Module 37: Partnership Taxation

Overview

This module presents the federal tax treatment of partnerships and partners. The tax consequences of partnership formation are covered first, followed by a review of the pass-through of partnership income and loss to partners. A partner’s basis for a partnership interest is covered next, with emphasis on the effect of partnership liabilities on a partner’s basis. Next reviewed are the special rules that apply to transactions with controlled partnerships, as well as the limitations that apply to a partnership’s adoption of a tax year. The module continues with a review of the tax effects of a partner’s sale of a partnership interest, and concludes with a review of the rules that apply to a partnership’s distribution of property to partners in both current and liquidating distributions. It is important to be able to determine a partner’s basis for distributed property, as well as the effect of the distribution on the partner’s basis for the partnership interest.

A. Entity Classification

B. Partnership Formation

C. Partnership Income and Loss

D. Partnership Agreements

E. Partner’s Basis in Partnership

F. Transactions with Controlled Partnerships

G. Taxable Year of Partnership

H. Partnership’s Use of Cash Method

I. Termination or Continuation of Partnership

J. Sale of a Partnership Interest

K. Pro Rata Distributions from Partnership

L. Non-Pro-Rata Distributions from Partnership

M. Optional Sec. 754 Adjustment to Basis of Partnership Property

N. Mandatory Adjustments to Basis of Partnership Property

Key Terms

Multiple-Choice Questions

Multiple-Choice Answers and Explanations

Simulations

Simulation Solution

Partnerships are organizations of two or more persons to carry on business activities for profit. For tax purposes, partnerships also include a syndicate, joint venture, or other unincorporated business through which any business or financial operation is conducted. Partnerships do not pay any income tax, but instead act as a conduit to pass through tax items to the partners. Partnerships file an informational return (Form 1065), and partners report their share of partnership ordinary income or loss and other items on their individual returns. The nature or character (e.g., capital, ordinary, Sec. 1231) of income or deductions is not changed by the pass-through nature of the partnership.

A. Entity Classification

1. Eligible business entities (a business entity other than an entity automatically classified as a corporation) may choose how they will be classified for federal tax purposes by filing Form 8832. A business entity with at least two members can choose to be classified as either an association taxable as a corporation or as a partnership. A business entity with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner.
a. An eligible business entity that does not file Form 8832 will be classified under default rules. Under default rules, an eligible business entity will be classified as a partnership if it has two or more members, or disregarded as an entity separate from its owner if it has a single owner.
b. Once an entity makes an election, a different election cannot be made for sixty months unless there is more than a 50% ownership change and the IRS consents.
2. General partnerships exist when two or more partners join together and do not specifically provide that one or more partners is a limited partner. Since each general partner has unlimited liability, creditors can reach the personal assets of a general partner to satisfy partnership debts, including a malpractice judgment against the partnership even though the partner was not personally involved in the malpractice.
3. Limited partnerships have two classes of partners, with at least one general partner (who has the same rights and responsibilities as a partner in a general partnership) and at least one limited partner. A limited partner generally cannot participate in the active management of the partnership, and in the event of losses, generally can lose no more than his or her own capital contribution. A limited partnership is often the preferred entity of choice for real estate ventures requiring significant capital contributions.
4. Limited liability partnerships differ from general partnerships in that with an LLP, a partner is not liable for damages resulting from the negligence, malpractice, or fraud committed by other partners. However, each partner is personally liable for his or her own negligence, malpractice, or fraud. LLPs are often used by service providers such as architects, accountants, attorneys, and physicians.
5. Limited liability companies that do not elect to be treated as an association taxable as a corporation are subject to the rules applicable to partnerships (a single-member LLC would be disregarded as an entity separate from its owner). An LLC combines the nontax advantage of limited liability for each and every owner of the entity, with the tax advantage of pass-through treatment, and the flexibility of partnership taxation. The LLC structure is generally available to both nonprofessional service providers as well as capital-intensive companies.
6. Electing large partnerships are partnerships that have elected to be taxed under a simplified reporting system that does not require as much separate reporting to partners as does a regular partnership. For example, charitable contributions are deductible by the partnership (subject to a 10% of taxable income limitation), and the Sec. 179 expense election is deducted in computing partnership ordinary income and not separately passed through to partners. To qualify, the partnership must not be a service partnership nor engaged in commodity trading, must have at least 100 partners, and must file an election to be taxed as an electing large partnership. A partnership will cease to be an electing large partnership if it has fewer than 100 partners for a taxable year.
7. Publicly traded partnerships are partnerships whose interests are traded on an established securities exchange or in a secondary market and are generally taxed as C corporations.

B. Partnership Formation

1. As a general rule, no gain or loss is recognized by a partner when there is a contribution of property to the partnership in exchange for an interest in the partnership. There are three situations where gain must be recognized.
a. A partner must recognize gain when property is contributed which is subject to a liability, and the resulting decrease in the partner’s individual liability exceeds the partner’s partnership basis.
(1) The excess of liability over adjusted basis is generally treated as a capital gain from the sale or exchange of a partnership interest.
(2) The gain will be treated as ordinary income to the extent the property transferred was subject to depreciation recapture under Sec. 1245 or 1250.
EXAMPLE
A partner acquires a 20% interest in a partnership by contributing property worth $10,000 but with an adjusted basis of $4,000. There is a mortgage of $6,000 that is assumed by the partnership. The partner must recognize a gain of $800, and has a zero basis for the partnership interest, calculated as follows:
Adjusted basis of contributed property $ 4,000
Less: portion of mortgage allocated to other partners (80% × $6,000) (4,800)
Partner’s basis (not reduced below 0) $ 0
b. Gain will be recognized on a contribution of property to a partnership in exchange for an interest therein if the partnership would be an investment company if incorporated.
c. Partner must recognize compensation income when an interest in partnership capital is received in exchange for services rendered.
EXAMPLE
X received a 10% capital interest in the ABC Partnership in exchange for services rendered. On the date X was admitted to the partnership, ABC’s net assets had a basis of $30,000 and a FMV of $50,000. X must recognize compensation income of $5,000, and would have an basis of $5,000 for the partnership interest.
2. Property contributed to the partnership has the same basis as it had in the contributing partner’s hands (a transferred basis).
a. The basis for the partner’s partnership interest is increased by the adjusted basis of property contributed.
b. No gain or loss is generally recognized by the partnership upon the contribution.
3. The partnership’s holding period for contributed property includes the period of time the property was held by the partner.
4. A partner’s holding period for a partnership interest includes the holding period of property contributed, if the contributed property was a capital asset or Sec. 1231 asset in the contributing partner’s hands.
5. Although not a separate taxpaying entity, the partnership must make most elections as to the tax treatment of partnership items. For example, the partnership must select a taxable year and various accounting methods which can differ from the methods used by its partners. Partnership elections include an overall method of accounting, inventory method, the method used to compute depreciation, and the election to expense depreciable assets under Sec. 179.
6. A partnership may elect to deduct up to $5,000 of organizational expenditures for the tax year in which the partnership begins business. The $5,000 amount must be reduced (but not below zero) by the amount by which organizational expenditures exceed $50,000. Remaining expenditures can be deducted ratably over the 180-month period beginning with the month in which the partnership begins business.
a. For amounts paid or incurred after September 8, 2008, the partnership is deemed to have made the election to amortize costs and does not have to attach a statement to its return. Alternatively, the partnership may elect to capitalize its costs on a timely filed return (including extensions) for the taxable year in which the partnership begins business.
b. Similar rules apply to partnership start-up expenditures.
c. Partnership syndication fees (expenses of selling partnership interests) are neither deductible nor amortizable.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 1 THROUGH 9

C. Partnership Income and Loss

1. Since a partnership is not a separate taxpaying entity, but instead acts as a conduit to pass-through items of income and deduction to individual partners, the partnership’s reporting of income and deductions requires a two-step approach.
a. First, all items having special tax characteristics (i.e., subject to partial or full exclusion, % or dollar limitation, etc.) must be segregated and taken into account separately by each partner so that any special tax characteristics are preserved.
(1) These special items are listed separately on Schedule K of the partnership return and include
(a) Capital gains and losses
(b) Sec. 1231 gains and losses
(c) Charitable contributions
(d) Foreign income taxes
(e) Sec. 179 expense deduction
(f) Interest, dividend, and royalty income
(g) Interest expense on investment indebtedness
(h) Net income (loss) from rental real estate activity
(i) Net income (loss) from other rental activity
b. Second, all remaining items (since they have no special tax characteristics) are ordinary in nature and are netted in the computation of partnership ordinary income or loss from trade or business activities
(1) Frequently encountered ordinary income and deductions include
(a) Sales less cost of goods sold
(b) Business expenses such as wages, rents, bad debts, and repairs
(c) Guaranteed payments to partners
(d) Depreciation
(e) Amortization (over 180 months) of partnership organization and start-up expenditures
(f) Sec. 1245, 1250, etc., recapture
(g) See Form 1065 outline at beginning of chapter for more detail
2. The character of any gain or loss recognized on the disposition of property is generally determined by the nature of the property in the hands of the partnership. However, for contributed property, the character may be based on the nature of the property to the contributing partner before contribution.
a. If a partner contributes unrealized receivables, the partnership will recognize ordinary income or loss on the subsequent disposition of the unrealized receivables.
b. If the property contributed was inventory property to the contributing partner, any gain or loss recognized by the partnership on the disposition of the property within five years will be treated as ordinary income or loss.
c. If the contributed property was a capital asset, any loss later recognized by the partnership on the disposition of the property within five years will be treated as a capital loss to the extent of the contributing partner’s unrecognized capital loss at the time of contribution. This rule applies to losses only, not to gains.
3. A person sitting for the examination should be able to calculate a partnership’s ordinary income by adjusting partnership book income (or partnership book income by adjusting ordinary income).
EXAMPLE
A partnership’s accounting income statement discloses net income of $75,000 (i.e., book income). The three partners share profit and losses equally. Supplemental data indicate the following information has been included in the computation of net income:
DR. CR.
Net sales $160,000
Cost of goods sold $ 88,000
Tax-exempt income 1,500
Sec. 1231 casualty gain 9,000
Section 1231 gain (other than casualty) 6,000
Section 1250 gain 20,000
Long-term capital gain 7,500
Short-term capital loss 6,000
Guaranteed payments ($8,000 per partner) 24,000
Charitable contributions 9,000
Advertising expense 2,000
$129,000 $204,000
Partnership ordinary income is $66,000, computed as follows:
Book income $ 75,000
Add:
Charitable contributions $ 9,000
Short-term capital loss 6,000 15,000
$ 90,000
Deduct:
Tax-exempt income $ 1,500
Sec. 1231 casualty gain 9,000
Section 1231 gain (other than casualty) 6,000
Long-term capital gain 7,500 24,000
Partnership ordinary income $66,000
Each partner’s share of partnership ordinary income is $22,000.
4. Three sets of rules may limit the amount of partnership loss that a partner can deduct.
a. A partner’s distributive share of partnership ordinary loss and special loss items is deductible by the partner only to the extent of the partner’s basis for the partnership interest at the end of the taxable year [Sec. 704(d)].
(1) The pass-through of loss is considered to be the last event during the partnership’s taxable year; all positive basis adjustments are made prior to determining the amount of deductible loss.
(2) Unused losses are carried forward and can be deducted when the partner obtains additional basis for the partnership interest.
EXAMPLE
A partner who materially participates in the partnership’s business has a distributive share of partnership capital gain of $200 and partnership ordinary loss of $3,000, but the partner’s basis in the partnership is only $2,400 before consideration of these items. The partner can deduct $2,600 of the ordinary loss ($2,400 of beginning basis + $200 net capital gain). The remaining $400 of ordinary loss must be carried forward.
b. The deductibility of partnership losses is also limited to the amount of the partner’s at-risk basis [Sec. 465].
(1) A partner’s at-risk basis is generally the same as the partner’s regular partnership basis with the exception that liabilities are included in at-risk basis only if the partner is personally liable for such amounts.
(2) Nonrecourse liabilities are generally excluded from at-risk basis.
(3) Qualified nonrecourse real estate financing is included in at-risk basis.
c. The deductibility of partnership losses may also be subject to the passive activity loss limitations [Sec. 469]. Passive activity losses are deductible only to the extent of the partner’s income from other passive activities (see Module 36).
(1) Passive activities include (a) any partnership trade or business in which the partner does not materially participate, and (b) any rental activity.
(2) A limited partnership interest generally fails the material participation test.
(3) To qualify for the $25,000 exception for active participation in a rental real estate activity, a partner (together with spouse) must own at least 10% of the value of the partnership interests.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 10 THROUGH 15

D. Partnership Agreements

1. A partner’s distributive share of income or loss is generally determined by the partnership agreement. Such agreement can have different ratios for income or loss, and may agree to allocate other items (e.g., credits and deductions) in varying ratios.
a. Special allocations must have substantial economic effect.
(1) Economic effect is measured by an analysis of the allocation on the partners’ capital accounts. The special allocation (a) must be reflected in the partners’ capital accounts, (b) liquidation distributions must be based upon the positive capital account balances of partners, and (c) there must be a deficit payback agreement wherein partners agree to restore any deficit capital account balances.
(2) An allocation’s economic effect will not be substantial if the net change recorded in the partners’ capital accounts does not differ substantially from what would have been recorded without the special allocation, and the total tax liability of all partners is less.
b. If no allocation is provided, or if the allocation of an item does not have substantial economic effect, the partners’ distributive shares of that item shall be determined by the ratio in which the partners generally divide the income or loss of the partnership.
c. If property is contributed by a partner to a partnership, related items of income, deduction, gain, or loss must be allocated among partners in a manner that reflects the difference between the property’s tax basis and its fair market value at the time of contribution.
EXAMPLE
Partner X contributes property with a tax basis of $1,000 and a fair market value of $10,000 to the XYZ Partnership. If the partnership subsequently sells the property for $12,000, the first $9,000 of gain must be allocated to X, with the remaining $2,000 of gain allocated among partners according to their ratio for sharing gains.
(1) If contributed property has a built-in loss, the built-in loss is taken into account only for determining the amount of partnership items allocated to the contributing partner. For purposes of determining the amount of partnership items allocated to other partners, the basis of contributed property is treated as being equal to FMV at date of contribution. If the contributing partner’s interest is transferred or liquidated, the partnership’s basis in the property for all future allocations will be based on its FMV at date of contribution, and the built-in loss will be eliminated.
(2) If property contributed to a partnership is distributed within seven years to a partner other than the partner who contributed such property, the contributing partner must recognize the pre-contribution gain or loss to the extent that the pre-contribution gain or loss would be recognized if the partnership had sold the property for its fair market value at the time of distribution.
(3) The above recognition rule will not generally apply if other property of a like-kind to the contributed property is distributed to the contributing partner no later than the earlier of (1) the 180th day after the date on which the originally contributed property was distributed to another partner, or (2) the due date (without extension) for the contributing partner’s return for the tax year in which the original distribution of property occurred.
d. If there was any change in the ownership of partnership interests during the year, distributive shares of partnership interest, taxes, and payments for services or for the use of property must be allocated among partners by assigning an appropriate share of each item to each day of the partnership’s taxable year.
EXAMPLE
Z becomes a 40% partner in calendar-year Partnership XY on December 1. Previously, X and Y each had a 50% interest. Partnership XY uses the cash method of accounting and on December 31 pays $10,000 of interest expense that relates to its entire calendar year. Z’s distributive share of the interest expense will be ($10,000 ÷ 365 days) × 31 days × 40% = $340.
2. Distributable shares of income and guaranteed payments are reported by partners for their taxable year during which the end of the partnership fiscal year occurs. All items, including guaranteed payments, are deemed to pass through on the last day of the partnership’s tax year.
a. Guaranteed payments are payments to a partner determined without regard to income of the partnership. Guaranteed payments are deductible by the partnership and reported as income by the partners.
EXAMPLE
Z (on a calendar-year) has a 20% interest in a partnership that has a fiscal year ending May 31. Z received a guaranteed payment for services rendered of $1,000 a month from 6/1/12 to 12/31/12 and $1,500 a month from 1/1/13 to 5/31/13. After deducting the guaranteed payment, the partnership had ordinary income of $50,000 for its fiscal year ended 5/31/13. Z must include $24,500 in income on Z’s calendar-year 2013 return ($50,000 × 20%) + ($1,000 × 7) + ($1,500 × 5).
b. Partners are generally not considered to be employees for purposes of employee fringe benefits (e.g., cost of $50,000 of group-term life insurance, exclusion of premiums or benefits under an employer accident or health plan, etc.). A partner’s fringe benefits are deductible by the partnership as guaranteed payments and must be included in a partner’s gross income.
3. Family partnerships are subject to special rules because of their potential use for tax avoidance.
a. If the business is primarily service oriented (capital is not a material income-producing factor), a family member will be considered a partner only if the family member shares in the management or performs needed services.
b. Capital is not a material income-producing factor if substantially all of the gross income of the business consists of fees, commissions, or other compensation for personal services (e.g., accountants, architects, lawyers).
c. A family member is generally considered a partner if the family member actually owns a capital interest in a business in which capital is a material income-producing factor.
d. Where a capital interest in a partnership in which capital is a material income-producing factor is treated as created by gift, the distributive shares of partnership income of the donor and donee are determined by first making a reasonable allowance for services rendered to the partnership, and then allocating the remainder according to the relative capital interests of the donor and donee.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 16 THROUGH 30

E. Partner’s Basis in Partnership

1. A partner’s original basis is generally determined by the manner in which the partnership interest was acquired (e.g., contribution of property, compensation for services, purchase, gift, received from decedent).
2. As the partnership operates, the partner’s basis for the partnership interest increases or decreases.
a. A partner’s basis is increased by the adjusted basis of any subsequent capital contributions.
b. Also, a partner’s basis is increased by any distributive share of
(1) Partnership ordinary income
(2) Capital gains and other special income items
(3) Tax-exempt income of the partnership
(4) The excess of the deduction for depletion over the partnership’s basis of the property subject to depletion
c. A partner’s basis is decreased (but not below zero) by
(1) The amount of money and the adjusted basis of other property distributed to the partner
(2) The partner’s distributive share of partnership ordinary loss and special expense items, as well as nondeductible items not properly chargeable to capital
(3) The amount of the partner’s deduction for depletion on oil and gas wells
EXAMPLE
In the example in Section C. 3, one partner’s tax basis (who had a $15,000 tax basis at the beginning of the year) would be $40,000 at the end of the year, calculated as shown below.
Beginning partnership basis $15,000
Add:
Distributive share of partnership ordinary income 22,000
Tax-exempt income 500
Sec. 1231 casualty gain 3,000
Section 1231 gain (other than casualty) 2,000
Long-term capital gain 2,500 30,000
$45,000
Less:
Short-term capital loss $ 2,000
Charitable contributions 3,000 5,000
Ending partnership basis $40,000
d. Changes in liabilities affect a partner’s basis.
(1) An increase in the partnership’s liabilities (e.g., loan from a bank, increase in accounts payable) increases each partner’s basis in the partnership by each partner’s share of the increase.
(2) Any decrease in the partnership’s liabilities is considered to be a distribution of money to each partner and reduces each partner’s basis in the partnership by each partner’s share of the decrease.
(3) Any decrease in a partner’s individual liability by reason of the assumption by the partnership of such individual liabilities is considered to be a distribution of money to the partner by the partnership (i.e., partner’s basis is reduced).
(4) Any increase in a partner’s individual liability by reason of the assumption by the partner of partnership liabilities is considered to be a contribution of money to the partnership by the partner. Thus, the partner’s basis is increased.
EXAMPLE
The XYZ partnership owns a warehouse with an adjusted basis of $120,000 subject to a mortgage of $90,000. Partner X (one of three equal partners) has a basis for his partnership interest of $75,000. If the partnership transfers the warehouse and mortgage to Partner X as a current distribution, X’s basis for his partnership interest immediately following the distribution would be $15,000, calculated as follows:
Beginning basis $ 75,000
Individual assumption of mortgage + 90,000
$165,000
Distribution of warehouse −120,000
Partner’s share of decrease in partnership’s liabilities − 30,000
Basis after distribution $15,000
EXAMPLE
Assume in the example above that one of the other one-third partners had a basis of $75,000 immediately before the distribution. What would the partner’s basis be immediately after the distribution to Partner X? The partner’s basis would be $45,000 (i.e., $75,000 less 1/3 of the $90,000 decrease in partnership liabilities).
e. A partner’s basis for the partnership is adjusted in the following order: (1) increased for all income items (including tax-exempt income); (2) decreased for distributions; and (3) decreased by deductions and losses (including nondeductible items not charged to capital).
EXAMPLE
A partner with a basis of $50 for his partnership interest at the beginning of the partnership year receives a $30 cash distribution during the year and is allocated a $60 distributive share of partnership ordinary loss, and an $8 distributive share of capital gain. In determining the extent to which the ordinary loss is deductible by the partner, the partner’s partnership basis of $50 is first increased by the $8 of capital gain and reduced by the $30 cash distribution to $28, so that his deductible ordinary loss is limited to his remaining basis of $28.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 31 THROUGH 37

F. Transactions with Controlled Partnerships

1. If a person engages in a transaction with a partnership other than as a member of such partnership, any resulting gain or loss is generally recognized. However, if the transaction involves a more than 50% owned partnership, one of three special rules may apply. Constructive ownership rules apply in determining whether a transaction involves a more than 50% owned partnership. For this purpose, an individual’s family includes brothers and sisters, spouse, ancestors, and lineal descendants.
a. No losses are deductible from sales or exchanges of property between a partnership and a person owning (directly or indirectly) more than 50% of the capital or profits interests in such partnership, or between two partnerships in which the same persons own (directly or indirectly) more than 50% of the capital or profits interests. A gain later realized on a subsequent sale by the transferee will not be recognized to the extent of the disallowed loss.
EXAMPLE
Partnership X is owned by three equal partners, A, B, and C, who are brothers. Partnership X sells property at a loss of $5,000 to C. Since C owns a more than 50% interest in the partnership (i.e., C constructively owns his brothers’ partnership interests), the $5,000 loss is disallowed to Partnership X.
EXAMPLE
Assume the same facts as in the above example. C later resells the property to Z, an unrelated taxpayer, at a gain of $6,000. C’s realized gain of $6,000 will not be recognized to the extent of the $5,000 disallowed loss to the Partnership X.
b. If a person related to a partner does not indirectly own a more than 50% partnership interest, a transaction between the related person and the partnership is treated as occurring between the related person and the partners individually.
EXAMPLE
X owns 100% of X Corp. and also owns a 25% interest in WXYZ Partnership. X Corp. sells property at a $1,200 loss to the WXYZ Partnership. Since X Corp. is related to partner X (i.e., X owns more than 50% of X Corp.), the transaction is treated as if it occurred between X Corp. and partners W, X, Y, and Z individually. Therefore, the loss disallowed to X Corp. is $1,200 × 25% = $300.
c. A gain recognized on a sale or exchange of property between a partnership and a person owning (directly or indirectly) more than 50% of the capital or profits interests in such partnership, or between two partnerships in which the same persons own (directly or indirectly) more than 50% of the capital or profits interests, will be treated as ordinary income if the property is not a capital asset in the hands of the transferee.
EXAMPLE
Assume the same facts as in the preceding example. Further assume that F is the father of W, Y, and Z. F sells investment property to Partnership WXYZ at a gain of $10,000. If the property will not be a capital asset to Partnership WXYZ, F must report the $10,000 gain as ordinary income because F constructively owns a more than 50% partnership interest (i.e., F constructively owns his children’s partnership interests).
d. A gain recognized on a sale or exchange of property between a partnership and a person owning (directly or indirectly) more than 50% of the capital or profits interests in such partnership will be treated as ordinary income if the property is depreciable property in the hands of the transferee.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 38 THROUGH 41

G. Taxable Year of Partnership

1. When a partnership adopts (or attempts to change) its taxable year, it is subject to the following restrictions:
a. A partnership must adopt the taxable year used by one or more of its partners owning an aggregate interest of more than 50% in profits and capital (but only if the taxable year used by such partners has been the same for the lesser of three taxable years or the period the partnership has existed).
EXAMPLE
A partnership is formed by a corporation (which receives a 55% partnership interest) and five individuals (who each receive a 9% partnership interest). The corporation has a fiscal year ending June 30, while the individuals have a calendar year. The partnership must adopt a fiscal year ending June 30.
b. If partners owning a more than 50% interest in partnership profits and capital do not have the same year-end, the partnership must adopt the same taxable year as used by all of its principal partners (i.e., a partner with a 5% or more interest in capital or profits).
c. If its principal partners have different taxable years, the partnership must adopt the taxable year that results in the least aggregate deferral of income to partners.
2. A different taxable year than the year determined above can be used by a partnership if a valid business purpose can be established and IRS permission is received. The business purpose test will be met if a partnership receives at least 25% of its gross receipts in the last two months of a twelve-month period, and this “25% test” has been satisfied for three consecutive years.
EXAMPLE
Partnership X is owned by three equal partners—A, B, and C, who use a calendar year. Partnership X has received at least 25% of its gross receipts during the months of June and July for each of the last three years. Partnership X may be allowed to change to a fiscal year ending July 31.
3. A partnership that otherwise would be required to adopt or change its tax year (normally to the calendar year) may elect to use a fiscal year if the election does not result in a deferral period longer than three months, or, if less, the deferral period of the year currently in use.
a. The “deferral period” is the number of months between the close of the fiscal year elected and the close of the required year (e.g., if a partnership elects a tax year ending September 30 and a tax year ending December 31 is required, the deferral period of the year ending September 30 is three months).
b. A partnership that elects a tax year other than a required year must make a “required payment” which is in the nature of a refundable, noninterest-bearing deposit that is intended to compensate the government for the revenue lost as a result of tax deferral. The required payment is due on May 15 each year and is recomputed for each subsequent year.
4. The taxable year of a partnership ordinarily will not close as a result of the death or entry of a partner, or the liquidation or sale of a partner’s interest. But the partnership’s taxable year closes as to the partner whose entire interest is sold or liquidated. Additionally, the partnership tax year closes with respect to a deceased partner as of date of death.
EXAMPLE
A partner sells his entire interest in a calendar-year partnership on March 31. His pro rata share of partnership income up to March 31 is $15,000. Since the partnership year closes with respect to him at the time of sale, the $15,000 is includible in his income and increases the basis of his partnership interest for purposes of computing gain or loss on the sale. However, the partnership’s taxable year does not close as to its remaining partners.
EXAMPLE
X (on a calendar year) is a partner in the XYZ Partnership that uses a June 30 fiscal year. X died on April 30, 2013. Since the partnership year closes with respect to X at his death, X’s final return for the period January 1 through April 30 will include his share of partnership income for the period beginning July 1, 2012, and ending April 30, 2013. His share of partnership income for May and June 2013 will be reported by his estate or other successor in interest.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 42 THROUGH 45

H. Partnership’s Use of Cash Method

1. The cash method cannot generally be used if inventories are necessary to clearly reflect income and cannot generally be used by tax shelters and partnerships that have a C corporation as a partner.
2. Any partnership (other than a tax shelter) can use the cash method if for every year it has average gross receipts of $5 million or less for any prior three-year period and does not have inventories for sale to customers.
3. A small partnership with average annual gross receipts of $1 million or less for any prior three-year period can use the cash method and is excepted from the requirements to account for inventories and use the accrual method for purchases and sales of merchandise.

I. Termination or Continuation of Partnership

1. A partnership will terminate when it no longer has at least two partners.
2. A partnership and its taxable year will terminate for all partners if there is a sale or exchange of 50% or more of the total interests in partnership capital and profits within a twelve-month period.
a. Sales or exchanges of at least 50% during any twelve-month period cause a termination.
EXAMPLE
The calendar-year ABC Partnership has three equal partners, A, B, and C. B sold his interest to D on November 1, 2012, and C sold his interest to E on April 1, 2013. The ABC Partnership is considered terminated on April 1 because at least 50% of the total interests have been sold within a twelve-month period.
b. If the same partnership interest is sold more than once during a twelve-month period, the sale is counted only once.
EXAMPLE
The calendar-year RST Partnership has three equal partners, R, S, and T. T sold his interest to X on December 1, 2012, and X sold his interest to Y on May 1, 2013. The RST Partnership is not terminated because multiple sales of the same partnership interest are counted only once.
3. In a merger of partnerships, the resulting partnership is a continuation of the merging partnership whose partners have a more than 50% interest in the resulting partnership.
EXAMPLE
Partnerships AB and CD merge on April 1, forming the ABCD Partnership in which the partners’ interests are as follows: Partner A, 30%; B, 30%; C, 20%; and D, 20%. Partnership ABCD is a continuation of the AB Partnership. The CD Partnership is considered terminated and its taxable year closed on April 1.
4. In a division of a partnership, a resulting partnership is a continuation of the prior partnership if the resulting partnership’s partners had a more than 50% interest in the prior partnership.
EXAMPLE
Partnership ABCD is owned as follows: A, 40%; and B, C, and D each own a 20% interest. The partners agree to separate and form two partnerships—AC and BD. Partnership AC is a continuation of ABCD. BD is considered a new partnership and must adopt a taxable year, as well as make any other necessary tax accounting elections.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 46 THROUGH 51

J. Sale of a Partnership Interest

1. Since a partnership interest is usually a capital asset, the sale of a partnership interest generally results in capital gain or loss.
a. Gain is excess of amount realized over the adjusted basis for the partnership interest.
b. Include the selling partner’s share of partnership liabilities in the amount realized because the selling partner is relieved of them.
EXAMPLE
Miller sold her partnership interest to Carter for $150,000 cash, plus Carter’s assumption of Miller’s $60,000 share of partnership liabilities. The amount realized by Miller on the sale of her partnership interest is $150,000 + $60,000 = $210,000.
2. Gain is ordinary (instead of capital) to extent attributable to unrealized receivables or appreciated inventory (Sec. 751 items).
a. The term unrealized receivables generally refers to the accounts receivable of a cash method taxpayer, but for this purpose also includes any potential recapture under Secs. 1245, 1250, and 1252.
b. The term inventory includes all assets except capital assets and Section 1231 assets.
EXAMPLE
X has a 40% interest in the XY Partnership. Partner X sells his 40% interest to Z for $50,000. X’s basis in his partnership is $22,000 and the cash-method partnership had the following receivables and inventory:
Adjusted basis Fair market value
Accounts receivable 0 $10,000
Inventory 4,000 10,000
Potential Sec. 1250 recapture 0 10,000
$4,000 $30,000
X’s total gain is $28,000 (i.e., $50,000 − $22,000). Since the Sec. 1250 recapture is treated as “unrealized receivables” and the inventory is appreciated, X will recognize ordinary income to the extent that his selling price attributable to Sec. 751 items ($30,000 × 40% = $12,000) exceeds his basis in those items ($4,000 × 40% = $1,600), that is, $10,400. The remainder of X’s gain ($28,000 − $10,400 = $17,600) will be treated as capital gain.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 52 THROUGH 56

K. Pro Rata Distributions from Partnership

1. Partnership recognizes no gain or loss on a distribution.
2. If a single distribution consists of multiple items of property, the distributed property reduces the partner’s basis for the partnership interest in the following order:
a. Money,
b. Adjusted basis of unrealized receivables and inventory, and
c. Adjusted basis of other property.
3. Partner recognizes gain only to the extent money received exceeds the partner’s partnership basis.
a. Relief from liabilities is deemed a distribution of money.
b. Gain is capital except for gain attributable to unrealized receivables and substantially appreciated inventory.
c. The receipt of property (other than money) will not cause the recognition of gain.
EXAMPLE
Casey had a basis of $9,000 for his partnership interest at the time that he received a non liquidating partnership distribution consisting of $5,000 cash and other property with a basis of $3,000 and an FMV of $8,000. No gain is recognized by Casey since the cash received did not exceed his partnership basis. Casey’s $9,000 basis for his partnership interest is first reduced by the $5,000 cash, and then reduced by the $3,000 basis of other property, to $1,000. Casey will have a basis for the other property received of $3,000.
4. Partner recognizes loss only upon complete liquidation of a partnership interest through receipt of only money, unrealized receivables, or inventory.
a. The amount of loss is the basis for the partner’s partnership interest less the money and the partnership’s basis in the unrealized receivables and inventory received by the partner.
b. The loss is generally treated as a capital loss.
c. If property other than money, unrealized receivables, or inventory is distributed in complete liquidation of a partner’s interest, no loss can be recognized.
EXAMPLE
Day had a basis of $20,000 for his partnership interest before receiving a distribution in complete liquidation of his interest. The liquidating distribution consisted of $6,000 cash and inventory with a basis of $11,000. Since Day’s liquidating distribution consisted of only money and inventory, Day will recognize a loss on the liquidation of his partnership interest. The amount of loss is the $3,000 difference between the $20,000 basis for his partnership interest, and the $6,000 cash and the $11,000 basis for the inventory received. Day will have an $11,000 basis for the inventory.
EXAMPLE
Assume the same facts as in the preceding example except that Day’s liquidating distribution consists of $6,000 cash and a parcel of land with a basis of $11,000. Since the liquidating distribution now includes property other than money, receivables, and inventory, no loss can be recognized on the liquidation of Day’s partnership interest. The basis for Day’s partnership interest is first reduced by the $6,000 cash to $14,000. Since no loss can be recognized, the parcel of land must absorb all of Day’s unrecovered partnership basis. As a result, the land will have a basis of $14,000.
5. In non liquidating (current) distributions, a partner’s basis in distributed property is generally the same as the partnership’s former basis in the property; but is limited to the basis for the partner’s partnership interest less any money received.
EXAMPLE
Sara receives a current distribution from her partnership at a time when the basis for her partnership interest is $10,000. The distribution consists of $7,000 cash and Sec. 1231 property with an adjusted basis of $5,000 and a FMV of $9,000. No gain is recognized by Sara since the cash received did not exceed her basis. After being reduced by the cash, her partnership basis of $3,000 is reduced by the basis of the property (but not below zero). Her basis for the property is limited to $3,000.
6. If multiple properties are distributed in a liquidating distribution, or if the partnership’s basis for distributed properties exceeds the partner’s basis for the partnership interest, the partner’s basis for the partnership interest is allocated in the following order:
a. Basis is first allocated to unrealized receivables and inventory items in an amount equal to their adjusted basis to the partnership. If the basis for the partner’s interest to be allocated to the assets is less than the total basis of these properties to the partnership, a basis decrease is required and is determined under (1) below.
b. To the extent a partner’s basis is not allocated to assets under a. above, basis is allocated to other distributed properties by assigning to each property its adjusted basis in the hands of the partnership, and then increasing or decreasing the basis to the extent required in order for the adjusted basis of the distributed properties to equal the remaining basis for the partner’s partnership interest.
(1) A basis decrease is allocated
(a) First to properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation (but only to the extent of each property’s unrealized depreciation), and
(b) Then in proportion to the respective adjusted basis of the distributed properties.
EXAMPLE
A partnership distributes two items of property (A and B) that are neither unrealized receivables nor inventory to Baker in liquidation of his partnership interest that has a basis of $20.
Partnership basis FMV
Property A $15 $15
Property B 15 5
Total $30 $20
Basis is first allocated $15 to A and $15 to B (their adjusted bases to the partnership). A $10 basis decrease is required because the assets’ bases of $30 exceeds Baker’s basis for his partnership interest of $20. The $10 decrease is allocated to B to the extent of its unrealized depreciation. Thus, Baker has a basis of $15 for property A and a basis of $5 for property B.
(2) A basis increase is allocated
(a) First to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation (but only to the extent of each property’s unrealized appreciation), and
(b) Then in proportion to the relative FMVs of the distributed properties.
EXAMPLE
A partnership distributes two items of property (C and D) that are neither unrealized receivables nor inventory to Alan in liquidation of his partnership interest that has a basis of $55.
Partnership basis FMV
Property C $ 5 $40
Property D 10 10
Total $15 $50
Basis is first allocated $5 to C and $10 to D (their adjusted bases to the partnership). The $40 basis increase (Alan’s $55 basis less the partnership’s basis for the assets $15) is then allocated to C to the extent of its unrealized appreciation of $35, with the remaining $5 of basis adjustment allocated according to the relative FMV of C and D [i.e., $4 to C (for a total basis of $44) and $1 to D (for a total basis of $11)]
7. Payments made in liquidation of the interest of a retiring or deceased partner are generally treated as partnership distributions made in exchange for the partner’s interest in partnership property. Such payments generally result in capital gain or loss to the retiring or deceased partner.
a. However, payments made to a retiring or deceased general partner in a partnership in which capital is not a material income-producing factor must be reported as ordinary income by the partner to the extent such payments are for the partner’s share of unrealized receivables or goodwill (unless the partnership agreement provides for a payment with respect to goodwill).
b. Amounts treated as ordinary income by the retiring or deceased partner are either deductible by the partnership (treated as guaranteed payments), or reduce the income allocated to remaining partners (treated as a distributive share of partnership income).
c. Capital is not a material income-producing factor if substantially all of the gross income of the business consists of fees, commissions, or other compensation for personal services (e.g., accountants, doctors, dentists, lawyers).
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 57 THROUGH 69

L. Non-Pro Rata Distributions from Partnership

1. A non-pro rata (disproportionate) distribution occurs when
a. A distribution is disproportionate as to a partner’s share of unrealized receivables or substantially appreciated inventory. Inventory is substantially appreciated if its FMV exceeds 120% of its basis.
(1) Partner may receive more than the partner’s share of these assets, or
(2) Partner may receive more than the partner’s share of other assets, in effect giving up a share of unrealized receivables or substantially appreciated inventory
b. The partner may recognize gain or loss.
(1) The gain or loss is the difference between the FMV of what is received and the basis of what is given up.
(2) The gain or loss is limited to the disproportionate amount of unrealized receivables or substantially appreciated inventory that is received or given up.
(3) The character of the gain or loss depends upon the character of the property given up.
c. The partnership may similarly recognize gain or loss when there is a disproportionate distribution with respect to substantially appreciated inventory or unrealized receivables.
EXAMPLE
A, B, and C each own a one-third interest in a partnership. The partnership has the following assets:
Adjusted basis FMV
Cash $ 6,000 $ 6,000
Inventory 6,000 12,000
Land 9,000 18,000
$21,000 $36,000
Assume that A has a $7,000 basis for his partnership interest and that all inventory is distributed to A in liquidation of his partnership interest. He is treated as having exchanged his 1/3 interest in the cash and the land for a 2/3 increased interest in the substantially appreciated inventory. He has a gain of $3,000. He received $8,000 (2/3 × $12,000) of inventory for his basis of $2,000 (1/3 × $6,000) in cash and $3,000 (1/3 × $9,000) of land. The gain is capital if the land was a capital asset. The partnership is treated as having received $8,000 (FMV of A’s 1/3 share of cash and land) in exchange for inventory with a basis of $4,000 (basis of inventory distributed in excess of A’s 1/3 share). Thus, the partnership will recognize ordinary income of $4,000.

M. Optional Sec. 754 Adjustment to Basis of Partnership Property

1. On a distribution of property to a partner, or on a sale by a partner of a partnership interest, the partnership may elect to adjust the basis of its assets to prevent any inequities that otherwise might occur. Once an election is made, it applies to all similar transactions unless IRS approves revocation of the election.
2. Upon the distribution of partnership property, the basis of remaining partnership property will be adjusted for all partners.
a. Increased by
(1) The amount of gain recognized to a distributee partner, and
(2) The excess of the partnership’s basis in the property distributed over the basis of that property in the hands of distributee partner
EXAMPLE
If the election were made under the facts used in K.5, the $2,000 of basis that otherwise would be lost will be allocated to remaining partnership Sec. 1231 property.
b. Decreased by
(1) The amount of loss recognized to a distributee partner, and
(2) The excess of basis of property in hands of distributee over the prior basis of that property in the partnership
3. Upon the sale or exchange of a partnership interest, the basis of partnership property to the transferee (not other partners) will be
a. Increased by the excess of the basis of the transferee’s partnership interest over the transferee’s share of the adjusted basis of partnership property
b. Decreased by the excess of transferee’s share of adjusted basis of partnership property over the basis for the transferee’s partnership interest
EXAMPLE
Assume X sells his 40% interest to Z for $80,000 when the partnership balance sheet reflects the following:
image
Z will have a basis for his partnership interest of $80,000, while his share of the adjusted basis of partnership property will only be $12,000. If the partnership elects to adjust the basis of partnership property, it will increase the basis of its assets by $68,000 ($80,000 − $12,000) solely for the benefit of Z. The basis of the receivables will increase from 0 to $40,000 with the full adjustment allocated to Z. When the receivables are collected, Y will have $60,000 of income and Z will have none. The basis of the real property will increase by $28,000 to $58,000, so that Z’s share of the basis will be $40,000 (i.e., $12,000 + $28,000).

N. Mandatory Adjustments to Basis of Partnership Property

1. A partnership is required to make a Sec. 743 adjustment to the basis of partnership property upon a transfer of a partnership interest by sale or exchange or on the death of a partner if the partnership has a substantial built-in loss immediately after such transfer. For this purpose, a partnership has a substantial built-in loss if the partnership’s adjusted basis for partnership property exceeds the FMV of such property by more than $250,000.
2. A partnership is required to make a Sec. 734 downward basis adjustment to partnership property in the event of a partnership distribution with respect to which there is a substantial basis reduction. For this purpose, a substantial basis reduction means a downward adjustment of more than $250,000 that would be made to the basis of partnership property if a Sec. 754 election were in effect with respect to the distribution.

KEY TERMS

Current distribution. A nonliquidating partnership distribution made to a partner (i.e., the distribution does not terminate the partner’s partnership interest.

Limited liability partnership. Differs from general partnerships in that with an LLP, a partner is not liable for damages resulting from the negligence, malpractice, or fraud committed by other partners. However, each partner is personally liable for his or her own negligence, malpractice, or fraud.

Limited partnership. A partnership with two classes of partners, with at least one general partner and at least one limited partner. A limited partner generally cannot participate in the active management of the partnership, and in the event of losses, generally can lose no more than his or her capital contribution.

Liquidating distribution. A single distribution, or one of a planned series of distributions, that completely terminates a partner’s interest in the partnership.

Partnership ordinary income or loss. All partnership items that do not have to be separately stated (because they have no special tax characteristics) and can be combined and just the net amount is passed through to partners.

Sec. 751 property. A partnership’s unrealized receivables (including the recapture potential in depreciable assets) and appreciated inventory. The gain on sale of a partnership interest generally must be recognized as ordinary income to the extent of the selling partner’s share of unrealized receivables and appreciated inventory. These assets are sometimes referred to as

Sec. 754 election. An optional election that can be made by a partnership to adjust the basis of its assets to prevent any inequities that might occur as a result of the partnership’s distribution of property or the sale by a partner of a partnership interest.

Multiple-Choice Questions (1–69)

B. Partnership Formation

1. At partnership inception, Black acquires a 50% interest in Decorators Partnership by contributing property with an adjusted basis of $250,000. Black recognizes a gain if

I. The fair market value of the contributed property exceeds its adjusted basis.

II. The property is encumbered by a mortgage with a balance of $100,000.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

2. On June 1, 2013, Kelly received a 10% interest in Rock Co., a partnership, for services contributed to the partnership. Rock’s net assets at that date had a basis of $70,000 and a fair market value of $100,000. In Kelly’s 2013 income tax return, what amount must Kelly include as income from transfer of the partnership interest?

a. $ 7,000 ordinary income.

b. $ 7,000 capital gain.

c. $10,000 ordinary income.

d. $10,000 capital gain.

3. Ola Associates is a limited partnership engaged in real estate development. Hoff, a civil engineer, billed Ola $40,000 in 2013 for consulting services rendered. In full settlement of this invoice, Hoff accepted a $15,000 cash payment plus the following:

Fair market value Carrying amount on Ola’s books
3% limited partnership interest in Ola $10,000 N/A
Surveying equipment 7,000 $3,000

What amount should Hoff, a cash-basis taxpayer, report in his 2013 return as income for the services rendered to Ola?

a. $15,000

b. $28,000

c. $32,000

d. $40,000

4. The following information pertains to property contributed by Gray on July 1, 2013, for a 40% interest in the capital and profits of Kag & Gray, a partnership:

As of June 30, 2012
Adjusted basis Fair market value
$24,000 $30,000

After Gray’s contribution, Kag & Gray’s capital totaled $150,000. What amount of gain was reportable in Gray’s 2013 return on the contribution of property to the partnership?

a. $0

b. $ 6,000

c. $30,000

d. $36,000

5. The holding period of a partnership interest acquired in exchange for a contributed capital asset begins on the date

a. The partner is admitted to the partnership.

b. The partner transfers the asset to the partnership.

c. The partner’s holding period of the capital asset began.

d. The partner is first credited with the proportionate share of partnership capital.

6. The following information pertains to Carr’s admission to the Smith & Jones partnership on July 1, 2013:

  • Carr’s contribution of capital: 800 shares of Ed Corp. stock bought in 1999 for $30,000; fair market value $150,000 on July 1, 2013.
  • Carr’s interest in capital and profits of Smith & Jones: 25%.
  • Fair market value of net assets of Smith & Jones on July 1, 2013, after Carr’s admission: $600,000.

Carr’s gain in 2013 on the exchange of the Ed Corp. stock for Carr’s partnership interest was

a. $120,000 ordinary income.

b. $120,000 long-term capital gain.

c. $120,000 Section 1231 gain.

d. $0.

7. The holding period of property acquired by a partnership as a contribution to the contributing partner’s capital account

a. Begins with the date of contribution to the partnership.

b. Includes the period during which the property was held by the contributing partner.

c. Is equal to the contributing partner’s holding period prior to contribution to the partnership.

d. Depends on the character of the property transferred.

8. On September 1, 2013, James Elton received a 25% capital interest in Bredbo Associates, a partnership, in return for services rendered plus a contribution of assets with a basis to Elton of $25,000 and a fair market value of $40,000. The fair market value of Elton’s 25% interest was $50,000. How much is Elton’s basis for his interest in Bredbo?

a. $25,000

b. $35,000

c. $40,000

d. $50,000

9. Basic Partnership, a cash-basis calendar-year entity, began business on February 1, 2013. Basic incurred and paid the following during 2013:

Filing fees incident to the creation of the partnership $ 3,600
Accounting fees to prepare the representations in offering materials 12,000

If Basic wishes to deduct organizational costs, what is the maximum amount that Basic can deduct on the 2013 partnership return?

a. $15,600

b. $ 3,600

c. $ 660

d. $ 220

C. Partnership Income and Loss

10. Thompson’s basis in Starlight Partnership was $60,000 at the beginning of the year. Thompson materially participates in the partnership’s business. Thompson received $20,000 in cash distributions during the year. Thompson’s share of Starlight’s current operations was a $65,000 ordinary loss and a $15,000 net long-term capital gain. What is the amount of Thompson’s deductible loss for the period?

a. $15,000

b. $40,000

c. $55,000

d. $65,000

11. In computing the ordinary income of a partnership, a deduction is allowed for

a. Contributions to recognized charities.

b. The first $100 of dividends received from qualifying domestic corporations.

c. Short-term capital losses.

d. Guaranteed payments to partners.

12. Which of the following limitations will apply in determining a partner’s deduction for that partner’s share of partnership losses?

At-risk Passive loss
a. Yes No
b. No Yes
c. Yes Yes
d. No No

13. Dunn and Shaw are partners who share profits and losses equally. In the computation of the partnership’s 2013 book income of $100,000, guaranteed payments to partners totaling $60,000 and charitable contributions totaling $1,000 were treated as expenses. What amount should be reported as ordinary income on the partnership’s 2013 return?

a. $100,000

b. $101,000

c. $160,000

d. $161,000

14. The partnership of Martin & Clark sustained an ordinary loss of $84,000 in 2013. The partnership, as well as the two partners, are on a calendar-year basis. The partners share profits and losses equally. At December 31, 2013, Clark, who materially participates in the partnership’s business, had an adjusted basis of $36,000 for his partnership interest, before consideration of the 2013 loss. On his individual income tax return for 2013, Clark should deduct a(n)

a. Ordinary loss of $36,000.

b. Ordinary loss of $42,000.

c. Ordinary loss of $36,000 and a capital loss of $6,000.

d. Capital loss of $42,000.

15. The partnership of Felix and Oscar had the following items of income during the taxable year ended December 31, 2013.

Income from operations $156,000
Tax-exempt interest income 8,000
Dividends from foreign corporations 6,000
Net rental income 12,000

What is the total ordinary income of the partnership for 2013?

a. $156,000

b. $174,000

c. $176,000

d. $182,000

D. Partnership Agreements

16. A guaranteed payment by a partnership to a partner for services rendered, may include an agreement to pay

I. A salary of $5,000 monthly without regard to partnership income.

II. A 25% interest in partnership profits.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

17. Chris, a 25% partner in Vista partnership, received a $20,000 guaranteed payment in 2013 for deductible services rendered to the partnership. Guaranteed payments were not made to any other partner. Vista’s 2013 partnership income consisted of

Net business income before guaranteed payments $80,000
Net long-term capital gains 10,000

What amount of income should Chris report from Vista Partnership on her 2013 tax return?

a. $37,500

b. $27,500

c. $22,500

d. $20,000

18. On January 2, 2013, Arch and Bean contribute cash equally to form the JK Partnership. Arch and Bean share profits and losses in a ratio of 75% to 25%, respectively. For 2013, the partnership’s ordinary income was $40,000. A distribution of $5,000 was made to Arch during 2013. What amount of ordinary income should Arch report from the JK Partnership for 2013?

a. $ 5,000

b. $10,000

c. $20,000

d. $30,000

19. Guaranteed payments made by a partnership to partners for services rendered to the partnership, that are deductible business expenses under the Internal Revenue Code, are

I. Deductible expenses on the US Partnership Return of Income, Form 1065, in order to arrive at partnership income (loss).

II. Included on Schedule K-1 to be taxed as ordinary income to the partners.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

20. The method used to depreciate partnership property is an election made by

a. The partnership and must be the same method used by the “principal partner.”

b. The partnership and may be any method approved by the IRS.

c. The “principal partner.”

d. Each individual partner.

21. Under the Internal Revenue Code sections pertaining to partnerships, guaranteed payments are payments to partners for

a. Payments of principal on secured notes honored at maturity.

b. Timely payments of periodic interest on bona fide loans that are not treated as partners’ capital.

c. Services or the use of capital without regard to partnership income.

d. Sales of partners’ assets to the partnership at guaranteed amounts regardless of market values.

22. Dale’s distributive share of income from the calendar-year partnership of Dale & Eck was $50,000 in 2013. On December 15, 2013, Dale, who is a cash-basis taxpayer, received a $27,000 distribution of the partnership’s 2013 income, with the $23,000 balance paid to Dale in February 2014. In addition, Dale received a $10,000 interest-free loan from the partnership in 2013. This $10,000 is to be offset against Dale’s share of 2014 partnership income. What total amount of partnership income is taxable to Dale in 2013?

a. $27,000

b. $37,000

c. $50,000

d. $60,000

23. At December 31, 2012, Alan and Baker were equal partners in a partnership with net assets having a tax basis and fair market value of $100,000. On January 2, 2013, Carr contributed securities with a fair market value of $50,000 (purchased in 2011 at a cost of $35,000) to become an equal partner in the new firm of Alan, Baker, and Carr. The securities were sold on December 15, 2013, for $47,000. How much of the partnership’s capital gain from the sale of these securities should be allocated to Carr?

a. $0

b. $ 3,000

c. $ 6,000

d. $12,000

24. Gilroy, a calendar-year taxpayer, is a partner in the firm of Adams and Company which has a fiscal year ending June 30. The partnership agreement provides for Gilroy to receive 25% of the ordinary income of the partnership. Gilroy also receives a guaranteed payment of $1,000 monthly which is deductible by the partnership. The partnership reported ordinary income of $88,000 for the year ended June 30, 2013, and $132,000 for the year ended June 30, 2014. How much should Gilroy report on his 2013 return as total income from the partnership?

a. $25,000

b. $30,500

c. $34,000

d. $39,000

25. On December 31, 2012, Edward Baker gave his son, Allan, a gift of a 50% interest in a partnership in which capital is a material income-producing factor. For the year ended December 31, 2013, the partnership’s ordinary income was $100,000. Edward and Allan were the only partners in 2013. There were no guaranteed payments to partners. Edward’s services performed for the partnership were worth a reasonable compensation of $40,000 for 2013. Allan has never performed any services for the partnership. What is Allan’s distributive share of partnership income for 2013?

a. $20,000

b. $30,000

c. $40,000

d. $50,000

Items 26 and 27 are based on the following:

Jones and Curry formed Major Partnership as equal partners by contributing the assets below.

image

The land was held by Curry as a capital asset, subject to a $12,000 mortgage, that was assumed by Major.

26. What was Curry’s initial basis in the partnership interest?

a. $45,000

b. $30,000

c. $24,000

d. $18,000

27. What was Jones’ initial basis in the partnership interest?

a. $51,000

b. $45,000

c. $39,000

d. $33,000

Items 28 and 29 are based on the following:

Flagg and Miles are each 50% partners in Decor Partnership. Each partner had a $200,000 tax basis in the partnership on January 1, 2013. Decor’s 2013 net business income before guaranteed payments was $45,000. During 2013, Decor made a $7,500 guaranteed payment to Miles for deductible services rendered.

28. What total amount from Decor is includible in Flagg’s 2013 tax return?

a. $15,000

b. $18,750

c. $22,500

d. $37,500

29. What is Miles’s tax basis in Decor on December 31, 2013?

a. $211,250

b. $215,000

c. $218,750

d. $222,500

30. Peters has a one-third interest in the Spano Partnership. During 2013, Peters received a $16,000 guaranteed payment, which was deductible by the partnership, for services rendered to Spano. Spano reported a 2013 operating loss of $70,000 before the guaranteed payment. What is (are) the net effect(s) of the guaranteed payment?

I. The guaranteed payment decreases Peters’ tax basis in Spano by $16,000.

II. The guaranteed payment increases Peters’ ordinary income by $16,000.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

E. Partner’s Basis in Partnership

31. Dean is a 25% partner in Target Partnership. Dean’s tax basis in Target on January 1, 2013, was $20,000. At the end of 2013, Dean received a nonliquidating cash distribution of $8,000 from Target. Target’s 2013 accounts recorded the following items:

Municipal bond interest income $12,000
Ordinary income 40,000

What was Dean’s tax basis in Target on December 31, 2013?

a. $15,000

b. $23,000

c. $25,000

d. $30,000

32. On January 4, 2013, Smith and White contributed $4,000 and $6,000 in cash, respectively, and formed the Macro General Partnership. The partnership agreement allocated profits and losses 40% to Smith and 60% to White. In 2013, Macro purchased property from an unrelated seller for $10,000 cash and a $40,000 mortgage note that was the general liability of the partnership. Macro’s liability

a. Increases Smith’s partnership basis by $16,000.

b. Increases Smith’s partnership basis by $20,000.

c. Increases Smith’s partnership basis by $24,000.

d. Has no effect on Smith’s partnership basis.

33. Gray is a 50% partner in Fabco Partnership. Gray’s tax basis in Fabco on January 1, 2013, was $5,000. Fabco made no distributions to the partners during 2013, and recorded the following:

Ordinary income $20,000
Tax exempt income 8,000
Portfolio income 4,000

What is Gray’s tax basis in Fabco on December 31, 2013?

a. $21,000

b. $16,000

c. $12,000

d. $10,000

34. On January 1, 2013, Kane was a 25% equal partner in Maze General Partnership, which had partnership liabilities of $300,000. On January 2, 2013, a new partner was admitted and Kane’s interest was reduced to 20%. On April 1, 2013, Maze repaid a $100,000 general partnership loan. Ignoring any income, loss, or distributions for 2013, what was the net effect of the two transactions for Kane’s tax basis in Maze partnership interest?

a. Has no effect.

b. Decrease of $35,000.

c. Increase of $15,000.

d. Decrease of $75,000.

35. Lee inherited a partnership interest from Dale during 2013. The adjusted basis of Dale’s partnership interest was $50,000, and its fair market value on the date of Dale’s death (the estate valuation date) was $70,000. What was Lee’s original basis for the partnership interest?

a. $70,000

b. $50,000

c. $20,000

d. $0

36. Which of the following should be used in computing the basis of a partner’s interest acquired from another partner?

Cash paid by transferee to transferor Transferee’s share of partnership liabilities
a. No Yes
b. Yes No
c. No No
d. Yes Yes

37. Hall and Haig are equal partners in the firm of Arosa Associates. On January 1, 2013, each partner’s adjusted basis in Arosa was $40,000. During 2013 Arosa borrowed $60,000, for which Hall and Haig are personally liable. Arosa sustained an operating loss of $10,000 for the year ended December 31, 2013. The basis of each partner’s interest in Arosa at December 31, 2013, was

a. $35,000

b. $40,000

c. $65,000

d. $70,000

F. Transactions with Controlled Partnerships

38. Doris and Lydia are sisters and also are equal partners in the capital and profits of Agee & Nolan. The following information pertains to 300 shares of Mast Corp. stock sold by Lydia to Agee & Nolan.

Year of purchase 2006
Year of sale 2013
Basis (cost) $9,000
Sales price (equal to fair market value) $4,000

The amount of long-term capital loss that Lydia recognized in 2013 on the sale of this stock was

a. $5,000

b. $3,000

c. $2,500

d. $0

39. In March 2013, Lou Cole bought 100 shares of a listed stock for $10,000. In May 2013, Cole sold this stock for its fair market value of $16,000 to the partnership of Rook, Cole & Clive. Cole owned a one-third interest in this partnership. In Cole’s 2013 tax return, what amount should be reported as short-term capital gain as a result of this transaction?

a. $6,000

b. $4,000

c. $2,000

d. $0

40. Kay Shea owns a 55% interest in the capital and profits of Dexter Communications, a partnership. In 2013, Kay sold an oriental lamp to Dexter for $5,000. Kay bought this lamp in 2007 for her personal use at a cost of $1,000 and had used the lamp continuously in her home until the lamp was sold to Dexter. Dexter purchased the lamp as an investment. What is Kay’s reportable gain in 2013 on the sale of the lamp to Dexter?

a. $4,000 ordinary income.

b. $4,000 long-term capital gain.

c. $2,200 ordinary income.

d. $1,800 long-term capital gain.

41. Gladys Peel owns a 50% interest in the capital and profits of the partnership of Peel and Poe. On July 1, 2013, Peel bought land the partnership had used in its business for its fair market value of $10,000. The partnership had acquired the land five years ago for $16,000. For the year ended December 31, 2013, the partnership’s net income was $94,000 after recording the $6,000 loss on the sale of land. Peel’s distributive share of ordinary income from the partnership for 2013 was

a. $47,000

b. $48,500

c. $49,000

d. $50,000

G. Taxable Year of Partnership

42. Under Section 444 of the Internal Revenue Code, certain partnerships can elect to use a tax year different from their required tax year. One of the conditions for eligibility to make a Section 444 election is that the partnership must

a. Be a limited partnership.

b. Be a member of a tiered structure.

c. Choose a tax year where the deferral period is not longer than three months.

d. Have less than seventy-five partners.

43. Which one of the following statements regarding a partnership’s tax year is correct?

a. A partnership formed on July 1 is required to adopt a tax year ending on June 30.

b. A partnership may elect to have a tax year other than the generally required tax year if the deferral period for the tax year elected does not exceed three months.

c. A “valid business purpose” can no longer be claimed as a reason for adoption of a tax year other than the generally required tax year.

d. Within thirty days after a partnership has established a tax year, a form must be filed with the IRS as notification of the tax year adopted.

44. Without obtaining prior approval from the IRS, a newly formed partnership may adopt

a. A taxable year which is the same as that used by one or more of its partners owning an aggregate interest of more than 50% in profits and capital.

b. A calendar year, only if it comprises a twelve-month period.

c. A January 31 year-end if it is a retail enterprise, and all of its principal partners are on a calendar year.

d. Any taxable year that it deems advisable to select.

45. Irving Aster, Dennis Brill, and Robert Clark were partners who shared profits and losses equally. On February 28, 2013, Aster sold his interest to Phil Dexter. On March 31, 2013, Brill died, and his estate held his interest for the remainder of the year. The partnership continued to operate and for the fiscal year ending June 30, 2013, it had a profit of $45,000. Assuming that partnership income was earned on a pro rata monthly basis and that all partners were calendar-year taxpayers, the distributive shares to be included in 2013 gross income should be

a. Aster $10,000, Brill $0, Estate of Brill $15,000, Clark $15,000, and Dexter $5,000.

b. Aster $10,000, Brill $11,250, Estate of Brill $3,750, Clark $15,000, and Dexter $5,000.

c. Aster $0, Brill $11,250, Estate of Brill $3,750, Clark $15,000, and Dexter $15,000.

d. Aster $0, Brill $0, Estate of Brill $15,000, Clark $15,000, and Dexter $15,000.

I. Termination or Continuation of Partnership

46. On January 3, 2013, the partners’ interests in the capital, profits, and losses of Able Partnership were

% of capital profits and losses
Dean 25%
Poe 30%
Ritt 45%

On February 4, 2013, Poe sold her entire interest to an unrelated person. Dean sold his 25% interest in Able to another unrelated person on December 20, 2013. No other transactions took place in 2013. For tax purposes, which of the following statements is correct with respect to Able?

a. Able terminated as of February 4, 2013.

b. Able terminated as of December 20, 2013.

c. Able terminated as of December 31, 2013.

d. Able did not terminate.

47. Curry’s sale of her partnership interest causes a partnership termination. The partnership’s business and financial operations are continued by the other members. What is (are) the effect(s) of the termination?

I. There is a deemed distribution of assets to the remaining partners and the purchaser.

II. There is a hypothetical recontribution of assets to a new partnership.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

48. Cobb, Danver, and Evans each owned a one-third interest in the capital and profits of their calendar-year partnership. On September 18, 2013, Cobb and Danver sold their partnership interests to Frank, and immediately withdrew from all participation in the partnership. On March 15, 2014, Cobb and Danver received full payment from Frank for the sale of their partnership interests. For tax purposes, the partnership

a. Terminated on September 18, 2013.

b. Terminated on December 31, 2013.

c. Terminated on March 15, 2014.

d. Did not terminate.

49. Partnership Abel, Benz, Clark & Day is in the real estate and insurance business. Abel owns a 40% interest in the capital and profits of the partnership, while Benz, Clark, and Day each owns a 20% interest. All use a calendar year. At November 1, 2013, the real estate and insurance business is separated, and two partnerships are formed: Partnership Abel & Benz takes over the real estate business, and Partnership Clark & Day takes over the insurance business. Which one of the following statements is correct for tax purposes?

a. Partnership Abel & Benz is considered to be a continuation of Partnership Abel, Benz, Clark & Day.

b. In forming Partnership Clark & Day, partners Clark and Day are subject to a penalty surtax if they contribute their entire distributions from Partnership Abel, Benz, Clark & Day.

c. Before separating the two businesses into two distinct entities, the partners must obtain approval from the IRS.

d. Before separating the two businesses into two distinct entities, Partnership Abel, Benz, Clark & Day must file a formal dissolution with the IRS on the prescribed form.

50. Under which of the following circumstances is a partnership that is not an electing large partnership considered terminated for income tax purposes?

I. Fifty-five percent of the total interest in partnership capital and profits is sold within a twelve-month period.

II. The partnership’s business and financial operations are discontinued.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

51. David Beck and Walter Crocker were equal partners in the calendar-year partnership of Beck & Crocker. On July 1, 2013, Beck died. Beck’s estate became the successor in interest and continued to share in Beck & Crocker’s profits until Beck’s entire partnership interest was liquidated on April 30, 2013. At what date was the partnership considered terminated for tax purposes?

a. April 30, 2013.

b. December 31, 2013.

c. July 31, 2012.

d. July 1, 2012.

J. Sale of a Partnership Interest

52. On December 31, 2013, after receipt of his share of partnership income, Clark sold his interest in a limited partnership for $30,000 cash and relief of all liabilities. On that date, the adjusted basis of Clark’s partnership interest was $40,000, consisting of his capital account of $15,000 and his share of the partnership liabilities of $25,000. The partnership has no unrealized receivables or appreciated inventory. What is Clark’s gain or loss on the sale of his partnership interest?

a. Ordinary loss of $10,000.

b. Ordinary gain of $15,000.

c. Capital loss of $10,000.

d. Capital gain of $15,000.

Items 53 and 54 are based on the following:

The personal service partnership of Allen, Baker & Carr had the following cash basis balance sheet at December 31, 2013:

Assets Adjusted basis per books Market value
Cash $102,000 $102,000
Unrealized accounts receivable __ 420,000
Totals $102,000 $522,000
Liability and Capital
Note payable $ 60,000 $ 60,000
Capital accounts:
Allen 14,000 154,000
Baker 14,000 154,000
Carr 14,000 154,000
Totals $102,000 $522,000

Carr, an equal partner, sold his partnership interest to Dole, an outsider, for $154,000 cash on January 1, 2014. In addition, Dole assumed Carr’s share of the partnership’s liability.

53. What was the total amount realized by Carr on the sale of his partnership interest?

a. $174,000

b. $154,000

c. $140,000

d. $134,000

54. What amount of ordinary income should Carr report in his 2014 income tax return on the sale of his partnership interest?

a. $0

b. $ 20,000

c. $ 34,000

d. $140,000

55. On April 1, 2013, George Hart, Jr. acquired a 25% interest in the Wilson, Hart, and Company partnership by gift from his father. The partnership interest had been acquired by a $50,000 cash investment by Hart, Sr. on July 1, 2007. The tax basis of Hart, Sr.’s partnership interest was $60,000 at the time of the gift. Hart, Jr. sold the 25% partnership interest for $85,000 on December 17, 2013. What type and amount of capital gain should Hart, Jr. report on his 2013 tax return?

a. A long-term capital gain of $25,000.

b. A short-term capital gain of $25,000.

c. A long-term capital gain of $35,000.

d. A short-term capital gain of $35,000.

56. On June 30, 2013, James Roe sold his interest in the calendar-year partnership of Roe & Doe for $30,000. Roe’s adjusted basis in Roe & Doe at June 30, 2013, was $7,500 before apportionment of any 2013 partnership income. Roe’s distributive share of partnership income up to June 30, 2013, was $22,500. Roe acquired his interest in the partnership in 2008. How much long-term capital gain should Roe report in 2013 on the sale of his partnership interest?

a. $0

b. $15,000

c. $22,500

d. $30,000

K. Pro Rata Distributions from Partnership

57. Stone and Frazier decided to terminate the Woodwest Partnership as of December 31. On that date, Woodwest’s balance sheet was as follows:

Cash $2,000
Land (adjusted basis) 2,000
Capital—Stone 3,000
Capital—Frazier 1,000

The fair market value of the land was $3,000. Frazier’s outside basis in the partnership was $1,200. Upon liquidation, Frazier received $1,500 in cash. What gain should Frazier recognize?

a. $0

b. $250

c. $300

d. $500

58. Curry’s adjusted basis in Vantage Partnership was $5,000 at the time he received a nonliquidating distribution of land. The land had an adjusted basis of $6,000 and a fair market value of $9,000 to Vantage. What was the amount of Curry’s basis in the land?

a. $9,000

b. $6,000

c. $5,000

d. $1,000

59. Hart’s adjusted basis in Best Partnership was $9,000 at the time he received the following nonliquidating distribution of partnership property:

Cash $ 5,000
Land
Adjusted basis 7,000
Fair market value 10,000

What was the amount of Hart’s basis in the land?

a. $0

b. $ 4,000

c. $ 7,000

d. $10,000

60. Day’s adjusted basis in LMN Partnership interest is $50,000. During the year Day received a nonliquidating distribution of $25,000 cash plus land with an adjusted basis of $15,000 to LMN, and a fair market value of $20,000. How much is Day’s basis in the land?

a. $10,000

b. $15,000

c. $20,000

d. $25,000

Items 61 and 62 are based on the following:

The adjusted basis of Jody’s partnership interest was $50,000 immediately before Jody received a current distribution of $20,000 cash and property with an adjusted basis to the partnership of $40,000 and a fair market value of $35,000.

61. What amount of taxable gain must Jody report as a result of this distribution?

a. $0

b. $ 5,000

c. $10,000

d. $20,000

62. What is Jody’s basis in the distributed property?

a. $0

b. $30,000

c. $35,000

d. $40,000

63. On June 30, 2013, Berk, a calendar-year taxpayer, retired from his partnership. At that time, his capital account was $50,000 and his share of the partnership’s liabilities was $30,000. Berk’s retirement payments consisted of being relieved of his share of the partnership liabilities and receipt of cash payments of $5,000 per month for eighteen months, commencing July 1, 2013. Assuming Berk makes no election with regard to the recognition of gain from the retirement payments, he should report income of

2013 2014
a. $13,333 $26,667
b. 20,000 20,000
c. 40,000 __
d. __ 40,000

64. The basis to a partner of property distributed in complete liquidation of the partner’s interest is the

a. Adjusted basis of the partner’s interest increased by any cash distributed to the partner in the same transaction.

b. Adjusted basis of the partner’s interest reduced by any cash distributed to the partner in the same transaction.

c. Adjusted basis of the property to the partnership.

d. Fair market value of the property.

Items 65 and 66 are based on the following data:

Mike Reed, a partner in Post Co., received the following distribution from Post:

Post’s basis Fair market value
Cash $11,000 $11,000
Inventory 5,000 12,500

Before this distribution, Reed’s basis in Post was $25,000.

65. If this distribution were nonliquidating, Reed’s basis for the inventory would be

a. $14,000

b. $12,500

c. $ 5,000

d. $ 1,500

66. If this distribution were in complete liquidation of Reed’s interest in Post, Reed’s recognized gain or loss resulting from the distribution would be

a. $7,500 gain.

b. $9,000 loss

c. $1,500 loss.

d. $0.

67. In 2008, Lisa Bara acquired a one-third interest in Dee Associates, a partnership. In 2013, when Lisa’s entire interest in the partnership was liquidated, Dee’s assets consisted of the following: cash, $20,000 and tangible property with a basis of $46,000 and a fair market value of $40,000. Dee has no liabilities. Lisa’s adjusted basis for her one-third interest was $22,000. Lisa received cash of $20,000 in liquidation of her entire interest. What was Lisa’s recognized loss in 2013 on the liquidation of her interest in Dee?

a. $0.

b. $2,000 short-term capital loss.

c. $2,000 long-term capital loss.

d. $2,000 ordinary loss.

68. For tax purposes, a retiring partner who receives retirement payments ceases to be regarded as a partner

a. On the last day of the taxable year in which the partner retires.

b. On the last day of the particular month in which the partner retires.

c. The day on which the partner retires.

d. Only after the partner’s entire interest in the partnership is liquidated.

69. John Albin is a retired partner of Brill & Crum, a personal service partnership. Albin has not rendered any services to Brill & Crum since his retirement in 2011. Under the provisions of Albin’s retirement agreement, Brill & Crum is obligated to pay Albin 10% of the partnership’s net income each year. In compliance with this agreement, Brill & Crum paid Albin $25,000 in 2013. How should Albin treat this $25,000?

a. Not taxable.

b. Ordinary income.

c. Short-term capital gain.

d. Long-term capital gain.

Multiple-Choice Answers and Explanations

Answers

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Explanations

1. (d) The requirement is to determine which statements are correct regarding Black’s recognition of gain on transferring property with an adjusted basis of $250,000 in exchange for a 50% partnership interest. Generally, no gain is recognized when appreciated property is transferred to a partnership in exchange for a partnership interest. However, gain will be recognized if the transferred property is encumbered by a mortgage, and the partnership’s assumption of the mortgage results in a decrease in the transferor’s individual liabilities that exceeds the basis of the property transferred. Here, the basis of the property transferred is $250,000, and the net decrease in Black’s individual liabilities is $50,000 (i.e., $100,000 × 50%), so no gain is recognized.

2. (c) The requirement is to determine the amount that must be included on Kelly’s 2013 income tax return as the result of the receipt of a 10% partnership interest in exchange for services. A taxpayer must recognize ordinary income when a capital interest in a partnership is received as compensation for services rendered. The amount of ordinary income to be included on Kelly’s 2013 return is the fair market value of the partnership interest received ($100,000 × 10% = $10,000).

3. (c) The requirement is to determine the amount that Hoff, a cash-basis taxpayer, should report as income for the services rendered to Ola Associates. A cash-basis taxpayer generally reports income when received, unless constructively received at an earlier date. The amount of income to be reported is the amount of money, plus the fair market value of other property received. In this case, Hoff must report a total of $32,000, which includes the $15,000 cash, the $10,000 FMV of the limited partnership interest, and the $7,000 FMV of the surveying equipment received. Note that since Hoff is a cash-basis taxpayer, he would not report income at the time that he billed Ola $40,000, nor would he be entitled to a bad debt deduction when he accepts $32,000 of consideration in full settlement of his $40,000 invoice.

4. (a) The requirement is to determine the amount of gain reportable in Gray’s return as a result of Gray’s contribution of property in exchange for a 40% partnership interest. Generally, no gain or loss is recognized on the contribution of property in exchange for a partnership interest. Note that this nonrecognition rule applies even though the value of the partnership capital interest received (40% × $150,000 = $60,000) exceeds the fair market value of the property contributed ($30,000).

5. (c) The requirement is to determine the correct statement regarding the holding period for a partnership interest acquired in exchange for a contributed capital asset. The holding period for a partnership interest that is acquired through a contribution of property depends upon the nature of the contributed property. If the contributed property was a capital asset or Sec. 1231 asset to the contributing partner, the holding period of the acquired partnership interest includes the period of time that the capital asset or Sec. 1231 asset was held by the partner. For all other contributed property, a partner’s holding period for a partnership interest begins when the partnership interest is acquired.

6. (d) The requirement is to determine the amount of gain recognized on the exchange of stock for a partnership interest. Generally no gain or loss is recognized on the transfer of property to a partnership in exchange for a partnership interest. Since Carr’s gain is not recognized, there will be a carryover basis of $30,000 for the stock to the partnership, and Carr will have a $30,000 basis for the 25% partnership interest received.

7. (b) The requirement is to determine the holding period for property acquired by a partnership as a contribution to the contributing partner’s capital account. Generally no gain or loss is recognized on the contribution of property to a partnership in exchange for a capital interest. Since the partnership’s basis for the contributed property is determined by reference to the contributing partner’s former basis for the property (i.e., a transferred basis), the partnership’s holding period includes the period during which the property was held by the contributing partner.

8. (b) The requirement is to determine Elton’s basis for his 25% interest in the Bredbo partnership. Since Elton received a capital interest with an FMV of $50,000 in exchange for property worth $40,000 and services, Elton must recognize compensation income of $10,000 ($50,000 − $40,000) on the transfer of services for a capital interest. Thus, Elton’s basis for his partnership interest consists of the $25,000 basis of assets transferred plus the $10,000 of income recognized on the transfer of services, a total of $35,000.

9. (b) The requirement is to determine the maximum amount of filing fees and accounting fees that Basic could deduct on the 2013 partnership return. The filing fees incident to the creation of the partnership are organizational expenditures. A partnership may deduct up to $5,000 of organizational expenditures for the tax year in which the partnership begins business, with any remaining expenditures deducted ratably over the 180-month period beginning with the month in which the partnership begins business. Here, since the organizational expenditures total only $3,600, they can be fully deducted for 2013.

The accounting fees to prepare the representations in offering materials are considered syndication fees. Syndication fees include the costs connected with the issuing and marketing of partnership interests such as commissions, professional fees, and printing costs. These costs must be capitalized and can neither be amortized nor depreciated.

10. (c) The requirement is to determine the amount of loss that Thompson can deduct as a result of his interest in the Starlight Partnership. A partner’s distributive share of partnership losses is generally deductible to the extent of the tax basis for the partner’s partnership interest at the end of the year. All positive basis adjustments and all reductions for distributions must be taken into account before determining the amount of deductible loss. Here, Thompson’s basis of $60,000 at the beginning of the year would be increased by the $15,000 of net long-term capital gain, reduced by the $20,000 cash distribution, to $55,000. As a result, Thompson’s deduction of the ordinary loss for the current year is limited to $55,000 which reduces the basis for his partnership interest to zero. He cannot deduct the remaining $10,000 of ordinary loss currently, but will carry it forward and deduct it when he has sufficient basis for his partnership interest.

11. (d) The requirement is to determine the item that is deductible in the computation of the ordinary income of a partnership. Guaranteed payments to partners are always deductible in computing a partnership’s ordinary income. Contributions to recognized charities and short-term capital losses cannot be deducted in computing a partnership’s ordinary income because they are subject to special limitations and must be separately passed through so that any applicable limitations can be applied at the partner level. Similarly, dividends are an item of portfolio income and must be separately passed through to partners in order to retain its character as portfolio income when reported on partners’ returns.

12. (c) The requirement is to determine whether the at-risk and passive activity loss limitations apply in determining a partner’s deduction for that partner’s share of partnership losses. A partner’s distributive share of partnership losses is generally deductible by the partner to the extent of the partner’s basis in the partnership at the end of the taxable year. Additionally, the deductibility of partnership losses is limited to the amount of the partner’s at-risk basis, and will also be subject to the passive activity loss limitations if they are applicable. Note that the at-risk and passive activity loss limitations apply at the partner level, rather than at the partnership level.

13. (b) The requirement is to determine the amount to be reported as ordinary income on the partnership’s return given partnership book income of $100,000. The $60,000 of guaranteed payments to partners were deducted in computing partnership book income and are also deductible in computing partnership ordinary income. However, the $1,000 charitable contribution deducted in arriving at partnership book income must be separately passed through to partners on Schedule K-1 and cannot be deducted in computing partnership ordinary income. Thus, the partnership’s ordinary income is $100,000 + $1,000 = $101,000.

14. (a) The requirement is to determine the amount and type of partnership loss to be deducted on Clark’s individual return. Since a partnership functions as a pass-through entity, the nature of a loss as an ordinary loss is maintained when passed through to partners. However, the amount of partnership loss that can be deducted by a partner is limited to a partner’s tax basis in the partnership at the end of the partnership taxable year. Thus, Clark’s distributive share of the ordinary loss ($42,000) is only deductible to the extent of $36,000. The remaining $6,000 of loss would be carried forward by Clark and could be deducted after his partnership basis has been increased.

15. (a) The requirement is to determine the ordinary income of the partnership. Income from operations is considered ordinary income. The net rental income and the dividends from foreign corporations are separately allocated to partners and must be excluded from the computation of the partnership’s ordinary income. Tax-exempt income remains tax-exempt and must also be excluded from the computation of ordinary income. Thus, ordinary income only consists of the income from operations of $156,000.

16. (a) The requirement is to determine the correct statement(s) concerning agreements for guaranteed payments. Guaranteed payments are payments made to a partner for services or for the use of capital if the payments are determined without regard to the amount of partnership income. Guaranteed payments are deductible by a partnership in computing its ordinary income or loss from trade or business activities, and must be reported as self-employment income by the partner receiving payment. A payment that represents a 25% interest in partnership profits could not be classified as a guaranteed payment because the payment is conditioned on the partnership having profits.

17. (a) The requirement is to determine the amount of income that Chris should report as a result of her 25% partnership interest. A partnership is a pass-through entity and its items of income and deduction pass through to be reported on partners’ returns even though not distributed. The amount to be reported by Chris consists of her guaranteed payment, plus her 25% share of the partnership’s business income and capital gains. Since Chris’s $20,000 guaranteed payment is for deductible services rendered to the partnership, it must be subtracted from the partnership’s net business income before guaranteed payments of $80,000 to determine the amount of net business income to be allocated among partners. Chris’s reportable income from the partnership includes

Guaranteed payment $20,000
Business income [($80,000 − $20,000) × 25%] 15,000
Net long-term capital gain ($10,000 × 25%) 2,500
$37,500

18. (d) The requirement is to determine Arch’s share of the JK Partnership’s ordinary income for 2013. A partnership functions as a pass-through entity and its items of income and deduction are passed through to partners according to their profit and loss sharing ratios, which may differ from the ratios used to divide capital. Here, Arch’s distributive share of the partnership’s ordinary income is $40,000 × 75% = $30,000. Note that Arch will be taxed on his $30,000 distributive share of ordinary income even though only $5,000 was distributed to him.

19. (c) The requirement is to determine whether the statements regarding partners’ guaranteed payments are correct. Guaranteed payments made by a partnership to partners for services rendered are an ordinary deduction in computing a partnership’s ordinary income or loss from trade or business activities on page 1 of Form 1065. Partners must report the receipt of guaranteed payments as ordinary income (self-employment income) and that is why the payments also must be separately listed on Schedule K and Schedule K-1.

20. (b) The requirement is to determine the correct statement regarding a partnership’s election of a depreciation method. The method used to depreciate partnership property is an election made by the partnership and may be any method approved by the IRS. The partnership is not restricted to using the same method as used by its “principal partner.” Since the election is made at the partnership level, and not by each individual partner, partners are bound by whatever depreciation method that the partnership elects to use.

21. (c) The requirement is to determine the correct statement regarding guaranteed payments to partners. Guaranteed payments are payments made to partners for their services or for the use of capital without regard to the amount of the partnership’s income. Guaranteed payments are deductible by the partnership in computing its ordinary income or loss from trade of business activities, and must be reported as self-employment income by the partners receiving payment.

22. (c) The requirement is to determine the total amount of partnership income that is taxable to Dale in 2013. A partnership functions as a pass-through entity and its items of income and deduction are passed through to partners on the last day of the partnership’s taxable year. Income and deduction items pass through to be reported by partners even though not actually distributed during the year. Here, Dale is taxed on his $50,000 distributive share of partnership income for 2013, even though $23,000 was not received until 2014. The $10,000 interest-free loan does not effect the pass-through of income for 2013, and the $10,000 offset against Dale’s distributive share of partnership income for 2014 will not effect the pass-through of that income in 2014.

23. (d) The requirement is to determine the amount of the partnership’s capital gain from the sale of securities to be allocated to Carr. Normally, the entire amount of precontribution gain would be allocated to Carr. However, in this case the allocation to Carr is limited to the partnership’s recognized gain resulting from the sale, $47,000 selling price − $35,000 basis = $12,000.

24. (c) The requirement is to determine the amount that Gilroy should report for 2013 as total income from the partnership. Gilroy’s income will consist of his share of the partnership’s ordinary income for the fiscal year ending June 30, 2013 (the partnership year that ends within his year), plus the twelve monthly guaranteed payments that he received for that period of time.

25% × $88,000 = $22,000
12 × $ 1,000 = 12,000
Total income = $34,000

25. (b) The requirement is to determine Allan’s distributive share of the partnership income. In a family partnership, services performed by family members must first be reasonably compensated before income is allocated according to the capital interests of the partners. Since Edward’s services were worth $40,000, Allan’s distributive share of partnership income is ($100,000 − $40,000) × 50% = $30,000.

26. (c) The requirement is to determine Curry’s initial basis for the 50% partnership interest received in exchange for a contribution of property subject to a $12,000 mortgage that was assumed by the partnership. Generally, no gain or loss is recognized on the contribution of property in exchange for a partnership interest. As a result, Curry’s initial basis for the partnership interest received consists of the $30,000 adjusted basis of the land contributed to the partnership, less the net reduction in Curry’s individual liability resulting from the partnership’s assumption of the $12,000 mortgage. Since Curry received a 50% partnership interest, the net reduction in Curry’s individual liability is $12,000 × 50% = $6,000. As a result, Curry’s basis for the partnership interest is $30,000 − $6,000 = $24,000.

27. (a) The requirement is to determine Jones’ initial basis for the 50% partnership interest received in exchange for a contribution of cash of $45,000. Since partners are individually liable for their share of partnership liabilities, an increase in partnership liabilities increases a partner’s basis in the partnership by the partner’s share of the increase. Jones’ initial basis consists of the $45,000 of cash contributed, increased by the increase in Jones’ individual liability resulting from the partnership’s assumption of Curry’s mortgage ($12,000 × 50% = $6,000). Thus, Jones’ initial basis for the partnership interest is $45,000 + $6,000 = $51,000.

28. (b) The requirement is to determine the total amount includible in Flagg’s 2013 tax return as a result of Flagg’s 50% interest in the Decor Partnership. Decor’s net business income of $45,000 would be reduced by the guaranteed payment of $7,500, resulting in $37,500 of ordinary income that would pass through to be reported on partners’ returns. Here, Flagg’s share of the includible income would be $37,500 × 50% = $18,750.

29. (c) The requirement is to determine Miles’s tax basis for his 50% interest in the Decor Partnership on December 31, 2013. The basis for a partner’s partnership interest is increased by the partner’s distributive share of partnership income that is taxed to the partner. Here, Decor’s net business income of $45,000 would be reduced by the guaranteed payment of $7,500, resulting in $37,500 of ordinary income that would pass through to be reported on partners’ returns and increase the basis of their partnership interests. Here, Miles’s beginning tax basis for the partnership interest of $200,000 would be increased by Miles’s distributive share of ordinary income ($37,500 × 50% = $18,750), to $218,750.

30. (b) The requirement is to determine the net effect(s) of the $16,000 guaranteed payment made to Peters by the Spano Partnership who reported an operating loss of $70,000 before deducting the guaranteed payment. A guaranteed payment is a partnership payment made to a partner for services or for the use of capital if the payment is determined without regard to the amount of partnership income. A guaranteed payment is deductible by a partnership in computing its ordinary income or loss from trade or business activities and must be reported as self-employment income by the partner receiving the payment, thereby increasing Peters’ ordinary income by $16,000. However, since Peters has only a one-third interest in the Spano Partnership, the $16,000 of guaranteed payment deducted by Spano would have the effect of reducing Peters’ tax basis in Spano by only one-third of $16,000.

31. (c) The requirement is to determine the basis for Dean’s 25% partnership interest at December 31, 2013. A partner’s basis for a partnership interest is increased or decreased by the partner’s distributive share of all partnership items. Basis is increased by the partner’s distributive share of all income items (including tax-exempt income) and is decreased by all loss and deduction items (including nondeductible items) and distributions received from the partnership. In this case, Dean’s beginning basis of $20,000 would be increased by the pass-through of his distributive share of the partnership’s ordinary income ($40,000 × 25% = $10,000) and municipal bond interest income ($12,000 × 25% = $3,000), and would be decreased by the $8,000 cash nonliquidating distribution that he received.

32. (a) The requirement is to determine the effect of a $40,000 increase in partnership liabilities on the basis for Smith’s 40% partnership interest. Since partners are individually liable for their share of partnership liabilities, a change in the amount of partnership liabilities affects a partner’s basis for a partnership interest. When partnership liabilities increase, it is effectively treated as if each partner individually borrowed money and then made a capital contribution of the borrowed amount. As a result, an increase in partnership liabilities increases each partner’s basis in the partnership by each partner’s share of the increase. Here, Smith’s basis is increased by his 40% share of the mortgage (40% × $40,000 = $16,000).

33. (a) The requirement is to determine Gray’s tax basis for a 50% interest in the Fabco Partnership. The basis for a partner’s partnership interest is increased by the partner’s distributive share of all partnership items of income and is decreased by the partner’s distributive share of all loss and deduction items. Here, Gray’s beginning basis of $5,000 would be increased by Gray’s 50% distributive share of ordinary income ($10,000), tax-exempt income ($4,000), and portfolio income ($2,000), resulting in an ending basis of $21,000 for Gray’s Fabco partnership interest.

34. (b) The requirement is to determine the net effect of the two transactions on Kane’s tax basis for his Maze partnership interest. A partner’s basis for a partnership interest consists of the partner’s capital account plus the partner’s share of partnership liabilities. A decrease in a partner’s share of partnership liabilities is considered to be a deemed distribution of money and reduces a partner’s basis for the partnership interest. Here, Kane’s partnership interest was reduced from 25% to 20% on January 2, resulting in a reduction in Kane’s share of liabilities of 5% × $300,000 = $15,000. Subsequently, on April 1, when there was a $100,000 repayment of partnership loans, there was a further reduction in Kane’s share of partnership liabilities of 20% × $100,000 = $20,000. Thus, the net effect of the reduction of Kane’s partnership interest to 20% from 25%, and the repayment of $100,000 of partnership liabilities would be to reduce Kane’s basis for the partnership interest by $15,000 + $20,000 = $35,000.

35. (a) The requirement is to determine the original basis of Lee’s partnership interest that was received as an inheritance from Dale. The basis of property received from a decedent dying during 2013 is generally its fair market value as of date of death. Since fair market value on the date of Dale’s death was used for estate tax purposes, Lee’s original basis is $70,000.

36. (d) The requirement is to determine whether cash paid by a transferee, and the transferee’s share of partnership liabilities are to be included in computing the basis of a partner’s interest acquired from another partner. When an existing partner sells a partnership interest, the consideration received by the transferor partner, and the basis of the transferee’s partnership interest includes both the cash actually paid by the transferee to the transferor, as well as the transferee’s assumption of the transferor’s share of partnership liabilities.

37. (c) The requirement is to determine the basis of each partner’s interest in Arosa at December 31, 2013. Since there are two equal partners, each partner’s adjusted basis in Arosa of $40,000 on January 1, 2013, would be increased by 50% of the $60,000 loan and would be decreased by 50% of the $10,000 operating loss. Thus, each partner’s basis in Arosa at December 31, 2013, would be $40,000 + $30,000 liability − $5,000 loss = $65,000.

38. (d) The requirement is to determine the amount of long-term capital loss recognized by Lydia from the sale of stock to Agee & Nolan. A loss is disallowed if incurred in a transaction between a partnership and a person owning (directly or constructively) more than a 50% capital or profits interest. Although Lydia directly owns only a 50% partnership interest, she constructively owns her sister’s 50% partnership interest. Since Lydia directly and constructively has a 100% partnership interest, her $5,000 loss is disallowed.

39. (a) The requirement is to determine the amount to be reported as short-term capital gain on Cole’s sale of stock to the partnership. If a person engages in a transaction with a partnership other than as a partner of such partnership, any resulting gain is generally recognized just as if the transaction had occurred with a nonpartner. Here, Cole’s gain of $16,000 − $10,000 = $6,000 is fully recognized. Since the stock was not held for more than twelve months, Cole’s $6,000 gain is treated as a short-term capital gain.

40. (b) The requirement is to determine the amount and nature of Kay’s gain from the sale of the lamp to Admor. A gain that is recognized on a sale of property between a partnership and a person owning a more than 50% partnership interest will be treated as ordinary income if the property is not a capital asset in the hands of the transferee. Although Kay has a 55% partnership interest, the partnership purchased the lamp as an investment (i.e., a capital asset), and Kay’s gain will solely depend on how she held the lamp. Since she used the lamp for personal use, Kay has a $5,000 − $1,000 = $4,000 long-term capital gain.

41. (d) The requirement is to determine Peel’s distributive share of ordinary income from the partnership. Although the $6,000 loss that was deducted in arriving at the partnership’s net income would also be deductible for tax purposes, it must be separately passed through to partners because it is a Sec. 1231 loss. Thus, the $6,000 loss must be added back to the $94,000 of partnership net income and results in partnership ordinary income of $100,000. Peel’s share is $100,000 × 50% = $50,000.

42. (c) The requirement is to determine the correct statement regarding a partnership’s eligibility to make a Sec. 444 election. A partnership must generally adopt the same taxable year as used by its one or more partners owning an aggregate interest of more than 50% in partnership profits and capital. However, under Sec. 444, a partnership can instead elect to adopt a fiscal year that does not result in a deferral period of longer than three months. The deferral period is the number of months between the end of its selected year and the year that it generally would be required to adopt. For example, a partnership that otherwise would be required to adopt a taxable year ending December 31, could elect to adopt a fiscal year ending September 30. The deferral period would be the months of October, November, and December. The partnership is not required to be a limited partnership, be a member of tiered structure, or have less than seventy-five partners.

43. (b) The requirement is to determine the correct statement regarding a partnership’s tax year. A partnership must generally determine its taxable year in the following order: (1) it must adopt the taxable year used by its one or more partners owning an aggregate interest of more than 50% in profits and capital; (2) if partners owning a more than 50% interest in profits and capital do not have the same year-end, the partnership must adopt the same taxable year as used by all of its principal partners; and (3) if principal partners have different taxable years, the partnership must adopt the taxable year that results in the least aggregate deferral of income to partners.

A different taxable year other than the year determined above can be used by a partnership if a valid business purpose can be established and IRS permission is received. Alternatively, a partnership can elect to use a tax year (other than one required under the general rules in the first paragraph), if the election does not result in a deferral of income of more than three months. The deferral period is the number of months between the close of the elected tax year and the close of the year that would otherwise be required under the general rules. Thus, a partnership that would otherwise be required to adopt a tax year ending December 31 could elect to adopt a fiscal year ending September 30 (three-month deferral), October 31 (two-month deferral), or November 30 (one-month deferral). Note that a partnership that makes this election must make “required payments” which are in the nature of refundable, noninterest-bearing deposits that are intended to compensate the Treasury for the revenue lost as a result of the deferral period.

44. (a) A newly formed partnership must adopt the same taxable year as is used by its partners owning a more than 50% interest in profits and capital. If partners owning more than 50% do not have the same taxable year, a partnership must adopt the same taxable year as used by all of its principal partners (i.e., partners with a 5% or more interest in capital and profits). If its principal partners have different taxable years, a partnership must adopt the tax year that results in the least aggregate deferral of income to partners.

45. (b) The requirement is to determine the distributive shares of partnership income for the partnership fiscal year ended June 30, 2013, to be included in gross income by Aster, Brill, Estate of Brill, Clark, and Dexter. Clark was a partner for the entire year and is taxed on his distributive 1/3 share ($45,000 × 1/3 = $15,000). Since Aster sold his entire partnership interest to Dexter, the partnership tax year closes with respect to Aster on February 28. As a result, Aster’s distributive share is $45,000 × 1/3 × 8/12 = $10,000. Dexter’s distributive share is $45,000 × 1/3 / 4/12 = $5,000.

Additionally, a partnership tax year closes with respect to a deceased partner as of date of death. Since Brill died on March 31, the distributive share to be included in Brill’s 2013 Form 1040 would be $45,000 × 1/3 × 9/12 = $11,250. Since Brill’s estate held his partnership interest for the remainder of the year, the estate’s distributive share of income is $45,000 × 1/3 × 3/12 = $3,750.

46. (b) The requirement is to determine the correct statement regarding the termination of the Able Partnership. A partnership is terminated for tax purposes when there is a sale or exchange of 50% or more of the total interests in partnership capital and profits within any twelve-month period. Since Poe sold her 30% interest on February 4, 2013, and Dean sold his 25% partnership interest on December 20, 2013, there has been a sale of 55% of the total interests within a twelve-month period and the Able Partnership is terminated on December 20, 2013.

47. (c) The requirement is to determine which statements are correct concerning the termination of a partnership. A partnership will terminate when there is a sale of 50% or more of the total interests in partnership capital and profits within any twelve-month period. When this occurs, there is a deemed distribution of assets to the remaining partners and the purchaser, and a hypothetical recontribution of these same assets to a new partnership.

48. (a) The requirement is to determine the date on which the partnership terminated for tax purposes. The partnership was terminated on September 18, 2013, the date on which Cobb and Danver sold their partnership interests to Frank, since on that date there was a sale of 50% or more of the total interests in partnership capital and profit.

49. (a) The requirement is to determine the correct statement concerning the division of Partnership Abel, Benz, Clark, & Day into two partnerships. Following the division of a partnership, a resulting partnership is deemed to be a continuation of the prior partnership if the resulting partnership’s partners had a more than 50% interest in the prior partnership. Here, as a result of the division, Partnership Abel & Benz is considered to be a continuation of the prior partnership because its partners (Abel and Benz) owned more than 50% of the interests in the prior partnership (i.e., Abel 40% and Benz 20%).

50. (c) The requirement is to determine under which circumstances a partnership, other than an electing large partnership, is considered terminated for income tax purposes. A partnership will be terminated when (1) there are no longer at least two partners, (2) no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership, or (3) within a twelve-month period there is a sale or exchange of 50% or more of the total interest in partnership capital and profits.

51. (a) The requirement is to determine the date on which the partnership was terminated. A partnership generally does not terminate for tax purposes upon the death of a partner, since the deceased partner’s estate or successor in interest continues to share in partnership profits and losses. However, the Beck and Crocker Partnership was terminated when Beck’s entire partnership interest was liquidated on April 30, 2013, since there no longer were at least two partners and the business ceased to exist as a partnership.

52. (d) The requirement is to determine the amount and character of gain or loss recognized on the sale of Clark’s partnership interest. A partnership interest is a capital asset and a sale generally results in capital gain or loss, except that ordinary income must be reported to the extent of the selling partner’s share of unrealized receivables and appreciated inventory. Here, Clark realized $55,000 from the sale of his partnership interest ($30,000 cash + relief from his $25,000 share of partnership liabilities). Since the partnership had no unrealized receivables or appreciated inventory and the basis of Clark’s interest was $40,000, Clark realized a capital gain of $55,000 − $40,000 = $15,000 from the sale.

53. (a) The requirement is to determine the total amount realized by Carr on the sale of his partnership interest. The total amount realized consists of the amount of cash received plus the buyer’s assumption of Carr’s share of partnership liabilities. Thus, the total amount realized is $154,000 + ($60,000 × 1/3) = $174,000.

54. (d) The requirement is to determine the amount of ordinary income that Carr should report on the sale of his partnership interest. Although the sale of a partnership interest generally results in capital gain or loss, ordinary income must be recognized to the extent of the selling partner’s share of unrealized receivables and appreciated inventory. Here, Carr must report ordinary income to the extent of his 1/3 share of the unrealized accounts receivable of $420,000, or $140,000.

55. (a) The requirement is to determine the amount and type of capital gain to be reported by Hart, Jr. from the sale of his partnership interest. Since the partnership interest was acquired by gift from Hart, Sr., Jr.’s basis would be the same as Sr.’s basis at date of gift, $60,000. Since Jr.’s basis is determined from Sr.’s basis, Jr.’s holding period includes the period the partnership interest was held by Sr. Thus, Hart, Jr. will report a LTCG of $85,000 − $60,000 = $25,000.

56. (a) The requirement is to determine the amount of LTCG to be reported by Roe on the sale of his partnership interest. Roe’s basis for his partnership interest of $7,500 must first be increased by his $22,500 distributive share of partnership income, to $30,000. Since the selling price also was $30,000, Roe will report no gain or loss on the sale of his partnership interest.

57. (c) The requirement is to determine Frazier’s recognized gain resulting from the cash received in liquidation of his partnership interest. A distributee partner will recognize any realized gain or loss resulting from the complete liquidation of the partner’s interest if only cash is received. Since Frazier’s basis for his partnership interest was $1,200 and he received $1,500 cash, Frazier must recognize a $300 capital gain.

58. (c) The requirement is to determine the basis for land acquired in a nonliquidating partnership distribution. Generally, no gain or loss is recognized on the distribution of partnership property to a partner. As a result, the partner’s basis for distributed property is generally the same as the partnership’s former basis for the property (a transferred basis). However, since the distribution cannot reduce the basis for the partner’s partnership interest below zero, the distributed property’s basis to the partner is limited to the partner’s basis for the partnership interest before the distribution. In this case, Curry’s basis for the land will be limited to the $5,000 basis for his partnership interest before the distribution.

59. (b) The requirement is to determine Hart’s basis for the land received in a nonliquidating partnership distribution. If both cash and noncash property are received in a single distribution, the basis for the partner’s partnership interest is first reduced by the cash, before being reduced by noncash property. Although a partner’s basis for noncash property is generally the same as the partnership’s basis for the property ($7,000 in this case), the partner’s basis for distributed property will be limited to the partner’s basis for the partnership interest reduced by any cash received in the same distribution. Here, the $9,000 basis of Hart’s partnership interest is first reduced by the $5,000 cash received, with the remaining basis of $4,000 allocated as basis for the land received.

60. (b) The requirement is to determine Day’s basis in the land received in a nonliquidating distribution. If both cash and noncash property are received in a single distribution, the basis for the partner’s partnership interest is first reduced by the cash, before the noncash property. Since partnership distributions are generally nontaxable, a distributee partner’s basis for distributed property is generally the same as the partnership’s former basis for the property (a transferred basis). Here, the basis of Day’s partnership interest of $50,000 is first reduced by the $25,000 of cash received, and then reduced by the $15,000 adjusted basis of the land, to $10,000. Day’s basis for the land received is $15,000.

61. (a) The requirement is to determine the amount of taxable gain that Jody must report as the result of a current distribution of cash and property from her partnership. No loss can be recognized as a result of a proportionate current (nonliquidating) distribution, and gain will be recognized only if the amount of cash received exceeds the basis for the partner’s partnership interest. If both cash and noncash property are received in a single distribution, the basis for the partner’s interest is first reduced by the cash, before noncash property. Since the $20,000 cash received does not exceed the $50,000 basis of Jody’s partnership interest immediately before the distribution, no gain is recognized.

62. (b) The requirement is to determine the basis of property received in a current distribution. If both cash and noncash property are received in a single distribution, the basis for the partner’s partnership interest is first reduced by the cash, before being reduced by noncash property. Although a partner’s basis for distributed property is generally the same as the partnership’s basis for the property ($40,000 in this case), the partner’s basis for distributed property will be limited to the partner’s basis for the partnership interest reduced by any money received in the same distribution. Here, the $50,000 basis of Jody’s partnership interest is first reduced by the $20,000 of cash received, with the remaining basis of $30,000 allocated as the basis for the property received.

63. (d) The requirement is to determine the amount of income from the receipt of retirement payments to be reported by Berk in 2013 and 2014. Payments to a retiring partner are generally treated as received in exchange for the partner’s interest in partnership property. As such, they are generally treated under the rules that apply to liquidating distributions. Retirement payments are not deductible by the partnership as guaranteed payments and are not treated as distributive shares of income. Under the rules for liquidating distributions, the $5,000 per month cash payments are treated as a reduction of the basis for Berk’s partnership interest, and result in gain to the extent in excess of basis. Berk’s $80,000 basis for his partnership interest ($50,000 capital + $30,000 share of liabilities) would first be reduced by the relief from $30,000 of liabilities to $50,000. Next, the $30,000 of cash payments received during 2013 (6 × $5,000) would reduce Berk’s basis to $20,000 and result in no gain to be reported for 2013. Finally, the $60,000 of payments for 2014 (12 × $5,000) would exceed his remaining basis and result in Berk’s reporting of $40,000 of capital gain for 2014.

64. (b) The requirement is to determine the correct statement regarding the basis of property to a partner that is distributed in complete liquidation of the partner’s interest. In a complete liquidation of a partner’s interest in a partnership, the property distributed will have a basis equal to the adjusted basis of the partner’s partnership interest reduced by any money received in the same distribution. Generally, in a liquidating distribution, the basis for a partnership interest is (1) first reduced by the amount of money received, (2) then reduced by the partnership’s basis for any unrealized receivables and inventory received, (3) with any remaining basis for the partnership interest allocated to other property received in proportion to their adjusted bases (not FV) to the partnership.

65. (c) The requirement is to determine the basis of the inventory received in a nonliquidating partnership distribution of cash and inventory. Here, the $25,000 basis of Reed’s partnership interest would first be reduced by the $11,000 of cash received, and then reduced by the $5,000 basis of the inventory to $9,000. Reed’s basis for the inventory received is $5,000.

66. (b) The requirement is to determine Reed’s recognized gain or loss resulting from the cash and inventory received in complete liquidation of Reed’s partnership interest. A distributee partner can recognize loss only upon the complete liquidation of the partner’s interest through the receipt of only money, unrealized receivables, or inventory. Since Reed received only money and inventory, the amount of recognized loss is the $9,000 difference between the $25,000 basis of his partnership interest and the $11,000 of cash and $5,000 basis for the inventory received.

67. (c) The requirement is to determine the amount of loss recognized by Lisa on the complete liquidation of her one-third partnership interest. A distributee partner can recognize loss only upon the complete liquidation of the partner’s interest through receipt of only money, unrealized receivables, or inventory. Since Lisa only received cash, the amount of recognized loss is the $2,000 difference between the $22,000 adjusted basis of her partnership interest and the $20,000 of cash received. Since a partnership interest is a capital asset and Lisa acquired her one-third interest in 2008, Lisa has a $2,000 long-term capital loss.

68. (d) The requirement is to determine when a retiring partner who receives retirement payments ceases to be regarded as a partner. A retiring partner continues to be a partner for income tax purposes until the partner’s entire interest has been completely liquidated through distributions or payments.

69. (b) The requirement is to determine the treatment for the payments received by Albin. Payments made by a personal service partnership to a retired partner that are determined by partnership income are distributive shares of partnership income, regardless of the period over which they are paid. Thus, they are taxable to Albin as ordinary income.

Simulations

Task-Based Simulation 1

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Situation

During 2012, Adams, a general contractor, Brinks, an architect, and Carson, an interior decorator, formed the Dex Home Improvement General Partnership by contributing the assets below.

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The land was a capital asset to Brinks, subject to a $5,000 mortgage, which was assumed by the partnership.

For items 1 and 2, determine and select the initial basis of the partner’s interest in Dex.

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Task-Based Simulation 2

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During 2012, the Dex Partnership breaks even but decides to make distributions to each partner.

For items 1 through 6, determine whether the statement is True or False.

1. A nonliquidating cash distribution may reduce the recipient partner’s basis in his partnership interest below zero. image image
2. A nonliquidating distribution of unappreciated inventory reduces the recipient partner’s basis in his partnership interest. image image
3. In a liquidating distribution of property other than money, where the partnership’s basis of the distributed property exceeds the basis of the partner’s interest, the partner’s basis in the distributed property is limited to his pre-distribution basis in the partnership interest. image image
4. Gain is recognized by the partner who receives a nonliquidating distribution of property, where the adjusted basis of the property exceeds his basis in the partnership interest before the distribution. image image
5. In a nonliquidating distribution of inventory, where the partnership has no unrealized receivables or appreciated inventory, the basis of inventory that is distributed to a partner cannot exceed the inventory’s adjusted basis to the partnership. image image
6. The partnership’s nonliquidating distribution of encumbered property to a partner who assumes the mortgage, does not affect the other partners’ bases in their partnership interests. image image

Task-Based Simulation 3

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The Dex Home Improvement General Partnership is planning to adopt a fiscal year ending September 30, while Brinks (a 20% partner) uses the calendar year as his taxable year. Research the Internal Revenue Code to determine how Brinks should determine the amount of income and other partnership items from the fiscal-year partnership that must be reported on Brinks’ 2012 calendar-year tax return. Indicate the section and subsection from the IRC in the shaded boxes below.

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Task-Based Simulation 4

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The Madison Restaurant (identification number 11-1111111) was formed as a cash method general partnership to operate the Madison Restaurant, which is located at 321 Anywhere Road, Davie, Florida 33314. Bob Buran (social security number 123-45-6789) manages the restaurant and has a 60% capital and profits interest. His address is 900 Nowhere Road, Plantation, Florida 33324. Ray Hughes owns the remaining 40% partnership interest but is not active in the restaurant business. The partnership made cash distributions of $66,000 and $44,000 to Buran and Hughes respectively, on December 31, 2012, but made no other property distributions. Madison’s income statement for the year, ended December 31, 2012, is presented below.

Sales $980,000
Cost of sales 460,000
Gross profit 520,000
Operating expenses
Salaries and wages (excluding partners) $190,000
Guaranteed payment to Bob Buran 70,000
Repairs and maintenance 10,000
Rent expense 24,000
Amortization of permanent liquor license 2,000
Annual liquor license fee 1,000
Depreciation 49,000
Advertising 20,000
Charitable contributions (cash) 8,000
Total expenses $374,000
Operating profit $146,000
Other income and losses
Gain on sale of ABE stock held 13 months $12,000
Loss on sale of TED stock held 7 months (7,000)
Sec. 1231 gain on sale of land 8,500
Interest from US Treasury bills 3,000
Dividends from ABE stock 1,500
Interest from City of Ft. Lauderdale general obligation bonds 1,000
Net other income 19,000
Net income $165,000

Additional information

  • Madison Restaurant began business on July 14, 2001, and its applicable business code number is 722110. It files its tax return with the Ogden, Utah IRS Service Center. The partnership had recourse liabilities at the end of the year of $25,000, and total assets of $282,000.
  • The guaranteed payment to Bob Buran was for services rendered and was determined without regard to partnership profits. Buran’s capital account at the beginning of 2012 totaled $135,000.
  • The permanent liquor license was purchased for $10,000 from a café that had gone out of business. This license, which is renewable for an indefinite period, is being amortized per books over the five-year term of Madison’s lease.
  • The cost of depreciable personal property used in the restaurant operations was $200,000. Madison elected to expense $24,000 of the cost for these Sec. 179 assets. The $49,000 depreciation includes the Sec. 179 expense deduction.
  • The gain on the sale of land resulted from the sale of a parking lot that the restaurant no longer needed.

Required:

Prepare Madison Restaurant’s income and deductions on page 1 of Form 1065, Partnership Return.

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Required:

Prepare Madison Restaurant’s Schedule K, Partners’ Shares of Income, Credits, Deductions, etc.

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Required:

Prepare Bob Buran’s Schedule K-1, Partner’s Share of Income, Credits, Deductions, etc. (Do not prepare a Schedule K-1 for Ray Hughes.)

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Task-Based Simulation 5

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In 2013, Madison is considering making a proportionate nonliquidating distribution of shares of stock that it owns in CDE Corporation to its partners. Research the Internal Revenue Code to determine the basis that the partners will have for the CDE stock that they receive. Indicate the section and subsection from the IRC in the shaded boxes below.

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Simulation Solutions

Task-Based Simulation 1

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Explanations

1. (C) The requirement is to determine Brinks’ initial basis for his 20% partnership interest received in exchange for a contribution of property subject to a $5,000 mortgage. Generally, no gain or loss is recognized on the contribution of property in exchange for a partnership interest. As a result, Brinks’ initial basis for the partnership interest received consists of the $12,000 basis of the land contributed to the partnership, less the net reduction in Brinks’ individual liability resulting from the partnership’s assumption of the mortgage. Since Brinks received a 20% partnership interest, the net reduction in Brinks’ individual liability equals $5,000 × 80% = $4,000. As a result, Brinks’ basis for the partnership interest is $12,000 − $4,000 = $8,000.

2. (A) The requirement is to determine Carson’s initial basis for his 30% partnership interest received in exchange for a contribution of inventory. Since partners are individually liable for their share of partnership liabilities, an increase in partnership liabilities increases a partner’s basis in the partnership by the partner’s share of the increase. Carson’s initial basis is the $24,000 adjusted basis of the inventory contributed, increased by the increase in his individual liability resulting from the partnership’s assumption of Brinks’ mortgage ($5,000 × 30% = $1,500). Thus, Carson’s initial basis for the partnership interest is $24,000 + $1,500 = $25,500.

Task-Based Simulation 2

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1. A nonliquidating cash distribution may reduce the recipient partner’s basis in his partnership interest below zero. image image
2. A nonliquidating distribution of unappreciated inventory reduces the recipient partner’s basis in his partnership interest. image image
3. In a liquidating distribution of property other than money, where the partnership’s basis of the distributed property exceeds the basis of the partner’s interest, the partner’s basis in the distributed property is limited to his pre-distribution basis in the partnership interest. image image
4. Gain is recognized by the partner who receives a nonliquidating distribution of property, where the adjusted basis of the property exceeds his basis in the partnership interest before the distribution. image image
5. In a nonliquidating distribution of inventory, where the partnership has no unrealized receivables or appreciated inventory, the basis of inventory that is distributed to a partner cannot exceed the inventory’s adjusted basis to the partnership. image image
6. The partnership’s nonliquidating distribution of encumbered property to a partner who assumes the mortgage, does not affect the other partners’ bases in their partnership interests. image image

Explanations

1. (F) A partner can never have a negative basis for a partnership interest. Partnership distributions can only reduce a partner’s basis to zero.

2. (T) Partnership distributions are generally nontaxable and reduce the recipient partner’s basis by the adjusted basis of the property distributed.

3. (T) A liquidating distribution of property other than money generally does not cause the distributee partner to recognize gain. As a result, the distributee partner’s basis in the distributed property is limited to the partner’s predistribution basis for the partnership interest.

4. (F) Gain is recognized by a distributee partner only if the amount of money distributed exceeds the partner’s predistribution basis for the partnership interest. Distributions of property other than money never result in the recognition of gain by the distributee partner.

5. (T) Generally, a nonliquidating distribution of inventory is not taxable, and the adjusted basis for the inventory carries over to the distributee partner. As a result, the distributee partner’s basis for the inventory cannot exceed the inventory’s adjusted basis to the partnership.

6. (F) Since partners are individually liable for partnership liabilities, a decrease in partnership liabilities will decrease the basis for a partner’s partnership interest by the partner’s share of the decrease. Thus, if a distributee partner assumes a mortgage on encumbered property, the other partners’ bases in their partnership interests will be decreased by their share of the decrease in partnership liabilities.

Task-Based Simulation 3

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Internal Revenue Code Section 706, subsection (a), provides that in computing the taxable income of a partner for a taxable year, the partnership items of income, gain, loss, deduction, or credit that should be included should be based on the taxable year of the partnership that ends with or within the taxable year of the partner. Therefore, Brinks’ calendar year 2012 tax return ending December 31 should reflect only Brinks’ distributive share of partnership items for the Dex Partnership fiscal year ended September 30, 2012.

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Task-Based Simulation 4

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A partnership is a pass-through entity acting as a conduit to pass through items of income, deduction, and credit to be reported on the tax returns of its partners. Partnership items having special tax characteristics (e.g., passive activity losses, deductions subject to dollar or percentage limitations, etc.) must be separately listed and shown on Schedules K and K-1 so that their special characteristics are preserved when reported on partners’ tax returns. In contrast, partnership ordinary income and deduction items having no special tax characteristics can be netted together in the computation of a partnership’s ordinary income and deductions from trade or business activities on page 1 of Form 1065.

The solutions approach is to determine whether each item listed in the problem should be included in the computation of Madison’s ordinary income and deductions on page 1 of Form 1065, or should be separately shown on Madison’s Schedule K and Bob Buran’s Schedule K-1 to retain any special tax characteristics that the item may have.

Schedule K is a summary schedule, listing the total of all partners’ shares of income, deductions, and credits, including the net amount of a partnership’s ordinary income (loss) from trade or business activities that is computed on page 1 of Form 1065. A Schedule K-1 is prepared for each partner listing only that particular partner’s share of partnership income, deductions, credits, etc. Since Bob Buran has a 60% partnership interest, Buran’s Schedule K-1 will generally reflect a 60% share of the amounts reported on Madison’s Schedule K.

Specific Items

  • Guaranteed payments made to a partner for services or for the use of capital are determined without regard to the income of the partnership. The $70,000 of guaranteed payments made to Bob Buran are deductible by the partnership in computing its ordinary income on page 1 of Form 1065, and must also be separately reported on line 4 of Schedules K and K-1 since the receipt of the guaranteed payments by Buran must be reported as ordinary income.
  • No amortization of the permanent liquor license is allowed for tax purposes because the license is renewable for an indefinite period.
  • The cost of qualifying property did not exceed $2 million for 2012, so the Sec. 179 expense deduction of $24,000 is available on Madison’s return. Since the Sec. 179 expense deduction is subject to a dollar limitation at both the partnership and partner levels, the Sec. 179 expense deduction must be separately reported on Schedules K and K-1. Since the depreciation deducted in the income statement includes the $24,000 of expense deduction, the income statement depreciation of $49,000 must be reduced by $24,000, which results in the $25,000 of depreciation that is deductible in computing Madison’s ordinary income. The $24,000 Sec. 179 expense deduction must be separately shown on line 12 of Madison’s Schedule K. $24,000 × 60% = $14,400 of Sec. 179 expense deduction reported on Bob Buran’s Schedule K-1.
  • The $8,000 of charitable contributions are not deductible in computing the partnership’s ordinary income. Instead, charitable contributions are separately reported on line 13a of Madison’s Schedule K and each partner’s Schedule K-1 so the appropriate percentage limitation can be applied on partners’ returns.
  • The $12,000 of long-term capital gain, $7,000 of short-term capital loss, $3,000 of interest income from Treasury bills, and $1,500 of dividends are items of portfolio income and must be separately reported on Madison’s Schedule K, with 60% of each item reported on Buran’s Schedule K-1. Similarly, the $8,500 of Sec. 1231 gain must be separately reported on Madison’s Schedule K and partners’ Schedules K-1 so that the Sec. 1231 netting process can take place at the partner level.
  • The $1,000 of interest from City of Ft. Lauderdale bonds is tax-exempt and is reported on line 18a of Schedules K and K-1, while the $110,000 of cash distributions to partners is reported on line 19a of Schedules K and K-1.
  • Partners are not employees but instead are treated as self-employed individuals. A partner’s share of a partnership’s ordinary income plus any guaranteed payments received by the partner must be reported as self-employment income and is subject to self-employment tax. On Schedule K, the ordinary income from trade or business activities of $180,000 (line 1) is added to the $70,000 of guaranteed payments (line 5), with the total of $250,000 reported on lines 14a and 14c as net earnings from self-employment. On Schedule K-1, Buran’s 60% share of the ordinary income ($180,000 × 60% = $108,000) is added to the $70,000 of guaranteed payments received by Buran with the total of $178,000 reported as Buran’s net earnings from self-employment in box 14.
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Explanation of Schedule K-1, Line L current year increase:

The tax basis for the partner’s capital account is increased by all income items and reduced by all loss and deduction items.

The basis for the capital account is increased by the ordinary income of $108,000, interest of $1,800, dividends of $900, net long-term capital gain of $7,200, net Sec. 1231 gain of $5,100, and tax-exempt income of $600.

The basis for the capital account is decreased by the net short-term capital loss of $4,200, Sec. 179 deduction of $14,400, and other deductions of $4,800. The resulting net change is an increase of $100,200.

Note that the guaranteed payments of $70,000 were already deducted in the computation of ordinary income and are not separately taken into account. Also note that there is only $900 of dividends even though that amount is reported on two lines.

Explanation of Schedule K-1, Line 14C self-employment earnings:

Under the nonfarm optional method, the partner’s share of gross income consists of the guaranteed payments received by the partner ($70,000) plus the partner’s distributive share of the partnership’s gross income after it is reduced by all guaranteed payments. In this case, $70,000 + ($520,000 − $70,000) (60%) = $340,000.

Task-Based Simulation 5

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Internal Revenue Code Section 732, subsection (a) provides that the basis of distributed property to a partner is generally the same as the adjusted basis of the property to the partnership immediately before the distribution.

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