ 25,000
Minus: Cash received
( 28,000)
Basis before distribution of land (but not less than zero)
Minus: Basis of land to Lisa
Ending basis

$
$

-0-0-0-

Lisa recognizes a $3,000 gain, the amount by which cash distributed exceeds her
partnership basis before the cash distribution. Her basis in the land is limited to zero, which is the
basis of her partnership interest reduced by the cash distributed.
d.

Partnership interest basis:


Beginning basis
Minus: Cash received
Basis before distribution of property
Minus: Basis of receivables and inventory
Basis before distribution of land
Minus: Basis of land to Lisa
Ending basis
$
-0-

$ 25,000
( 4,000)
$ 21,000
( 10,000)
$ 11,000
( 11,000)

Lisa recognizes no gain. Her basis in the receivables is zero, and her basis in the
inventory is $10,000. Her basis in the land is limited to $11,000, which is the basis of her
partnership interest reduced by the cash distributed and by the basis of receivables and inventory
distributed.
e.

FMV of land distributed


Minus: Basis of land distributed
Gain recognized by the corporation (Sec. 311(b))

$ 30,000
( 14,000)
$ 16,000

In addition, the corporation increases its E&P by the E&P gain (which also is $16,000),
decreases E&P by taxes on the tax gain, and decreases E&P by the $34,000 ($4,000 cash +
$30,000 FMV of land) dividend distribution to Lisa (Sec. 312).
Lisa recognizes a $34,000 ($4,000 cash + $30,000 FMV of land) dividend (Sec. 301(c)
and Sec. 316). Her basis in the land is its $30,000 FMV (Sec. 301(d)), and her basis in her
corporate stock remains at $25,000.
C10-9

f.

FMV of land distributed


Minus: Basis of land distributed
Gain recognized by the corporation (Sec. 311(b))

$ 30,000
( 14,000)
$ 16,000

One-half the $16,000 gain passes through to Lisa.


Lisas basis in S corporation stock:
Beginning basis
Plus: Gain pass-through
Basis before distributions
Minus: Distributions excluded from Lisa gross income
Ending basis

$ 25,000
8,000
$ 33,000
( 33,000)
$
-0-

Lisa received a $34,000 ($4,000 cash + $30,000 FMV of land) distribution, which
exceeded her stock basis before the distribution. Thus, in addition to the $8,000 pass-through
gain, Lisa recognizes a $1,000 capital gain on the excess distribution (Sec. 1368(b)(2)). Her basis
in the land is its $30,000 FMV (Sec. 301(d)).
pp. C10-2 through C10-7, C4-2 through C4-11, and C11-24 through C11-28
C10-27
Partner's
a.

Gain/Loss
-0-

Postdistribution
basis
$7,000

b.

-0-

$4,000

c.

$9,000

-0-

d.

-0-

$14,000

pp. C10-2 through C10-7.

C10-10

Property
Land
Machinery
Land
Inventory
Land - Parcel 1
Land - Parcel 2
Land - Parcel 1
Land - Parcel 2
Land - Parcel 3

Basis
to Partner
$4,000
3,000
6,000
7,000
-0-04,000
6,000
4,000

C10-28 a.
Because Mario does not receive cash exceeding his partnership basis, he
recognizes no gain under the current distribution rules of Sec. 731. However, Sec. 737 requires
an additional step when some precontribution gain remains unrecognized. Mario must recognize
gain equal to the lesser of:
1.
Remaining precontribution gain ($8,000 = $18,000 - $10,000) or
2.
The excess of the FMV of the property distributed over the adjusted basis of the
partnership interest immediately preceding the distribution ($3,000 = $23,000 $20,000 partnership basis).
Under Sec. 737, Mario must recognize a $3,000 gain, which takes its character from the land
Mario contributed to the partnership having the precontribution gain.
b.
Under Sec. 731, his basis in his partnership interest is reduced by the carryover
basis of the property distributed to him.
Mario's basis in partnership interest before
the distribution
Plus: Sec. 737 gain recognized on the distribution
Minus: Carryover basis of property distributed
Basis in partnership interest after the distribution

$20,000
3,000
(15,000)
$ 8,000

Because Mario recognized gain under Sec. 737, he must increase the basis of his
partnership interest by the $3,000 amount of the Sec. 737 gain. His basis is increased before
reducing the basis for the distribution.
c.
Because Mario recognizes $3,000 of gain under Sec. 737, the partnership must
increase its basis in the property related to the precontribution gain that Mario recognized. The
partnership's basis in the land is increased to $13,000 ($10,000 carryover basis from Mario at the
time of the contribution + $3,000 Sec. 737 gain recognized on this distribution).
Students may note that $5,000 of precontribution gain related to this land remains, which
could be recognized under Sec. 737 if Mario receives other distributions that trigger the
recognition of this gain within seven years of the original contribution of the land to the
partnership. pp. C10-2 through C10-7.
C10-29 a.
Andrew must recognize the gain that would have been allocated to him had the
partnership sold the land for its FMV instead of distributing it to Bob.
Amount deemed realized
Minus: Adjusted basis
Capital gain on deemed sale

$21,000
( 18,000)
$ 3,000

b. and c. All $3,000 of the gain would have been allocated to Andrew because his precontribution gain was $4,000, so Andrew must recognize a $3,000 gain. He increases his basis in
the partnership interest by the $3,000 gain he recognizes to $24,000. Bob's basis in his
partnership interest is not affected by the gain recognition. The partnership's basis in the land is
deemed increased by the $3,000 gain to $21,000 immediately before the land is distributed.
Accordingly, the basis of the land to Bob is $21,000, and Bob's basis in his partnership interest is
reduced to $9,000 ($30,000 - $21,000) by the distribution. Andrew's basis in his partnership
interest is not affected by the distribution. pp. C10-2 through C10-7.
C10-11

C10-30 First, Beth and Cathy must recognize precontribution gains on the distributed property.
1.

Land: Amount deemed realized


Minus: Adjusted basis
Gain on deemed sale

$10,000
( 4,000)
$ 6,000

The precontribution gain allocated to Beth on the deemed sale is $4,000 ($8,000 FMV - $4,000
basis at contribution). Beth's basis in her partnership interest after the deemed sale is $19,000
($15,000 + $4,000 gain recognized). The land's basis to the partnership immediately before the
distribution is $8,000 ($4,000 basis + $4,000 gain recognized).
2.

Inventory: Amount deemed realized


Minus: Adjusted basis
Gain on deemed sale

$10,000
( 1,000)
$ 9,000

The precontribution gain allocated to Cathy on the deemed sale is $3,000 ($4,000 FMV - $1,000
basis at contribution). Cathy's basis in the partnership interest after the deemed sale is $21,000
($18,000 + $3,000 gain recognized). The inventory's basis to the partnership immediately before
the distribution is $4,000 ($1,000 + $3,000 gain recognized).
Then, the current distributions must be analyzed using the normal rules.
Alonzo's distribution:
Basis in partnership interest before distribution
Minus: Carryover basis in land (see 1 above)
Basis in partnership interest after distribution

$19,000
( 8,000)
$11,000

Beth's distribution:
Basis in partnership interest before distribution
(see 1 above)
Minus: Carryover basis in inventory (see 2 above)
Basis in partnership interest after distribution

$19,000
( 4,000)
$15,000

Cathy's distribution:
Basis in partnership interest before distribution
(see 2 above)
Minus: Cash received in distribution
Basis in partnership interest after distribution

$21,000
( 10,000)
$11,000

pp. C10-2 through C10-7.


C10-31 a.
Accounts receivable and depreciation recapture on the equipment.
b.
Yes. The inventory's $76,000 FMV ($16,000 + $52,000 + $1,500 equipment
depreciation recapture + $6,500) exceeds 120% of its adjusted basis [1.20 x ($0 + $50,000 + $0 +
$6,000) = $67,200].
c.
(1)
Kay's Interest

(2)
Kay's Interest

C10-12

(3)
Fictional

(4)

(5)

Beginning
Partnership
Amount
Sec. 751 Assets:
Receivables
Inventory
Supplies
Recapture
Total
Other Assets:
Cash
Equipment
Land
Total

Before
Distribution
(1/3)

After
Distribution
(1/4)

Proportionate
Distribution
(3)=(1)-(2)

$16,000
52,000
6,500
1,500
$76,000

$ 5,333
17,333
2,167
500
$25,333

$ 4,000
13,000
1,625
375
$19,000

$ 1,333
4,333
542
125
$ 6,333

$ 30,000
9,000
65,000
$104,000

$10,000
3,000
21,667
$34,667

$ 2,500
2,250
16,250
$21,000

$ 7,500
750
5,417
$13,667

Kay's sale:
Amount realized
Minus: Adjusted basis
Recognized gain (ordinary income)
Kays basis in partnership interest:
Beginning basis
Minus: Sec. 751 transaction:
Inventory ($50,000/$52,000 x $4,333)
Supplies ($6,000/$6,500 x $542)
Basis after Sec. 751 transaction
Minus: Non-Sec. 751 distribution
Ending partnership interest basis

Actual
Distribution

Difference
(5)=(4)-(3)

$-0-0-0-0$-0-

($1,333)
( 4,333)
( 542)
( 125)
($6,333)

$20,000
-0-0$20,000

$12,500
( 750)
( 5,417)
$ 6,333

$ 6,333
( 4,666)a
$ 1,667

$33,750
( 4,166)
( 500)
$29,084
(13,667)b
$15,417

$0 receivables + $4,166 inventory + $500 supplies + $0 depreciation recapture


$20,000 total - $6,333 Sec. 751 exchange.

pp. C10-7 through C10-11.


C10-32 a.
Sec. 1245 recapture on machinery.
b.
Yes. The inventory's $86,000 FMV ($12,000 + $24,000 + $50,000 machinery
depreciation recapture) exceeds 120% of its adjusted basis [1.20 x ($12,000 + $21,000 + $0) =
$39,600].

C10-13

c.

Sec. 751 Assets:


Receivables
Inventory
Recapture
Total
Other Assets:
Cash
Machinery
Land
Total

Beginning
Partnership
Amount

(1)
Jack's
Interest Before
Distribution
(1/4)

(2)
Jack's Interest
After
Distribution
(1/5)

(3)
Fictional
Proportionate
Distribution
(3)=(1)-(2)

$12,000
24,000
50,000
$86,000

$ 3,000
6,000
12,500
$21,500

$ 2,400
4,800
10,000
$17,200

$ 600
1,200
2,500
$4,300

$-0-0-0$-0-

($ 600)
( 1,200)
( 2,500)
($4,300)

$ 48,000
190,000
76,000
$314,000

$12,000
47,500
19,000
$78,500

$ 4,600
38,000
15,200
$57,800

$ 7,400
9,500
3,800
$20,700

$25,000
-0-0$25,000

$17,600
( 9,500)
( 3,800)
$ 4,300

Jack's sale:
Amount realized
Minus: Adjusted basis
Recognized gain (ordinary income)
Jack's basis in partnership interest:
Beginning basis
Minus: Sec. 751 transaction
Accounts receivable
Inventory ($21,000/$24,000 x $1,200)
Basis after Sec. 751 transaction
Minus: Non-Sec. 751 distribution
Ending basis
$600 receivables + $1,050 inventory + $0 recapture.
$25,000 total - $4,300 Sec. 751 exchange.

pp. C10-7 through C10-11.

C10-14

(4)

(5)

Actual
Distribution

Difference
(5)=(4)-(3)

$ 4,300
( 1,650)a
$ 2,650
$76,875
( 600)
( 1,050)
$75,225
(20,700)b
$54,525

C10-33
Beginning
Partnership
Amount
Sec. 751 Assets:
Receivables
Inventory
Total
Other Assets:
Cash

$ 40,000
100,000
$140,000
$86,000
$ 20,000

(1)
Paulas
Interest Before
Distribution
(1/4)

(2)
Paula's Interest
After
Distribution
(1/5)

$10,000
25,000
$35,000

$ 8,000
18,000
$36,000

$ 5,000

$ 4,000

(3)
Fictional
Proportionate
Distribution
(3)=(1)-(2)

(4)

(5)

Actual
Distribution

Difference
(5)=(4)-(3)

$2,000
7,000
$9,000

$ -010,000
$10,000

$ 1,000

Deemed cash distribution

$1,000

Partnerships sale of inventory for cash:


Amount realized
Minus: Adjusted basis of inventory (0.80 x $1,000)
Partnerships recognized gain

$1,000
( 800)a
$ 200b

-0-

($2,000)
3,000
$1,000

($1,000)
($1,000)

Because the total basis for the inventory is $80,000 and the total FMV is $100,000, the
basis of this portion of the inventory is assumed to be 80% of its FMV.
b
The $200 gain is allocated one-third to each of the other three partners (Reg. Sec. 1.7511(b)(2)(ii)). Thus, each other partner recognizes $67 of ordinary income.
a

Basis in partnership interest:

Beginning basis
Plus: Share of partnership income
Minus: Deemed distribution of cash
Distribution of remaining inventory
(adjusted basis = 0.80 x $9,000)
Ending basis

Paula

Partner Q

Partner R

Partner S

$25,000

$25,000
67

$25,000
67

$25,000
67

_______
$25,067

_______
$25,067

_______
$25,067

( 1,000)
( 7,200)
$16,800

Paulas basis in inventory:


Portion deemed purchased from
partnership (cost)
Remaining distribution (adjusted basis)
Total
pp. C10-7 through C10-11.

C10-15

$1,000
7,200
$8,200

C10-34

Partner's
Postdistribution
Basis
None

a.

Gain/Loss
-0-

b.

-0-

None

c.

$9,000

None

d.

-0-

None

Predistribution basis
Less: Cash distribution
Basis to allocate

Basis
to Partner
$11,000a
3,000
10,000b
7,000
-0-c
-06,462d
10,769
10,769

Property
Land
Machinery
Land
Inventory
Land - 1
Land - 2
Land - 1
Land - 2
Land - 3
$20,000
( 6,000)
$14,000

Basis of property to partners:

Land

First allocate to property basis


Then allocate to property appreciation
Total

$ 4,000
7,000
$11,000

Predistribution basis
Less: Cash distribution
Basis to allocate
Less: Allocation to inventory
Allocation to land

$20,000
( 3,000)
$17,000
( 7,000)
$10,000

Predistribution basis
Less: Cash distribution
Basis to allocate (but not less than
zero)

$26,000
( 35,000)
$
-0-

Machinery
$ 3,000
-0$ 3,000

Basis of property to partners:

Predistribution basis
First allocate to property basis
Balance
Then allocate to property appreciation
Finally allocate based on relative FMV
Total

Land-1

Land-2

Land-3

$4,000

$ 6,000

$ 4,000

2,000
462
$6,462

4,000
769
$10,769

6,000
769
$10,769

Basis to
Allocate
$28,000
( 14,000)
$14,000
( 12,000)
$ 2,000

pp. C10-12 through C10-16.


C10-35 Even though Marinda does not receive her proportionate share of each partnership asset
in the liquidating distribution, the transaction has no Sec. 751 implications because the partnership
C10-16

has no Sec. 751 assets. Marinda is deemed to have received $110,000 in cash or deemed cash
($100,000 cash + $10,000 release from liability). Accordingly, she must recognize capital gain of
$30,000 ($110,000 received - $80,000 basis). The partnership recognizes no gain. pp. C10-12
through C10-16.
C10-36
Basis before liability reduction
Minus: Liability reduction (deemed distribution)
Basis before distributions
Minus: Cash distributions
Basis to be allocated
Minus: Basis allocable to inventory
Basis allocable to receivables
Amount allocable to other property
Minus: Basis allocable to land
Basis allocable to building
Ending basis in partnership interest

C10-17

Alison
$110,000
( 50,000)
$ 60,000
( 20,000)
$ 40,000
( 32,195)a
( 7,805)a
$
-0(
-0-)
(
-0-)
$
-0-

Bob
$180,000
( 50,000)
$130,000
( 20,000)
$110,000
( 33,000)
( 10,000)
$ 67,000
( 15,000)b
( 52,000)b
$
-0-

Allisons allocation:

FMV of asset
Minus: Partnerships basis for the asset
Difference
Step 1: Give each asset the partnerships basis
for the asset
Minus: Allisons basis to be allocated
Decrease to allocate
Step 2: Asset basis after Step 1
Allocate the decrease first to assets
that have declined in value
Adjusted basis at this point in the
calculation
Step 3: Allocate $1,000 remaining decrease
based on relative adjusted basis at this
point in the calculation
Allisons basis in the assets

Inventory

Receivables

$ 35,000
( 33,000)
$ 2,000

$ 8,000
( 10,000)
( $2,000)

$43,000
(43,000)
$
-0-

$ 33,000

$10,000

$ 33,000

$10,000

$43,000
( 40,000)
$ 3,000
$43,000

( 2,000)

( 2,000)

$ 33,000

$ 8,000

$41,000

(
805)*
$ 32,195

( 195)
$ 7,805

( 1,000)
$40,000

-0-

Total

*$33,000/($33,000 + $8,000) x $1,000 remaining decrease to be allocated.


Bobs allocation:

FMV of asset
Minus: Partnerships basis for the asset
Difference
Step 1: Give each asset the partnerships basis
for the asset
Minus: Bobs basis to be allocated
Increase to allocate
Step 2: Allocate the $12,000 increase first to
assets that have appreciated in value
Bobs basis in the asset

Land

Building

Total

$10,000
( 15,000)
($ 5,000)

$60,000
( 40,000)
$20,000

$70,000
( 55,000)
$15,000

$15,000

$40,000

$55,000
( 67,000)
$12,000

-0$15,000

12,000
$52,000

12,000
$67,000

The basis in each asset received is the number used to reduce the partners basis in the partnership
interest. Note that Alison's basis in the inventory and receivables is smaller than a carryover basis
from the partnership while Bob's basis in the building is larger than a carryover basis. Neither the
partners nor the partnership recognize any gain or loss. pp. C10-12 through C10-14.

C10-18

C10-37 a, b, and c.

Larrys basis in his partnership interest:

Part a
$40,000
( 2,500)
$37,500
( 8,000)
$29,500

Basis before distribution


Minus: Cash distribution
Basis to be allocated
Minus: Basis allocable to inventorya
Basis to be allocated to capital assets b

Part b
$46,500
( 2,500)
$44,000
( 8,000)
$36,000

Part c
$46,500
( 2,500)
$44,000
( 8,000)
$36,000

Inventory is not substantially appreciated. Therefore, Sec. 751 does not apply.
See Parts a c below for remaining allocations. Also see summary of bases after Part c.

a.
FMV of asset
Minus: Partnerships basis for the asset

Capital Asset 1
$15,000
( 10,000)

Capital Asset 2
$17,500
( 15,000)

$ 5,000

$ 2,500

$10,000

$15,000

$10,000

$15,000

$25,000
( 29,500
)
$ 4,500
$25,000

3,000
$13,000

1,500
$16,500

4,500
$29,500

Difference
Step 1: Give each asset the partnerships basis
for the asset
Minus: Larrys basis to be allocated
Increase to allocate
Step 2: Basis after Step 1
Allocate the $4,500 increase to assets
that have increased in value*
Larrys basis in the capital assets

Total
$32,500
( 25,000
)
$ 7,500

*Based on relative unrealized appreciation: Capital Asset 1, $5,000/$7,500 x $4,500;


Capital Asset 2, $2,500/$7,500 x $4,500

C10-19

b.
FMV of asset
Minus: Partnerships basis for the asset

Capital Asset 1
$15,000
( 10,000)

Capital Asset 2
$17,500
( 15,000)

$ 5,000

$ 2,500

$10,000

$15,000

$10,000

$15,000

$25,000
( 36,000
)
$11,000
$25,000

5,000
$15,000

2,500
$17,500

7,500
$32,500

1,615
$16,615

1,885
$19,385

3,500
$36,000

Difference
Step 1: Give each asset the partnerships basis
for the asset
Minus: Larrys basis to be allocated
Increase to allocate
Step 2: Basis after Step 1
Allocate the increase to assets
that have increased in valuea
Basis after Step 2
Step 3: Allocate the remaining $3,500
increaseb
Larrys basis in the capital assets

Total
$32,500
( 25,000
)
$ 7,500

But not more than the unrealized appreciation.


Based on relative FMV: Capital Asset 1, $15,000/$32,500 x $3,500;
Capital Asset 2, $17,500/$32,500 x $3,500

c.

FMV of asset
Minus: Partnerships basis for the asset

Capital Asset 1
$15,000
( 10,000)

Difference
Step 1: Give each asset the partnerships basis
for the asset
Minus: Larrys basis to be allocated
Increase to allocate
Step 2: Basis after Step 1
Allocate the increase to assets
that have increased in valuea
Basis after Step 2
Step 3: Allocate the remaining $1,000
increaseb
Larrys basis in the capital assets

Capital Asset 2
$17,500
( 20,000)

$ 5,000

($ 2,500)

$10,000

$20,000

$10,000

$20,000

$30,000
( 36,000
)
$ 6,000
$30,000

5,000
$15,000

-0$20,000

5,000
$35,000

462
$15,462

538
$20,538

1,000
$36,000

But not more than the unrealized appreciation.


Based on relative FMV: Capital Asset 1, $15,000/$32,500 x $1,000;
Capital Asset 2, $17,500/$32,500 x $1,000

C10-20

Total
$32,500
( 30,000
)
$ 2,500

Summary of asset bases:

Part a
$ 2,500
8,000
13,000
16,500
$40,000

Cash
Inventory
Capital Asset 1
Capital Asset 2
Total

Part b
$ 2,500
8,000
16,615
19,385
$46,500

Part c
$ 2,500
8,000
15,462
20,538
$46,500

pp. C10-12 through C10-14.


C10-38 a.

Kelly's January 1 basis


$35,000
Plus: Share of January income [($15,000 + $6,000) x ]
7,000
Kelly's February 1 basis
$42,000

b.
The partnership has inventory and Sec. 1250 property. Accordingly, the sales
transaction must be analyzed as follows:
Application of step 1 yields the following gain on Kellys sale of her partnership interest:
Amount realized on sale
($45,000 cash + $20,000 liabilities)
$65,000
Minus: Adjusted basis of partnership interest (42,000)
Total gain realized
$23,000
Application of step 2 yields the following allocation to Sec. 751 property:
Deemed Sale of Assets
Inventory
Building
Land

Partnership Gain

Kellys Share (1/3)

$60,000
4,000 (all Sec. 1250 gain)
5,000

$20,000
1,333
1,667

Thus, on the sale of her partnership interest, Kelly recognizes ordinary income of
$20,000 and a Sec. 1250 gain of $1,333.
Application of Step 3 yields the following residual allocation to capital gain:
Total gain realized
Minus: Allocation to ordinary income and Sec. 1250 gain
Capital gain recognized

$23,000
( 21,333)
$ 1,667

In summary, on the sale of her partnership interest, Kelly recognizes $20,000 of ordinary income,
$1,333 of Sec. 1250 gain, and a $1,667 capital gain.
c.
$65,000 = $45,000 cash paid + $20,000 share of partnership liabilities.
d.
Unchanged from the basic facts.
C10-21

pp. C10-16 through C10-18.


C10-39 a.

The results of the sale are determined as follows:


Application of step 1 yields the following gain on Clays sale of his partnership

interest:
Amount realized on sale
($75,000 cash + $15,000 liabilities)
Minus: Adjusted basis of partnership interest
($168,000 x 0.50)
Total gain realized

$90,000
( 84,000)
$ 6,000

Application of step 2 yields the following allocation to Sec. 751 property:


Deemed Sale of Assets
Inventory
Land

Partnership
Gain (Loss)

Clays Share (60% x 0.50)

$ 30,000
( 10,000)

$ 9,000
( 3,000)

Thus, on the sale of his partnership interest, Clay recognizes ordinary income of $9,000.
Application of step 3 yields the following residual allocation to capital loss:
Total gain realized
Minus: Allocation to ordinary income
Capital loss recognized

$ 6,000
( 9,000)
($ 3,000)

In summary, on the sale of his partnership interest, Clay recognizes $9,000 of


ordinary income and a $3,000 capital loss.
b.
Steve's basis is $90,000, his purchase price of $75,000 cash paid plus $15,000 in
liabilities assumed.
c.
The partnership's basis will not be affected.
d.
If Clay sold his entire interest to Steve, the partnership would terminate on the
date of the sale. Clay's gain is twice the amounts shown in Part a ($18,000 ordinary income and
$6,000 capital loss). Steve's basis in the partnership interest is $180,000 ($150,000 cash paid +
$30,000 in liabilities assumed).
Under Reg. Sec. 1-708-(b)(iv), the old CAP Partnership is deemed to contribute all its assets and
liabilities to a new partnership (NewCAP) in exchange for an interest in NewCAP. Under Sec.
723, NewCap takes a carryover basis (and holding period) in each of the assets contributed to it.
Old CAP then distributes interests in NewCAP to Steve and the remaining partners. Each
partners basis in the NewCap interest is the same as his or her basis in the old CAP Partnership
interest.
pp. C10-16 through C10-18 and C10-22 through C10-24.
C10-22

C10-40 a.

The result of the sale is determined as follows:


Application of step 1 yields the following gain on Alices sale of her partnership

interest:
Amount realized on sale
($125,000 cash + $35,000 liabilities)
$160,000
Minus: Adjusted basis of partnership interest ( 110,000)
Total gain realized
$ 50,000
Application of step 2 yields the following allocation of Sec. 751 property:
Deemed Sale of Assets
Receivable
Inventory
Machinery
Building
Land
Investments

Partnership
Gain (Loss)

Alices
Share ()

$21,000
15,000
42,000a
45,000b
( 6,000)
33,000

$ 7,000
5,000
14,000a
15,000b
( 2,000)
11,000

Partnership depreciation is $36,000, and Alices share is $12,000.


Partnership Sec. 1250 gain is $30,000, and Alices share is $10,000.

Thus, on the sale of her partnership interest, Alice recognizes ordinary income of
$24,000 ($7,000 + $5,000 + $12,000 recapture). In addition, Alices Sec. 1250 gain is $10,000.
Application of step 3 yields the following residual allocation to capital gain:
Total gain realized
Minus: Allocation to ordinary income
and Sec. 1250 gain
Capital gain recognized

$50,000
(34,000)
$16,000

In summary, on the sale of her partnership interest, Alice recognizes $24,000 of


ordinary income, $10,000 of Sec. 1250 gain, and a $16,000 capital gain.
b.
Darlas basis in her partnership interest is $160,000 ($125,000 cash paid + $35,000
share of liabilities assumed). pp. C10-16 through C10-19.
C10-41 a.
Suzanne's share of partnership assets is $135,000 (1/3 x $405,000). Therefore,
$135,000 of the $150,000 she receives ($130,000 cash + $20,000 release from liabilities) is a Sec.
736(b) payment. The Sec. 736(b) payment is treated as a distribution, so Suzanne must recognize
a $30,000 gain (cash distribution of $135,000 exceeding $105,000 basis). The gain is capital gain
if Suzanne held the partnership interest as a capital asset. The remaining $15,000 payment does
not represent a payment for property. Because the payment is not determined based on
C10-23

partnership income, it is a guaranteed payment. Thus, the $15,000 payment is ordinary income to
Suzanne.
b.
Suzanne's capital account will be removed because she is no longer a partner. The
partnership gets no deduction for the payments taxed as Sec. 736(b) payments, but the
partnership can deduct the guaranteed payment of $15,000. The remaining partners' bases in the
partnership must be increased to reflect the additional amount of liability each is allocated when
Suzanne is no longer a partner. pp. C10-19 and C10-20.
C10-42 a.

Brian's interest in Sec. 736(b) property is $49,600 (0.40 x $124,000 assets).


Amount realized ($41,600 cash + $8,000 liability)
$49,600
Minus: Sec. 736(b) payment
(49,600)
Sec. 736(a) payment
$
-0Sec. 736(b) payment
Minus: Basis in partnership
Capital gain

b.

$ 49,600
( 40,000)
$ 9,600

Brian's interest in the Sec. 736(b) property is $49,600 (0.40 x $124,000).


Amount realized ($50,000 cash + $8,000 liability)
Minus: Sec. 736(b) payment
Sec. 736(a) payment

$58,000
( 49,600)
$ 8,400

Sec. 736(b) payment


Minus: Basis in partnership
Capital gain

$49,600
( 40,000)
$ 9,600

Brian is taxed on the Sec. 736(a) payment as a guaranteed payment, and the partnership
deducts the payment. pp. C10-19 and C10-20.

C10-24

C10-43 a.

Amount realized ($65,000 cash + $25,000 liabilities) $90,000


Minus: Sec. 736(b) payment (FMV of property interest)
( 90,000)
Sec. 736(a) payment
$
-0Sec. 736(b) payments
Minus: Basis in partnership
Recognized gain

$90,000
( 75,000)
$15,000

The character of the gain is capital because the partnership has no unrealized receivables
or substantially appreciated inventory.
b.

Amount realized ($75,000 cash + $25,000 liabilities) $100,000


Minus: Sec. 736(b) payment (FMV of property interest)
( 90,000)
Sec. 736(a) payment
$ 10,000
Sec. 736(b) payments
Minus: Basis in partnership
Recognized gain

$ 90,000
( 75,000)
$ 15,000

The character of the gain is capital gain because the partnership has no Sec. 751 assets.
The Sec. 736(a) payment is treated as a guaranteed payment because it is determined without
reference to partnership income. It is ordinary income to Kim and deductible by the partnership.
pp. C10-19 and C10-20.
C10-44 a.
The FMV of Jerry's partnership interest is $160,000 (0.40 x $400,000) at the date
of his death. His estate will receive payments totaling $250,000 ($220,000 cash + $30,000
release from liabilities) during the two-year period following death. Up to the FMV of his share
of the assets ($160,000), the payments are Sec. 736(b) payments. The basis of his partnership
interest to his successor-in-interest is its FMV on the date of Jerry's death ($160,000).
Accordingly, the first $160,000 of payments is treated as liquidating distributions and will
generate no gain. The remaining payments ($90,000) are Sec. 736(a) payments, which are not
tied to partnership income and therefore are taxed as guaranteed payments to the successor-ininterest. These payments will be taxed as ordinary income to the successor-in-interest.
b.
The partnership gets no deduction for the Sec. 736(b) payments, but it can deduct
the Sec. 736(a) payments. Because this was a two-person partnership, the partnership will
continue only until the partnership makes the last payment to Jerry's successor-in-interest. At the
time the partnership makes the last payment, the partnership will terminate unless a new partner(s)
is admitted. pp. C10-19 and C10-20.
C10-45 a.

Amount realized ($130,000 cash + $20,000 liabilities)


Minus: Adjusted basis (FMV at date of death)

$150,000
(150,000)

Realized gain

-0-

b.
10% of partnership income is treated as Bruce's successor-in-interest's distributive
share in each of the next three years. It is not deductible by the partnership.
c.
When the partnership makes the final payment.
C10-25

pp. C10-19 through C10-21.


C10-46 a.
Because the accounts receivable have a basis equal to their FMV and because the
building has no depreciation recapture potential, the partnership holds no unrealized receivables.
However, the building does have Sec. 1250 gain potential.
John's sales: Each of the two sales (one to Stephen and one to Andrew) is as follows:
Total
Amount realized
$222,000a
Minus: Adjusted basis ( 166,800)b
Recognized gain
$ 55,200
a
$186,000 + $36,000 release from liabilities
b
($261,600 x 0.50) + $36,000 share of liabilities
John's total gain from the two sales is $110,400, of which $60,000 is a Sec. 1250 gain subject to
the 25% capital gains tax rate, and $50,400 is a capital gain.
The sale of a 60% interest terminates the JAS Partnership. If Andrew and Stephen continue to
operate as a partnership, the old partnership makes a deemed contribution of assets to a new
partnership and liquidating distribution of interests in the new partnership (NewJAS) to Andrew
and Stephen. The NewJAS Partnership must make all necessary elections, such as taxable year
and accounting methods. The termination has the following results:
Tax result for Andrew or Stephen continuing:
Beginning basis in existing partnership
interest ($87,200 + $24,000 liabilities)
$111,200
Basis in partnership interest purchased
from John ($186,000 + $36,000 liabilities)
222,000
Basis before deemed distribution of NewJAS Partnership interest
$333,200
Basis in NewJAS Partnership interest after deemed distribution
$333,200
When the new partnership is formed, the assets will have carryover bases from the old partnership
as follows (the holding periods also carryover).
Cash
Receivables
Building
Land

$160,000
100,000
200,000
96,000

b.
John's distributions are Sec. 736(b) distributions. For distribution purposes, the
partnership holds no Sec. 751 assets. Thus, no Sec. 751 exchange occurs, and John will
recognize no gain or loss on the distribution. His basis in each asset is determined as follows:
Beginning basis in partnership interest
($261,600 + $72,000 share of liabilities)
Minus: Actual cash
C10-26

$333,600
( 24,000)

Deemed cash (liability relief)


Receivables
Basis allocable to land and building
Minus: Building
Land
Ending basis in partnership interest

( 72,000)
( 60,000)
$177,600
(120,000)
( 57,600)
$
-0-

John holds the following assets after the distribution:


Adjusted Basis
Cash
Receivables
Building
Land
Total

$ 24,000
60,000
120,000
57,600
$261,600

FMV
$ 24,000
60,000
180,000
108,000
$372,000

Notice that the built-in gain on these assets is $110,400 ($372,000 - $261,600). Thus, Johns
total gain is the same as in Part a except here the gain is deferred rather than recognized
immediately.
The partnership does not terminate and has the following postdistribution balance sheet:
Partnerships Basis

FMV

Assets:
Cash
Receivables
Building
Land
Total

$136,000
40,000
80,000
38,400
$294,400

$136,000
40,000
120,000
72,400
$368,000

Liabilities and Capital:


Liabilities
Capital - Andrew
- Stephen
Total

$120,000
87,200
87,200
$294,400

$120,000
124,000
124,000
$368,000

Andrew and Stephen each will have an outside basis of $147,200 ($87,200 + $60,000 share of
liabilities).
pp. C10-12 and C10-18 and C10-22 through C10-24.
C10-47 a.
Sec. 736(b) property:
Cash
$ 60,000
Receivables
20,000
Land
100,000
$180,000
The amount realized equals $160,000 cash + $20,000 release from liabilities, which is
allocated all to the Sec. 736(b) property.
C10-27

Amount realized ($160,000 cash + $20,000 liabilities)


Minus: Adjusted basis of partnership interest
( 120,000)
Recognized gain or loss
$ 60,000

$180,000

The character of the gain is capital gain because the partnership has no Sec. 751 assets or
Sec. 1250 property.
b.
Amount realized ($160,000 cash and $20,000 liabilities)
Minus: Adjusted basis of partnership interest
( 120,000)
Recognized gain or loss
$ 60,000

$180,000

The character of the gain is capital because the partnership has no Sec. 751 assets or Sec.
1250 property. Thus, in total, the results are the same as in Part a.
pp. C10-12 through C10-18.
C10-48 a.
A taxable transaction occurs.
determined as follows:

The recognized gains for Josh and Diana are

Josh: Amount realized


Minus: Adjusted basis
Recognized gain

$60,000
(40,000)
$20,000

Diana: Amount realized


Minus: Adjusted basis
Recognized gain

$60,000
(20,000)
$40,000

All or part of the gains might be Sec. 1250 gain if the underlying real property was subject to
depreciation.
b.
An exchange of a partner's general partnership interest for a limited partnership
interest in the same partnership is treated much like a corporate recapitalization and is likely to be
nontaxable. pp. C10-20 and C10-21.

C10-28

C10-49 a.
No. Only 40% is treated as having changed hands.
b.
No. Liquidating distributions do not terminate a partnership.
c.
Yes. Only one member of the partnership continues as owner.
d.
Yes. The partnership terminates on June 1 of the current year.
e.
The ABC Partnership terminates on December 30 of the current year. The WXY
Partnership is treated as having continued.
f.
The WXY Partnership terminates on January 1 of the current year.
pp. C10-22 through C10-26.
C10-50 a.
The KL Partnership continues while the MN Partnership terminates.
b.
The ABC Partnership continues while the CD Partnership terminates.
c.
The YZ and WX Partnerships both terminate.
d.
The DE Partnership is a continuation of the DEFG Partnership.
Partnership is a new partnership.
e.
The HIJK Partnership terminates.

The FG

pp. C10-25 and C10-26.


C10-51 Amount realized
Minus: Adjusted basis
Recognized gain

$100,005a
(
-0-)
$100,005

$5 cash + release from $100,000 liability.

pp. C10-16 through C10-18 and C10-22 through C10-25.


C10-52 a.

b.

The total optional basis adjustment is $20,000 computed as follows:


Cash purchase price

$100,000

Minus: Pattys share of partnerships


basis in assets (1/3 x $240,000)
Optional basis adjustment

( 80,000)
$ 20,000

The partnership recognizes a $60,000 ($220,000 - $160,000) gain.

c.
Pattys share of the gain is $20,000. However, she recognizes none of this gain
because of her $20,000 basis adjustment. pp. C10-26 through C10-29.

C10-29

C10-53 a.
The ABC Company (an LLC) will be treated as a partnership. Alex will report his
one-third share of each income item reported by the LLC.
Ordinary income
Short-term capital gain
Long-term capital loss

$10,000
4,000
( 2,000)

The distribution is not taxable because it does not exceed Alex's basis in his ABC
Company interest.
b.

Beginning basis
Plus: Share of ordinary income
Minus: Capital loss
Distribution
Ending basis

$40,000
14,000
( 2,000)
(12,000)
$40,000

p. C10-30.
C10-54 a.

Ordinary income:
Ordinary income before adjustments
Minus: Charitable contributions
Plus: Net short-term capital gain
Ordinary income
a

b.

$ 5,200,000
( 164,000)
390,300a
$5,426,300

$827,400 STCG - $437,100 LTCL

Separately stated items:


Rental loss (passive)

$2,000,000

pp. C10-31 through C10-34.


C10-55 a.

Ordinary income:
Ordinary income before adjustments
Minus: Net Sec. 1231 loss
Net loss

$ 700,000
( 107,800)a
$ 592,200

Sec. 1231 gains


Minus: Sec. 1231 losses
Net Sec. 1231 loss

$ 27,000
( 134,800)
($107,800)

C10-30

b.

Separately stated items:


Passive income
Long-term capital gains
General business tax credits

$3,000,000
437,600
43,000

pp. C10-31 through C10-34.

Comprehensive Problems
C10-56 a.

Formation of Lifecycle Partnership:

Able, Baker, and Lifecycle Partnership recognize no gain or loss on the transfer of
land to the partnership. Lifecycle Partnership takes the following tax basis and book values in the
land:
Tax Basis
Book Value
Land A
Land B

$16,000
22,000

$30,000
20,000

The partnerships tax holding period for the land includes Ables and Bakers holding periods prior
to the transfers. Ables beginning basis in his partnership interest is $16,000, and Bakers
beginning basis is $22,000.
b.

(1) Partnership ordinary and separately stated items:


2005

Sales
Minus: Cost of goods sold
Gross profit
Minus:
Depreciation
Interest expense
Salary expense (guaranteed payment)
Operating expenses
Partnership ordinary income (loss)
Separately stated items:
Dividend income
STCG; LTCG
Tax-exempt interest
Charitable contribution
Qualified production activities income
reported to partners
C10-31

2006

2007

$964,000
(450,000)
$514,000

$990,000
(500,000)
$490,000

$500,000
(280,000)
$220,000

( 94,000)
(140,000)
-0( 30,000)
$250,000

(150,000)
(130,000)
( 12,000)
( 40,000)
$158,000

(115,000)
(125,000)
-0( 60,000)
($
80,000)

-0-0-0-0-

$250,000

2,000
1,000
1,500
500)

$158,000

-03,000
-0-0None

(2) Book capital accounts:


Contribution of land (FMV)
Plus: Partnership ordinary income
Balance 12/31/05
Plus: Partnership ordinary income
Short-term capital gain
Dividend income
Tax-exempt interest
Minus: Charitable contribution
Distributions to partners
Balance 12/31/06
Plus:
Long-term capital gain
Minus: Partnership ordinary loss
Balance 12/31/07

Able

Baker

$ 30,000
150,000
$180,000
94,800
600
1,200
900
(
300)
( 42,000)
$235,200
1,800
( 48,000)
$189,000

$ 20,000
100,000
$120,000
63,200
400
800
600
(
200)
( 28,000)
$156,800
1,200
( 32,000)
$126,000

Able

Baker

$ 16,000
1,200,000
150,000
$1,366,000
94,800
600
1,200
900
(
300)
( 42,000)
( 60,000)
$1,361,200
1,800
( 48,000)
( 18,000)
$1,297,000

$ 22,000
800,000
100,000
$922,000
63,200
400
800
600
(
200)
( 28,000)
( 40,000)
$918,800
1,200
( 32,000)
( 12,000)
$876,000

(3) Basis in partnership interests:

Contribution of land (tax basis)


Plus:
Increase in partnership liabilities
Partnership ordinary income
Balance 12/31/05
Plus:
Partnership ordinary income
Short-term capital gain
Dividend income
Tax-exempt interest
Minus: Charitable contribution
Distributions to partners
Decrease in partnership liabilities
Balance 12/31/06
Plus:
Long-term capital gain
Minus: Partnership loss
Decrease in partnership liabilities
Balance 12/31/07

c.

(1) Results of asset sales:

Sale of assets for books:


Total
C10-32

Able

Baker

Selling price
Minus: Total book value
Book gain

$1,366,000
(1,191,000)
$ 175,000

$ 105,000

$70,000

Able

Baker

14,000
105,000
$ 119,000

($ 2,000)
70,000
$68,000

Sale of assets for tax:


Total
Selling price
Minus: Total adjusted basis
Tax gain

$1,366,000
(1,179,000)
$ 187,000

Precontribution gain (loss)


Postcontribution gain
Total

12,000
175,000
$ 187,000

(2) Book capital accounts:


Able
Balance 12/31/07
Plus: Book gain on asset sales
Balance before liquidating distributions

$ 189,000
105,000
$ 294,000

Baker
$126,000
70,000
$196,000

(3) Basis in partnership interests:


Able
Basis 12/31/07
Plus: Tax gain (loss) on asset sales:
Precontribution
Postcontribution
Minus: Decrease in partnership liabilities
Basis before liquidating distributions

Baker

$1,297,000

$876,000

14,000
105,000
(1,122,000)
$ 294,000

2,000)
70,000
(748,000)
$196,000

(4) Upon liquidation, Able receives $294,000, and Baker receives $196,000, which
are the amounts of their book capital accounts. Able, Baker, and Lifecycle Partnership recognize
no gain or loss on the liquidating distributions. The partners have no basis in the partnership
because it has terminated.

C10-33

C10-57
WARNING. Be aware that this problem is very complex because it combines a
number of concepts from within this chapter. Students are likely to need assistance in
completing it.
a. Annes tax results:
Cash payment
Liability relief
Total payment

$220,000
31,200
$251,200

Sec. 736(b) payment (52% of asset FMV)


Sec. 736(a) payment [Total - 736(b)]

$222,560
$ 28,640

This Sec. 736(a) payment of $28,640 is a guaranteed payment (ordinary income) to


Anne.
Analysis of Sec. 736(b) payment ($222,560):
First separate out the Sec. 751 portion of the Sec. 736(b) payment. Assume the partnership first
distributed her share of these assets to Anne and then purchased her share of these assets for their
FMV.
Deemed distribution of Sec. 751 assets to Anne:
Annes basis before the Sec. 751 transaction
Basis of Sec. 751 assets deemed distributed
Annes basis after the Sec. 751 transaction
Deemed sale to the partnership at FMV:
FMV of 52% of Sec. 751 assets [0.52 x ($64,000 + $24,000)]
Adjusted basis of 52% of Sec. 751 assets
Ordinary income Anne must recognize
Analysis of remaining Sec. 736(b) payment ($222,560 - $45,760):
Annes basis after Sec. 751 transaction
Cash distribution ($222,560 - $45,760)
Cash distribution in excess of basis (capital gain)

$120,000
12,480
$107,520
$ 45,760
12,480
$ 33,280
$107,520
176,800
$ 69,280

Summary: Anne must recognize a guaranteed payment of $28,640, other ordinary income
of $33,280, and capital gain of $69,280.
Partnership tax results:
Deduct the guaranteed payment of $28,640 paid to Anne. (In addition, the partnership
would increase its basis in its accounts receivable to reflect the fact that some receivables were
deemed purchased from Anne for $33,280.)

C10-34

b.

Annes tax results:


Application of step 1 yields the following gain on Annes sale of her partnership

interest:
Amount realized on sale
($220,000 cash + $31,200 liabilities)
Minus: Adjusted basis of partnership interest
Total gain realized

$251,200
( 120,000)
$131,200

Application of step 2 yields the following allocation to Sec. 751 property:


Partnership gain on receivable = $64,000; Annes share = $64,000 x 0.52 = $33,280.
Thus, on the sale of her partnership interest, Anne recognizes ordinary income of
$9,000.
Application of step 3 yields the following residual allocation to capital gain:
Total gain realized
Minus: Allocation to ordinary income
Capital gain recognized

$131,200
( 33,280)
$ 97,920

In summary, on the sale of her partnership interest, Anne recognizes $33,280 of ordinary income
and a $97,200 capital gain.
Partnership tax results:
ABC Partnership terminates because more than 50% of the capital and profits interest of
the partnership has been sold. The new partnership will elect a tax year and make all necessary
accounting elections. The assets of old ABC will be assumed contributed to new ABC.
Accordingly, the basis and holding period of the assets will be unchanged by the termination and
formation of a new partnership.
pp. C10-16 through C10-20 and C10-22 through C10-24.

C10-35

Tax Strategy Problem


C10-58 a.

The three options are analyzed below.

Option 1 (disproportionate distribution of cash)

Beginning
Partnership
Amount

(1)
Daniels
Interest
Before
Distribution
(1/3)

(2)
Daniels
Interest
After
Distribution
(-0-)

(3)

(4)

(5)

Fictional
Proportionate
Distribution
(3)=(1)-(2)

Actual
Distribution

Difference
(5)=(4)-(3)

Sec. 751 Assets:


Receivables

$ 60,000

$20,000

-0-

$20,000

$ 60,000
60,000
$120,000

$20,000
20,000
$40,000

-0-0-0-

$20,000
20,000
$40,000

-0-

($20,000)

$60,000
-0$60,000

$40,000
(20,000)
$20,000

Other Assets:
Cash
Land
Total

Deemed distribution of receivables (adjusted basis)

-0-

Daniels deemed sale of receivables for cash:


Amount realized
Minus: Adjusted basis of receivables
Daniels recognized gain (ordinary income)

$20,000
(
-0-)
$20,000

Daniels basis in partnership interest:


Beginning basis
Minus: Deemed distribution of receivables
Distribution of remaining cash ($60,000 - $20,000)
Ending basis (but not less than zero)

$30,000
(
-0-)
(40,000)
$
-0-

Because the $40,000 remaining cash distribution exceeds Daniels partnership basis
($30,000), he recognizes a $10,000 capital gain.
Summary of results:
Current ordinary income
Current capital gain

$20,000
10,000

Option 2 (proportionate distribution of assets)


C10-36

Daniel receives the following assets:


Cash
Receivables
Land A
Total

Basis

FMV

$20,000
-010,000
$30,000

$20,000
20,000
20,000
$60,000

Because Daniels partnership basis exceeds the amount of cash distributed, he recognizes no
gain on the distribution. His partnership basis is $10,000 after reduction for the cash distribution.
He takes a zero basis in the receivables and a $10,000 basis in Land A. Daniel recognizes gain or
income when he sells the assets.
Summary of results:
Deferred ordinary income
Deferred capital gain

$20,000
10,000

Option 3 (sale of partnership interest)


The results of the sale are determined as follows:
Application of step 1 yields the following gain on Daniels sale of his partnership interest:
Amount realized on sale
Minus: Adjusted basis of partnership interest
Total gain realized

$60,000
( 30,000)
$30,000

Application of step 2 yields the following allocation of Sec. 751 property:


Partnership
Gain (Loss)

Deemed Sale of Assets


Receivables
Land A
Land B
Land C

$60,000
10,000
10,000
10,000

Daniels Share (1/3)


$20,000
3,333
3,333
3,333

Thus, on the sale of his partnership interest, Daniel recognizes ordinary income of $20,000.

Application of step 3 yields the following residual allocation to capital gain:


Total gain realized
Minus: Allocation to ordinary income

$30,000
( 20,000)
C10-37

Capital gain recognized

$10,000

Summary of results:
Current ordinary of income
Current capital gain

$20,000
10,000

b.
Options 1 and 3 yield the same results: current gain recognition, a disadvantage, and
current receipt of cash, an advantage. Conversely, Option 2 defers gain recognition and cash
collection until Daniel collects on the receivables and sells the land. Thus, if Daniel has immediate
need for cash, he should select Option 1 or Option 3. If he does not have immediate cash needs, he
should consider Option 2.

Case Study Problems


C10-59 The points presented below are the major ones that should be covered in the
memorandum to the two brothers. This information should be incorporated by the student into a
properly structured memorandum using good form with proper grammar and punctuation.
Option 1: Michaels purchase of interest.
Amount realized = ($120,000 cash + $330,000 installment note
+ $200,000 liabilities)
$650,000
Minus: Adjusted basis
Realized gain (LTCG)
$350,000

( 300,000)

Because the sale is an installment sale, Mark would recognize his gain on an installment
basis. In the first year, he would recognize gain of $93,333, calculated as follows:
Gain realized
Contract price

x Installment

C10-38

$350,000
x $120,000 = $93,333
$450,000

At a 15% maximum rate, the gain would result in taxes of $14,000, leaving Mark $106,000
($120,000 - $14,000) of after-tax proceeds for the first year. In each of the following three years,
he would recognize gain of $85,556, calculated as follows:
Gain realized
Contract price

$350,000
$450,000

x $110,000 = $85,556

At a 15% maximum rate each year, the gain would result in taxes of $12,833, leaving Mark
$97,167 ($110,000 - $12,833) of after-tax proceeds each year. Total proceeds for Mark for the
four years are $450,000, and total taxes are $52,500 ($350,000 x 0.15). Thus, Marks total aftertax proceeds are $397,500 ($450,000 - $52,500).
Note that Michael is using after-tax dollars to pay Mark each year. Because this
transaction is an installment sale between related parties, Mark would have to recognize any
unrecognized gain if Michael later resold this partnership interest to another partner.
If no other partner is admitted to the partnership, the partnership will terminate when
Michael buys Mark's interest. Michael would receive all the partnership assets in a liquidating
distribution. The basis of the partnership assets would be changed as follows:
Michael's partnership interest basis
$ 300,000
Basis of partnership interest purchased from Mark ($450,000
installment sale + $200,000 share of liabilities)
650,000
Deemed cash contributed by Michael because
he assumes the partnership's liability
400,000
Balance before distributions
$1,350,000
Minus: Cash and deemed cash distributed
( 600,000)
Accounts receivable
( 90,000)
Remaining basis allocable to land
$ 660,000
Notice that this basis adjustment has greatly decreased the potential capital gain that Michael will
recognize on the subsequent sale of the land investment.
Option 2A: Retirement from the partnership for $150,000 plus 50% of partnership profits for
the next three years.
Assuming the brothers correctly project income to be approximately $200,000 for each of
the next three years, Mark will receive a total of $450,000 over the four years. His gain will be
$350,000, calculated as follows:
Amount realized
Minus: Adjusted basis
Realized gain

$650,000
(300,000)
$350,000

In the initial year, Mark will receive $150,000 cash that he will treat as a normal
partnership distribution that reduces his basis. In future years, he will be allocated a 50% share of
the partnership earnings (with the character they have at the partnership level), which will increase
C10-39

his basis. He also will receive a distribution from the partnership equal to the amount of income
he recognizes, and this distribution will reduce his basis by the same amount the income
recognition increases it. Accordingly, he will not be taxed on the distribution. After the final
payment, Mark no longer will be a partner, so his final payment will include the deemed cash from
the release of his liability share. Mark will report approximately $300,000 of income under this
method, and the character of the income is determined at the partnership level. Because the main
source of partnership income is the sale of investment land, most of the gain Mark will recognize
also will be capital gain.
Assuming all partnership income is capital gain for the three years, each year Mark will be
allocated $100,000 in capital gains and will pay taxes of $15,000 so that he has after-tax income
of $85,000. The first year's payment is tax-free so he has after-tax receipts of $150,000 for the
first year. Cash received over the four years is $450,000, and he will pay taxes of $45,000,
leaving after-tax receipts of $405,000 ($450,000 - $45,000).
Michael's share of income for the three years is reduced by the income allocated to Mark.
The partnership will continue in operation under this option until Mark receives his final payment
from the partnership.
Option 2B:
Retirement from the partnership for $150,000 cash plus $100,000 guaranteed
payment for three years.
In this option, as in the preceding one, Mark's first year payment is simply a distribution
from the partnership, which reduces his basis in the partnership interest. Likewise, in the final
year Mark will be deemed to receive cash equal to the share of liabilities that he no longer will be
liable for. Assuming the liabilities do not change, these two distributions will have the following
results:
Beginning basis
Minus: Year one cash
Basis after cash distribution
Minus: Year four liability release
Basis (but not less than zero)

$300,000
(150,000)
150,000
(200,000)
$

-0-

Mark will recognize a $50,000 long-term capital gain in year four. At a 15% maximum tax
rate, he will owe taxes of $7,500. Because this gain is caused by the deemed cash distribution
from the liability release, Mark is not receiving any cash to pay these taxes. The $100,000
guaranteed payment will be taxed as ordinary income in each of the next three years. Assuming
Marks ordinary tax rate is 35% each year, he will pay $35,000 in taxes for an after-tax amount of
$65,000. Over the four years, Mark will receive cash of $450,000 and will pay taxes of $112,500
[($35,000 x 3) + $7,500] for after-tax receipts of $337,500 ($450,000 - $112,500).
Option 3: Outside purchase of interest.
Under this option, Mark will report a $350,000 long-term capital gain determined as
follows:
Amount realized ($450,000 cash + $200,000 liabilities)
C10-40

$650,000

Minus: Adjusted basis


Realized gain (LTCG)

(300,000)
$350,000

At a 15% maximum tax rate, the gain would result in taxes of $52,500, leaving Mark
$397,500 ($450,000 cash - $52,500 taxes) of after-tax proceeds. (Mark receives the same aftertax benefits that he receives if Michael is the purchaser.)
Although this option technically terminates the partnership because of the 50% sale, the
partnership nevertheless continues as a new partnership. This results contrasts with Option 1,
where the partnership goes out of existence. If Michael wants to continue the partnership form of
conducting the investment, he should consider this option. Also, unless the partnership has made
a Sec. 754 election, no increased basis for the investment land occurs under this option.
Summary: Mark's after-tax receipts are highest for Option 2A -- the retirement from the
partnership for $150,000 cash plus a 50% distributive share for the next three years. The
memorandum should emphasize to Mark that this option is the only sales arrangement under
which uncertainty exists about what he will receive. If land sales are unusually slow for the threeyear payout period, Mark may receive little more than the $150,000 first year payment.
Accordingly, students may want to recommend the sale to John or the sale to Michael
depending on whether or not Michael wants to continue as a sole proprietor or as John Watson's
partner.
C10-60 Relevant facts:
Miguel wrote an opinion letter used in the prospectus of a tax shelter and prepared the
first year tax-return. The tax shelter has grossly overvalued assets, and other revenues and
expenses were falsified. The investors and the IRS do not know about the overvalued assets nor
about the falsified revenues and expenses.
The AICPA bylaws designate the Accounting and Review Services Committee as the
senior technical committee authorized to issue pronouncements in connection with the unaudited
financial statements or other unaudited financial information of a nonpublic entity. The
Committee promulgates Statements on Standards for Accounting and Review Services (SSARSs)
and is authorized to promulgate attestation standards in its area of responsibility. Miguel must
follow these standards in conducting the review for Mr. Azul. The information contained in the
financial statements must conform with Generally Accepted Accounting Principles (GAAP) or, if
applicable, with another comprehensive basis of accounting. The standard review report contains
three paragraphs. The report does not have a title and is usually addressed to the owner or party
who engaged the accountant.
The first paragraph of the review report states which financial statements have been
reviewed and that the review was conducted in accordance with SSARSs issued by the AICPA. It
also states that all information contained in the review report is the representation of management
or the owners of the company. The second paragraph of the review report describes what occurs
during a review. A review consists principally of inquiries of company personnel and analytical
procedures applied to financial data. It also states that a review is substantially less in scope than
C10-41

an examination in accordance with Generally Accepted Auditing Standards (GAAS). No opinion


regarding the financial statements taken as a whole is expressed in a review report. The last
paragraph of the review report states that the accountant is not aware of any material
modifications that should be made to the accompanying financial statements for them to conform
with GAAP. If GAAP is not followed, the departure from GAAP, including its effects, should be
disclosed in a separate paragraph of the review report. The conclusion paragraphs of the review
report should use the phrase "with the exception of" or "except for." The accountant is not
required to determine the effects of the departure. If management or the owners have not
determined the effects of the departure, the accountant should state that a determination has not
been made.
Miguel apparently should have learned more about the cattle feeding operation before
taking on the client. His work with local ranchers obviously was not enough experience to serve
Mr. Azul's business properly. He should have immediately questioned the size of the tax
advantages in the prospectus and not taken Mr. Azul's word that they were fairly usual for the
industry. Miguel should have looked into why the asset values seemed high during the audit.
Miguel also should have brought in a specialist to evaluate the fairness of the asset values. Lastly,
Miguel did take the correct action by investigating why the numbers looked so good from Mr.
Azul while the local gossip around town was that the cattle feeding operations were about to fold.
Miguel could have avoided the problems he encountered by learning more about the industry and
using better client acceptance techniques. Miguel violated the AICPA's Code of Professional
Conduct because he failed to exercise due care while conducting the audit. He should have
brought in a specialist with expertise concerning cattle feeding operations.
The following additional items should be addressed regarding the valuation and other
issues:
Ethical issues:
1.
2.
3.

Should Miguel inform the limited partners about the problems?


Should Miguel inform the IRS about the problems?
Is Miguel at fault for not investigating the partnership, or does all the fault lie with Mr.
Azul?

C10-42

Possible alternatives:
1.
2.
3.
4.
5.

Prepare the return and say nothing.


Refuse to prepare the return and say nothing.
Refuse to prepare the return and tell only the investors.
Refuse to prepare the return and tell only the IRS.
Refuse to prepare the return and tell both the investors and the IRS.
Questions about the ethics of the alternatives:

1.
2.
3.
4.
5.
6.
7.
8.

What are the possible consequences to Miguel, to the investors, to the tax authorities, and
to Mr. Azul of each alternative?
Which alternative would provide the greatest benefit to the largest number of people?
Which alternative would be most fair to the investors? To the tax authorities? To Miguel?
Does Miguel have the right to report the tax shelter to the IRS?
Did Miguel meet his obligations under the AICPA's Statements on Standards for Tax
Services, No. 1 and No. 3?
Does Miguel have a potential problem with the IRS under the tax return preparer rules
(see Chapter C15).
Does Miguel have a potential problem with Treasury Department Circular 230 (see
Chapter C15).
Should the federal government be able to require tax preparers to investigate what their
clients tell them?

Tax Research Problems


C10-61
Tax Results:
Revenue Ruling 84-111, 1984-2 C.B. 88, requires that the tax results for incorporating a
partnership must follow the results generated by the form of the transaction. Accordingly, the
formation of the corporation is tax free under Sec. 351 and is tax free to both the transferee
corporation and the transferor partnership. The liquidation of the partnership is a liquidating
distribution and is subject to the rules of Sec. 731, and the ex-partners basis in the new
corporations stock is governed by Sec. 732.
Asset and Liability Transfer:
Each asset will take a carryover basis from the partnership transferor, so the total basis of
corporate assets will be $460,000. The partnership, as the sole shareholder, has a basis in its
corporate stock equal to the carryover basis of its assets ($460,000) reduced by the partnership's
liability assumed by the corporation ($100,000), or $360,000.

C10-43

Partnership Liquidation:
Partner

Arnie

Basis before transfer


Minus: liab. reduction
Basis before distribution
Basis in stock

Becky

$80,000
(33,333)
$46,667
$46,667

$120,000
( 33,333)
$ 86,667
$ 86,667

Clay
$160,000
( 33,334)
$126,666
$126,666

Total
$360,000
(100,000)
$260,000

Neither the partner nor the partnership recognizes gain or loss on the asset and liability transfer.
Financial Accounting Results:
First, the partnerships assets would be appraised and written up to reflect the current
FMV of each asset. All gains and losses would be recognized for financial accounting purposes
and allocated among the three partners according to their interest in gains and losses (equally).
Each partners capital account would be increased by his or her share of the $110,000 gain that
would result. See Reg. Sec. 1.704-1(b)(2)(iv)(f).
The entries on the partnerships financial accounting books to record the gains would be as
follows:
Inventory
50,000
Land
60,000
Arnies capital
36,667
Beckys capital
36,667
Clays capital
36,666
Recording the transfer of assets and liabilities to the new corporation in exchange for the stock of
the new corporation would require the following entries on the partnerships books (assuming the
corporation opens a new set of books instead of continuing to use the partnership books):
Investment in ABC Corp. stock
500,000
Liabilities
100,000
Cash
50,000
Accounts receivable
55,000
Inventory
200,000
Land
295,000
To distribute the stock and close the partnerships books would require the final entry:
Arnies capital
Beckys capital
Clays capital
Investment in ABC Corp. stock

C10-44

166,667
166,667
166,666
500,000

To establish the new ABC Corporation, the corporation would record the following entry:
Cash
Accounts receivable
Inventory
Land
Liabilities
Common stock

50,000
55,000
200,000
295,000
100,000
500,000

Assets would be recorded on the corporations books at their FMV, so the total basis of
the assets for financial accounting purposes would be $600,000 (APB 29).
C10-62

Della's share of property:

Sec. 736(b) property - Cash


Receivables
Equipment
Building
Land
Goodwill
Total

$16,667
10,000
16,667
33,333
13,333
7,000
$97,000

All payments based on partnership income also will be Sec. 736(a) payments taxed as distributive
shares.
Total fixed payments = $20,000 x 5 = $100,000
Sec. 736(b) payments as portion of fixed payments: $97,000/$100,000 = 97%
Allocation of payments for years 1-5:
$20,000 payment: Sec. 736(b) (97%)
Sec. 736(a) (3%)

$19,400a

600 guaranteed payment that


is taxed as ordinary income
5,000 distributive share
$25,000

5% of partnership income: Sec. 736(a)


Total
a

Sec. 736(b) payment


$19,400
Minus: One-fifth basis in partnership interest
Capital gain
$ 5,400

C10-45

(14,000)

Taxation of the partnership is not affected by the payments made for Della's interest in
property. It takes no deduction and does not reduce the continuing partners' distributive share of
the payments made for the interest in property. The small guaranteed payment each year is
deductible by the partnership. The $5,000 distributive share results in a smaller distributive share
for each of the remaining partners.
C10-63 Transfer of an interest in a partnership by gift does not terminate the partnership tax year
for the donor. (Little authority exists to suggest how a part-sale, part-gift will be treated, but
most practitioners agree that it will be treated the same as a gift transfer for this purpose.)
However, the donor must recognize income from the partnership up to the date of the gift.
Because the partnership tax year does not close on the date of the gift, the income is included in
the partner's tax year that includes the normal partnership year-end (Reg. Sec. 1.706-1(c)(5)). On
his tax return for the tax year ending June 30 of the current year, Pedro will report partnership
income from the tax year that ended on December 31 of last year. He will report partnership
income earned between January 1 of the current year and his June 15 gift on his tax return for the
tax year that ends on the next June 30th. Juan and the American Red Cross must report all
partnership income earned after June 14 of the current year.
Transfer of a majority interest by gift does not constitute a sale or exchange that can
terminate a partnership (Reg. Sec. 1.708-1(b)(1)(ii)). Although part-sale, part-gift transactions
like this one are not clearly covered by the Treasury Regulation, the sale portion of the transaction
does not appear to be a majority interest.
The transfer to Juan is a part-sale and part-gift. See Victor P. Diedrich v. CIR, 47 AFTR
2d 81-977, 81-1 USTC 9249 (8th Cir., 1981). The 30% interest transferred to Juan is
considered sold to him because the liability is one-half of the FMV ($50,000 liability $100,000
FMV of partnership interest transferred). Pedro must recognize gain on the sale of a 15% interest
of $30,000 ($50,000 liabilities transferred - $20,000 basis). The remaining 15% interest is a gift
to Juan. Pedro must report the gift portion for gift tax purposes at its FMV of $50,000.
The transfer to the American Red Cross also is a part-sale and part-gift but the allocation
of basis to the sale and gift differ from the allocation above (Rev. Rul. 75-194, 1975-1 C.B. 80).
Only a pro rata portion of the basis is allocated to the sale transaction, so basis of $10,000
([$50,000 liability $100,000 FMV] x $20,000 basis) is allocated to the sale, and the remaining
$10,000 of basis is allocated to the gift portion of the transaction. On the sale transaction, Pedro
must recognize gain of $40,000 ($50,000 liability transferred - $10,000 basis allocated to sale
transaction). Pedro makes a charitable contribution of the remaining partnership interest, which
has a basis of $10,000 and FMV of $50,000. The contribution is eligible for a charitable
contribution deduction.

C10-45

What Would You Do In This Situation? Solution


Ch. C10, p. C10-4. A New Kind of Tax-Free Exchange?
You probably should tell Betty and Thelma that the transaction will not be tax-free. First,
Sec. 704 requires that the contributing partner must recognize any remaining precontribution gain
(up to the amount of precontribution gain that would be recognized if the property were sold on
the distribution date) when contributed property is distributed to another partner within five years
of the contribution. Therefore, both Betty and Thelma would recognize gain when the properties
were distributed unless the partnership held the property for more than five years.
Second, Treasury Regulations might prevent tax-free treatment even if the partnership held the
property for more than five years. During 1995, the Treasury Department issued regulations to
stop the abusive use of the partnership form to get tax treatment that is not available otherwise.
These regulations require that all transactions be entered into for a substantial business purpose,
and Thelma and Betty have no apparent business purpose for contributing these properties to the
partnership or for distributing the properties from the partnership. Further, the regulations
provide that if the partnership is used to frustrate any IRC provision, the IRS can treat the
partnership as an aggregate of the partners. Because the exchange contemplated by Thelma and
Betty clearly does not qualify as a tax-free like-kind exchange if the exchange were made directly
between the two women, it is unlikely that they can make it tax-free by routing the exchange
through their partnership.

C10-46