chapter c9

Prentice Hall's Federal Taxation 2016: Corporations, 29e (Pope)Chapter C9: Partnership Formation and Operation

LO1: Definition of a Partnership

1) Formation of a partnership requires legal documentation filed with the Secretary of State.Answer: FALSEPage Ref.: C:9-2Objective: 1

2) Identify which of the following statements is true.A) Formation of a partnership requires legal documentation.B) An individual engaged in the active conduct of a business must elect not to be taxed as a partnership.C) A partnership exists as long as there are at least two individuals or entities engaged in the active conduct of a trade or business or a financial operation, and the business is not a trust or a corporation.D) All of the above are false.Answer: CPage Ref.: C:9-2Objective: 1

3) The definition of a partnership does not includeA) a syndicate.B) a group.C) a pool.D) All of the above are included.Answer: DPage Ref.: C:9-2Objective: 1

4) Identify which of the following statements is true.A) All of the partners in a limited partnership have limited liability.B) A limited partnership must have at least two general partners.C) A limited partnership cannot have a corporate general partner.D) All of the above are false.Answer: DPage Ref.: C:9-3Objective: 1

5) Which of the following is false?A) A large partnership must not be a service partnership.B) A large partnership must have fewer than 100 partners.C) A large partnership must not be engaged in commodity trading.D) A large partnership is subject to a different system of audits.Answer: BPage Ref.: C:9-4Objective: 1

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6) Electing large partnership rules differ from other partnership rules in all of the following areas exceptA) partnership income reporting.B) partnership termination.C) partnership audits.D) All of the above are large partnership rule differences.Answer: DPage Ref.: C:9-4Objective: 1

LO2: Overview of Taxation of Partnership Income

1) A partner's basis for his partnership interest can be negative.Answer: FALSEPage Ref.: C:9-5Objective: 2

2) On the first day of the partnership's tax year, Karen purchases a 50% interest in a general partnership for $30,000 cash and she materially participates in the operation of the partnership for the entire year. The partnership has $40,000 in recourse liabilities when Karen enters the partnership. Partners share the economic risk of loss from recourse liabilities in the same way they share partnership losses. There is no minimum gain related to the nonrecourse liability. During the year, the partnership incurs a $120,000 loss and a $20,000 increase in liabilities. How much of the loss can Karen report on her tax return for the current year?A) $30,000B) $40,000C) $50,000D) $60,000Answer: DExplanation: Beginning basis $30,000Plus: 50% of beginning-of-year liabilities 50% of increase in liabilities

20,00010,000

Karen's Sec. 704(d) basis $60,000Karen's at-risk basis $60,00050% of partnership loss ($120,000 × 0.50) $60,000

The loss is deductible only to the extent of Karen's at-risk basis, or $50,000.Page Ref.: C:9-5; Example C:9-3Objective: 2


3) Identify which of the following statements is true.A) Distribution of partnership income in the form of cash to partners is generally tax-free to the partners and the partnership.B) When partners receive cash distributions from the partnership, they pay taxes on those distributions.C) If money distributions exceed the partner's basis in the partnership interest, the partner would have to recognize gain on the distribution from the partnership. Such gain is usually an ordinary gain.D) All of the above are true.Answer: APage Ref.: C:9-5Objective: 2

4) George pays $10,000 for a 20% interest in a general partnership, which has recourse liabilities of $20,000. The partners share the economic risk of loss from recourse liabilities in the same way they share partnership losses. George's basis in his partnership interest isA) $10,000.B) $12,000.C) $14,000.D) $30,000.Answer: CExplanation: Beginning basis $10,000Plus: 20% of liabilities 4,000 George's basis $14,000

Page Ref.: C:9-5; Example C:9-1Objective: 2

5) On January 1, Helmut pays $2,000 for a 10% capital, profits, and loss interest in a partnership, which has recourse liabilities of $20,000. The partners share economic risk of loss from recourse liabilities in the same way they share partnership losses. In the same year, the partnership incurs losses of $6,000 and the recourse liabilities increase by $5,000. Helmut and the partnership use a calendar tax year-end. Helmut's basis at year-end isA) $1,500.B) $2,000.C) $3,500.D) $3,900.Answer: DExplanation: Beginning basis $2,000 Plus: 10% of January 1 liabilities 2,000 Plus: 10% of increase in liabilities 500 Minus: 10% of loss passthrough ( 600)Basis at end of the year $3,900



6) Identify which of the following statements is true.A) Although a partner's basis in the partnership cannot go below zero, a partner's book capital account (equity) may be negative.B) Tom purchased for cash a 40% capital, profits, and loss interest in the TP General Partnership. His $140,000 basis in his partnership interest includes his $45,000 share of recourse debt and his $30,000 of nonrecourse debt (that is not qualified nonrecourse real estate financing). His at-risk basis cannot be more than $65,000.C) Terri is a limited partner in the STU Partnership, which manufactures children's toys. Because the partnership is actively involved in a trade or business, Terri's income from the partnership is classified as active income for the passive activity loss rules.D) All of the above are false.Answer: APage Ref.: C:9-4 and C:9-5Objective: 2

7) Doug purchases a 20% interest in the Quix Partnership for $10,000 on January 1, 2019, and begins to materially participate in the partnership's business. The Quix Partnership uses the calendar year as its tax year. At the time of the purchase, the Quix Partnership has $4,000 in liabilities, and Doug's share is 20%. What is Doug's basis in his partnership interest on January 1, 2010?Answer: Purchase of partnership interest $10,000Plus: share of liabilities (0.20 × $4,000) 800Basis in partnership interest on January 1 $10,800Page Ref.: C:9-5; Example C:9-1Objective: 2

8) Dan purchases a 25% interest in the Haymarket Partnership for $20,000 on January 1, 2010, and begins to materially participate in the partnership's business. The Haymarket Partnership uses the calendar year as its tax year. At the time of the purchase, the Haymarket Partnership has $2,000 in liabilities, and Dan's share is 25%. During the year, the Haymarket Partnership incurs $8,000 in losses and its liabilities increase by $4000. What is Dan's basis in his partnership interest on December 31, 2010?Answer: Purchase of partnership interest $20,000Plus: share of liabilities (0.25 × $2,000) 500Share of liability increase (0.25 × $4,000) 1,000Minus: share of partnership losses (0.25 × $8,000)( 2,000)Basis in partnership interest on December 31 $19,500Page Ref.: C:9-5; Example C:9-2Objective: 2


9) Dan purchases a 25% interest in the Haymarket Partnership for $20,000 on January 1, 2010, and begins to materially participate in the partnership's business. The Haymarket Partnership uses the calendar year as its tax year. At the time of the purchase, the Haymarket Partnership has $2,000 in liabilities, and Dan's share is 25%. During the year, the Haymarket Partnership incurs $100,000 in losses and its liabilities increase by $4000. What is Dan's basis in his partnership interest on December 31, 2010?Answer: Purchase of partnership interest $20,000Plus: share of liabilities (0.25 × $2,000) 500Share of liability increase (0.25 × $4,000) 1,000December 31 basis before losses $21,500Minus: maximum loss to be deducted (21,500)Basis in partnership interest on December 31 $ 0

Dan is allocated $25,000 (0.25 × $100,000) of the partnership losses, but he is limited to the amount of the basis in his partnership interest before deduction for the losses. The remaining $3,500 in losses carry over to a subsequent year and are deducted when he has sufficient basis in his partnership interest.Page Ref.: C:9-5; Example C:9-3Objective: 2

10) Jeremey is a partner in the Jimimey partnership. Why does he need to know his basis in his partnership interest?Answer: Jeremey needs to know the basis of his partnership interest in order to determine the amount of partnership losses that he can deduct and the taxability of distributions made to him by the partnership. He also needs to know his basis to determine the gain or loss if he sells his partnership interest.Page Ref.: C:9-4Objective: 2

11) Explain the difference between partnership distributions and distributive shares.Answer: Partnership distributions represent the receipt of earnings that have already been taxed to the partners. They reduce each partner's basis in his or her partnership interest, and generally are tax-free. If the distribution exceeds the partner's basis in his or her partnership interest, the partner will recognize a gain equal to the amount of the excess. A partner's distributive share is the portion of the partnership's taxable and nontaxable items that are allocated to the partner for a given partnership year. Each partner must report and pay taxes on his or her distributive share. The partner's distributive share is normally determined by the terms of the partnership agreement. If the partnership agreement is silent, all of the facts and circumstances are considered when determining the partner's overall interest in the partnership. Actual partnership distributions allocated to a partner may be more or less than his or her distributive share for that partnership year.Page Ref.: C:9-5 and C:9-17Objective: 2


LO3: Tax Implications of Formation of a Partnership

1) The holding period of a partnership interest acquired in exchange for a contributed capital asset begins on the date the partner transfers the asset to the partnership.Answer: FALSEPage Ref.: C:9-8Objective: 3

2) Identify which of the following statements is true.A) A contribution of services for a partnership interest is a tax-free transaction.B) For federal income tax purposes, formation of a partnership is governed by Sec. 721.C) When a partnership assumes a liability on property contributed by a partner, the only effect on the contributing partner's basis in his or her partnership interest is that his or her basis will be increased by the amount of the liability assumed by the other partners.D) All of the above are false.Answer: BPage Ref.: C:9-6 and C:9-7Objective: 3

3) Yong contributes a machine having an adjusted basis of $20,000 and an FMV of $25,000 for a 10% partnership interest. Yong had taken $10,000 of depreciation prior to the contribution. The partnership has no liabilities. As a result of the contribution, Yong must recognizeA) no gain or loss.B) a $5,000 Sec. 1245 gain.C) a $5,000 capital gain.D) $10,000 ordinary income.Answer: AExplanation: No gain or loss is recognized at the time of the contribution.Page Ref.: C:9-6 and C:9-7Objective: 3

4) Identify which of the following statements is true.A) A partner's relief of debt is treated as if the partner receives a cash distribution.B) When a partnership assumes any liabilities of the transferor, the transferor has an increase in the basis of his or her partnership interest.C) Gain recognized by a contributing partner because of the assumption of liabilities by the partnership increases the partnership's basis in the contributed property.D) All of the above are false.Answer: APage Ref.: C:9-6 and C:9-7Objective: 3


5) For a 20% interest in partnership capital, profits, and losses, Kasi contributes a machine having a basis of $30,000 and an FMV of $40,000. The partnership also assumes a $24,000 recourse liability secured by the machine. The partnership has $6,000 in recourse liabilities immediately preceding Kasi's contributions. Partners share the economic risk of loss from recourse liabilities in the same way they share partnership losses. Kasi's basis in the partnership interest isA) $10,800.B) $12,000.C) $13,200.D) $30,000.Answer: BExplanation: Beginning basis (machine basis) $30,000 Minus: liability assumed by other partners (19,200)Plus: 20% of other partnership liabilities 1,200 Kasi's basis $12,000


6) For a 30% interest in partnership capital, profits, and losses, Carol contributes a machine with a basis of $40,000 and an FMV of $80,000. The partnership assumes a $70,000 recourse liability on the machine. At the time of the contribution, the partnership had recourse liabilities of $10,000. Partners share the economic risk of loss from recourse liabilities in the same way they share partnership losses. Following the contribution, Carol hasA) a capital loss due to the contribution of $6,000 and a zero basis in the partnership interest.B) a capital gain due to the contribution of $6,000 and a zero basis in the partnership interest.C) a $34,000 basis in the partnership interest and no gain or loss.D) a $43,000 basis in the partnership interest and no gain or loss.Answer: BExplanation: Beginning basis (carryover from machinery) $40,000 Minus: liability assumed by other partners (49,000)Plus: liability assumed by Carol 3,000 Tentative partnership interest basis ($ 6,000)

Capital gain recognized by Carol $ 6,000

Basis: larger of 0 or ($6,000) $ 0



7) Stella acquired a 25% interest in the STUV Partnership by contributing land having an adjusted basis of $32,000 and a fair market value of $100,000. The land was subject to a $48,000 mortgage, which was assumed by STUV. No other liabilities existed at the time of contribution. What is Stella's basis in her partnership interest?A) $0B) $32,000C) $52,000D) $64,000Answer: APage Ref.: C:9-7; Example C:9-7Objective: 3

8) David contributes investment land with a basis of $24,000 and an FMV of $40,000 to a partnership for a 10% interest in partnership capital, profits, and losses. The land is subject to a $30,000 recourse liability, which is assumed by the partnership. The partnership has other recourse liabilities of $18,000. Partners share the economic risk of loss from recourse liabilities in the same way they share partnership losses. David must recognize aA) $3,000 capital gain.B) $3,000 capital loss.C) $1,200 capital gain.D) $1,200 capital loss.Answer: CExplanation: Beginning basis (carryover from land) $24,000 Minus: liability assumed by other partners (27,000)Plus: liability assumed by David 1,800 Tentative basis for partnership interest ($1,200)Capital gain recognized by David $ 1,200



9) Rashad contributes a machine having a basis of $30,000 and an FMV of $25,000 to a partnership in exchange for a 20% interest in partnership capital, profits, and losses. Prior to the contribution, the partnership had recourse liabilities of $20,000. The partnership assumes a $20,000 recourse liability that is owed by Rashad on the machine. Partners share the economic risk of loss from recourse liabilities in the same way they share partnership losses. Rashad's basis in his partnership interest isA) $11,000.B) $18,000.C) $22,000.D) $34,000.Answer: BExplanation: Beginning basis (carryover from machine) $30,000Plus: share of partnership liabilities 4,000 Minus: liabilities assumed by others partners (16,000)Rashad's basis $18,000

Page Ref.: C:9-7Objective: 3

10) Albert contributes a Sec. 1231 asset to a partnership on June 1 of this year in exchange for a 10% partnership interest. He had purchased the asset on March 1, 2002. His holding period for the partnership interest beginsA) March 1, 2002.B) March 2, 2002.C) June 1 of the current year.D) June 2 of the current year.Answer: APage Ref.: C:9-8Objective: 3

11) Mario contributes inventory to a partnership on August 1 of this year in exchange for a 20% partnership interest. Mario had purchased the inventory on July 2 of last year. His holding period for the partnership interest beginsA) July 2 of last year.B) July 3 of last year.C) August 1 of the current year.D) August 2 of the current year.Answer: DPage Ref.: C:9-8Objective: 3


12) Allen contributed land, which was being held for sale to Allen's customers, to a partnership in exchange for a 20% interest. The partnership uses the land in its business for three years and then sells the property. When the property was contributed, it had a basis in Allen's hands of $500,000 and an FMV of $600,000. The partnership sells the land for $700,000. The gain reported by the partnership isA) $100,000 of ordinary income and $100,000 of Sec. 1231 gain.B) $100,000 of Sec. 1231 gain and $100,000 of capital gain.C) $200,000 of ordinary income.D) $200,000 of Sec. 1231 gain.Answer: CExplanation: Amount realized $700,000Minus: adjusted basis (500,000)Ordinary income $200,000

Land, which is held as inventory by Allen, retains its character as inventory in the hands of the partnership for five years after the contribution.Page Ref.: C:9-8 and C:9-9Objective: 3

13) Bao had investment land that he purchased in 1990 for $80,000. Two years ago, when the land was contributed to a partnership, the FMV was $50,000. The land is inventory in the hands of the partnership. The partnership then sells the land in the current year for $46,000. The partnership's recognized loss isA) a $34,000 capital loss.B) a $34,000 ordinary loss.C) a $30,000 capital loss and a $4,000 ordinary loss.D) a $4,000 capital loss and a $30,000 ordinary loss.Answer: CExplanation: The $30,000 precontribution loss retains its character as a capital loss, but the loss accrued since the contribution date is ordinary loss.Page Ref.: C:8-9Objective: 3

14) Karl arranges financing for a limited partnership to purchase real estate in exchange for a 50% interest in partnership profits. Two weeks later, Karl sells the profits interest for $30,000. In this tax year, Karl must recognizeA) no gain or loss.B) a $30,000 short-term capital gain.C) a $30,000 ordinary income.D) a $30,000 Sec. 1231 gain.Answer: CPage Ref.: C:9-10; Example C:9-12Objective: 3


15) Identify which of the following statements is true.A) The contribution of Sec. 1245 property to a partnership triggers recognition of ordinary income by the contributor at the time of the transfer.B) A partner may not recognize ordinary income when receiving a capital and profits interest in a partnership in exchange for services.C) When a partnership interest is given to a partner in exchange for services, the partnership can deduct or capitalize the FMV of the services, depending on the nature of the services.D) All of the above are false.Answer: CPage Ref.: C:9-11Objective: 3

16) Ali, a contractor, builds an office building for a construction partnership in exchange for a capital and profits interest in the partnership worth $500,000. Which of the following statements is correct?A) Ali recognizes $500,000 of ordinary income and the partnership can deduct $500,000 in the current year.B) Ali recognizes no income and the partnership can deduct nothing in the current year.C) Ali recognizes $500,000 ordinary income and the partnership deducts the $500,000 over the building's MACRS recovery period as a depreciation expense.D) Ali recognizes ordinary income in the current year in an amount equal to the depreciation deduction the partnership claims this year for the $500,000 capitalized amount.Answer: CPage Ref.: C:9-11; Example C:9-14Objective: 3

17) Jane contributes land with an FMV of $100,000 and a basis of $80,000 to the Green Partnership in exchange for a 25% partnership interest. The partnership assumes the $40,000 mortgage on the land. Mary has a 25% share of partnership liabilities. The Green Partnership has $8,000 in liabilities immediately before Jane's contribution. What is Jane's basis in her partnership interest?Answer: Basis of contributed property $80,000Plus: Jane's share of existing partnership liabilities ($8,000 × 0.25) 2,000Minus: Jane's liabilities assumed by the other partners ($40,000 × 0.75)(30,000)Jane's basis in her partnership interest $52,000

Jane does recognize any gain on the partnership's assumption of her liability because the deemed cash distribution from the assumption of her $30,000 in liabilities by the partnership does not exceed her $82,000 basis in the partnership interest immediately preceding the fictional distribution.Page Ref.: C:9-7; Example C:9-6Objective: 3


18) Jane contributes land with an FMV of $100,000 and a basis of $40,000 to the Green Partnership in exchange for a 25% partnership interest. The partnership assumes the $80,000 mortgage on the land. Mary has a 25% share of partnership liabilities. The Green Partnership has $8,000 in liabilities immediately before Jane's contribution. What is Jane's basis in her partnership interest?Answer: Basis of contributed property $40,000Plus: Jane's share of existing partnership liabilities ($8,000 × 0.25) 2,000Minus: Jane's liabilities assumed by the other partners ($80,000 × 0.75)(60,000)Jane's basis in her partnership interest $ 0

The cash deemed distributed in excess of Jane's predistribution basis causes her to recognize an $18,000 ($60,000 - $42,000) gain. Jane reduces her basis to zero since a partner's basis in the partnership interest can never be less than zero.Page Ref.: C:9-7Objective: 3

19) Bob contributes cash of $40,000 and Carol contributes land with a basis of $25,000 and an FMV of $40,000 to become equal partners in the BC Partnership. The partnership immediately obtains a $30,000 mortgage on the land and the partners will share the economic risk of loss equally. What are the two partners' bases in the partnership after these transactions are completed?Answer:

Bob CarolBasis of contributed propertyPlus: share of partnership's liabilityBasis in partnership interest

$40,000 15,000$55,000

$25,000 15,000$40,000


20) Kay and Larry each contribute property to become equal partners in the KL General Partnership. Kay contributes office furniture with an adjusted basis of $40,000 and an FMV of $50,000, which she has depreciated using MACRS. Larry contributes land with a basis of $60,000 and an FMV of $50,000, which he had been holding as an investment. The partnership will use the land as a parking lot for their business.a) What is the partnership's basis in each of the two pieces of property?b) If the land that Larry contributed is sold four years after the contribution for $45,000, what is the amount and character of the gain or loss which Larry should report?Answer: a) The partnership basis for the two assets is a carryover basis from the contributor partners. The office furniture has a basis of $40,000 and the land has a basis of $60,000.

b) Precontribution loss of $10,000 is allocated to Larry, and it is a capital loss because Larry held the land as a capital asset prior to its contribution. Capital loss property retains its character for five years after a contribution to a partnership.

The $5,000 postcontribution loss is divided equally between the partners. Since this loss accrued while the partnership held the land as Sec. 1231 property, Larry's $2,500 share of this loss is a Sec. 1231 loss.Page Ref.: C:9-8 and C:9-9Objective: 3

21) Sarah purchased land for investment in 2008 for $80,000. In 2009 when the FMV of the land was only $70,000, she contributed it to the SL Partnership, which is in the business of developing and selling lots. SL Partnership developed the contributed land and sold it in


2010 for $50,000. What is the amount and character of the gain or loss?Answer: There is a $30,000 loss ($50,000 - $80,000). The $10,000 loss that accrued while Sarah held the asset retains its character and is a capital loss. The remaining $20,000 of loss is an ordinary loss, as the land was part of the partnership's inventory.Page Ref.: C:9-9; Example C:9-11Objective: 3

22) George receives a 10% limited partnership interest (capital and profits interest) in the HIJ Partnership in return for managing the partnership's rental property. The partnership interest has an FMV of $35,000. What is the amount and character of the income (if any) that George must report as a result of becoming a partner?Answer: George recognizes $35,000 of ordinary income because the partnership interest is property that he received in exchange for his services.Page Ref.: C:9-10Objective: 3

23) The RT Limited Partnership incurs the following expenses during the time that the partnership is being organized:

Attorneys' fees:For drawing up the partnership agreement $10,000For advice on marketing the partnership interests on a stock exchange14,000

Accountants' fees:For establishing the accounting system 6,000For the first quarter's bookkeeping 600

What is the maximum amount that the partnership can deduct as an organization and syndication expense for the first year in which the partnership begins business, assuming the business began on October 1?Answer: The attorneys' fees for drawing up the partnership agreement and the accountants' fees for establishing the accounting system are eligible to be amortized as organization and syndication expenses. $5,000 of the expenses can be deducted in the first year and the remainder amortized over 180 months, resulting in a $61 deduction per month ($11,000/180). The total expense is $5,183 [$5,000 + (61 × 3)]. The accountants' fees for bookkeeping are deductible as trade or business expenses under Sec. 162. The attorneys' advice is deducted when the partnership terminates or is liquidated.Page Ref.: C:9-12Objective: 3


24) Does the contribution of services to a partnership in exchange for an unrestricted partnership interest qualify for Sec. 721 nontaxable treatment?Answer: No. The service partner recognizes income to the extent of the FMV of the partnership interest received less cash or other property contributed by the partner.Page Ref.: C:9-10Objective: 3

25) Explain the tax consequences for both the service partner and the partnership when a contribution of services is made to the partnership.Answer: The service partner has income to the extent of the FMV of an undivided interest in the partnership assets is deemed to have been received. The service partner's basis in their partnership interest equals the amount of income recognized by the service partner.

The partnership recognizes a gain/loss on the assets deemed transferred. The partnership adjusts its basis for the portion of the asset(s) deemed transferred. This adjustment reflects the gain/loss recognized by the partnership on the deemed asset transfer. The partnership will also have a deduction or capital expenditure for the partnership's outlay.Page Ref.: C:9-10Objective: 3

26) Victor and Kristina decide to form VK Partnership. They will be equal partners. Victor contributes a building with a $150,000 FMV and a $105,000 adjusted basis to the partnership. The building has a $60,000 mortgage, which the partnership assumes. Kristina contributes land with a $70,000 FMV and a $95,000 adjusted basis. Kristina will manage the day-to-day activities of the partnership. She will begin to receive a guaranteed payment for her work, starting in the second year of operations, and continuing on as long as she manages the operations of the partnership. Victor and Kristina have agreed that the guaranteed payment will be $10,000 per year. What tax issues should Victor, Kristina, and the partnership consider with respect to the formation and operation of the partnership?Answer: • Does Victor recognize any gain on the formation? When will his precontribution gain be recognized?• What is Victor's basis and holding period for his partnership interest?• Does Kristina recognize any loss on the contribution of property in exchange for her partnership interest? When will her precontribution loss be recognized? What will the character of the loss be?• What is Kristina's basis and holding period for the partnership interest she received in exchange for property?• What basis and holding period does the partnership have in the property received?• What happens to the depreciation recapture for the building?• Did Kristina receive any of her partnership interest for services?• If so, what gain/loss/deductions must the partnership recognize?• What income must Kristina recognize?

Victor must determine his basis in the partnership interest ($75,000 = $105,000 - $60,000 + $30,000 share of liabilities) and his holding period for his interest in the partnership (begins with his ownership of the office building). Since Victor recognizes no gain or loss, he does not have to be concerned with any recapture potential under Sec. 1250. Victor will have to recognize precontribution gain on the office building at a future date.


Kristina must determine her basis in the partnership interest ($125,000 = $95,000 + $30,000 share of liabilities) and her holding period for her interest in the partnership (begins with her ownership of the land). Kristina recognizes no loss at the time of the partnership formation. If the land was a capital asset to Kristina and the land is sold by the partnership within five years of Kristina's contribution, the loss will be a capital loss up to $25,000, and that capital loss will be allocated to Kristina as a precontribution loss. After five years, the character of the loss will be determined by the character of the land to the partnership, but Kristina will still have to report any precontribution loss. Guaranteed payments will be reported as ordinary income.

The partnership must be concerned with the basis and holding period of the assets it receives (carryover for both basis and holding period). The partnership can deduct from ordinary income the guaranteed payments made to Kristina.

An additional tax issue must be addressed. Victor contributed property with a net value of $90,000 for a one-half interest in the partnership, while Kristina contributed property with a net value of only $70,000 for a one-half interest in the same partnership. The total partnership has a net value of $160,000 ($150,000 + $70,000 - $60,000 liability). There must be some explanation. One possibility is that Bob has made a $10,000 gift to Kristina. If this is so, both partners' bases must be adjusted to reflect the gift. Alternatively, the facts suggest that Kristina may be receiving some of her partnership interest in exchange for her services in managing the business for the first year while receiving no guaranteed payment. If this is so, Kristina must recognize ordinary income and increase her basis for the value of the partnership interest she received in exchange for services. If Kristina is receiving some of her partnership interest for services, the partnership must recognize a gain or loss in the partnership assets she is deemed to receive and must adjust the basis of the assets for her deemed re-contribution. The partnership also must deduct the guaranteed payment.Page Ref.: C:9-5 and C:9-17Objective: 3

27) When the PDQ Partnership formed, it knew it had a good product, but it was a bit short on cash. After seeing the product, Jim, a CPA, said that he would set up an accounting system for the partnership in exchange for a 15% profits interest in the partnership. The partners agreed to this, as Jim was receiving only a profits interest and not a capital interest in the partnership. Jim's usual fee for this type of service would be approximately $5,000. What tax issues should Jim and the PDQ Partnership consider with respect to the payment made for the services?Answer: • Is the receipt of a profits interest in the PDQ Partnership in exchange for Jim's services a taxable event?• If it is a taxable event, what is the amount and character of the income recognized?• What is Jim's basis and holding period for his partnership interest?

The receipt of the partnership interest is not a taxable event. Under Rev. Proc. 93-27 (1993-2 C.B. 343), the receipt of a profits interest is taxable only under circumstances where the FMV of the interest can be readily determined. This situation does not fit into one of the three exceptions contained in the revenue procedure guidelines as being a taxable event.Page Ref.: C:9-10 through C:9-12Objective: 3


28) Jason, a lawyer, provided legal services for the employees of the ABC Partnership during the first six months of the current year. In exchange, he received a 2% capital and profits interest in the partnership. The value of the interest is $5,000. What are the tax consequences to Jason, the ABC Partnership, and the employees of ABC?Answer: Jason must include the $5,000 in his current-year gross income. The legal services were a fringe benefit to the employees and therefore, not taxable to them. The ABC Partnership can deduct the $5,000 in the current year and will allocate the $5,000 expense to all partners other than Jason.Page Ref.: C:9-11; Example C:9-13Objective: 3

29) Dinia has agreed to provide services valued at $30,000 to the L-M Partnership. On January 1 of the current year, she is given a 20% capital and profits interest in the partnership in exchange for her services. The partnership has no liabilities at the time but has assets with a basis of $50,000 and an FMV of $70,000. What are the tax consequences to Dinia and the partnership?Answer: The transaction is taxed as if Dinia received a one-fifth interest in each asset. She is taxed on the $30,000 FMV of the assets and takes a $30,000 basis in the partnership interest. The partnership must recognize $4,000 of gain [0.20 × ($70,000 FMV - $50,000 basis)] on the assets deemed paid to Dinia. The partnership calculates gain or loss for each asset it holds, and the character of each asset determines the character of the gain or loss recognized. The partnership's original basis in its assets ($50,000) is increased by the $4,000 recognized gain.Page Ref.: C:9-11Objective: 3


30) Mary and Martha, who had been friends for years, decided to open a retail store to sell kitchen and bath items. In June, they spent $500 looking for a suitable location. They paid an attorney $1,500 to have their partnership agreement drawn up, and they paid an accountant $400 to set up their accounting system. During July, they searched for vendors for the merchandise they planned to carry and stocked their shelves. The store opened in August and was immediately successful. They paid the accountant $300 to prepare an income statement for August. What tax issues should the partnership consider with regard to beginning this business?Answer: • What items qualify as organizational expenses, which are start-up expenses, and what items can be expensed now?• Does the partnership want to amortize organizational expenses and/or start-up expenses? If so, over what time period does the amortization occur?• When does the partnership business begin?

The partnership must first characterize each expense as an organizational expense, a start-up expense (Chapter C3), another expense to be capitalized, or as a current-period expense. The costs of drawing up the partnership agreement and of establishing the accounting system are organizational expenses. The expenses of searching for a location is a start-up expense, and the expense of having an income statement prepared is a current-period expense.

A partnership can elect to deduct the first $5,000 of organizational expenses and amortize the excess over 180 months. If the amount of organizational expenses exceeds $50,000, the total amount by which the organizational expenses exceed $50,000 reduces the $5,000 deduction limit.

Another issue the partnership must face is when the partnership is considered to begin business. Regulation Sec. 1.709-2(c) states that business begins when the partnership "starts the business operation for which it was organized." Amortization of both the organizational expenses and the start-up expense begins with the month in which business begins.Page Ref.: C:9-12Objective: 3


LO4: Partnership Elections

1) Bob, Kara, and Mark are partners in the BKM Partnership. Bob is a 40% partner and has a June 30 tax year-end. Kara owns a 40% interest in the partnership and has a September 30 tax year-end, and Mark owns the remaining 20% interest and has an October 31 tax year-end. The partnership does not have a natural business year. What is the required tax year-end for the partnership (if no Sec. 444 election is made)?A) June 30B) September 30C) October 31D) December 31Answer: AExplanation: The least aggregate deferral for the alternative tax year-ends is:

June 30 2.0September 30 3.8October 31 7.6December 31 8.0

The smallest of the four alternatives is June 30.Page Ref.: C:9-12 through C:9-14; Example C:9-17Objective: 4

2) Identify which of the following statements is true.A) The Fisher Partnership is owned equally by four individual partners. Two of the partners have fiscal years ending March 31 and two partners have fiscal years ending June 30. The partnership has a natural business year. The partnership must adopt a calendar year for tax reporting purposes unless a Sec. 444 election is made.B) Partnerships make most of the tax elections for the partnership rather than the partners.C) A partner can elect the depreciation method to be applied to the partner's share of the partnership's depreciable assets.D) All of the above are false.Answer: BPage Ref.: C:9-15Objective: 4

3) Charles Jordan files his income tax return on a calendar-year basis. He is a principal partner in a partnership using a tax year ending June 30. Jordan's share of the partnership's ordinary income was $24,000 for the fiscal year ending June 30 of last year and $72,000 for the fiscal year ending June 30 of the current year. Assume the partnership earned its income evenly throughout the year. How much should Jordan report on his Form 1040 for last year as his share of the partnership's ordinary income?Answer: $24,000 of partnership ordinary income from the partnership return for the year ending June 30 of last year. None of the income for the July 1 - December 31 portion of the partnership return for the year ending June 30 of this year is included in the partner's return for last year.Page Ref.: C:9-12Objective: 4


4) The XYZ Partnership is held by ten partners who have the following capital and profits ownership of the partnership. The tax year-end used by each of the ten partners is also indicated. Assume each partner has used this year-end for at least five years.

Partner Ownership Partner's Tax Year-End

ABCDEFGHIK

8%8%8%

10%10%10%10%12%12%12%

12/316/309/306/306/30

10/319/30

12/316/306/30

What is the required year-end for the XYZ Partnership, assuming that the business has no natural business year and has not filed a Sec. 444 election?Answer: The partnership's required year-end under Sec. 706 is June 30 because a majority of the partnership interests (52%) are held by partners (B, D, E, I, and K) with that year-end.Page Ref.: C:9-12 and C:9-13Objective: 4

5) What are the three rules and their order when determining a partnership tax year?Answer: First, the partnership tax year will be the majority (own in the aggregate more than 50%) partner's (or partners')tax year. If the first rule is not applicable, then it will be the tax year of all principal partners (5% or more partners). If neither of the preceding rules is applicable, then it will be the tax year that allows the least aggregate deferral.Page Ref.: C:9-12 and C:9-13Objective: 4

LO5: Partnership Reporting of Income

1) A partnership cannot make charitable contributions.Answer: FALSEPage Ref.: C:9-16Objective: 5

2) Identify which of the following statements is true.A) A partnership cannot have an NOL carryback or carryforward.B) A partnership cannot make charitable contributions.C) Dividends received by a partnership from a domestic corporation are included in the partnership's ordinary income.D) All of the above are false.Answer: APage Ref.: C:9-16Objective: 5


3) Identify which of the following statements is true.A) Tax-exempt interest received by a partnership is taxable to the partners if distributed.B) Partnership gains and losses from two different casualty and theft occurrences in one year are passed through to the partners as two separate items.C) The amount and character of any gains/losses is determined at the partnership level.D) All of the above are false.Answer: CPage Ref.: C:9-16Objective: 5

4) Matt and Joel are equal partners in the MJ Partnership. For the current year ended December 31, the partnership has book income of $80,000, which includes the following deductions: (1) guaranteed payments (salaries) to partners: Matt, $35,000; and Joel, $25,000; and (2) charitable contributions, $6,000. The book income amount does not include any sales of capital assets or Sec. 1231 assets or any tax-exempt income. Based on the above information, what amount should be reported as ordinary income on the partnership return?A) $60,000B) $80,000C) $86,000D) $140,000Answer: CExplanation: Book income $80,000Plus: charitable contributions 6,000 Ordinary income $86,000


5) Identify which of the following statements is true.A) A partner's distributive share includes the full amount of partnership ordinary income, which she must report on her tax return plus her share of separately stated taxable and tax-exempt items.B) Sam has a 20% interest in partnership capital and profits but a 40% interest in partnership losses. The partnership has no special allocations or precontribution gains or losses. In a year in which the partnership reports ordinary income of $100,000 and a capital loss of $30,000, Sam's distributive share is $20,000 ordinary income and $12,000 capital loss.C) The partner's distributive share is the partner's share of any assets distributed by the partnership.D) All of the above are false.Answer: APage Ref.: C:9-17Objective: 5


6) In computing the ordinary income of a partnership, a deduction is allowed forA) net Sec. 1231 losses.B) bad debts.C) foreign income taxes paid.D) charitable contributions.Answer: BPage Ref.: C:9-17Objective: 5

7) AT Pet Spa is a partnership owned equally by Travis and Ashley. The partnership had the following revenues and expenses this year. Which of the following items are separately stated? Nonseparately stated? What is each partner's distributive share of ordinary income?

Revenues $500,000Salary expense (nonpartners) 250,000Supplies 40,000Insurance 50,000Depreciation (no Sec. 179 amounts) 10,000Dividend income 2,000Long-term capital gain 30,000Answer: Separately-stated items are the dividend income, long-term capital gain. and the partnership's ordinary income. The remaining items are nonseparately stated. The partnership's ordinary income is:

Revenues $500,000Salary expense (nonpartners) 250,000Supplies 40,000Insurance 50,000Depreciation (no Sec. 179 amounts) 10,000 350,000Partnership ordinary income $150,000Page Ref.: C:9-17Objective: 5


8) The WE Partnership reports the following items for its current tax year:

Item AmountIncomeOperating income $90,000Rental income 15,000Interest income:

Tax-exempt municipal bonds 2,000Corporate bonds 4,000

Sec. 1231 gain 20,000Sec. 1245 gain 18,000Long-term capital gain 7,000

ExpensesRental expenses 12,000Salaries paid to employees (not partners) 30,000Charitable contributions 5,000Interest paid related to borrowings used to finance municipal bonds 3,000

What is the WE Partnership's ordinary income for the current year?Answer: The income items, which are ordinary, total $108,000 ($90,000 operating income + $18,000 Sec. 1245 gain). The only ordinary expense is the $30,000 of salaries. Accordingly, partnership ordinary income totals $78,000 ($108,000 - $30,000).Page Ref.: C:9-17Objective: 5

9) Briefly explain the aggregate and entity theories as they relate to partnerships.Answer: The aggregate theory of partnerships holds that the partnership is merely an aggregate of its partners, thus the partnership's income flows through to its partners. The entity theory views a partner's separate entity from its partners, thus the partnership makes elections at the entity level.Page Ref.: C:9-17Objective: 5

10) What is included in partnership taxable income?Answer: Partnership taxable income includes both the separately stated items and the partnership's ordinary income or loss. The ordinary income or loss is the sum of all taxable items that are not separately stated.Page Ref.: C:9-17Objective: 5


LO6: Partner Reporting of Income

1) ABC Partnership distributes $12,000 to partner Al. Al's distributive share of partnership income is $20,000. Al is taxed on $20,000.Answer: TRUEPage Ref.: C:9-17Objective: 5

2) A partner's "distributive share" is the partner's share of any assets distributed by the partnership.Answer: FALSEPage Ref.: C:9-17Objective: 5

3) Identify which of the following statements is true.A) The Hunter Partnership has a net long-term capital gain of $4,000 and a net short-term capital loss of $1,000 for the current tax year. The gain and loss will be netted and the partners will include their proportionate share of the $3,000 net long-term capital gain on their return.B) The Right Partnership sells a delivery truck and recognizes a gain of $2,000, which represents depreciation recaptured under Sec. 1245. The $2,000 gain will retain its identity as a separately stated item.C) For tax purposes, the partnership takes a carryover basis in the contributed property that references the contributing partner's basis.D) All of the above are false.Answer: CPage Ref.: C:9-18 and C:9-19Objective: 6

4) On January 2 of the current year, Calloway and Taylor contribute cash equally to form the CT Partnership. Calloway and Taylor share profits and losses in a ratio of 75% and 25%, respectively. The partnership's ordinary income for the year was $40,000. Calloway received a distribution of $5,000 during the year. What is Calloway's share of taxable income for the year?A) $5,000B) $10,000C) $20,000D) $30,000Answer: DPage Ref.: C:9-18Objective: 6


5) The XYZ Partnership reports the following operating results for the current year:

Net long-term capital loss ($40,000)Net Sec. 1231 loss ( 16,000)Ordinary income 50,000

Tai has a 20% profits interest and a 25% loss interest in the XYZ Partnership. His distributive share of ordinary income isA) $6,800.B) $8,500.C) $10,000.D) $12,500.Answer: DExplanation: Since the partnership has a net loss [($40,000) + ($16,000) + $50,000 = ($6,000)] for the year, Tai's distributive share of the $50,000 of ordinary income is calculated using the 25% loss interest.Page Ref.: C:9-18; Example C:9-20Objective: 6

6) Latoya owns a 10% interest in the ABC Partnership from January 1 through June 30 (the 181st day of the tax year) of the current year (a non-leap year). On July 1, Latoya buys an additional 10% interest in the partnership. The XYZ Partnership's ordinary income is $109,500 and it is earned evenly throughout the year. Latoya's distributive share of the ordinary income isA) $16,380.B) $16,425.C) $16,470.D) $21,900.Answer: CExplanation: $109,500 × 181/365 × 0.10 = $ 5,430$109,500 × 184/365 × 0.20 = 11,040Total 16,470


7) On December 1, Antonio, a member of a three-person partnership, purchases investment securities from the partnership for their $37,000 FMV. All partners share profits and losses equally. The securities were acquired by the partnership for $25,000 cash in March of the current year. What amount and character of gain will Antonio recognize because of this transaction?A) $0 gainB) $4,000 ordinary incomeC) $4,000 short-term capital gainD) $12,000 ordinary incomeAnswer: CExplanation: ($37,000 - $25,000) × 1/3 = $4,000 short-term capital gain from the sale of securities.Page Ref.: C:9-18Objective: 6

8) Meg and Abby are equal partners in the AM Partnership, which earns $40,000 ordinary income, $6,000 long-term capital gain (LTCG), and $2,000 Sec. 1231 loss during the


current year. What is the amount and character of income that must be reported on Abby's tax return for this year's partnership operations?A) $20,000 ordinary income, $3,000 LTCG, $1,000 Sec. 1231 lossB) $19,000 ordinary income, $3,000 LTCGC) $23,000 ordinary income, $1,000 Sec. 1231 lossD) $22,000 ordinary incomeAnswer: APage Ref.: C:9-18Objective: 6

9) On December 31 of last year, Alex and Jackson become equal partners in the AJ Partnership with assets having a tax basis and FMV of $120,000. The partnership, which deals in securities, had no liabilities at the end of last year. In January of this year, Franklin contributes his investment securities with an FMV of $60,000 (purchased two years ago at a cost of $45,000) to become an equal partner in the new AJF Partnership. The securities, which are inventory to the partnership, are sold on December 15 of the current year for $90,000. What amount and character of gain from the sale of these securities should be allocated to Franklin?A) $10,000 ordinary incomeB) $15,000 capital gain and $10,000 ordinary incomeC) $25,000 capital gainD) $25,000 ordinary incomeAnswer: DExplanation: Precontribution gain $15,000Plus: one-third of the postcontribution gain 10,000Total gain recognized by Jackson $25,000

There is no special provision to preserve the capital gain character for Jackson, so the entire gain is ordinary income.Page Ref.: C:9-18 and C:9-19Objective: 6

10) At the formation of the BD Partnership, Betty contributes land with a basis of $10,000 and an FMV of $30,000 and Dick contributes cash of $30,000. Betty and Dick share profits and losses equally. When the land is sold two years later for $50,000, Betty must recognize a gain ofA) $10,000.B) $20,000.C) $30,000.D) $40,000.Answer: CExplanation: Precontribution gain ($30,000 - $10,000) $20,000Plus: one-half of the postcontribution gain 10,000Total gain recognized by Betty $30,000


11) Identify which of the following statements is false.A) Jean and Blossom form an equal partnership. Jean contributes $10,000 cash and Blossom contributes property with a $10,000 FMV and a $5,000 basis. When the


partnership sells the property contributed by Blossom for $10,000 shortly after the formation, Blossom must include the $5,000 gain in her income.B) In order to shift income/loss between partners, there must be substantial economic effect.C) The BB Partnership wants to make a special allocation of $10,000 of long-term capital gain to Bob and a special allocation of $10,000 of ordinary income to Briana. This allocation will have a substantial economic effect.D) Partners must make up negative balances in their capital accounts upon liquidation of the partnership.Answer: CPage Ref.: C:9-19Objective: 6

12) Elijah contributes securities with a $90,000 FMV (purchased in 2008 at a cost of $50,000) to become a one-third partner in the EJK Partnership on January 1 of the current year. The securities are sold on December 15 of the current year for $105,000. How much of the partnership's capital gain from the sale of these securities should be allocated to Elijah?Answer: ($90,000 - $50,000) + [($105,000 - $90,000) × 0.333] = $45,000.Page Ref.: C:9-19Objective: 6

13) Under what conditions will a special allocation of partnership depreciation be recognized? Assume the partnership has no nonrecourse liabilities.Answer: A special allocation must be stated in the partnership agreement or the amount will be allocated in accordance with the partners' interest in the partnership. In addition, the allocation must have substantial economic effect. To have economic effect, the allocation must meet all of the following requirements throughout the term of the partnership:• Capital accounts must be maintained under the capital account maintenance rules of the Sec. 704 regulations.• Upon liquidation of the partnership, liquidating distributions must be made in accord with positive capital accounts.• If a partner has a deficit capital account balance after all adjustments for the year of liquidation, that partner must be unconditionally obligated to restore the deficit. (The regulations provide some alternatives to an unconditional obligation to restore the deficit, but the alternatives are not covered in this introductory textbook.)

For the economic effect of the special allocation to be considered substantial, there must be a reasonable possibility that the allocation will substantially affect the dollar amounts to be received by the partners independent of any tax consequences.Page Ref.: C:9-18 through C:9-20Objective: 6


14) Tracy has a 25% profit interest and a 20% loss interest in the Dupont Partnership. The Dupont Partnership reports the following income and loss items for the current year:

Net long-term capital loss $50,000Net Sec. 1231 gain 45,000Ordinary income 110,000

What is Tracy's distributive share?Answer: The partnership has a $105,000 ($110,000 + $45,000 - $50,000) net profit for the year. Tracy's distributive share is calculated using her profits interest percentage, 25%.

Net long-term capital loss $12,500Net Sec. 1231 gain 11,250Ordinary income 27,500

The loss percentage is only used in years in which the partnership has a net loss.Page Ref.: C:9-18; Example C:9-20Objective: 6

15) Mike and Jennifer form an equal partnership. Mike contributes cash of $15,000 and Jennifer contributes land having a $15,000 FMV and a basis of $5,000. If the partnership sells the land three years later for $18,000, what are the tax consequences to Mike and Jennifer?Answer: The precontribution gain of $10,000 ($15,000 - $5,000) is allocated only to Jennifer. The $3,000 gain that accrued while the partnership held the land ($18,000 - $15,000) is allocated equally to Mike and Jennifer. Jennifer's total gain is $11,500 and Mike's gain is $15,000.Page Ref.: C:9-19; Example C:9-23Objective: 6

LO7: Basis for Partnership Interest

1) A partner's share of nonrecourse debt increases that partner's share of basis.Answer: TRUEPage Ref.: C:9-22Objective: 7

2) A partner's basis for his or her partnership interest is increased by his share of the partnership's tax-exempt income.Answer: TRUEPage Ref.: C:9-24Objective: 7


3) William and Irene each contribute $20,000 cash to the WI Partnership on January 1 of last year. William and Irene share profits and losses equally. Last year, the partnership reported tax-exempt interest income of $4,000. This year, each partner receives $1,000 of the tax-exempt interest income in a cash distribution. There are no partnership liabilities and no other income, loss, contributions, or distributions during both years. William's basis in the partnership interest following these transactions isA) $19,000.B) $20,000.C) $21,000.D) $22,000.Answer: CExplanation: Beginning basis $20,000Plus: one-half of tax-exempt interest income 2,000Minus: distribution ( 1,000)Postdistribution basis $21,000

Page Ref.: C:9-21 through C:9-23Objective: 7

4) Miguel has a 50% interest in partnership capital, profits, and losses. The basis for his partnership interest is $50,000. The partners share the economic risk of loss from recourse liabilities in the same way they share partnership losses. Miguel receives a distribution of land that has an FMV of $40,000 and an adjusted basis of $30,000. The land is subject to a $15,000 liability, which Miguel assumes. His basis in the partnership interest following the land distribution isA) $12,500.B) $20,000.C) $27,500.D) $35,000.Answer: CExplanation: Predistribution basis $50,000 Minus: distribution (30,000)Minus: release from one-half of partnership liability for land ( 7,500)Plus: liability assumed from partnership 15,000 Postdistribution basis $27,500



5) Identify which of the following statements is true.A) A general partner's share of recourse debt is based on his or her economic risk of loss, and his or her share of nonrecourse debt is predominantly based on his or her share of partnership profits.B) A partner's basis for his or her partnership interest is increased by his or her share of the partnership's tax-exempt income.C) If all tax-exempt interest income is distributed when received by a partnership, the partners' bases are the same after the distribution as they were before the tax-exempt interest was received by the partnership.D) All of the above are true.Answer: DPage Ref.: C:9-22 and C:9-23Objective: 7

6) Identify which of the following statements is true.A) When adjusting a partner's basis in a partnership interest, the negative basis adjustments are made prior to the positive basis adjustments.B) Martin and Carlos formed an equal partnership to which Martin contributed $10,000 cash and Carlos contributed a building worth $10,000 with a basis of $2,000. In the first year of operation, the partnership suffered a $10,000 ordinary loss. Martin and Carlos can each deduct a $5,000 loss on their personal tax returns.C) Any distributive share of a loss that cannot be deducted by a partner because of the Sec. 704(d) basis loss limitation is permanently lost.D) All of the above are false.Answer: DPage Ref.: C:9-24 and C:9-25Objective: 7

7) Stan had a basis in his partnership interest at the beginning of last year of $30,000. There was no change in partnership liabilities during the year. His share of the partnership's ordinary loss last year was $40,000 and the partnership had no separately stated items. This year, Stan has a distributive share of ordinary income of $30,000. The taxable income from the partnership reported on Stan's personal income tax return this year (ignoring the at-risk and passive activity loss limitations) isA) $10,000 ordinary loss.B) $20,000 ordinary income.C) $30,000 ordinary income.D) $40,000 ordinary income.Answer: BExplanation: $30,000 - $10,000 loss carryover = $20,000.

Beginning basis $30,000 Minus: share of loss deducted last year (30,000)End-of-year basis (last year) 0 Plus: share of current-year income 30,000Minus: loss carryover from last year (10,000)End-of-year basis (this year) $20,000


8) A partnership has one general partner, Allen, who materially participates in the business. Allen had a $30,000 distributive share of ordinary losses for this year and the partnership had no separately stated gains or losses. There are no changes in liabilities


during this year and there are no additional contributions or distributions. At the beginning of this year, the Sec. 705 basis was $40,000 and the at-risk basis was $15,000. The basis on December 31 of this year based on the above information isA) $10,000.B) $15,000.C) $25,000.D) $40,000.Answer: AExplanation: $40,000 - $30,000 = $10,000Page Ref.: C:9-25Objective: 7

9) Clark and Lewis are partners who share the profits and losses of the C&L Partnership 60% and 40%, respectively. The tax basis of each partner's interest in the partnership as of December 31 of last year was as follows: Clark, $14,000; Lewis, $12,000. During the current year, the partnership had ordinary income of $20,000 and a long-term capital loss of $10,000 from the sale of securities. The partnership made cash distributions proportionately to the two partners during this year totaling $20,000. What is the amount of Lewis's tax basis of his partnership interest on December 31 of the current year?Answer: Lewis's basis = $12,000 + (0.40 × $20,000) - (0.40 × $10,000) - $8,000 distributions = $8,000Page Ref.: C:9-24Objective: 7

10) The partners of the MCL Partnership, Martin, Clark, and Lewis, share profits and losses in a ratio of 4:3:3, respectively. The tax basis of each partner, as of December 31 of the current year, is as follows: Martin, $7,200; Clark, $6,000; and Lewis, $2,500. During the current year, the partnership incurred an ordinary loss of $15,000. The loss is not reflected in the tax basis figures presented above. Nothing else occurs during the year that would affect the partners' bases. As a result of this loss, what amount should Martin, Clark, and Lewis report on their individual tax returns for the current year? What limitations (other than the Sec. 704(d) loss limitations) may prevent them from deducting their losses in the current year?Answer: The loss allocation is:Martin: $15,000 × 0.40 = $6,000Clark: $15,000 × 0.30 = $4,500Lewis: $15,000 × 0.30 = $4,500

Martin and Clark are limited to deducting $6,000 and $4,500, respectively, by their allocation of the partnership loss and not by their bases for their partnership interests under Sec. 704(d). Lewis, on the other hand, has his $4,500 share of the partnership loss limited by his $2,500 basis for the partnership interest under Sec. 704(d). These amounts may be further restricted by the at-risk rules and the passive activity limitations.Page Ref.: C:9-23 through C:9-25Objective: 7


11) The Troika Partnership has an ordinary loss of $48,000 for the year. Before allocation of the loss at the end of the year, Shaad's one-third limited partnership interest has an adjusted basis of $5,000. Shaad's only other income or loss is his $30,000 salary from a factory job. What amount can Shaad deduct on his tax return as his share of the partnership's loss?Answer: Shaad's distributive share of loss is $16,000 ($48,000 × 0.333). His loss deduction is first limited to his $5,000 adjusted basis under Sec. 704(d). His loss is further restricted by the passive loss rules and, since he has no passive income, he cannot deduct any of the loss from this partnership.Page Ref.: C:9-23 through C:9-25Objective: 7

12) Explain the three different limitation provisions that a partner must satisfy before a loss can be deducted.Answer: In the order of application, these limitations are: (1) adequate partnership basis under Sec. 704(d), (2) the at-risk loss limitations, and (3) the passive activity limitations.Page Ref.: C:9-24Objective: 7

13) Jerry has a 10% interest in the EKG Partnership capital, profits, and losses. He is a limited partner. At the beginning of the current year, his basis in his partnership interest is $10,000. The partnership earned $20,000 of ordinary income this year and repaid a $150,000 nonrecourse liability. What tax issues should Jerry consider with respect to reporting the results of this year's activities for the EKG Partnership on his personal return?Answer: • What is Jerry's basis in his partnership interest?• Does the repayment of the partnership liability cause an adjustment to Jerry's basis in his partnership interest?• Is the repayment of the nonrecourse liability a taxable event for Jerry? If so, what are the amount and character of the income reported?

Repayment of partnership liabilities is treated as distributions to the partners. A distribution made to a partner that exceeds their basis for the partnership interest produces a taxable gain. The gain can be calculated as follows:

Basis at the beginning of the year $10,000Plus: George's share of income

(0.10 × $20,000) 2,000George's basis before the distribution $12,000Minus:George's deemed distribution from

repayment of partnership liability(0.10 × $150,000) (15,000)

George's recognized gain $ 3,000Page Ref.: C:9-21 through C:9-24Objective: 7


14) Samantha works 40 hours a week as a clerk in the mall and earns $28,000. In addition, she works five hours each week in the XYZ Partnership's office. Samantha, a 15% limited partner in the XYZ Partnership, has been allocated a $4,000 loss from the partnership for the current year. The basis for her interest in XYZ before accounting for current operations is $7,000. What tax issues should Samantha consider with respect to her interest in, and employment by, the XYZ Partnership?Answer: • What is Samantha's deductible loss from her partnership investment?• What is Samantha's Sec. 704(d) basis in her partnership interest?• What is Samantha's at-risk basis in her partnership interest?• Is the loss from the XYZ Partnership a passive loss?• Does Samantha have passive income from this investment or other investments? If so, can she deduct her losses? If not, do the losses carry over to later years?

As a limited partner, Samantha is presumed not to materially participate in the partnership. Therefore, because it is a loss from a passive activity, her loss cannot be deducted unless she has passive income from other investments, or she terminates her interest in the limited partnership. If no such income exists, the losses carry over to later years.Page Ref.: C:9-23 through C:9-25Objective: 7

15) At the beginning of the current year, Terry has a $40,000 basis for his general partnership interest in the TKE Partnership. He materially participates in the business activities of the partnership. On November 1, he receives a $4,000 distribution. His distributive share of TKE's current items is a $5,000 net long-term capital gain and a $50,000 ordinary loss. What amount will he include in his current year's tax return?Answer: Terry has a $41,000 ($40,000 + $5,000 - $4,000) basis in his partnership interest at the end of the year before including the ordinary loss. His loss deduction is limited to his basis. Therefore, he will include the $5,000 long-term capital gain and $41,000 of the ordinary loss. The remaining $9,000 ordinary loss can be deducted in the following year if he has sufficient basis in his partnership interest.Page Ref.: C:9-24; Example C:9-29Objective: 7

LO8: Special Loss Limitations

1) Limited partners must consider the at-risk, basis, and passive loss limitations when determining the amount of their deductible loss.Answer: TRUEPage Ref.: C:9-26 and C:9-27Objective: 8

2) No gain is recognized on the sale of property between a partnership and a more-than-50% partner.Answer: FALSEPage Ref.: C:9-28Objective: 9


3) Martin is a limited partner in a card shop. At the end of the partnership's tax year, Martin's basis in the partnership interest is $25,000 ($5,000 cash investment plus a $20,000 share of nonqualified nonrecourse financing). Martin's distributive share of partnership losses for the tax year is $33,000. Martin has $30,000 of passive income this year from other activities. How much of the $33,000 partnership loss can be used by Martin in the year of the loss?A) $5,000B) $25,000C) $30,000D) $33,000Answer: AExplanation: Martin's total basis under Sec. 704(d) is $25,000. However, his $5,000 cash investment is the only amount for which he is at risk under the at-risk rules and sets the limit on his loss deduction, since he has $30,000 of passive income.Page Ref.: C:9-26; Example C:9-32Objective: 8

4) David purchased a 10% capital and profits interest in a partnership this year. He does not participate in the partnership's business. David has no passive income in the current year. His distributive share of the partnership's loss is $40,000 for this year. David's Sec. 705 basis in the partnership is $32,000 and his at-risk basis is $16,000 at the end of the current year. How much of the loss can David deduct on his tax return?A) $0B) $16,000C) $32,000D) $40,000Answer: AExplanation: David's passive loss limitation is zero and is the controlling factor.Page Ref.: C:9-27; Example C:9-33Objective: 8

LO9: Transactions Between a Partner and the Partnership

1) Guaranteed payments are always ordinary income to the recipient.Answer: TRUEPage Ref.: C:9-28Objective: 9


2) Jangyoun sells investment land having a $30,000 basis to a partnership in which he has a 60% partnership interest. The partnership pays $26,000 (FMV) for the land. Later, the partnership sells the investment land to a nonpartner for $31,000. On the sale of the land, the partnership must recognize aA) $0 gain or loss.B) $1,000 capital gain.C) $4,000 capital gain and $1,000 Sec. 1231 gain.D) $5,000 capital gain.Answer: BExplanation: Amount realized $31,000 Minus: basis to partnership (26,000)Realized gain $ 5,000

Jangyoun realized a $4,000 loss ($26,000 - $30,000) on the sale of the land to the partnership. The $4,000 loss is disallowed in the year of Jangyoun's sale, but can offset the partnership's realized gain, thus reducing it to a $1,000 recognized gain. The gain is capital because the land was held for investment purposes by the partnership.Page Ref.: C:9-28; Example C:9-36Objective: 9

3) Identify which of the following statements is true.A) A partner who performs services for a partnership is usually not considered an employee of the partnership.B) It may be necessary for the partnership to capitalize a partner's guaranteed payment.C) Guaranteed payments are ordinary income to the recipient.D) All of the above are true.Answer: DPage Ref.: C:16-28 and C:16-29Objective: 9

4) When computing the partnership's ordinary income, a deduction is allowed forA) contributions to charitable organizations.B) net operating losses.C) net short-term capital losses.D) guaranteed payments to partners.Answer: DPage Ref.: C:9-29Objective: 9

5) When determining the guaranteed payment, which of the following statements is correct?A) If the distributive share is less than the guaranteed minimum amount, the guaranteed payment is equal to the difference between the distributive share and the guaranteed minimum amount.B) If the distributive share is greater than the guaranteed minimum amount, the guaranteed payment is equal to the difference between the distributive share and the guaranteed minimum amount.C) Guaranteed payments are payments determined with regard to the partnership income.D) The distinction between guaranteed payments and distributive shares is clear in practice.Answer: APage Ref.: C:9-29Objective: 9

6) Yee manages Huang real estate, a partnership in which she is also a partner. She receives 40% of all partnership income before guaranteed payments, but no less than


$80,000 per year. In the current year, the partnership reports $400,000 in ordinary income. What is Yee's distributive share and her guaranteed payment?

A)

Distributive ShareGuaranteed Payment

$80,000 $80,000

B)


$160,000 0

C)


$160,000 $80,000

D)


$160,000 $160,000

Answer: BPage Ref.: C:9-29; Example C:9-38Objective: 9


7) Yee manages Huang real estate, a partnership in which she is also a partner. She receives 40% of all partnership income before guaranteed payments, but no less than $80,000 per year. In the current year, the partnership reports $100,000 in ordinary income. What is Yee's distributive share and her guaranteed payment?

A)


$40,000 0

B)


$40,000 $80,000

C)


$40,000 $40,000

D)


0 $80,000

Answer: CPage Ref.: C:9-29; Example C:9-39Objective: 9

8) In January of this year, Arkeva, a calendar-year taxpayer, receives a $50,000 guaranteed payment from NFR Partnership. NFR deducted the payment during its tax year ending November 30 of last year. What tax year must Arkeva report her guaranteed payment in?A) She may elect either year.B) last yearC) current yearD) She does not need to report guaranteed payments on her return.Answer: BPage Ref.: C:9-29; Example C:9-40Objective: 9


9) Henry has a 30% interest in the HMS Partnership's capital, profits, and losses computed after taking into account his guaranteed payment of $40,000. In the current year, HMS reports ordinary income of $30,000 and capital gains of $60,000 before taking into account Henry's guaranteed payment. What is the amount and character of all income or loss that Henry must report as a result of partnership activities?A) $40,000 guaranteed payment (ordinary income), $3,000 ordinary loss, $18,000 capital gainB) $40,000 guaranteed payment (ordinary income), $15,000 capital gainC) $40,000 guaranteed payment (ordinary income), $9,000 ordinary income, $6,000 capital gainD) $13,000 guaranteed payment (ordinary income), $6,001 ordinary income, $38,820 capital gainAnswer: AExplanation: OI = $40,000 guaranteed payment; OL = ($30,000 - $40,000) × 0.30 = ($3,000); capital gains = $60,000 × 0.30 = $18,000.Page Ref.: C:9-29; Example C:9-41Objective: 9

10) Edward owns a 70% interest in the capital, profits, and losses of the Edward and Moore Partnership. During the year, Edward purchases surplus inventory from the partnership for $5,000. On the date of the sale, the inventory has an adjusted basis to the partnership of $8,000. For the year, the partnership's ordinary income is $50,000 after including the loss on the sale of the inventory to Edward. Assuming that there are no other partnership items to be separately stated, what is Edward's distributive share of the partnership's ordinary income for the year?Answer: The loss will not be recognized by the partnership because Edward owns more than 50% of the partnership capital or profits interests and is considered a related party under Sec. 707(b). The partnership has ordinary income of $53,000 ($50,000 + $3,000) of which Edward's share is $37,100 (0.70 × $53,000).Page Ref.: C:9-27Objective: 9

11) In January, Daryl and Louis form a partnership with each contributing $75,000 in cash. The partnership agreement provides that Daryl would receive a guaranteed payment for salary of $20,000 and that partnership profits and losses (computed after deducting Daryl's salary) would be shared equally. For the year, the partnership's operations result in an $18,000 ordinary loss after payment of Daryl's guaranteed payment. The partnership has no outstanding liabilities at year-end. What is the basis amount of Daryl's partnership interest at year-end?Answer: Daryl's basis would be unaffected by the guaranteed payment. It would be reduced by $9,000 for the portion of the ordinary loss that he is allocated and would total $66,000 ($75,000 - $9,000).Page Ref.: C:9-29Objective: 9

12) What is the tax impact of guaranteed payments on the partner and the partnership?Answer: The partner recognizes ordinary income in the partner's tax year during which the partnership tax year ends regardless of when the payment is received. The partnership deducts or capitalizes the guaranteed payments, since it is treated as if it were made to an outsider.Page Ref.: C:9-28Objective: 9


13) Janice has a 30% interest in the Jansen Partnership. She is to receive a guaranteed payment for deductible services of $50,000. The partnership reports $30,000 of ordinary income and a $100,000 long-term capital gain before deducting the guaranteed payment. What is her income from the partnership?Answer: Janice will report the guaranteed payment of $50,000. She will also report her distributive share of the partnership's ordinary loss, $6,000 [0.30 × ($30,000 - $50,000)] and her distributive share of the partnership's long-term capital gain, $30,000 (0.30 × $100,000).Page Ref.: C:9-29; Example C:9-40Objective: 9

L10: Family Partnerships

1) Identify which of the following statements is true.A) Bob gives his 16-year-old daughter Michelle a 20% capital and profits interest in his accounting practice. She does no work for the partnership and is not involved at all with the operations of the partnership. In fact, she does not know that her dad transferred the interest in the partnership to her. If the partnership allocates an $8,000 distributive share of ordinary income to her, it is properly reported on Michelle's individual tax return.B) Valid family partnership partners may be subject to the "kiddie tax."C) Joan gives her daughter, Sarah, a 25% interest in a partnership that operates a steel mill. Sarah, age 19, was allocated $20,000 from the partnership as her share of the partnership ordinary income. The IRS will require the income to be included on Sarah's return.D) All of the above are false.Answer: BPage Ref.: C:9-30Objective: 10


2) Nicholas, a 40% partner in Nedeau Partnership, gives one-half of his interest to his sister, Michelle. During the current year, Nicholas performs services for the partnership for which reasonable compensation is $80,000, but for which he accepts no pay. Nicholas and Michelle are each credited with a $100,000 distributive share, all of which is ordinary income. What are Nicholas' and Michelle's distributive share?

A) Nicholas Michelle$100,000 $100,000

B) Nicholas Michelle$ 60,000 $ 60,000

C) Nicholas Michelle$180,000 $100,000

D) Nicholas Michelle$140,000 $ 60,000

Answer: DExplanation: Total distributive shares ($100,000 × 2) $200,000Minus: reasonable compensation for Nicholas 80,000Income to allocate $120,000

Nicholas' distributive share [(20%/40%) × $120,000] + $80,000 = $140,000Michelle's distributive share (20%/40%) × $120,000 = $60,000Page Ref.: C:9-31; Example C:9-42Objective: 10


3) Bud has devoted his life to his business, the BK Partnership, in which he owns an 85% capital and profits interest. Because he has worked so hard all his life, he never married and has no children. He has decided to give a 25% capital and profits interest to Berry, a close friend, if Berry will work in the business for five years. Berry will receive guaranteed payments for his work. Bud devotes all his time to the partnership, but he takes no salary. What tax issues should Bud and Berry consider with respect to the gift of the partnership interest and Bud's employment arrangement with the partnership?Answer: • Do the family partnership rules apply when there is no family relationship?• Does reasonable compensation need to be paid to Bud for his services?• If so, what is reasonable compensation for Bud's services?• Does Berry need to be recognized as a partner in the BK Partnership?• If so, what is Berry's allocable share of the partnership income?• What is Bud's allocable share of the partnership income?

The family partnership rules are written in terms of the donor-donee relationship. Accordingly, they apply in this situation. Both Bud and Berry would be allocated a reasonable compensation amount. Then, the remainder of the income originally allocated to Bud and Berry would be reallocated to them based on their relative capital interests.Page Ref.: C:9-29 and C:9-30Objective: 10

L11: Tax Planning Considerations

1) There are no questions for this section.

L12: Compliance and Procedural Considerations

1) A partnership must file Form 1065 only if its income exceeds $1,000.Answer: FALSEPage Ref.: C:9-32 and C:9-33Objective: 12

2) Brent is a general partner in BC Partnership. His distributive share of partnership income and his guaranteed payment for the year are as follows:

Ordinary income $30,000Short-term capital gain $18,000Guaranteed payment $36,000

What is his self-employment income?A) $84,000B) $66,000C) $48,000D) $36,000Answer: BExplanation: ($30,000 + $36,000)Page Ref.: C:9-33; Example C:9-44Objective: 12

3) Brent is a limited partner in BC Partnership. His distributive share of partnership income and his guaranteed payment for the year are as follows:

Ordinary income $30,000Short-term capital gain $18,000


Guaranteed payment $36,000

What is his self-employment income?A) $84,000B) $66,000C) $48,000D) $36,000Answer: DPage Ref.: C:9-33; Example C:9-45Objective: 12


chapter c9

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