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Chapter 11

Chapter 11. Partnerships: Distributions, Transfer of Interests, and Terminations. The Big Picture (slide 1 of 4).

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Chapter 11

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  1. Chapter 11 Partnerships: Distributions, Transfer of Interests, and Terminations

  2. The Big Picture (slide 1 of 4) In the previous chapter, Josh, Kyle, and Maria created Beachside Properties, LLC, to own and operate the Beachsider Cafe´ and to own, manage, and lease the remaining properties in the Shorefront Center. Several years have passed since the LLC was formed. The LLC interests and the net underlying assets are currently valued at approximately $10 million (including $1 million of goodwill for the Beachsider Cafe´). During this period, the LLC has made significant distributions of cash and property to its members.

  3. The Big Picture (slide 2 of 4) The area has grown substantially, and it appears to be a good time to develop the remaining 7 acres of property. The cost of development is estimated at $10 million. Josh wants to manage the expansion. Kyle and Maria are nearing retirement age. They would prefer to dispose of their interests (valued at $9.5 million, or 95% of the net LLC value). Josh has been approached by a group of developers who are willing to invest the $19.5 million necessary to make the improvements and to purchase Kyle’s and Maria’s interests.

  4. The Big Picture (slide 3 of 4) The transfer of Kyle’s and Maria’s interests and the admission of the new LLC members can be accomplished in two ways. First, the LLC could admit the new members for $19.5 million of cash Use $9.5 million to redeem the interests of Kyle and Maria. Second, Kyle and Maria could sell their LLC interests directly to the new members for $9.5 million. The new members would also contribute $10 million of cash to the LLC for the expansion.

  5. The Big Picture (slide 4 of 4) Although the two alternatives have identical economic effects, the tax results could differ substantially. How are the distributions of cash and property to the LLC members treated over the years? What are the tax consequences of admitting the new members to the LLC and redeeming the interests of Kyle and Maria? What are the results if the new members acquire the interests directly from Kyle and Maria and contribute the cash for expansion to the LLC? Read the chapter and formulate your response.

  6. Distributions from a Partnership(slide 1 of 4) A payment from a partnership to a partner is not necessarily treated as a distribution e.g., Partnership may pay interest or rent to a partner, make a guaranteed payment, or purchase property from a partner If a payment is treated as a distribution, it will fall into one of two categories: Liquidating distributions Nonliquidating distributions Depends on whether the partner remains a partner in the partnership after the distribution

  7. Distributions from a Partnership (slide 2 of 4) • A liquidating distribution occurs when either: • Partnership itself liquidates and distributes all its property to the partners, or • Ongoing partnership redeems interest of one of its partners • e.g., Partner retires

  8. Distributions from a Partnership (slide 3 of 4) • A nonliquidating distribution is any distribution from a continuing partnership to a continuing partner • Two types of nonliquidating distributions • Draw • Distribution of partner’s share of current or accumulated profits • Partial liquidation • Reduces partner’s interest in partnership capital but does not liquidate partner’s interest

  9. Distributions from a Partnership(slide 4 of 4) • Distributions from a partnership may be either: • Proportionate—Partner receives his or her share of certain ordinary income-producing assets • Disproportionate—Partner’s share of certain ordinary income-producing assets increases or decreases

  10. The Big Picture – Example 1Distributions From A Partnership Return to the facts of The Big Picture on p. 11-2. Assume that Josh’s basis in his interest in Beachside Properties, LLC, is $300,000. The LLC distributes $50,000 cash to Josh at the end of the year. Josh does not recognize any gain on the distribution and reduces his basis by $50,000 (the amount of the distribution) to $250,000. Josh’s basis in the cash he received is $50,000,and the LLC’s inside basis for his assets is reduced by the $50,000 cash distributed.

  11. Proportionate Nonliquidating Distributions (slide 1 of 3) • In general, neither partner nor partnership recognizes gain or loss on proportionate nonliquidating distributions • Partner usually takes a carryover basis in assets distributed • Basis in partnership interest is reduced by amount of cash and basis of property distributed

  12. Proportionate Nonliquidating Distributions (slide 2 of 3) • Partner recognizes gain to extent cash received exceeds partner’s adjusted basis (outside basis) in partnership interest • Reduction in partner’s share of partnership debt is treated as a distribution of cash • First reduces partner’s basis in partnership • Any reduction in excess of partner’s basis in partnership results in taxable gain to the partner • Partner cannot recognize loss on a proportionate nonliquidating distribution

  13. Proportionate Nonliquidating Distributions (slide 3 of 3) • Property distributions • In general, no gain recognized on a property distribution • If inside basis of property distributed exceeds partner’s outside basis in partnership interest, distributed asset takes substituted basis • Assets are deemed distributed and basis applied in a certain order

  14. Ordering Rules • 1. Cash • 2. Unrealized receivables and inventory • 3. All other assets • Basis is allocated to assets within a category based on adjusted basis to partnership

  15. Bill’s basis in partnership interest: $30,000 Proportionate nonliquidating distributions (independent fact situations): Assets Distributed A B C . Cash $15,000 $15,000 $ 5,000 Land—basis N/A $ 6,000 N/A (Fair mkt value) N/A $10,000 N/A Accts rec—basis N/A N/A -0- (Fair mkt value) N/A N/A $16,000 Proportionate Nonliquidating Distribution Examples (slide 1 of 6)

  16. A B C. Basis in interest $30,000 $30,000 $30,000 Cash distributed ( 15,000)(15,000)(5,000) Basis after cash 15,000 15,000 25,000 Acct. rec. distrib. N/A N/A (-0-) Basis after A.R. 15,000 15,000 25,000 Land Distrib. N/A ( 6,000) N/A Basis after all dist. $15,000 $ 9,000 $25,000 Proportionate Nonliquidating Distribution Examples (slide 2 of 6)

  17. A B C . Basis in p’ship int. $15,000 $9,000 $25,000 Basis in cash 15,000 15,000 5,000 Basis in land N/A 6,000 N/A Basis in A/R N/A N/A -0- Total basis $30,000 $30,000 $30,000 Sale of non-cash assets at FMV: Selling price N/A $10,000 $16,000 Basis N/A (6,000) (-0-) Gain N/A $4,000 $16,000 Proportionate Nonliquidating Distribution Examples (slide 3 of 6)

  18. Bill’s basis in partnership interest: $30,000 Proportionate nonliquidating distributions (independent fact situations): Assets DistributedD E F . Cash $40,000 N/A $20,000 Relief of liabilities N/A 40,000 N/A Land-basis N/A N/A $30,000 (Fair mkt value) N/A N/A $50,000 Proportionate Nonliquidating Distribution Examples (slide 4 of 6)

  19. D E F . Basis in interest $30,000 $30,000 $30,000 Cash distributed (40,000) N/A (20,000) Relief of liabilities N/A (40,000) N/A Gain recognized 10,000 10,000 N/A . Basis after cash (and deemed cash) dist. -0- -0- 10,000 Land distrib. N/A N/A (10,000) Basis after all distrib. -0- -0- -0- Proportionate Nonliquidating Distribution Examples (slide 5 of 6)

  20. D E F. Basis in p'ship int. -0- -0- -0- Basis in cash 40,000 N/A 20,000 Liabilities relieved N/A 40,000 N/A Basis in land N/A N/A 10,000 Gain recognized (10,000)(10,000) N/A . Original basis 30,000 30,000 30,000 Sale of non-cash assets at FMV: Selling price N/A N/A $50,000 Basis N/A N/A (10,000) Gain N/A N/A $40,000 Proportionate Nonliquidating Distribution Examples (slide 6 of 6)

  21. Effect of Liquidating Distribution • In general: • No gain or loss is recognized by partnership • Partner reduces basis in partnership interest by basis in property received at each level using Ordering Rules • Partner’s entire basis in interest will be absorbed by distributed assets

  22. Exceptions to Liquidating Distribution Rules (slide 1 of 2) • Gain is recognized if: • Cash distributed exceeds partner’s basis • Precontribution gain exceptions • Disproportionate distribution

  23. Exceptions to Liquidating Distribution Rules (slide 2 of 2) • Loss is recognized only if: • Assets received include only cash, unrealized receivables and inventory, and • Outside basis exceeds partnership’s inside basis in distributed property

  24. Bill’s basis in partnership interest: $30,000 Proportionate liquidating distributions (partnership also liquidates) (independent fact situations): G H I. Cash $50,000 $10,000 $10,000 Unrealized rec. N/A -0- -0- (Fair mkt value) N/A $16,000 $16,000 Filing cabinet (1231) N/A N/A 300 (Fair mkt value) N/A N/A 300 Proportionate Liquidating Distribution Examples (slide 1 of 4)

  25. G H I . Basis in interest $30,000 $30,000 $30,000 Cash distribution (50,000)(10,000)(10,000) Gain recognized 20,000 N/A N/A Basis after cash -0- 20,000 20,000 A/R distrib. N/A -0- -0- Loss recognized N/A (20,000) N/A Basis after A/R -0- -0- 20,000 Filing cabinet N/A N/A (20,000) Ending basis $ -0- $ -0- $ -0- Proportionate Liquidating Distribution Examples (slide 2 of 4)

  26. G H I. Basis in p’ship int. $ -0- $ -0- $ -0- Basis in cash 50,000 10,000 10,000 Basis in A/R N/A -0- -0- Basis in filing cabinet N/A N/A 20,000 Capital (Gain)/loss (20,000) 20,000 N/A . Original basis $30,000 $30,000 $30,000 Proportionate Liquidating Distribution Examples (slide 3 of 4)

  27. Sale of non-cash assets at FMV: Example H: A/R Fil.Cab. Total. Selling price $16,000 N/A $16,000 Basis -0- N/A -0- . Gain/(loss) $16,000 N/A $16,000 (Ordinary) Example I: Selling price $16,000 $ 300 $16,300 Basis -0- 20,000 20,000 Gain/(loss) $16,000 ($19,700) ($3,700) (Ordinary) (May be ord) Proportionate Liquidating Distribution Examples (slide 4 of 4)

  28. Property Distributions with Special Tax Treatment (slide 1 of 4) • Disguised sales • Contribution of appreciated property to partnership followed by a cash distribution to the contributing party may be treated as a disguised sale • Treated as a sale of property resulting in gain recognition • Partnership’s basis in the asset is cost

  29. Property Distributions with Special Tax Treatment (slide 2 of 4) • Marketable securities • FMV of marketable securities distributed to a partner is treated as a cash distribution • Some or all of excess of FMV of securities distributed over partner’s outside basis is taxable gain • Marketable securities include most actively traded debt or equity interests, options, futures, and derivatives • Exceptions apply

  30. Property Distributions with Special Tax Treatment (slide 3 of 4) • Precontribution gain property • Contributing partner recognizes gain on distribution of precontribution gain property in two situations: • 1. If property is distributed to another partner within 7 years of contribution date, contributing partner recognizes remaining precontribution gain • Partner’s basis in partnership and basis of distributed property is increased by gain recognized

  31. Property Distributions with Special Tax Treatment (slide 4 of 4) • Precontribution gain property • Contributing partner recognizes gain on distribution of precontribution gain property in two situations (cont’d): • 2. If partnership distributes any property other than cash to a partner within 7 years after that partner contributes appreciated property, the partner recognizes the lesser of: • Remaining net precontribution gain • Excess of FMV of distributed property over partner’s basis in partnership interest

  32. Disproportionate Distributions(slide 1 of 3) • Occurs when partnership distributes cash or property to a partner which increases or decreases the partner’s share of ordinary income-producing assets (hot assets)

  33. Disproportionate Distributions(slide 2 of 3) • If partner receives less than proportionate share of hot assets, then treated as if: • Partnership distributed some of the assets, and • Partner sold these hot assets back to partnership • Partner recognizes ordinary income on sale of the hot assets; Partnership’s basis in hot assets is cost

  34. Disproportionate Distributions(slide 3 of 3) • Hot assets include: • Substantially appreciated inventory • Inventory includes all assets other than cash, capital and §1231 assets • Substantially appreciated means FMV > 120% of partnership’s adjusted basis in inventory • Unrealized receivables • Rights to receive future amounts that will result in ordinary income recognition

  35. §736: Liquidating Distribution Where P’ship Does Not Liquidate (slide 1 of 3) • §736(a) income payment: • Treated as distributive share of partnership income or guaranteed payment to partner • Certain items if partnership is service-provider and retiring partner is a general partner: • Unrealized receivables (except depreciation recapture) • Goodwill (unless provided for in partnership agreement) • §736(b) property payment: • Payments made for liquidated partner’s share of partnership’s assets

  36. §736: Liquidating Distribution Where P’ship Does Not Liquidate (slide 2 of 3) • §736(a) income payment: • Partner has: • Ordinary income (guaranteed payment), or • Distributive share of income • Partnership has: • Guaranteed payment (deductible) if determined without regard to partnership profits • Distributive share if based on profits

  37. §736: Liquidating Distribution Where P’ship Does Not Liquidate (slide 3 of 3) • §736(b) property payment: • Disproportionate distribution to extent of partner’s share of hot assets • Return of basis (and capital gain (loss) for remainder)

  38. The Big Picture – Example 27§ 736(b) Property Payments (slide 1 of 4) Return to the facts of The Big Picture on p. 11-2. Recall that the members of Beachside Properties, LLC, are considering two alternatives for its future expansion. Assume that they decide to admit new partners for $19.5 million and use $9.5 million of the cash to redeem the interests of Kyle and Maria. Because the LLC itself is not liquidating, the distribution to Kyle and Maria is classified under § 736.

  39. The Big Picture – Example 27 § 736(b) Property Payments (slide 2 of 4) The current balance sheet for Beachside Properties, LLC, is as follows:

  40. The Big Picture – Example 27 § 736(b) Property Payments (slide 3 of 4) Capital is a ‘‘material income-producing factor’’ for Beachside Properties, LLC. The entire $9.5 million distribution from the LLC to Kyle and Maria is a § 736(b) payment for their interests in the partnership’s property. Kyle and Maria will recognize gain to the extent that this cash distribution (including forgiveness of their shares of the LLC’s debt) exceeds their bases in the LLC interests.

  41. The Big Picture – Example 27 § 736(b) Property Payments (slide 4 of 4) Because Kyle and Maria receive cash in lieu of their shares of the LLC’s unrealized receivables and inventory, this is a disproportionate distribution. They will recognize ordinary income to the extent that their gain relates to these receivables and inventory. The remaining gain will be a capital gain. As there are no § 736(a) payments, the LLC cannot claim any deductions. Absent a § 754 election (discussed later), the basis of the LLC’s property will not be affected

  42. Sale of Partnership Interest (slide 1 of 4) • Generally, results in gain or loss recognition by selling partner • Gain (loss) = amount realized less partner’s basis in partnership interest • Partnership liabilities assumed by purchasing partner are treated as part of consideration paid for the partnership interest

  43. Sale of Partnership Interest (slide 2 of 4) • Partnership tax year closes for selling partner on sale date • Partner’s share of income through sale date is calculated • Can prorate annual income or use interim closing of the books • Taxed to selling partner and increases basis in partnership interest

  44. Sale of Partnership Interest (slide 3 of 4) • Effect of hot assets • Hot assets include: • Unrealized receivables (same as for disproportionate distributions) • Inventory • Includes all partnership property except money, capital assets, and §1231 assets

  45. Sale of Partnership Interest (slide 4 of 4) • Effect of hot assets (cont’d) • Must allocate sales price of partnership interest between “hot” (ordinary income) assets and “nonhot” (capital gain) components • Selling partner’s gain is classified as a capital gain or loss portion and an ordinary income or loss amount related to the hot assets

  46. The Big Picture – Example 36 Effect Of Hot Assets(slide 1 of 2) Return to the facts of The Big Picture on p. 11-2 Recall that the second restructuring option for Beachside Properties, LLC, is for Kyle and Maria to sell their interests directly to the new members of the LLC. The new members will contribute $10 million of cash to Beachside Properties and pay $4.75 million each to Kyle and Maria in exchange for their interests in the LLC.

  47. The Big Picture – Example 36 Effect Of Hot Assets(slide 2 of 2) Refer back to the balance sheet in Example 27. Kyle and Maria will receive cash of $9.5 million (total) plus relief of their shares of the LLC’s debt. Their bases in the LLC interests equal their capital account balances plus their shares of the LLC’s liabilities. The difference must be recognized as a gain. The gain is ordinary income to the extent that it relates to Kyle’s and Maria’s shares of the LLC’s accounts receivable, inventory, and depreciation recapture. The remaining gain is a capital gain. Absent a § 754 election (discussed later), the basis of the LLC’s property will not be affected.

  48. Other Dispositions of Partnership Interests (slide 1 of 8) • Transfer of a partnership interest to a controlled corporation • Tax free if §351 requirements are met • If 50% or more of the total interest in capital and profits of the partnership are transferred, the partnership terminates

  49. Other Dispositions of Partnership Interests (slide 2 of 8) • Incorporating a partnership • At least three methods available: • 1. Transfer each partner’s interest to the corp in exchange for stock • Partnership terminates • Corp becomes owner of all partnership assets • Corp has substituted basis in assets; Old partners have substituted basis in stock

  50. Other Dispositions of Partnership Interests (slide 3 of 8) • Incorporating a partnership (cont’d) • 2. Transfer partnership assets to corp in exchange for stock and assumption of partnership liabilities • Partnership distributes stock to partners in liquidating distribution • Corp has carryover basis in assets; Old partners have substituted basis in stock

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