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Chapter C9

Partnership Formation and Operation


Discussion Problems
C9-1 Advantages of a partnership for Yong and Li include:
1.
The partnership itself is not subject to tax, thereby eliminating the problem of
double taxation that exists for C corporations. p. C9-4.
2.
Partners may divide the partnership's profit or loss among themselves without
regard to their proportionate capital interests. pp. C9-17 through C9-20.
3.
Partnerships are popular because of the relative simplicity and informality inherent
in creating and operating such entities. No legal agreement is required to form a partnership but a
written agreement is advisable. p. C9-2.
4.
Under the conduit principle of taxation, partnership losses and other items
receiving special tax treatment flow through to the partners. p. C9-4.
C9-2 A corporation provides limited liability protection for the business owners while a general
partnership does not. The purchase of the inn is likely to be financed with debt and additional
debt is likely to be incurred during the renovations. The construction required during the
renovation and the day-to-day operation of the inn provide significant exposure for liability from
lawsuits. The partnership form would not protect the owners of the business from possibly losing
their individual assets. pp. C9-2 and C9-3.
C9-3 Since Sam will be providing business advice, this partnership should be arranged as a
general partnership. Both brothers will be actively managing the business and therefore limited
liability protection would not be available to Sam if the partnership is created as a limited
partnership with Sam as the limited partner. pp. C9-2 and C9-3.
C9-4 Whether Doug receives a profits interest or a capital and profits interest, he must report
the value of the property he receives for services as ordinary income. The amount he reports as
income is the initial basis for his partnership interest. While there is no theoretical difference in the
receipt of a profits interest, practically it is seldom possible to value solely a profits interest. If the
profits interests can not be valued, Doug recognizes no income and has a zero basis in his
partnership interest. pp. C9-10 and C9-11.
C9-5 a.
The existing partner could contribute the property tax-free to the partnership, but
Sec. 704(c) makes it mandatory that the tax attributes from contributed property must be
allocated to the partner that contributes the property. Under Sec. 704(c), the partners must
specially allocate among themselves the income, gain, loss and deductions attributable to
contributed property in a manner which reflects the difference between the property's FMV and its
tax basis at the time of the contribution. In addition, the partnership will have the property with a
carryover basis which is below its FMV. For depreciable assets, the partnership will get smaller
depreciation deductions and the special allocation of depreciation among the partners may not
totally compensate the other partners. pp. C9-5 through C9-12 and C9-18 through C9-20.
C9-1

b.
Sell or lease the property to the partnership, or sell the property to a third party
who then contributes the property to the partnership. pp. C9-26 and C9-27.
c.
Ordinary income recognition is required on a partner's sale of property to the
partnership where the seller owns more than 50% of the capital or profits interests if the property
is either depreciable, or is not a capital asset, in the hands of a partnership. If the partner leases
property to a partnership, the partner retains the depreciation and other deductions with respect to
the property. The leasing partner also avoids the depreciation recapture provisions. Rentals
received from the partnership are taxed as ordinary income. A sale of the property to a third party
is taxed as any other sale would be with no special tax consequences. pp. C9-26 and C9-27.
C9-6 a.
The partner must recognize gain on the contribution of property and assumption of
a liability if the amount of the liability assumed by the other partners exceeds the contributing
partner's basis in the contributed property plus her share of existing partnership liabilities. pp. C95 through C9-7.
b.
The basis in the partnership interest will be decreased by the amount of the liability
assumed by the other partners. pp. C9-7 and C9-8.
C9-7 a, b, and d. p. C9-12.
C9-8 Partnership ordinary income, or Sec. 702(a)(8) income, is the total of partnership income
and deduction items which do not have to be separately stated. This partnership has $100,000 of
ordinary income. Partnership taxable income is the sum of all taxable items which are either
separately stated or included in ordinary income. BW has taxable income of $150,000 ($100,000
ordinary income + $50,000 long-term capital gain). p. C9-17.
C9-9 b, c, d, e, and g. pp. C9-15 through C9-17.
C9-10 The partner's distributive share will equal the sum of his earnings for one-half of his
beginning-of-the-year interest for the entire year and his earnings for the other one-half of his
beginning-of-the-year interest for nine months (calculated on a daily basis). pp. C9-17 through
C9-18.
C9-11 Yes. A limited partner's basis can be increased by recourse liabilities only to the extent the
limited partner is liable to stand an economic loss. This would add to the limited partner's basis
any amounts that he would be obligated to repay a general partner should the general partner have
to pay the debt as well as any amounts of the debt which were guaranteed by the limited partner.
pp. C9-20 through C9-24.
C9-12 Qualified nonrecourse real estate financing is included in the at-risk basis of both general
and limited partners. This financing meets the requirements for qualified nonrecourse real estate
financing. pp. C9-24 and C9-25.
C9-13 The Sec. 704(d) loss limitation rule is less restrictive than the at-risk rules. Section 704(d)
limits the loss to the adjusted basis (before reduction by current year's losses) of a partner's
interest in the partnership at the end of the partnership tax year in which the loss is incurred. The
at-risk rules reduce this basis amount by any nonrecourse debt. pp. C9-23 through C9-25.
C9-2

C9-14 As a limited partner in the JRS Partnership, Jeff is almost certainly subject to the passive
loss limitation rules on losses from this partnership. Accordingly, income from a general
partnership in which Jeff does materially participate (and thus earns active income) cannot be used
to offset the passive losses. Losses from the JRS Partnership can only be used to offset passive
income or can be claimed when Jeff sells the entire interest in the JRS Partnership or the
partnership terminates. pp. C9-25 and C9-26.
C9-15 ABC Partnership will hold the land as inventory for resale to customers and not as a
capital asset. Since Helen owns more than a 50% interest in the ABC Partnership, the sale of the
land to the partnership will generate ordinary income instead of capital gain for Helen. If Helen
instead contributes the land to the partnership, no gain will be recognized until the partnership
sells the lots. Then, when each lot is sold, Helen will recognize the pre-contribution gain as well
as her share of any post-contribution appreciation and all of the gain will be ordinary income
taxable at a marginal rate(s) of up to 39.6%. In total, the ordinary income under this alternative
will be the same as if Helen had sold the land to the partnership. A contribution will allow her to
delay the gain recognition. Even better results occur if Helen can dispose of 5% or more of her
partnership interest so then she owns, directly and indirectly, 50% or less of the ABC Partnership.
If she owns 50% or less, she can recognize capital gain on the sale of the land to the partnership
and use these gains to offset any capital losses she may have already recognized or that she may
desire to recognize. The capital gains are taxed to most taxpayers at a maximum marginal tax rate
of 20% or up to 19.6 percentage points below the rate applicable to ordinary income.
Alternatively, she could sell the land to a third party who would then contribute the land to the
ABC Partnership. Her gain on the sale of the land would then be capital gain, and the
contributing partner would recognize no gain when the land was transferred to the partnership.
pp. C9-26 and C9-27.
C9-16 A guaranteed amount is stated as a fixed dollar amount regardless of the partnership's
income or loss. A guaranteed minimum can only be determined after the profitability of the
partnership's operations has been determined. A guaranteed minimum may be paid partly out of
the partner's distributive share and partly as a guaranteed payment which total to the amount of
the guaranteed minimum. pp. C9-27 and C9-28.
C9-17 Regulation Sec. 1.707-1(c) provides that a partner reports guaranteed payments as
ordinary income in the partner's tax year which includes the last day of the partnership's tax year
in which the partnership deducted the payments under its method of accounting. A partner's
distributive share of partnership items (determined under Sec. 702(a)) is reported in the tax year
which includes the last day of the partnership's tax year. Thus, to report the two payments is the
same to Tracy. pp. C9-27 and C9-28.
C9-18 The Sec. 704(e) rules apply only to a capital interest in a partnership, where capital is a
material income producing factor, and where the family member is the true owner of the interest.
If capital is a material income producing factor for the partnership, the family partnership rules
apply. pp. C9-29 and C9-30.
C9-19 The distributive shares allocated to Andrew and Steve will be combined and then a
reasonable salary for Andrew's personal services will be allocated to him. The remaining portion
C9-3

of the distributive share (after a reasonable salary to Andrew) will be allocated 30/50ths to
Andrew and 20/50ths to Steve. pp. C9-29 and C9-30.

Issue Identification Questions


C9-20

Does Bob recognize any gain on the formation? When will his
precontribution gain be recognized?

What is Bob's basis and holding period for his partnership interest?
Does Kate recognize any loss on the contribution of property in exchange for her
partnership interest? When will her precontribution loss be recognized? What will
the character of the loss be?

What is Kate's basis and holding period for the partnership interest she
received in exchange for property?
What basis and holding period does the partnership have in the property received?
What happens to the depreciation recapture for the building?
Did Kate receive any of her partnership interest for services?

If so, what gain/loss/deductions must the partnership recognize?

What income must Kate recognize?

Bob must determine his basis in the partnership interest ($65,000 = $95,000 - $60,000 +
$30,000 share of liabilities) and his holding period for his interest in the partnership
(begins with his ownership of the office building). Since Bob recognizes no gain or loss,
he does not have to be concerned with any recapture potential under Sec. 1250. Bob will
have to recognize precontribution gain on the office building at a future date.
Kate must determine her basis in the partnership interest ($105,000 = $75,000 + $30,000
share of liabilities) and her holding period for her interest in the partnership (begins with
her ownership of the land). Kate recognizes no loss at the time of the partnership
formation. If the land was a capital asset to Kate and the land is sold by the partnership
within five years of Kate's contribution, the loss will be a capital loss up to $25,000 and
that capital loss will be allocated to Kate as a precontribution loss. After five years, the
character of the loss will be determined by the character of the land to the partnership, but
Kate will still have to report any precontribution loss which is recognized. Guaranteed
payments will be reported as ordinary income.
The partnership must be concerned with the basis and holding period of the assets it
receives (carryover for both basis and holding period). The partnership can deduct from
ordinary income the guaranteed payments made to Kate.
There is an additional tax issue which must be addressed. Bob contributed property with a
net value of $70,000 for a one-half interest in the partnership while Kate contributed
property with a net value of only $50,000 for a one-half interest in the same partnership.
The total partnership has a net value of $120,000 ($130,000 + $50,000 - $60,000
liability). There must be some explanation. One possibility is that Bob has made a
$10,000 gift to Kate. If this is so, both partners bases must be adjusted to reflect the gift.
Alternatively, the facts suggest that Kate may be receiving some of her partnership interest
C9-4

in exchange for her services in managing the business for the first year while receiving no
guaranteed payment. If this is so, Kate must recognize ordinary income and increase her
basis for the value of the partnership interest she received in exchange for services. If
Kate is receiving some of her partnership interest for services, the partnership must
recognize gain or loss in the partnership assets she is deemed to receive and must adjust
the basis of the assets for her deemed recontribution. The partnership must also deduct
the guaranteed payment. pp. C9-5 through C9-12.
C9-21

What items qualify as organizational expenses, which are start-up expenses,


and which can be expensed now?

Does the partnership want to amortize organizational expenses and/or


start-up expenses? If so, over what time period does the amortization
occur?

When does the partnership business begin?


The partnership must first characterize each expense as an organizational expense, a startup expense (Chapter C3), another expense to be capitalized or as a current period
expense. The costs of drawing up the partnership agreement and of establishing the
accounting system are organizational expenses. The expenses of searching for a retail
outlet is a start-up expense, and the expense of having an income statement prepared is a
current period expense.
The partnership must then decide if it wants to amortize the organizational and start-up
expenses. Usually a partnership would choose to amortize the expenses since the
alternative is to let the expenses sit in an asset account until the partnership ceases to do
business. If the partnership decides to amortize the expenses, the election under Sec. 195
and/or Sec. 709 must be made. Each of the accounts can be amortized over not less than
60 months, but most taxpayers see no reason to amortize over any period longer than the
minimum.
Another issue the partnership must face is when is the partnership is considered to begin
business. Regulation Sec. 1.709-2(c) states that business begins when the partnership
"starts the business operation for which it was organized." Amortization of both the
organizational expenses and the start-up expense begins with the month in which business
begins. p. C9-12.

C9-22

Is the receipt of a profits interest in the ABC Partnership in exchange for


Cara's services a taxable event?

If it is a taxable event, what is the amount of character of the income that is


recognized?

What is Cara's basis and holding period for her partnership interest?

The receipt of the partnership interest is not a taxable event. Under Rev. Proc. 93-27
(1993-2 C.B. 343), the receipt of a profits interest is taxable only under circumstances where the
FMV of the interest can be readily determined. This situation does not fit into one of the three
C9-5

exceptions contained in the revenue procedure guidelines as being a taxable event. pp. C9-10
through C9-12.
C9-23

What is George's basis in his partnership interest?


Does the repayment of the partnership liability cause an adjustment to
George's basis in his partnership interest?
Is the repayment of the nonrecourse liability a taxable event for George? If
so, what is the amount and character of the income reported?

Repayment of partnership liabilities are treated as distributions to the partners. A


distribution made to a partner that is in excess of their basis for the partnership interest produces a
taxable gain. The gain can be calculated as follows:
Basis at the beginning of the year
Plus: George's share of income
(0.20 x $20,000)
George's basis before the distribution
Minus: George's deemed distribution from
repayment of partnership liability
(0.20 x $100,000)
George's recognized gain

$15,000
4,000
$19,000
(20,000)
$ 1,000

pp. C9-21 through C9-24.


C9-24

What is Katie's deductible loss from her partnership investment?


What is Katie's Sec. 704(d) basis in her partnership interest?
What is Katie's at risk basis in her partnership interest?
Is the loss from the JKL Partnership a passive loss?
Does Katie have passive income from this investment or other investments?
If so, can she deduct her losses? If not, do the losses carryover to later
years?

As a limited partner, Katie is presumed not to materially participate in the partnership.


Therefore, her loss can not be deducted because it is a loss from a passive activity unless she has
passive income from other investments, or she terminates her interest in the limited partnership. If
no such income exists, they carry over to later years. pp. C9-23 through C9-26.
C9-25

Do the family partnership rules apply when there is no family relationship?

Does reasonable compensation need to be paid to Daniel for his services?

If so, what is reasonable compensation for Daniel's services?

Does David need to be recognized as a partner in the CD Partnership?

If so, what is David's allocable share of the partnership income?

What is Daniel's allocable share of the partnership income?


The family partnership rules are written in terms of the donor-donee relationship.
Accordingly, they apply in this situation. Both Daniel and David would be allocated a reasonable
C9-6

compensation amount. Then the remainder of the income originally allocated to Daniel and David
would be reallocated to them based on their relative capital interests. pp. C9-29 and C9-30.

Problems
C9-26 a.

Neither partner recognized gain nor loss (Sec. 721).

b.
Basis of contributed property
Minus: Partnership assumption
of individual liabilities
Plus: Share of partnership liabilities
Basis in partnership

Suzanne
$59,000

Bob
$95,000

40,000
$99,000

(80,000)a
40,000
$55,000

Bob's basis can also be determined by reducing the basis of his contributed property by the
liabilities assumed by the other partner ($95,000 - $40,000 = $55,000).
a

c.
The partnership takes a carryover basis in each asset:
$14,000; land, $45,000; and building, $50,000.
d.

Amount realized
Minus: Adjusted basis
Realized gain

inventory (securities),

$20,000
( 14,000)
$ 6,000

Precontribution gain of $1,000 ($15,000 FMV at contribution - $14,000 basis) is allocated


to Suzanne. The remaining $5,000 gain is shared equally by Bob and Suzanne. Suzanne reports
$3,500 of gain and Bob reports $2,500 of gain. The gain is ordinary (and not capital) because the
property was inventory to Suzanne and the partnership sold the inventory within five years of its
contribution. pp. C9-5 through C9-10 and C9-20 through C9-21.
C9-27 a.
Fred recognizes ordinary income (compensation) of $15,000. Ed recognizes
$87,000 (calculated in part c below) of capital (Sec. 1231) gain. The other partners do not
recognize any gain or income.
b.
The partnership recognizes no gain, loss or income on the transfers.
c.
Al:
$ 15,000 Cash contribution
19,500 Mortgage allocated to partner
$ 34,500 Basis of partnership interest
Bob:

$ -0- Accounts receivable basis to Bob


26,000 Mortgage allocated to partner
$ 26,000 Basis of partnership interest

Clay: $ 13,000 Equipment basis to Clay


19,500 Mortgage allocated to partner
$ 32,500 Basis of partnership interest
C9-7

Dave: $ 50,000 Land basis to Dave


19,500 Mortgage allocated to partner
$ 69,500 Basis of partnership interest
Ed:

$ 15,000 Building basis to Ed


(130,000) Mortgage contributed to partnership
26,000 Mortgage allocated to partner
($89,000) Tentative basis (and amount of gain recognized)
$ -0- Actual basis (basis cannot be less than zero)

Fred: $ 15,000 Services contributed by Fred


19,500 Mortgage allocated to partner
$ 34,500 Basis of partnership interest
d.
Cash, $15,000; building, $15,000; accounts receivable, $-0-; organizational
expenditures, $15,000; equipment, $13,000; and land, $50,000.
e.
There is no depreciation recapture on the building since straight-line MACRS
depreciation has been used. The depreciation recapture potential for the office equipment carries
over to the partnership. It will be recognized when the partnership sells or exchanges the
property in a taxable transaction.
f.
If Fred's profits interest had an ascertainable value, the result is unchanged. If the
profits interest has no ascertainable value at the time of the transaction, Fred recognizes no
income and the partnership has no organizational expenditure for which an amortization deduction
can be claimed.
g. Partnership: Amount realized
Minus: Adjusted basis
Recognized loss
Dave: Pre-contribution loss:
Fair market value
Minus: Adjusted basis
Pre-contribution loss

$ 9,000
( 50,000)
($41,000)
$15,000
50,000
($35,000)

Total loss
Minus: precontribution loss
Post-contribution loss

$41,000
(35,000)
$ 6,000

Pre-contribution loss
Plus: Share of post-contribution
loss (0.15 x $6,000)
Dave's distributive share of loss

$35,000

Other Partners: Post-contribution loss allocated


to other partners ($6,000 - $900)
C9-8

900
$35,900
$ 5,100

Note that each partner can claim his share of the $5,100 loss only when he has enough basis in his
partnership interest. pp. C9-5 through C9-11, and C9-18 and C9-19.
C9-28 a.
Julie and Kay recognize no income on the partnership formation. Susan
recognizes ordinary income equal to the value of the partnership interest received, or $30,000.
b.

Basis of property contributed


Plus: Share of liabilities
Minus: Liabilities assumed by partnership
Plus:
Income recognized
Basis in partnership interest

Julie

Kay

$ -027,000

$80,000
36,000
(90,000)

$27,000

$26,000

Susan
N/A
$27,000
30,000
$57,000

c.

Accounts receivable
$ -0Land
50,000
Building
30,000
Organizational expenditure
30,000
d.
All of Kay's precontribution loss is allocated to her and the remaining loss, if any, is
shared ratably among the three partners.
Julie
(30%)
Precontribution loss*
Postcontribution loss**
Total loss

Kay (40%)
$30,000
800
$30,800

$ 600
$ 600

Susan
(30%)
$ 600
$ 600

Total (100%)
$30,000
2,000
$32,000

*$50,000 basis - $20,000 FMV = $30,000 precontribution loss.


**$20,000 FMV - $18,000 sales price = $2,000 postcontribution loss.
pp. C9-5 through C9-12, C9-18 and C9-19.
C9-29 a.
Sean reports $75,000 of ordinary income and has a $75,000 basis in his partnership
interest. The partnership deducts $75,000 as compensation. The partnership (and the remaining
partners) must also recognize gains and losses as if 20% of each asset had been sold at its FMV to
pay for Sean's services. The basis in each asset having a gain (or loss) related to it will be adjusted
upward (or downward) by the amount of the gain (or loss) recognized.
b.
Under the Sol Diamond case, if there is an ascertainable FMV for the interest, such
value must be reported as income by Sean and is deductible by the XYZ Partnership. If there
truly is no ascertainable FMV for the 20% interest, neither Sean nor the XYZ Partnership has any
current tax consequences. See Rev. Proc. 93-27 where the IRS indicated that only in three
specific instances will it tax a profits interest received for services. pp. C9-10 through C9-12.
C9-9

C9-30 Marjorie:

Eldorado:

Income: $15,000 ($20,000 FMV of interest - $5,000 cash)


Basis in partnership interest: $15,000 income recognized +
$5,000 cash contributed + Marjorie's share of partnership
liabilities (not given in problem).
Capitalizes the $15,000 as part of the capital raised by the
partnership. This amount is a syndication fee and can not
be deducted now nor amortized in the future as an
organizational expenditure. The $5,000 cash contribution
increases the partnership's assets. Marjorie's capital
account includes $15,000 + $5,000, or $20,000.

pp. C9-5 through C9-12.

C9-10

C9-31 a.

6/30
Partner
Name
Beth
Cindy
Delux

Partnership
Interest

Tax
Year

Months
Deferred

1/3
1/3
1/3

6/30
9/30
10/31

0
3
4

9/30
Total
.00
1.00
1.33
2.33

Months
Deferred
9
0
1

10/31
Total
3.00
.00
.33
3.33

Months
Deferred
8
11
0

Total
2.67
3.67
.00
6.34

The partnership must use a June 30 year-end, or with a Sec. 444 election, a tax year which
ends on March 31, April 30, or May 31.
b.
The natural business year which ends on January 31.
c.
The partnership would be required to use an October 31 year-end, or the tax year
of the majority partner. Alternatively, if IRS permission was received, a natural business year-end
(January 31) could be used, or with a Sec. 444 election, a tax year which did not exceed a threemonth deferral of income could be used. pp. C9-12 through C9-15.
C9-32 a.
The tax year-end of majority partners Bipin and Damien is December 31, and this
is the required year-end for the partnership.
b.
Yes. Possible year-ends are those that allow for no more than a three-month
deferral from the required December 31 year-end. These include September 30, October 31, and
November 30. pp. C9-12 through C9-15.
C9-33 a.

Separately stated items:


Dividends
Municipal bonds interest
Corporate bond interest
Pre-contribution gain on land
specially allocated to Karen
Sec. 1231 loss
Net long-term capital loss
Short-term capital losses
Charitable contributions
Investment interest expense
Guaranteed payment to Karen
Rehabilitation expenditure

$ 19,000*
18,000
29,000*
25,000**
28,000
4,000
5,000
23,000
16,000*
37,000
164,000

*Items which must be separately stated so that investment interest limitation and portfolio income
can be properly reported by the partners.
**The land was held by Karen as inventory and therefore will generate $40,000 of ordinary
income if sold by the partnership within five years of the contribution. All pre-contribution gain

($25,000) must be allocated to Karen while the remaining $15,000 of post-contribution gain is
shared by all of the partners in part b.
b.

KLM's ordinary income:


Operating profit (minus guaranteed payment
[$120,000 - $37,000]
Post-contribution gain on land contributed by Karen
MACRS depreciation allowance
Ordinary income

$83,000
15,000
(36,000)
$62,000

pp. C9-15 through C9-20.


C9-34

Transaction
INCOME
Operating Profit
Rental income
Interest municipal bonds
Interest corporate bonds
Dividend
Gain on investment land
LTCG
STCL
Sec. 1231 gain
Sec. 1251 gain
EXPENSES
Depreciation
Interest:
Mortgage
Mun. bond loan
Guaranteed payment
TOTAL

(a.)
Taxable
Income

(b.)
Ordinary
Income

$ 94,000
30,000
15,000
3,000
20,000
60,000
10,000
( 7,000)
9,000
44,000

$ 94,000
31,000*

$ 94,000

3,000
20,000
66,000b
10,000
( 7,000)
9,000
44,000

44,000

( 39,000)

( 41,000)d

( 29,000)

( 18,000)
( 5,000)
( 30,000)
$186,000

( 18,000)

Book
Income

-0- e
$211,000

(c.)
Separately
Stated Items

$ 31,000
15,000
3,000
20,000
66,000c
10,000
( 7,000)
9,000

( 30,000)
$ 79,000

12,000
( 18,000)
( 5,000)
30,000

Prepaid rental income is reported for tax purposes when it is received.


For financial accounting purposes, the basis of the land was $15,000 and gain of $60,000 was
reported. The tax basis was $6,000 smaller so the tax gain would be $6,000 larger.
c
The precontribution gain of $6,000 ($15,000 - $9,000) must be specially allocated to Jim while
the postcontribution gain of $60,000 ($66,000 total gain - $6,000 precontribution gain) is
allocated ratably to all three of the partners.
d
MACRS depreciation is used for tax purposes.
e
Note that the guaranteed payment has no net effect on taxable income. The guaranteed payment
both reduces ordinary income and increases separately stated income items that are taxable.
a

Each partner will be notified of his share of low income housing expenditures qualifying for the
credit.
pp. C9-15 through and C9-20.
C9-35 a.
Partner
Items

Total

Ordinary income
Long-term capital gain
Short-term capital loss
Charitable contribution deduction

$120,000
18,000
6,000
20,000

Becky

Chuck

Dawn

$24,000
3,600
1,200
4,000

$36,000
5,400
1,800
6,000

$60,000
9,000
3,000
10,000

b.
Partnership
Total

Becky's
Amount

Chuck's
Amount

1/1 through 6/30a


Ordinary income
LTCG
STCL
Charitable contribution

$59,507
8,925
2,975
9,918

20%
20%
20%
20%

$11,901
1,785
595
1,984

30%
30%
30%
30%

$17,852
2,678
893
2,975

7/1 through 12/31b


Ordinary income
LTCG
STCL
Charitable contribution

$60,493
9,074
3,025
10,082

25%
25%
25%
25%

$15,123
2,269
756
2,521

25%
25%
25%
25%

$15,123
2,269
756
2,521

1/1 through 6/30 is 181 days in a non-leap year.


7/1 through 12/31 is 184 days in a non-leap year.

pp. C9-17 and C9-18.

C9-36 a.

Ordinary loss
LTCG
Sec. 1231 gain
STCL

Total

Amy (25%)

Brad (35%)

($120,000)
190,000
40,000
( 30,000)

($30,000)
47,500
10,000
( 7,500)

($42,000)
66,500
14,000
( 10,500)

Craig (40%)
($48,000)
76,000
16,000
( 12,000)

b.
Brad
Partnership
Ordinary Loss
1/1-6/30a
7/1-12/31b
LTCG
1/1-6/30
7/1-12/31
Sec. 1231
1/1-6/30
7/1-12/31
STCL
1/1-6/30
7/1-12/31

35%

Craig
55%

($59,507)
( 60,493)

($20,827)

94,219
95,781

32,977

19,836
20,164

6,943

( 14,877)
( 15,123)

( 5,207)

($33,271)

40%
($23,803)

20%

($12,099)

32,688
52,680
11,090

19,156
7,934

4,033

( 5,951)
( 8,318)

( 3,025)

1/1 through 6/30 is 181 days in a non-leap year.


7/1 through 12/31 is 184 days in a non-leap year.

pp. C9-17 and C9-18.


C9-37 Patty:
Ordinary income:
Long-term capital gain:
Precontribution
Postcontribution
Total income/gain

$ 3,200 (0.40 x $8,000)


$ 6,000 ($10,000 - $4,000)
1,600 [0.40 x ($10,000 - $6,000)]
$10,800

Dave reports $4,800 ($8,000 x 0.60) of ordinary income and $2,400 ($4,000 x 0.60) of long-term
capital gain.
pp. C9-18 through C9-19.
C9-38 a.
Yes. If any income is allocated in any way other than according to the partner's
interest in the partnership, there is a special allocation. Neither the capital gain nor the ordinary
income is allocated according to the partners' 50-50 interests. However, the special allocation

does not meet the test of having substantial economic effect, and will not be acceptable to
IRS.
b.
The special allocation affects only the partners's tax consequences and not
economic consequences. Each partner's distributive share is still $100,000. Accordingly,
special allocation will not be accepted, and the income must be allocated according to
partners' 50-50 interest in the partnership. The partners must report the following:
Capital gain
Ordinary income

Total
$ 60,000
140,000

Clark
$30,000
70,000

the
the
the
the

Lois
$30,000
70,000

pp. C9-19 and C9-20.


C9-39 a.
The special allocation could have substantial economic effect in 1998 but not in
1999 or 2000 since Diane does not have to repay negative capital account balances.
b.
The special allocation will have substantial economic effect in all three years.
c.
The special allocation will not have substantial economic effect in 1999 or 2000
since Diane will have a negative capital account balance in both years. The liability increases
basis, but does not increase her capital account. pp. C9-19 and C9-20.
C9-40 a.

Carryover basis of contributed property


$14,000
Minus: Debt assumed by partners (0.80 x $10,000)
( 8,000)
Partnership interest basis
$ 6,000
b.
Carryover basis from friend
$34,000
Plus: Share of partnership liabilities
20,000
Partnership interest basis
$54,000
c.
The interest's FMV used in valuing the estate ($120,000) is Kelly's basis. pp. C920 through C9-24.
C9-41 a.
b.

The FMV of the partnership interest, or $25,000.


Land basis
Car basis
Cash contributed
Recourse liabilities (0.40 x $100,000)
Basis in partnership interest

$ 6,000
15,000
2,000
40,000
$63,000

pp. C9-20 through C9-24.


C9-42 a.

Purchase price
Plus: Share of liabilities (0.40 x $200,000)

$ 50,000
80,000

b.

c.

Taxable distributive share ($30,000 +


$10,000 - $1,000)
Nontaxable distributive share ($8,000 - $2,000)
Minus: Change in liabilities (0.40 x $20,000)
Basis on December 31
Purchase price
Plus: Share of liabilities (0.30 x $200,000)
Taxable distributive share
Nontaxable distributive share
Increase in nonrecourse liabilities (0.40 x $80,000)
Minus: Reduction in recourse liabilities (0.30 x $100,000)
Basis on December 31
Purchase price
Plus: Taxable distributive share
Nontaxable distributive share
Increase in nonrecourse liabilities (0.40 x $80,000)
Basis on December 31

39,000
6,000
( 8,000)
$167,000
$ 50,000
60,000
39,000
6,000
32,000
( 30,000)
$157,000
$ 50,000
39,000
6,000
32,000
$127,000

pp. C9-20 through C9-24.


C9-43 a.
Kerry

City Corporation

January 1 basis
Short-term capital gain
Nonrecourse liability
Sec. 704(d) basis before losses
At-risk basis before losses

$300,000
150,000
50,000
$500,000
$450,000

$300,000
150,000
50,000
$500,000
N/Aa

Distributive share of loss:


Ordinary loss
Long-term capital loss
Deductible loss

$450,000
50,000
450,000

$450,000
50,000
500,000

City Corporation is not closely-held and is therefore exempt from the at-risk rules.
b.
The basis after the loss is zero for each partner.
c.
The nonrecourse liability is considered to be at-risk. Therefore, both partners can
deduct the full $500,000 loss and have a zero basis for their partnership interest after the year's
operations. pp. C9-24 and C9-25.
a

C9-44
Gary
(general
Tax Basis
Beginning basis
Recourse debt
Nonrecourse debt
Operating loss
Deductible loss
Ending basis

$ 60,000
18,000
60,000
$138,000
(120,000)
$ 18,000

At-Risk Basis
$ 60,000
18,000
$ 78,000
( 78,000)
$ -0-

Mary
(general
Tax Basis

At-Risk Basis

$40,000
12,000
40,000
$92,000
(80,000)

$ 40,000
12,000
$ 52,000
( 52,000)
$ -0-

$12,000

Gary recognizes a $78,000 loss and Mary recognizes a $52,000 loss both of which have
been limited because of the at-risk rules.
pp. C9-24 and C9-25.
C9-45 a.
Eve

Tom

Beginning basis
Plus: Share of LTCG
Basis before losses

$46,000
8,000
$54,000

$75,000
12,000
$87,000

Share of losses

$56,000

$84,000

Limitations on losses Sec. 704(d) limit


At-risk limit
Passive activity limit

$54,000
54,000
N/A

$87,000
87,000a
12,000b

Deductible loss

$54,000

$12,000

Since the partnership has no nonrecourse liabilities, the at-risk basis equals the regular
basis for both partners and the at-risk rules do not limit the losses they can deduct.
a

Eve materially participates in the partnership business so the partnership's ordinary loss is
an active loss for her. Tom is a limited partner and does not materially participate so his
deduction for losses is limited to the passive income he earns from this (and all other)
passive activities during this year. Since the problem states that he has no other income
except his salary, Tom's losses can be deducted only to the extent of his share of the
income (long-term capital gain) from this partnership. [Note that these rules determine the
b

amount of loss which Tom can deduct. The character (and the treatment of Tom's income
on the tax return) remains $12,000 ordinary loss and $12,000 long-term capital gain.]
b.
The additional $100,000 recourse debt would increase both the Sec. 705 basis and
the at-risk basis for Eve. This would give her enough basis to deduct her full $56,000 distributive
share of partnership losses. As a limited partner, Tom would have a basis increase only if he had
some agreement to assume an economic risk of loss related to the recourse borrowings. Even if
he had a basis increase (which is unlikely), Tom would not likely be able to deduct any additional
loss since the passive activity loss rules still limit passive losses to passive income.
pp. C9-24 through C9-26.
C9-46 a.
Kate

Chad

Stan

Basis before year-end


Plus: Capital gain
Basis before losses
At-risk basis before losses

$100,000
20,000
$120,000
$ 70,000

$100,000
20,000
$120,000
$ 70,000

$ 50,000
10,000
$ 60,000
$ 35,000

Distributive share of loss


Character of loss
Deductible loss

$ 80,000
Active
$ 70,000

$ 80,000
Passive
$ 20,000*

$ 40,000
Passive
$ 10,000*

*The passive losses are deductible to the extent of passive income earned during the year. This
assumes there is no passive income from other sources which can be offset by the passive loss and
that the capital gains are not portfolio income.
b.
Rental activities are passive activities so Kate and Chad are limited to a $25,000
loss deduction which may be reduced if Kate and Chad have AGIs in excess of $100,000. Stan
does not actively participate in the rental activity so he has the same deductible loss as above. pp.
C9-24 through C9-26.
C9-47 a.

Amount realized
$ 40,000
Minus: Adjusted basis
( 60,000)
Realized loss
($20,000)
The loss cannot be recognized because Susan is deemed to own 100% of the partnership. The
partnership has a cost basis of $40,000 in the securities.
b.
Amount realized
$ 40,000
Minus: Adjusted basis
( 50,000)
Realized loss
($10,000)
The realized loss is fully recognized because Susan owns only 15% of the partnership.
c.
Amount realized
$ 40,000
Minus: Adjusted basis
( 30,000)
Realized gain
$ 10,000
The entire $10,000 is recognized as a capital gain, even though Susan owns, directly and
indirectly, 65% of the partnership, because the property is a capital asset to the partnership.

pp. C9-26 and C9-27.


C9-48 a.

Amount realized
$ 30,000
Minus: Adjusted basis
( 40,000)
Realized loss
($10,000)
The loss is fully recognized by Jack as a capital loss.
b.
Amount realized
$ 30,000
Minus: Adjusted basis
( 44,000)
Realized loss
($14,000)
Jack's loss is not recognized since he owns directly and indirectly more than 50% of the
partnership.
c.
Amount realized
$ 30,000
Minus: Adjusted basis
( 20,000)
Realized gain
$ 10,000
The gain is recognized by Jack as a capital gain.
d.
The gain is recognized as ordinary income since Jack owns directly and indirectly
100% of the partnership and the land is ordinary income property to the partnership.
pp. C9-26 and C9-27.
C9-49

Maura

KLM
15%
35%

Kara
(Maura's Mother)

45%

20%

3%
Lynn

Maura's interest in KTV is counted as indirectly owned by Kara. Therefore, KLM and KTV are
partnerships in which the same persons own directly or indirectly more than 50% of the capital or
profits interests.
a.

Amount realized
Minus: Adjusted basis
Realized loss
The loss is not recognized by the KTV Partnership.
b.
Amount realized
Minus: Adjusted basis
Realized gain
The gain is recognized as a capital gain by the KTV Partnership.

$50,000
(80,000)
$30,000
$50,000
(23,000)
$27,000

c.

Amount realized
Minus: Adjusted basis
Realized gain
The gain is recognized as ordinary income by the KTV Partnership.

$50,000
(35,000)
$15,000

pp. C9-26 and C9-27.


C9-50
SD
Partnership
Ordinary income
Minus: Guaranteed payment
Partnership ordinary income
Capital gain

$23,000
(10,000)
$13,000
$14,000

Allocation to
Partner:
Scott
$5,000 OI
$6,500 OI
$7,000 LTCG

$5,000 OI
$6,500 OI
$7,000 LTCG

pp. C9-27 and C9-28.


C9-51 a.
AB
Partnership
Guaranteed payment
Ordinary income
Total received

$ 90,000
70,000a
$160,000

Allocation to
Partner:
Allen
$35,000
$35,000

$ 90,000
35,000
$125,000

b.

Ordinary income before


guaranteed payment
Minus: Adjustment for
guaranteed payment*
Income allocation
*Guaranteed minimum
Minus: Bob's distributive share
Guaranteed payment

AB
Partnership

Allocation to
Partner:
Allen

$160,000

$80,000

$ 80,000

-0$160,000

(10,000)
$70,000

10,000
$ 90,000

$ 90,000
( 80,000)
$ 10,000

c.
AB
Partnership
LTCG
Guaranteed payment
Minus: Ordinary loss allocatedb
Total received

$140,000
80,000
( 80,000)
$140,000

Allocation to
Partner:
Allen
$70,000
(40,000)
$30,000

$ 70,000
80,000
( 40,000)
$110,000

$160,000 - $90,000 = $70,000


-0- ordinary income before guaranteed payment - $80,000 guaranteed
payment = ($80,000) ordinary loss.

pp. C9-27 and C9-28.


C9-52 a.
PS
Partnership
LTCG
Guaranteed payment
Minus: Ordinary loss allocated
Total received

$ 10,000
40,000
(40,000)a
$ 10,000

$-0- - $40,000 = ($40,000) ordinary loss.

b.

Allocation to
Partner:
Pam
$ 3,000
40,000
(12,000)
$31,000

$ 7,000
( 28,000)
($21,000)

PS
Partnership
Guaranteed payment
Ordinary income allocated
Sec. 1231 gain
Total received

$ 35,000
35,000b
60,000
$130,000

Allocation to
Partner:
Pam
$35,000
Susan
7,000
12,000
$54,000

$28,000
48,000
$76,000

$70,000 - $35,000 = $35,000 ordinary income.

c.

Ordinary income before guaranteed payment


Times: Pam's distributive share of partnership income
Pam's distributive share
Plus: Pam's guaranteed payment ($60,000 - $48,000)
Pam's total payment (guaranteed minimum)
PS
Partnership

Guaranteed payment
Ordinary income allocated
Total received

$ 12,000
108,000c
$120,000

Allocation to
Partner:
Pam
$12,000
48,000
$60,000

$120,000
x 0.40
$48,000
12,000
$60,000

$60,000
$60,000

$120,000 - $12,000 = $108,000

pp. C9-27 and C9-28.


C9-53 Assuming Son passes the tests for ownership of the partnership interest, Son is a partner
since capital is a material income producing factor. Allocation of the income would occur as
follows:
Dad (0.70 x $100,000)
Fred (0.10 x $100,000)
Son (0.20 x $100,000)
Total distributive share

$ 70,000
10,000
20,000
$100,000

pp. C9-29 through C9-30.


C9-54 Partnership income before guaranteed payment
Minus: Reasonable compensation for Steve
Partnership ordinary income
Distributive shares: Steve (60%)
Tracy (20%)
Vicki (20%)

$160,000
( 70,000)
$ 90,000
$ 54,000
18,000
18,000

Total

$ 90,000

In addition to his distributive share, Steve would receive $70,000 of ordinary income from
the guaranteed payment, or $124,000.
pp. C9-29 through C9-30.

Tax Form/Return Preparation Problem


C9-55 (See Instructor's Guide)

Case Study Problems


C9-56 (See Instructor's Guide)
C9-57 (See Instructor's Guide)

Tax Research Problems


C9-58 (See Instructor's Guide)
C9-59 (See Instructor's Guide)
C9-60 (See Instructor's Guide)