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Advanced Taxation LLCs and Partnerships

Advanced Taxation LLCs and Partnerships. Advanced Taxation LLCs and Partnerships. Advanced Taxation LLCs and Partnerships. Chapter 1. Allocation of Partnership and LLC Income under Section 704(b). Allocation of Partnership Income under Section 704(b).

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Advanced Taxation LLCs and Partnerships

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  1. Advanced Taxation LLCs and Partnerships

  2. Advanced Taxation LLCs and Partnerships

  3. Advanced Taxation LLCs and Partnerships

  4. Chapter 1 Allocation of Partnership and LLC Income under Section 704(b)

  5. Allocation of Partnership Income under Section 704(b) • Economic Effect – Partner allocated a tax gain must also receive economic benefit of that gain • Likewise, partner allocated tax loss must bear the economic burden of that loss • Measured through capital accounts

  6. Substantiality • Economic effect is not enough • Effect on partners must also be substantial, that is, meaningful and relatively long-lasting

  7. Economic Effect – The General Test • Maintenance of partner capital accounts • Partners entitled to balance in their capital accounts upon liquidation or retirement from the partnership • Partners must be obligated to restore deficit balances in their capital accounts (at liquidation)

  8. Capital Account Maintenance • Accounts must be increased by • Cash contributions to partnership • FMV of property contributions (net of liabilities) • Allocated book income (including nontaxable income and gain) • Not increased by partner’s share of partnership liabilities

  9. Capital Account Maintenance • Accounts must be decreased by • Cash distributions to partner • FMV of property distributed to partner by the partnership (net of liabilities) • Allocated expenses and losses (including nondeductible expenses and losses)

  10. Capital Account Maintenance • Property distributions typically require recognition of gain or loss for book and allocation among partners • Book depreciation must be computed at same rate as tax depreciation

  11. Capital Account Maintenance On January 1, Y3, B contributes 5-year property to BCD Investors; a limited liability company that has chosen to be taxed as a partnership for federal income tax purposes. Property, which B purchased in Y1 for $20,000 Approximate value at Y3 $15,000 B elected in Y1 to depreciate the property over 5 years using the statutory method under Section 168: DDB, mid-year convention. Basis at the date of contribution is $9,600, as follows: $20,000x.40x.5=4,000 $20,000-4,000)x.40=6,400 $4,000+6,400=$10,400 $20,000-10,400=$9,600

  12. Capital Account Maintenance A and B form AB, a limited liability partnership, with the following contributions: A contributes $500 cash in exchange for a 50% interest in the entity. B receives the remaining 50% interest in exchange for a contribution of property with a basis and fair market value of $650, but encumbered by a nonrecourse liability of $150. Under Section 704(b), the balance in A’s capital account is $500 ($500 contributed, less 0 debt transferred to the partnership). Basis in partnership interest will be $500, plus 50% share of the partnership’s debt, $75.   Although the fair market value of the property contributed by B is $650, the balance in 704(b) capital account will be $500 ($650 contributed less $150 liability transferred); basis in her partnership interest will be $500, plus $75 share of the partnership’s liabilities.

  13. Capital Account Maintenance A and B form AB, a limited liability partnership, with the following contributions. A contributes $500 cash in exchange for a 50% interest in the entity. B receives the remaining 50% interest in exchange for a contribution of property with a basis and fair market value of $650, but encumbered by a nonrecourse liability of $150. Under Section 704(b), the balance in A’s capital account is $500 ($500 contributed, less 0 debt transferred to the partnership). Basis in partnership interest will be $500, plus 50% share of the partnership’s debt, $75.   Although the fair market value of the property contributed by B is $650, the balance in her §704(b) capital account will be $500 ($650 contributed less $150 liability transferred); basis in her partnership interest will be $500, plus $75 share of the partnership’s liabilities.

  14. Contributions to Capital A and B establish AB Co., a limited liability company Equal contributions of $1,500 cash. The LLC borrows $12,000 and purchases video arcade equipment for $15,000. The equipment is placed in convenience stores in exchange for a share of the income from use of the machines. Income before depreciation in the first year of LLC operations is $3,000. Depreciation expense is $3,000. The agreement between A and B provides that depreciation expense will be allocated entirely to A. All other items of income and expense are shared equally.

  15. Contributions to Capital • As a result, the balances in the members’ capital accounts at the end of year 1 are as follows: AB Beginning balances $1,500 $1,500 Income before depreciation 1,500 1,500 Depreciation expense (3,000) 0 Ending balances $ 0 $3,000 • If the members’ rights in liquidation are tied to their capital accounts, a disposition of the equipment for its book value followed by liquidation of the LLC would entitle B to receive a payment of $3,000 while A receives nothing.

  16. Contributions to Capital • Thus, the allocation of the depreciation expense entirely to A has economic effect and will be recognized under Section 704(b). • If, on the other hand, the LLC agreement provides that liquidation proceeds will be split equally between the members (regardless of the balances in their capital accounts), the allocation of depreciation can be seen to have had no effect on A’s economic rights in liquidation and therefore will not be recognized under Section 704(b).

  17. Deemed Economic Effect • If partnership agreement is silent with regard to capital accounts, liquidation rights and deficit restoration requirements, allocations are generally determined not to have economic effect • Silence is disregarded if there are no special allocations

  18. Alternate Test for Economic Effect • If partnership agreement requires • Capital account maintenance, • Liquidation proceeds distributed in accordance with capital balances, and • Qualified income offset, then • Allocations that do not cause or increase deficit balances will have economic effect

  19. Qualified Income Offset • Unexpected allocations that increase deficit beyond required level of restoration must be offset by special allocation of profit or gain “as quickly as possible” • Provision must be included in partnership agreement if any partners are not required to restore deficits

  20. Partial Economic Effect • Under the alternative test for economic effect, allocations can have partial economic effect • Only that part of the allocation that does not create or increase deficit has economic effect

  21. Partial Economic Effect • Assume that in LLC’s first year of operations, it reports income before depreciation of $2,000. As in Example 4, it reports depreciation expense of $3,000. Absent Section 704(b), capital accounts at the end of the first year would be as follows:  A B Beginning balances $1,500 $1,500 Income before depreciation 1,000 1,000 Depreciation expense (3,000) 0 Ending balances $ (500) $2,500

  22. Partial Economic Effect • Because A is not obligated to restore the deficit in his capital account, the above allocations will not be considered to have economic effect under the general provisions of Section 704(b). • If the partnership agreement meets the requirements of the alternate test, however, • The allocations to A will be considered to have economic effect to the extent they do not reduce the balance in his capital account below zero (because he is not obligated to restore a deficit balance in his capital account).

  23. Partial Economic Effect • Thus, under the alternate test only $(500) of the net allocation must be reallocated. Since A’s net allocation was $(2,000), 1/4 of each item allocated to A must be reallocated to B. • Accordingly, B will be allocated approximately $250 of the income before depreciation that was originally allocated to A, and $750 of the depreciation originally allocated to A.

  24. Partial Economic Effect • The new allocations will be as follows: A B Beginning balances $1,500 $1,500 Income before depreciation 750 1,250 Depreciation expense (2,250) (750) Ending balances $ 0 $2,000 • As illustrated above, the reallocations will leave A with a zero balance in his capital account. B’s capital balance will be $2,000.

  25. Substantiality • “Shifting Tax Consequences” test, and • “Transitory Allocations” test

  26. Shifting Tax Consequences • Allocations lack substantiality if there is a “strong likelihood” that • Net capital changes would not differ substantially without the special allocation, and • Aggregate partner tax liability is lower than if the allocation were not made

  27. Transitory Allocations • Same requirements as “shifting tax consequences” test • Applied over five years, rather than one • Property FMV deemed equal to book value, so future hypothetical gain will not offset allocation of current depreciation

  28. Overall Tax Effects Test • Allocation lacks substantiality if • It may, in present value terms, increase the after-tax economic consequences of at least one partner; and • There is a strong likelihood that no partner will suffer reduced after-tax economic consequences (again, in present value terms)

  29. Section 734(b) Adjustments • Q, R and S form a general equal partnership, to which each contributes $30,000. • The partnership makes an Internal Revenue Code (IRC) Code Sec. 754 election. • Partnership uses $50,000 to buy stock of X Corp. • After several years X stock and cash are only partnership assets, and value of X stock is $80,000. • The partnership liquidates Q's interest in exchange for $40,000 cash.

  30. Section 734(b) Adjustments • Assuming Q’s basis and capital account are still $30,000, distribution will cause Q to recognize gain of $10,000. • Partnership must increase its basis in X stock by $10,000 (amount of gain Q recognizes). • Q's capital account must be increased by $10,000 gain, and reduced by distribution: $40,000. • Result is: Q’s capital account after liquidating distribution will be zero. R's and S's capital accounts are not adjusted.

  31. Section 734(b) Adjustments • Same facts except: Partnership distributes $40,000 in cash to Q in a non-liquidating distribution. • Assuming Q’s basis and capital account are still $30,000, distribution will cause Q to recognize gain of $10,000. • Partnership must increase basis in X stock by $10,000 (gain Q recognizes). • Each partner's capital account increased by share of $10,000 gain, and Q’s capital account reduced by amount of distribution: $40,000.

  32. Section 734(b) Adjustments • Q’s capital account after the non liquidating distribution will be $30,000 + $3,333 - $40,000+$6,667 = 0. • Q’s capital account will be brought to zero since he recognized $10,000 of gain ($3,333 +$6,667). Otherwise Q’s capital account would be -$6,667. • A partners’ capital account cannot be negative if it is caused by a cash distribution.

  33. Optional Revaluation of Partnership Assets • Allowed in following circumstances • Contribution of property to partnership by any partner, • Distribution of property by partnership to any partner, or sale or exchange of partnership interest • Grant of an interest in the partnership in exchange for services, or • Substantially all partnership’s assets are tradable securities

  34. Nonrecourse Deductions • Allocations will be recognized if • Partnership agreement calls for proper maintenance of capital accounts, • Liquidation proceeds must be distributed based on capital balances, • Partnership agreement requires either deficit restoration or minimum gain chargeback, and • Allocation must be consistent with other significant items

  35. Minimum Gain Chargeback • “Minimum gain” is equal to excess of nonrecourse debt over property basis • Each partner’s share is sum of partner’s previous nonrecourse deductions (depreciation) • This gain must first be allocated to partners with deficit capital balances to extent of such deficits

  36. Chapter 2 Allocations with Respect to Contributed Property: Section 704(c)(1)(A)

  37. Section 704(c) – Allocations with Respect to Contributed Property • A contributes land to AB, Ltd., an LLC • A and B each own 50% of AB • Tax basis of land at the date of contribution is $100,000; fair market value is $250,000 • If land is sold, Section 704(c) will require first $150,000 of gain allocated to A • If not for Section 704(c), the partners would share the gain equally and A would have effectively shifted $75,000 of gain to B

  38. Section 704(b) Allocations • Special allocations of gain or loss on disposition of contributed property by a partnership or LLC, • Any tax gain or loss recognized by entity is first allocated to contributing partner or LLC member to the extent of the remaining built-in gain or loss inherent in the property at the date of the sale.

  39. Allowable Methods • Traditional Method • Traditional Method with Curative Allocations • Remedial Allocations Method • Other Methods with Permission

  40. Traditional Method • Gain or Loss on Sale of Contributed Asset • Any remaining “built-in” gain or loss at date of sale is allocated to contributor-partner • Remaining gain or loss is allocated among partners in accordance with the partnership agreement

  41. Traditional Method: Depreciation • Tax depreciation allocated to partners other than contributor to extent of their allocated book depreciation • Allocations are subject to the ceiling rule – aggregate allocations cannot exceed total amount of depreciation allowable for tax • Contributing partner gets remainder, if any • Allocations made property-by-property

  42. Traditional Method with “Curative Allocations” • Same as Traditional Method, but • Ceiling Rule distortions offset by special allocations of other items (e.g., depreciation on other properties) • Offsetting allocations must have same character as section 704(c) item

  43. Remedial Allocations Method • Allocate same amounts of tax depreciation, gain, or loss to non-contributor-partners as they receive for book • Ignore ceiling rule • If allocations to other partners exceed total amount available for tax (that is, total amount on tax return), contributor-partner receives an offsetting allocation equal to the excess • For example, if allocated depreciation exceeds available, contributing partner is allocated income equal to excess

  44. Section 704(c) Revaluations • All entity assets can be revalued to FMV for book purposes, if • New partner is admitted in exchange for a contribution of property • An existing partner is liquidated • A partnership interest is granted after May 5, 2004, in exchange for services to the partnership

  45. Section 704(c) Revaluations • A contributes depreciable property to AB LP • Tax basis = $3,000 and FMV = $10,000 • B contributes cash = $10,000 • Yr 1 depreciation = $5,000 allocated 50% each • Yr 1 tax depreciation = $ 1,500

  46. Section 704(c) Revaluations Remedial Method • 704 (c) requires first $2,500 of tax depreciation allocated to B, any remainder to A • Ceiling rule: B can only be allocated $1,500 • creating a $1,000 book-tax disparity in B’s capital account • $1,000 remedial depreciation allocable to B

  47. Section 704(c) Revaluations Remedial Method • A B • BookTaxBookTax • Initial contribution $10,000 $3,000 $10,000$10,000 • Depreciation (2,500) 0 (2,500) (1,500) Remedial depreciation (1,000) • Remedial income 1,000Ending balances $7,500 $4,000 $7,500 $7,500

  48. Chapter 3 Allocation of Partnership Recourse Liabilities under Section 752

  49. Contribution of Encumbered Property • Net relief of liabilities treated as a distribution of cash • Will result in gain to contributing partner at partnership formation if net relief of liabilities is greater than basis of property contributed

  50. Distribution of Encumbered Property • Net assumption of debt treated as a contribution of cash to partnership • Net relief of debt is treated as a distribution of cash

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