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Malpractice In One Easy Lesson

Malpractice In One Easy Lesson . Or 704 (c) for Dummies. The Court Case. “I own the whole dang company Your Honor.” . The Facts:. Fairly new operating company with product, client base and workforce in place.

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Malpractice In One Easy Lesson

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  1. Malpractice In One Easy Lesson Or 704 (c) for Dummies

  2. The Court Case “I own the whole dang company Your Honor.”

  3. The Facts: • Fairly new operating company with product, client base and workforce in place. • The company is about to turn the financial corner into solid profitability, however; • They need an infusion of capital to get there. • They are organized as an LLC. • They have about $100,000 of capital remaining.

  4. Facts continued: • They find an investor who is willing to invest $400,000 for 40% of capital and profits. • They now have $500,000 in capital to work with. • They lost $400,000 early in that year, but turned the corner and have recovered $100,000 of the loss by year end, so they lost $300,000 for the year. • The books are kept on the tax basis.

  5. The tax return and financials show after the $300,000 loss : 60% owners 40% owner (new investor) Beginning Cap. $400,000 Loss for year ($120,000) Ending Cap. $280,000 • Beginning Cap. $100,000 • Loss for year ($180,000) • Ending Cap. ($80,000)

  6. The new investor concludes: • That she now owns all of the capital of the company and therefore owns the company outright. • She sues to have the original investors removed and take control. • Is she right?

  7. My job is to teach the judge how to work this out.(I am hired by the attorney for the original investors) • What should I teach him? • Cost basis accounting is a basic accounting principle. • Recording at cost is a basic tax accounting principle. • What argument do the original investors have?

  8. Sometimes the tax code actually makes sense. • One of the most important principles in partnership tax accounting is: • The tax books must always reflect the economic deal. • Code section 704(b) & (c) and their regulations.

  9. Look out, this will be litigators heaven. • Who will be the targets? • Lawyers who draft LLC and partnership agreements and do not understand the rules. • CPAs who prepare tax returns without correctly applying the principles of IRC Section 704.

  10. So what did I tell the judge? • That the tax books and records must always reflect the economic deal. • This requires fair market value accounting. • It is mandatory to record appreciated property that is contributed to a partnership at fair market value and that FMV is to be accounted for in the capital accounts.

  11. Tell the Judge continued • When an additional contribution that results in an ownership change is made to a partnership, it is exceedingly wise to adjust all assets in the partnership to FMV and reflect the FMV adjustment in the capital accounts of the existing partners. • While this reverse adjustment is optional, the requirement that the tax books reflect the economic deal is never optional.

  12. So what was the economic deal in this case? • It was that the new investor would own 40% of the LLC for a $400,000 investment. • Since the original investors had $100,000 in working capital (cash) for our purposes, there was implicit in the agreement, an intangible asset of $500,000, owned by the original owners.

  13. The calculation • $400,000 / .4 = $1,000,000 • $1,000,000 - $400,000 = $600,000 • $600,000 less $100,000 of working capital = $500,000.

  14. The adjustment • An intangible asset of $500,000 should have been put on the tax books immediately prior to the infusion of $400,000 by the new investor. • This would have been a clear reflection of the economic deal. • Once again, the tax books must reflect the economic deal.

  15. The corrected tax return and financials show after the $300,000 loss ; 60% owners 40% owner (new investor) Beginning Cap. $400,000 Loss for year ($120,000) Ending Cap. $280,000 The proof: $420,000 + $280,000 = $700,000 $700,000 * .4 = $280,000 • Beginning Cap. $100,000 • Reverse 704(c) Adjustment $500,000 • Loss for year ($180,000) • Ending Cap $420,000

  16. Now the tax books reflect the economic deal. • What you have just seen is one reason professionals will be sued for not applying or misapplying 704 ( c ). • The are other reasons.

  17. More ramifications of misapplication:adjustments must or should be made- • At contribution • At distribution • At the time of gifts? • At the time of additional contributions • At the time of the sale of an interest • At death

  18. At Contribution 704(c) • A and B form partnership. They are 50/50 partners. • A contributes land-FMV=$100,000 • A’s basis in the land is $10,000 • B contributes $100,000 cash

  19. 704(c) Continued Fair Market Value $100,000 Tax Basis 10,000 Pre-contribution gain $ 90,000 • The pre-contribution gain ($90,000) should be booked as an asset and as part of capital – otherwise the amount of PCG will be lost.

  20. Second Set of Books = 704(c) Adjustments Dr Cr Cash 100,000 Pre-contribution gain 90,000 (Allocable to partner A) Asset Land (Tax Basis) 10,000 Capital A 100,000 Capital B 100,000

  21. Assume an immediate sale of land at FMV Cash (new) 100,000 Land (basis) 10,000 Gain (Pre-contribution) 90,000 • Gain is allocated to A. With this allocation the cost basis books and the FMV books (pre-contribution gain) are in sync.

  22. Assume an Immediate Sale of Land at FMV Continued Cash $200,000 Capital A $100,000 Capital B $100,000

  23. Improper Allocation • If the tax gain is allocated equally B would pay tax on $45,000 of A’s gain. (B had already paid tax on his $100,000 of cash.) This would not be equalized until liquidation of the partnership when A’s gain on liquidation would be $45,000 larger and B’s gain $45,000 smaller or the basis of A’s assets would be $45,000 smaller.

  24. How happy would you be? • If you were A? (B just paid half of your tax.) • If you were B? • Are you sure you are happy if you are A? • If the books are on the tax basis B may feel like he is in charge. • What are the tax capital accounts? • This could be even worse than the court case because improper tax amounts have been allocated and paid.

  25. Adjustments at time of gifting. (assume no sale occurred) • Assume gifts are made when the total value of the assets are $250,000 • Per tax books, the additional $50,000 of value must (should) be booked in order to properly reflect capital accounts and track gifts • Therefore the books are adjusted immediately prior to the gift • We now must track basis, pre-contribution gain, and pre-gift appreciation

  26. Example (assume original facts, no sale, $50,000 of additional appreciation) • Cash $100,000 • Land $10,000 • Pre-contribution Gain $90,000 (land allocable to A) • Pre-gift Appreciation $50,000 (Allocable to assets and A and B capital) • Capital A $125,000 • Capital B $125,000

  27. Example Continued – gifts to C (A’s son) and D (B’s son) of 25% interests each. • Capital A $62,500 • Capital B $62,500 • Capital C 704(c) $45,000 • Capital C basis $ 5,000 • Capital C pre-gift $12,500 • Capital D basis $50,000 • Capital D pre-gift $12,500

  28. Fourth Set of Books = Additional Contributions – Reverse 704(c) • Assume partnership property is now worth $300,000 – basis $110,000 • Assume a new partner E wants to contribute $100,000 for a 25% interest • A new level of pre-contribution gain is created and must be tracked and allocated (4 levels of allocation now). This level of pre-contribution gain must be tracked and allocated as before. • The new amount is $50,000 ($300,000- $250,000)

  29. The Journal Entry (704(c) to existing Partners) • Pre-contribution gain $50,000 • Capital A 704(c) $12,500 • Capital B 704(c) $12,500 • Capital C 704(c) $12,500 • Capital D 704(c) $12,500

  30. New Balance Sheet • Cash $ 200,000 • Land $ 10,000 • Pre-contribution Gain $ 90,000 (land allocable to A&C) • Pre-gift Appreciation $ 50,000 (Allocable to assets and A and B capital then C&D) • Reverse 704 (c )Appreciation $ 50,000 (Allocable to A,B,C,D) • Capital A $ 75,000 • Capital B $ 75,000 • Capital C $ 75,000 • Capital D $ 75,000 • Capital E $100,000

  31. OK that was the easy stuff. The attorneys must give us the right language to work with, as you will see during the technical part of the presentation.

  32. 704(c) Allocations

  33. The Problem • Where property contributed to partnership has FMV > adjusted basis (AB), i.e. built-in gain or 704(c) variation • This occurs upon formation of a new partnership or revaluation of partnership property upon admission of a new partner or any time a 704(c) adjustment is required or elected. Ex 1 DD LLC is formed by Dylan and Dave (50/50 members) Dylan capital contribution: Value $10,000 AB $ 4,000 Dave capital contribution: Cash $10,000 Dylan’s responsibility (704(c) variation) is $6,000.

  34. Terminology & Exception • Partner who contributes 704(c) property is the contributing partner (CP) and is responsible for allocating variation to the non-contributing partner (NCP) • May not wait until disposal of property to eliminate the variation* • *Small Disparity Rule – ignore the variation or wait until disposal to correct it if • the partner’s total disparity (variation) in all property s/he contributed ≤ 15% of the total adjusted basis of the property contributed by the partner, and • Total disparity ≤ $20,000

  35. Aggregation • 704(c) properties may be aggregated if • (1) properties are in same general asset account, are not real property, placed in service same year, and same depreciable life and method; • (2) AB of properties is zero and not real property; • (3) Inventory; or • (4) Securities partnerships

  36. The Goal of 704(c) Allocation • Place the NCP in the same position s/he would have been in had s/he purchased an interest in the partnership property • i.e. partnership interest % x FMV of 704(c) property

  37. Three Allocation Methods • Three methods • Traditional • Curative • Remedial • All three methods start in the same place – depreciate the agreed-upon value (or FMV) of the 704(c) property and allocate book depreciation between partners based on the economic deal. Then, allocate the first tax dep’n to the NCP to attempt to match the book dep’n • The methods vary in how book dep’n is calculated and what happens if tax dep’n isn’t sufficient enough to match book dep’n allocated to the NCP

  38. Traditional Method • Specially allocate tax dep’n to the NCP up to allowable book dep’n. Note: tax dep’n allocated to the NCP cannot exceed the allowable tax depreciation for the year (ceiling rule) • Book dep’n is based on the value of the property but is limited to the tax life of the asset. • If the special allocations are insufficient to correct the disparity, then the remaining variation will be specially allocated at disposition of the asset but within the limits of the ceiling rule.

  39. Assume same facts as Ex 1 Ex 2 – Traditional Method *10,000 FMV / 10 yr. life =1,000 / 2 = 500 each; book value must be depreciated asset over the asset’s remaining tax life. **“Ceiling Rule” does not permit the creation of additional tax deductions. The total tax deductions allocated to the NCP can’t exceed the pship’s tax deductions with respect to the asset: 4,000 / 10 = 400

  40. Curative Method • Operates in same manner as traditional method but allows curative allocations (of other partnership items including gross income) to offset limitations imposed by the ceiling rule. • Allocations must be of the same character and result in same tax consequence as the tax item affected by the ceiling rule (e.g. pship can’t allocate capital gain where depreciation (ordinary) had been limited by the ceiling rule). • Final disposition does allow curative allocation of capital gain where dep’n deductions had been limited if allowed by pship agreement. • The ceiling rule disparity amount is allocated over the life of the asset.

  41. Assume same facts as Ex 1 Ex 3 – Curative Method *Book value must be depreciated over the asset’s tax life. **Curative allocations must be of same character, e.g. ordinary income and ordinary loss.

  42. Remedial Method • Often viewed as a compromise between traditional and curative methods. • Allocations are made over both the book and tax life of the asset using a two step process: • 1. Adjusted tax basis of property depreciated over tax life of the asset. • 2. the Book basis in excess of the tax basis (i.e. the 704(c) variation) is depreciated over the full book life as if it were a newly purchased property of the same kind • If there are insufficient p’ship items to allocate in order to eliminate the ceiling rule disparity, the p’ship “invents” tax deductions to allocate to the NCP. These “invented” items must be matched with corresponding income allocations to the CP.

  43. Assume same facts as Ex 1 Ex 4 – Remedial Method *Pship has $700/yr. of book dep’n in first 10 years ($7,000 total). $4,000 of remaining tax basis / 10 yrs. = $400/yr. $6,000 of book basis in excess of tax / 20 yrs. = $300/yr.

  44. Assume same facts as Ex 1 Ex 4 – Remedial Method (cont.) **First $350 of tax dep’n for first 10 years is allocated to Dave ($3,500 total) to correspond with allocations of book dep’n; remaining $50/yr. ($500 total) goes to Dylan.

  45. Assume same facts as Ex 1 Ex 4 – Remedial Method (cont.) ***Years 11-20: remedial allocations of ordinary deduction items (actual or created) to the NCP and corresponding allocations of gross income to the CP in amounts equivalent to the remedial allocations of ordinary deduction items.

  46. Method Selection • If there are significant differences among the final results (or during the interim) of the three methods, it may be necessary for the partners to negotiate which method to use prior to execution of the partnership agreement. • The method that is selected must be reasonable in light of the unique circumstances of each partnership.

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