federal taxation ii chapter 21 review questions

CHAPTER 21

PARTNERSHIPSTRUE/FALSE

1. Unlike a subchapter C corporation, a partnership is subject to only one level of taxation and can often liquidate in a tax-deferred manner.

ANS: TA partnership is a flow-through entity subject to only one level of taxation. Liquidation of the partnership is generally tax-deferred.

PTS: 1 REF: p. 21-2 | p. 21-3

2. Section 721 provides that no gain or loss is recognized on contribution of property to a partnership in exchange for an interest in the partnership. An exception might apply if the taxpayer receives a cash distribution from the partnership soon after the property contribution.

ANS: TA contribution of property to a partnership followed by a distribution soon thereafter may be recharacterized as a disguised sale of the property by the partner to the partnership. A disguised sale does not receive tax-deferred treatment under § 721.

PTS: 1 REF: p. 21-10

3. Jim and Nancy formed an equal partnership on June 1 of the current year. Jim contributed $10,000 cash and land with a basis of $8,000 and a fair market value of $6,000. Nancy contributed equipment with a basis of $14,000 and a value of $16,000. Nancy’s tax basis in her interest is $14,000; Jim’s tax basis is $18,000.

ANS: TJim’s basis includes the $8,000 substituted basis for the contributed land plus $10,000 cash, for a total of $18,000. Nancy’s basis is $14,000, a substituted basis from the contributed equipment.

PTS: 1 REF: Example 7 | Example 14

4. Rachel and Barry formed the equal RB Partnership during the current year, with Rachel contributing $100,000 in cash and Barry contributing land (basis of $60,000, fair market value of $80,000) and equipment (basis of $0, fair market value of $20,000). Barry recognizes a $40,000 gain on the contribution and his basis in his partnership interest is $100,000.

ANS: FUnder § 721, neither the partnership nor a partner will generally recognize gain or loss on contribution of property to a partnership. Barry’s substituted basis in his partnership interest is his $60,000 basis in the assets contributed ($60,000 basis in land plus $0 basis in equipment).


21-1

21-2 2008 Comprehensive Volume/Test Bank

5. John and Ken formed the equal JK Partnership during the current year, with John contributing $50,000 in cash and Ken contributing land (basis of $30,000, fair market value of $20,000) and equipment (basis of $0, fair market value of $30,000). Ken recognizes no gain or loss on the contribution and his basis in his partnership interest is $30,000.

ANS: TUnder § 721, neither the partnership nor a partner will generally recognize gain or loss on contribution of property to a partnership. Ken’s basis in his partnership interest is the $30,000 basis in the assets contributed ($30,000 basis in land plus $0 basis in equipment).


6. Julie is a real estate developer and owns property that is treated as inventory (not a capital asset) in her business. She contributed a parcel of this land (basis $60,000; fair market value $58,000) to a partnership, which will also hold it as inventory. After three years, the partnership sells the land for $56,000. The partnership will recognize a $4,000 ordinary loss on sale of the property.

ANS: TSince the property was not a capital asset in Julie’s hands, the partnership is not subject to the requirement that precontribution losses (realized and recognized by the partnership within five years of contribution) be treated as capital losses.

PTS: 1 REF: Example 16

7. The XYZ Partnership, a calendar year taxpayer, was formed on April 1 of the current year. It incurred $23,000 of legal fees on formation. XYZ may deduct $5,000 and amortize the remaining $18,000 over 180 months, for $900 in the current year.

ANS: TAll organization costs incurred by the end of the first taxable year of the partnership may be expensed (up to $5,000) and the balance amortized over 180 months commencing with the month the taxpayer begins business.


8. PaulCo, DavidCo, and Ralph form a partnership with cash contributions of $80,000, $50,000 and $30,000, respectively, and agree to share profits and losses in the ratio of their original cash contributions. PaulCo uses a January 31 fiscal year-end, while DavidCo and Ralph use a November 30 and December 31 fiscal year-end, respectively. Since PaulCo is a majority partner, this partnership will use a January 31 year-end.

ANS: FThe partnership has no majority partners, since PaulCo does not own more than 50%. Also, the three principal partners do not have the same year-end. Therefore, the least aggregate deferral method must be used to determine the partnership’s year-end.

PTS: 1 REF: Figure 21-2

Partnerships 21-3

9. Meagan purchased her partnership interest from Lisa on the first day of the current year for $30,000 cash. She received a $15,000 cash distribution from the partnership during the year, and her share of partnership income is $12,000. If her share of partnership liabilities on the last day of the partnership year is $10,000, her outside basis for her partnership interest at the end of the year is $27,000.

ANS: FMeagan’s adjusted basis at the end of the year is $37,000, determined as follows: $30,000 cash (paid to acquire interest) + $12,000 (share of income) + $10,000 (share of partnership liabilities) – $15,000 (cash distribution).

PTS: 1 REF: Example 31 | Figure 21-3

10. During the current year, TAZ Partnership reported the following items of receipts and expenditures: $100,000 sales, $5,000 utilities, $8,000 rent, $30,000 salaries to employees, $20,000 guaranteed payment to partner Zoe, investment interest income of $1,250, and a distribution of $6,000 to partner Tony. Arnold, a 40% partner, will receive a K-1 that reflects a $14,800 share of partnership ordinary income and a $500 share of partnership interest income.

ANS: TThe partnership’s ordinary taxable income is:

Sales $100,000 Utilities (5,000)Rent (8,000)Salaries (30,000)Guaranteed payment to Zoe (20,000)Partnership ordinary income $ 37,000

Separately stated interest income $ 1,250

The distribution to Tony is not deductible by the partnership. Arnold’s share of partnership items is $37,000 40% = $14,800 and $1,250 40% = $500.

PTS: 1 REF: p. 21-19 | p. 21-20 | Example 20 | Example 41


11. On the first day of the current tax year, Melanie’s basis in her partnership interest was $85,000. Her Schedule K-1 from the partnership reflected the following items for the current year: share of partnership ordinary loss, $95,000; interest income from money market accounts, $6,000. On her personal tax return, Melanie will report a loss from the partnership of $91,000, and interest income of $6,000.

ANS: TMelanie’s deductible loss from the partnership will be determined as follows under § 704(d):

Basis at beginning of year $85,000 Plus: interest income 6,000

$91,000 Less: allowable share of ordinary loss (91,000) Ending basis for her partnership interest $ -0-

Melanie’s remaining $4,000 loss is suspended and carried forward to a year in which her basis is adequate to absorb the loss.

PTS: 1 REF: p. 21-24 to 21-26 | Example 33 | Figure 21-3

12. Michael contributes land with a value of $120,000 and a basis of $80,000 to the MNO Partnership in exchange for a 1/4 interest. Soon thereafter, the partnership sells the land for $140,000. Of the gain on the land sale, $20,000 is allocated to Michael.

ANS: FThe total gain on the land sale is $60,000 [$140,000 (selling price) – $80,000 (substituted basis)]. The $40,000 precontribution gain [$120,000 (value at contribution date) – $80,000 (basis)] is allocated to Michael. In addition, Michael is allocated 1/4, or $5,000 of the post-contribution gain ($140,000 – $120,000 FMV at contribution date).

PTS: 1 REF: p. 21-24 | Example 24

13. During the current year, John and Ashley form the JA Partnership and agree to share profits and losses equally. John contributes cash of $50,000 and Ashley contributes land with a fair market value of $80,000 (subject to a $30,000 nonrecourse mortgage). On the contribution date, Ashley’s adjusted basis in the land is $40,000. Immediately after formation, John’s partnership outside basis is $65,000, Ashley’s partnership outside basis is $25,000, and JA’s basis in the land is $40,000.

ANS: TNo gain or loss is recognized when a partner contributes property subject to nonrecourse debt to a partnership according to Reg. § 1.752-3. One-half of the debt, $15,000, is allocated to Ashley. Therefore, Ashley is relieved of $15,000 of debt under § 752(b) for a net basis of $25,000 [$40,000 (land basis) – $30,000 (debt relief) + $15,000 (debt share)]. John has an adjusted basis for his partnership interest of $65,000 [$50,000 (cash contributed) + $15,000 (liability assumed)]. The land takes a carryover basis under § 723 of $40,000.


Partnerships 21-5

14. Nina and Sue form an equal partnership during the current year. Nina contributes cash of $100,000, and Sue contributes property (adjusted basis of $40,000, fair market value of $250,000) subject to a nonrecourse liability of $150,000. As a result of these transactions, Sue has a recognized gain of $35,000 and a basis in her partnership interest of $75,000.

ANS: FTypically, no gain or loss is recognized when a partner contributes property subject to nonrecourse debt to a partnership. Sue is allocated the first $110,000 of debt ($150,000 debt – $40,000 basis), plus one-half of the remaining debt. She has an adjusted basis for her partnership interest of $20,000, calculated as follows:

Basis, property transferred $ 40,000 Less: liability assumed by partnership (150,000)Plus: § 704(c) allocation of debt 110,000Basis before remaining allocation $ -0- Remaining allocation of debt ($40,000 50%) 20,000 Sue’s basis $ 20,000


15. Hardy’s basis in his partnership interest was $5,000 at the beginning of the tax year. For the year, his share of the partnership’s loss was $6,000, and he also received a distribution of $3,000. Hardy can deduct a $2,000 loss, and the remaining $4,000 loss is suspended until a year in which he has adequate basis.

ANS: THardy’s basis is first adjusted for the distribution he received, so it is reduced to $2,000 ($5,000 – $3,000 distribution). The loss is limited under § 704(d) to his basis after the distribution, or $2,000, with the remainder being deferred to a future year.

PTS: 1 REF: Example 34 | Figure 21-3

16. Roxanne contributes land to the RB Partnership in exchange for a 40% interest. The land has an adjusted basis and fair market value of $75,000 and is subject to a liability of $25,000, which the partnership assumes. None of this liability is repaid at year-end. At the end of the year, the partnership has trade accounts payable of $30,000. Assume all liabilities are allocated proportionately to the partners. Total partnership income for the year is $100,000. Roxanne’s basis in her partnership interest at the end of the year is $112,000.

ANS: TRoxanne’s basis in the partnership interest at the end of the year is determined as follows:

Basis in land contributed to RB $ 75,000 Less: relief of liability assumed by partnership (25,000)Plus: share of liability attached to land ($25,000 40%) 10,000 Plus: share of trade accounts payable 12,000 Plus: share of partnership income 40,000Ending basis in partnership interest $112,000

PTS: 1 REF: p. 21-26 | p. 21-27 | Example 26 | Example 27


17. Bill’s basis in his 20% interest in the BMW Partnership was $10,000 on the first day of the current tax year. The partnership reported “book” (GAAP) income of $60,000 (net of a deduction for a guaranteed payment made to Bill of $40,000). There were no other differences between book and tax income. Bill’s ending basis in his partnership interest is $22,000, and he will report income items from the partnership totaling $52,000.

ANS: TThe guaranteed payment to Bill is deductible by the partnership, so the partnership’s taxable income is the same as its book income of $60,000. Bill’s 20% share is $12,000. Bill must also report the $40,000 guaranteed payment as income on his personal return. Total income from the partnership then, is $52,000.

Bill’s ending basis is determined as follows:Beginning basis $10,000Share of partnership income 12,000Ending basis $22,000

The guaranteed payment does not affect his basis in the partnership, except through the deduction claimed by the partnership in determining its ordinary taxable income.

PTS: 1 REF: Example 40 to 42

18. Maria owns a 60% interest in the KLM Partnership. Four years ago her father gave her a parcel of land. The gift basis of the land to Maria is $60,000. In the current year, Maria had still not figured out how to use the land for her own personal or business use; consequently, she sold the land to the partnership for $75,000. The partnership immediately started using the land as a parking lot for its employees. Maria recognizes a capital gain of $15,000 on the sale.

ANS: FSince Maria owns more than a 50% interest in the partnership’s capital or profits and the land sold to the partnership is not a capital asset in its hands, any gain is an ordinary gain to Maria. Thus, she has ordinary income of $15,000 ($75,000 less $60,000).

PTS: 1 REF: Example 45 | § 707(b)(2) | Reg. § 1.707-1(b)(2)

19. Loss will be recognized on any distribution in which cash, unrealized receivables, and/or appreciated inventory are the only items distributed.

ANS: FLoss will not always be recognized on a distribution in which cash, unrealized receivables, and/or appreciated inventory are the only items distributed. The distribution must be a liquidating distribution. In addition, the inside basis of the assets distributed must be less than the distributee partner’s outside basis of the partnership interest immediately before the distribution.

PTS: 1 REF: p. 21-45 | p. 21-12 | Example 58

Partnerships 21-7

20. Tim receives a proportionate nonliquidating distribution from the RST Partnership when the basis of his interest is $60,000. The distribution consists of cash of $40,000 and inventory with a partnership basis of $30,000 and fair market value of $35,000. As a result of this distribution, Tim recognizes a $10,000 gain and takes a $30,000 basis in the inventory.

ANS: FTim recognizes no gain or loss on the distribution. His basis in the inventory is limited to the $20,000 basis remaining after taking into account the $40,000 cash distribution. In a proportionate nonliquidating distribution, gain is recognized to the extent the distributed cash exceeds the partner’s basis in the partnership interest. The basis in noncash property is the lesser of the partnership’s inside basis in the property or the partner’s outside basis before the distribution.


21. Sarah owns a 30% interest in the capital and profits of the STP Partnership. Immediately before she receives a proportionate nonliquidating distribution from STP, the basis of her partnership interest is $25,000. The distribution consists of $20,000 in cash and land with a fair market value of $40,000. STP’s adjusted basis in the land immediately before the distribution is $30,000. As a result of the distribution, Sarah recognizes a gain of $35,000 and her basis in the land is $40,000.

ANS: FUnder § 731(a) gain is recognized by a distributee partner in a nonliquidating distribution only if the cash (including marketable securities or liability relief treated as cash) received exceeds the basis of the partner’s interest. Since Sarah received cash of only $20,000, no gain results. Sarah’s basis in the land is limited to $5,000, and her interest basis is reduced to zero.


22. Lori, a partner in the Warbler partnership, received a proportionate nonliquidating distribution of $10,000 cash, unrealized receivables with a basis of $0 and a fair market value of $15,000, and land with a basis of $6,000 and a fair market value of $10,000. Her basis in the partnership interest immediately before the distributions was $14,000. She will recognize $0 gain on the distribution, and her basis in the land will be $4,000.

ANS: TLori will take a carryover basis of $10,000 and $0, respectively, for the cash and unrealized receivables. The distribution of these assets will reduce her outside basis for her partnership interest to $4,000 ($14,000 – $10,000 – $0). She will take a $4,000 substituted basis for the land.



23. Matt, a partner in the MB Partnership, receives a proportionate, nonliquidating distribution of property having a fair market value of $16,000 and a partnership basis of $23,000. Matt’s basis in the partnership is $10,000 before the distribution. In this situation, Matt will take a $10,000 basis in the property, and his basis in the partnership interest is reduced to zero.

ANS: TSection 732(a)(2) limits the basis of distributed property to the basis of the partner’s interest before the distribution, reduced by any cash distributed in the transaction, or $10,000.


24. Tim and Janet are equal partners in the TJ Partnership. Partnership income for the year is $20,000. Tim needs cash in order to pay tax on his share of the partnership income, but Janet wants to leave the cash in the partnership for expansion. If the partners agree, it is acceptable to distribute $5,000 to Tim, and no cash or other property to Janet.

ANS: TDisproportionate distributions are permitted. To ensure equity to all partners, though, capital accounts must be maintained in accordance with §§ 704(b) and (c). In addition, the distribution cannot be a disguised sale.

PTS: 1 REF: p. 21-38

25. Larry’s partnership interest basis is $60,000. Larry receives a proportionate, liquidating distribution from a liquidating partnership of $45,000 cash and inventory having a basis of $30,000 to the partnership and a fair market value of $28,000. Larry assigns a basis of $15,000 to the inventory and recognizes no gain or loss.

ANS: TLarry’s basis is reduced to $15,000 by the cash distribution. Since $15,000 is less than the partnership’s $30,000 basis in the inventory, the inventory takes a substituted basis of $15,000, and Larry recognizes no gain or loss.

PTS: 1 REF: p. 21-45 | Example 58

26. Carlos receives a proportionate liquidating distribution consisting of $8,000 cash and inventory with a basis to the partnership of $5,000 and a fair market value of $6,000. His basis in his partnership interest was $15,000 immediately before the distribution. Carlos assigns a basis of $5,000 to the inventory, and recognizes a $2,000 capital loss.

ANS: TThe cash distribution reduces Carlos’s outside basis in his partnership interest to $7,000 ($15,000 – $8,000). He will take a $5,000 substituted basis for the inventory and recognize a $2,000 capital loss.

PTS: 1 REF: p. 21-43 to 21-45

Partnerships 21-9

27. The JIH Partnership distributed the following assets to partner James in a proportionate liquidating distribution in which the partnership also liquidated: $25,000 cash, land parcel A (basis of $5,000, value of $30,000), and land parcel B (basis of $5,000, value of $15,000). James’s basis in his partnership interest was $85,000 immediately before the distribution. James will allocate bases of $40,000 to parcel A and $20,000 to parcel B, and he will have no remaining basis in his partnership interest.

ANS: TJames takes a total substituted basis in the land parcels of $60,000 (basis in interest of $85,000 less $25,000 cash distribution). That basis must be allocated between the two properties. First, the properties take a carryover basis of $5,000 each. Next, the remaining basis is allocated to each property, up to its fair market value, resulting in basis allocations of $30,000 and $15,000, respectively. Last, the remaining $15,000 of basis is allocated between the properties according to their respective fair market values (bases after the second allocations): 2/3 of the $15,000 is added to the $30,000 basis of the first parcel and 1/3 is added to the $15,000 basis of the second parcel. Final basis allocations are $40,000 and $20,000, respectively.


28. Terry received a proportionate share of partnership inventory in complete liquidation of her partnership interest. If Terry holds the distributed property as a capital asset for six years and sells it for a gain, the gain is taxed as a long-term capital gain.

ANS: TUnder § 735(a)(2), the sale or exchange of inventory items results in ordinary income or loss if the partner sells or exchanges such items within five years of the distribution date. After five years, the character is determined based on the partner’s use of the property.

PTS: 1 REF: p. 21-45

29. A partnership has accounts receivable with a basis of $0 and a fair market value of $10,000 and depreciation recapture potential of $15,000. All other assets of the partnership are either cash, capital assets, or § 1231 assets. If a purchaser acquires a 30% interest in the partnership from another partner, the selling partner will be required to recognize ordinary income of $7,500.

ANS: TThe selling partner must recognize ordinary income to the extent of gain inherent in the partner’s share of unrealized receivables. The seller’s 30% share of receivables and recapture is $7,500 [($10,000 + $15,000) 30%]. The partnership has no basis in these items, so ordinary income must be recognized for the entire $7,500.

PTS: 1 REF: p. 21-46 to 21-47 | Example 62


30. A limited liability company generally provides limited liability for those owners that are not active in the management of the LLC but requires owner-managers of the LLC to have unlimited personal liability for LLC debts.

ANS: FA properly established limited liability company provides limited liability for all of its members, regardless of whether they are active in the management of the LLC.

PTS: 1 REF: p. 21-47 | p. 21-48

MULTIPLE CHOICE

1. A partnership will take a cost basis in an asset it acquires when:a. The partnership acquires the asset through a § 1031 like-kind exchange.b. The partnership acquires the asset from a partner as a contribution to partnership capital

under § 721.c. The partnership leases the asset from a partner on a one-year lease.d. A partner owning 25% of partnership capital and profits sells the asset to the partnership.e. None of the above.

ANS: DThe purchase of an asset from either a partner or an outside party will result in the asset taking a cost basis to the partnership. Under § 1031, a partnership takes a substituted basis for the asset received in the exchange (choice a.). When a partner contributes an asset to a partnership in exchange for a partnership interest under § 721(a), the partnership takes a carryover basis for the asset under § 723 (choice b.). When a partnership leases an asset from a partner under a short-term lease, the asset is not a partnership asset and is not recorded on the partnership books (choice c.).

PTS: 1 REF: p. 21-9 to 21-12

2. On January 1 of the current year, Sarah and Bart form an equal partnership. Sarah makes a cash contribution of $60,000 and a property contribution (adjusted basis of $160,000; fair market value of $140,000) in exchange for her interest in the partnership. Bart contributes property (adjusted basis of $120,000; fair market value of $200,000) in exchange for his partnership interest. Which of the following statements is true concerning the income tax results of this partnership formation?a. Sarah has a $200,000 tax basis for her partnership interest.b. The partnership has a $140,000 adjusted basis in the property contributed by Sarah.c. Bart recognizes an $80,000 gain on his property transfer.d. Bart has a $120,000 tax basis for his partnership interest.e. None of the statements is true.

ANS: DThe contributions are tax-free and the carryover and substituted basis rules of §§ 722 and 723 apply. Bart’s basis for his partnership interest will be the same as his $120,000 basis for the property contributed. Sarah will have a $220,000 tax basis for her partnership interest; the partnership will have a $160,000 adjusted basis for the property contributed by Sarah; and neither Bart nor Sarah will recognize a gain or loss on the property contribution.


Partnerships 21-11

3. Kevin, Chuck, and Greg contributed assets to form the equal KCG Partnership. Kevin contributed cash of $50,000 and land with a basis of $80,000 (fair market value of $50,000). Chuck contributed cash of $30,000 and land with a basis of $40,000 (fair market value of $70,000). Greg contributed cash of $60,000 and a fully depreciated property ($0 basis) valued at $40,000. Which of the following tax treatments is not correct?a. Kevin’s basis in his partnership interest is $130,000.b. Chuck’s basis in his partnership interest is $100,000.c. Greg’s basis in his partnership interest is $60,000.d. KCG has a basis of $80,000, $40,000, and $0 in the land and property (excluding cash)

contributed by Kevin, Chuck, and Greg, respectively.e. None of the above.

ANS: BChuck’s basis in the partnership interest equals the $30,000 cash plus his $40,000 basis in the property contributed. The other three statements are correct. Kevin’s basis equals the cash contribution plus the $80,000 basis in the land. Greg’s basis equals the $60,000 cash contribution since he had no basis in the property he contributed. The partnership takes a carryover basis in the three contributed properties.


4. Alicia and Barry form the AB Partnership at the start of the current year with a land contribution by Barry and a cash contribution by Alicia. Barry’s contributed property is subject to a recourse mortgage assumed by the partnership. Immediately after formation, Barry has an 80% interest in AB’s profits and losses. The land has been held by Barry for the past 6 years as an investment. It will be used by AB as an operating asset in its parking lot business. Which of the following statements is correct?a. Immediately after formation, Alicia’s basis in the partnership equals the cash contributed

by Alicia.b. Immediately after formation, Alicia’s basis in the partnership equals the cash she

contributed plus her share of the recourse debt contributed by Barry.c. Since the debt is recourse, the constructive liquidation scenario is not applicable for

determining the allocation of debt to the partners.d. AB’s basis in the land contributed by Barry equals Barry’s basis in the land immediately

before the contribution date, less the amount of the recourse debt assumed by the partnership.

e. None of the above.

ANS: BChoice a. is incorrect because the debt on the land contributed by Barry will increase Alicia’s interest in AB.

Choice c. is incorrect since the constructive liquidation scenario is the method used to allocate debt to the partners.

Choice d. is incorrect since the basis of the land to AB equals its basis to Barry immediately before the contribution date.

PTS: 1 REF: Example 14 | Example 26 | §§ 721 to 723


5. Tina and Randy formed the TR Partnership four years ago. Because they decided the company needed some expertise in multimedia presentations, they offered Susan a 1/3 interest in partnership capital and profits if she would come to work for the partnership. On July 1 of the current year, the unrestricted partnership interest (fair market value of $25,000) was transferred to Susan. How should Susan treat the receipt of the partnership interest in the current year?a. Nontaxable.b. $25,000 short-term capital gain.c. $25,000 long-term capital gain.d. $25,000 ordinary income.e. None of the above.

ANS: DA person who receives an unrestricted partnership capital interest for services rendered recognizes ordinary income when the interest is received. The amount of income recognized is the fair market value of the partnership interest on the date it is received.


6. Which of the following independent transactions would most likely be characterized as a disguised sale?a. Partner George contributes appreciated property to the GMVV Partnership, and three

years later GMVV distributes $100,000 proportionately to all the partners.b. Barbara contributes property with a basis of $20,000 and a fair market value of $50,000 to

the BGB Partnership in exchange for a 20% interest. The partnership agrees to distribute $20,000 to Barbara in fifteen months if partnership cash flows from operations exceed $100,000. The partnership does not expect to produce operating cash flows of over $100,000 for at least five years.

c. Bill contributes appreciated property to the BLP Partnership. Twenty-six months later, he receives a distribution from the partnership of $15,000 cash. There was no agreement that BLP would make the distribution, and none of the other partners received one. Bill would have made the contribution whether or not the partnership made the distribution.

d. None of the above will be treated as a disguised sale.e. a., b., and c. are all treated as disguised sales.

ANS: DChoice a. is not a disguised sale, because the partner is merely receiving his share of partnership cash flows. Choice b. is not a disguised sale because the distribution is subject to entrepreneurial risk. Choice c. is not a disguised sale because the contribution was not contingent on a future distribution being made. In addition, the distribution in c meets the IRS’s two-year time frame in which a distribution is generally not presumed to be part of a disguised sale.


Partnerships 21-13

7. When property is contributed to a partnership for a capital and profits interest, the holding period of the contributing partner’s interest:a. May include the holding period of the contributed property.b. Always starts the day after the contribution date.c. Always starts the day the property was contributed.d. Never includes the holding period of the contributed property.e. None of the above.

ANS: AGenerally, the holding period of a partner’s interest includes the holding period of any capital gain property contributed by the partner.

PTS: 1 REF: Concept Summary 21-1

8. Cheryl and Nina formed a partnership. Cheryl received a 40% interest in partnership capital and profits in exchange for contributing land with a basis of $60,000 and a fair market value of $80,000. Nina received a 60% interest in partnership capital and profits in exchange for contributing $120,000 of cash. Three years after the contribution date, the land contributed by Cheryl is sold by the partnership to a third party for $90,000. How much taxable gain will Cheryl recognize from the sale?a. $4,000.b. $12,000.c. $24,000.d. $30,000.e. None of the above.

ANS: CSection 704(c)(1)(A) requires that any precontribution gain must be allocated entirely to Cheryl. Therefore, Cheryl is allocated the $20,000 precontribution (“built-in”) gain and 40% ($4,000) of the $10,000 post-contribution gain.



9. Marcella contributed fully depreciated ($0 basis) property valued at $16,000 to the MNOP Partnership in exchange for a 50% interest in partnership capital and profits. During the first year of partnership operations, MNOP had net taxable income of $60,000 and tax-exempt income of $3,000. The partnership distributed $10,000 cash to Marcella. Her share of partnership recourse liabilities on the last day of the partnership year was $12,000. Marcella’s adjusted basis (outside basis) for her partnership interest at year-end is:a. $32,000.b. $33,500.c. $49,500.d. $76,000.e. None of the above.

ANS: BMarcella is a 50% partner and will share in 50% of the partnership taxable income and tax-exempt income. In addition, her basis will include her allocable share of the partnership’s recourse liabilities. Her basis will be reduced by the cash distribution during the year. Marcella’s ending basis is calculated as follows: $0 beginning basis + $30,000 (50% $60,000) income + $1,500 (50% $3,000) tax-exempt income – $10,000 distribution + $12,000 share of liabilities.

PTS: 1 REF: Figure 21-3 | Example 31

Partnerships 21-15

10. In the current year, the DOE Partnership received revenues of $100,000 and paid the following amounts: $20,000 in rent and utilities, a $30,000 guaranteed payment to 50% partner Don, $6,000 to partner Eugene for consulting services, and $10,000 as a distribution to partner Olivia. In addition, the partnership earned $4,000 of qualifying dividend income during the year. Don’s basis in his partnership interest was $35,000 at the beginning of the year, and includes a $10,000 share of partnership liabilities. At the end of the year, his share of partnership liabilities was $20,000. How much income must Don report for the tax year, and what is his basis in his partnership interest at the end of the year?a. $25,000 ordinary income; $2,000 of qualifying dividends; $62,000 basis.b. $24,000 ordinary income; $30,000 guaranteed payment; $89,000 basis.c. $22,000 ordinary income; $2,000 of qualifying dividends; $30,000 guaranteed payment;

$69,000 basis.d. $17,000 ordinary income; $2,000 of qualifying dividends; $30,000 guaranteed payment;

$84,000 basis.e. None of the above.

ANS: CThe partnership’s ordinary income is calculated as follows:

Revenues $100,000 Less: rent and utilities (20,000)Less: guaranteed payment to Don (30,000)Less: consulting expenses to Eugene (6,000)Ordinary income $ 44,000

The distribution to Olivia is not deductible. The payment to Eugene is a deductible business expense. Don’s share of DOE’s ordinary income is $22,000. The $4,000 of dividend income is a separately stated item, of which Don’s share is $2,000. In addition, Don must report the $30,000 guaranteed payment as income.

Don’s basis in his partnership interest is calculated as follows:

Beginning basis $35,000Plus: increase in share of partnership liabilities 10,000Plus: share of ordinary income 22,000Plus: share of qualifying dividend income 2,000Ending basis $69,000

Don’s guaranteed payment does not affect his basis.

PTS: 1 REF: Example 20 | Example 31 | Example 41


11. Sharon and Sara are equal partners in the S&S Partnership. On January 1 of the current year, each partner’s adjusted basis in S&S was $50,000 (including each partner’s $15,000 share of the partnership’s $30,000 of liabilities). During the current year, S&S repaid the beginning liabilities and borrowed $20,000 for which Sharon and Sara are equally liable. In the current year ended December 31, S&S also sustained a net operating loss of $25,000 and earned $5,000 of interest and qualified dividend income from investments. If liabilities are shared equally by the partners, on January 1 of the next year each partner’s basis in her interest in S&S is:a. $35,000.b. $40,000.c. $45,000.d. $47,500.e. None of the above.

ANS: AEach partner’s initial basis in the partnership is $50,000. The basis is reduced by the $15,000 of repaid debt and increased by each partner’s $10,000 share of new liabilities. Each partner’s basis is then reduced by the $12,500 share of the net operating loss and increased by the $2,500 share of qualified dividends.


12. Fern, Inc., Ivy Inc., and Jason formed a general partnership, each contributing equally. Fern, Inc. files its tax return on a July 1 - June 30 fiscal year; Ivy Inc. files on a September 1 - August 31 fiscal year; and Jason is a calendar year taxpayer. Which of the following statements is true regarding the taxable year the partnership can choose?a. The partnership must choose the calendar year since it has no principal partners.b. The partnership can choose the taxable year of any of its “principal partners” without

obtaining IRS permission.c. The partnership can choose a January 31 fiscal year without obtaining IRS permission, if

the partnership can prove that the January 31 fiscal year will reduce the cost of preparing the partnership tax return.

d. The partnership can choose the taxable year that provides for the “least aggregate deferral” without obtaining IRS permission.

e. None of the above

ANS: DThe partnership chooses the taxable year that provides for the least amount of aggregate deferral. Because the partnership does not have any majority partners and since the principal partners do not all have the same taxable year, the least aggregate deferral rule determines the partnership "required" taxable year. The partnership may be able to obtain IRS permission to adopt a different taxable year if it can demonstrate to the IRS that it has a substantial business purpose for choosing that year. The partnership can also make an election under § 444 (not an option choice in this problem).

PTS: 1 REF: Figure 21-2

Partnerships 21-17

13. In the current year, Greg formed an equal partnership with Melvin. Greg contributed land with an adjusted basis of $90,000 and a fair market value of $150,000. Greg also contributed $75,000 cash to the partnership. Melvin contributed land with an adjusted basis of $100,000 and a fair market value of $200,000. The land contributed by Greg was encumbered by a $50,000 nonrecourse debt. The land contributed by Melvin was encumbered by $25,000 of nonrecourse debt. Assume the partners share debt equally. Immediately after the formation, the basis of Melvin’s partnership interest is:a. $0.b. $77,500.c. $112,500.d. $125,000.e. $137,000.

ANS: CMelvin’s basis is determined as follows:

Basis of land $100,000 Deemed cash distribution (relief of Melvin’s debt) (25,000)Share of Melvin’s debt 12,500 Share of Greg’s debt 25,000Melvin’s basis $112,500


14. Richard made a contribution of property to the newly formed QRST Partnership. The property had a $30,000 adjusted basis to Richard and a $100,000 fair market value on the contribution date. The property was also encumbered by a $50,000 nonrecourse debt, which was transferred to the partnership on that date. Another partner, Sylvia, shares 1/3 of the partnership income, gain, loss, deduction, and credit. Under IRS regulations, Sylvia’s share of the nonrecourse debt for basis purposes is:a. $10,000.b. $30,000.c. $36,667.d. $40,000.e. $50,000.

ANS: AThe § 704(c) portion of the debt must first be allocated to the contributing partner, Richard. The § 704(c) portion of the nonrecourse debt that is allocated to Richard under this rule is $20,000 ($50,000 – $30,000). The rest of the nonrecourse debt is allocated in the manner that the partners share in the deductions that relate to the debt. Therefore, Sylvia shares in $10,000 ($30,000 1/3) of the remaining nonrecourse debt.



15. Jim and Marta created the JM Partnership by contributing $60,000 each. The $120,000 cash was used by the partnership to acquire a depreciable asset. The partnership agreement provides that the partners’ capital accounts will be maintained in accordance with Reg. § 1.704-1(b) (the “economic effect” Regulations) and that any partner with a deficit capital account will be required to restore that capital account when the partner’s interest is liquidated. The partnership agreement provides that MACRS will be allocated 10% to Jim and 90% to Marta. All other items of partnership income, gain, loss, deduction, and credit will be allocated equally between the partners. If the first year MACRS is $20,000 and no other operating transactions occur, which of the following statements satisfies the economic effect test of the Regulations?a. If the property is sold at the end of the year for $100,000 and the partnership is liquidated

immediately thereafter, cash will be distributed $58,000 to Jim and $42,000 to Marta.b. Because each partner’s profit and loss sharing ratio is 50%, a sale of the property for

$108,000 at the end of the year, followed by an immediate liquidation of the partnership, will result in both partners receiving $54,000 cash.

c. MACRS cannot be allocated to the partners in a 90/10 ratio since Regulations require that the allocation of MACRS must follow the relative capital contributions of the partners. Therefore, MACRS must be allocated equally between Jim and Marta.

d. If the property is sold at the end of the first year for $120,000 and the partnership liquidated immediately thereafter, $60,000 cash would be distributed each to Jim and to Marta.

e. None of the above.

ANS: ADistributions upon liquidation must follow the capital accounts for each partner. After MACRS allocations, Jim will have a capital account balance of $58,000 ($60,000 – $2,000) and Marta’s capital account balance will be $42,000 ($60,000 – $18,000). If the asset is sold for its $100,000 carrying value on the partnership books, no gain or loss will be recognized on the sale and, therefore, no further adjustment needs to be made to the partner’s capital accounts. Upon liquidation, the partners will receive the balances in their capital accounts.


Partnerships 21-19

16. René is a partner in the RST Partnership, which is not publicly traded. Her allocable share of RST’s passive ordinary losses from a nonrealty activity for the current year is ($60,000). René has a $40,000 adjusted basis (outside basis) for her interest in RST (before deduction of any of the passive losses). Her amount “at risk” under § 465 is $30,000 (before deduction of any of the passive losses). She also has $25,000 of passive income from other sources. How much of her ($60,000) allocable loss can René deduct on her current year’s tax return?a. $25,000.b. $30,000.c. $40,000.d. $60,000.e. None of the above.

ANS: AThe $60,000 passive loss must be limited first by René’s $40,000 outside basis for her partnership interest. The “at risk” rules further limit her deduction to $30,000, the amount she is “at risk” in RST. She can deduct $25,000 of this loss because that is the amount she has of passive income from other sources.


17. George and Helen do business as the GH Partnership, sharing profits and losses equally. George is a material participant in the partnership, and the partnership has no outstanding debt. All parties use the calendar year for tax purposes. On January 1 of the current year, George’s basis and at-risk amount in the partnership was $25,000; he made no withdrawals from the partnership during the year. George has no passive income from other sources. If the partnership sustained an operating loss of $90,000 in the current year, George’s personal income tax return should include:a. An ordinary loss of $45,000.b. An ordinary loss of $25,000.c. An ordinary loss of $25,000 and a capital loss of $20,000.d. No income or loss from GH.e. None of the above.

ANS: BSection 704(d) limits the deduction of a partner’s distributive share of partnership losses to the adjusted basis of the partner’s interest at the end of the partnership year in which the losses were incurred, before considering any losses. George is entitled to carry forward and deduct any excess losses against his end-of-the-year basis occurring in subsequent years. Since George is a material participant in the partnership, § 469 does not limit the deductibility of the losses.

PTS: 1 REF: p. 21-31 to 21-34


18. Meagan is a 40% general partner in the calendar year, cash basis MKK Partnership. The partnership received $100,000 income from services and paid the following other amounts:

Rent expense $10,000Salary expense to employees 30,000Payment to Meagan for services, per the partnership agreement 20,000Distributions to partners, Kristin and Kaylyn 12,000Payment to 40% cash basis partner Kaylyn for tax and accounting services 8,000

How much is Meagan’s adjusted gross income increased as a result of the above items?a. $8,000.b. $12,800.c. $32,000.d. $32,800.e. $40,800.

ANS: DThe $20,000 payment to Meagan is a guaranteed payment and is deductible by the partnership. The $8,000 payment to Kaylyn is deductible under § 707(a), since it was paid during the year. The distributions to Kristen and Kaylyn are not deductible by the partnership. The partnership’s ordinary income, then, is $32,000.

Income from services $100,000 Less: Rent expense $10,000 Salaries to employees 30,000 Guaranteed payment to Meagan 20,000 Payment to Kaylyn for services 8,000 (68,000)Partnership income $ 32,000

Of this $32,000 partnership income, 40%, or $12,800, is allocated to Meagan. She must also include the $20,000 guaranteed payment in her gross income this year, since she and the partnership use the same reporting period.


Partnerships 21-21

19. Rachel uses a June 30 fiscal year. She owns a 50% profit and loss interest in a calendar year partnership. For the 2007 calendar year, the partnership’s taxable income (after guaranteed payments) was $40,000, and for the 2008 calendar year it was $50,000. During the 2007 calendar year, the partnership paid Rachel a guaranteed payment of $100 per month. During the 2008 calendar year, it paid Rachel a guaranteed payment of $200 per month. Rachel must report the following total amount of income from the partnership for her June 30, 2008, tax year.a. $26,800.b. $26,200.c. $21,800.d. $21,200.e. None of the above.

ANS: DFor Rachel’s June 30, 2008, tax year, she reports gross income from the entity for the 2007 calendar year, because this partnership year ends within her 2008 tax year. § 706(a)

One-half of 2007 partnership taxable income $20,000Plus: Guaranteed payment of $100/mo. for 12 months 1,200Total income from partnership $21,200


20. In computing the ordinary income of a partnership, a deduction is generally allowed for:a. Guaranteed payments to partners.b. A standard deduction.c. Partners’ personal exemptions.d. The net operating loss deduction.e. All of the above can be deducted.

ANS: AGenerally, payments made to a partner for services are called guaranteed payments. The amount of such payments must be determined without any relationship to the profits of the partnership. Such payments generally are deductible by the partnership.

PTS: 1 REF: Example 40 to 42


21. Wendy receives a proportionate nonliquidating distribution from the WXY Partnership. The distribution consists of $75,000 cash and property with an adjusted basis to the partnership of $20,000 and a fair market value of $25,000. Immediately before the distribution, Wendy’s adjusted basis for her partnership interest is $90,000. Wendy’s basis in the noncash property received is:a. $0.b. $15,000.c. $20,000.d. $25,000.e. None of the above.

ANS: BWendy’s basis in the partnership interest is first reduced to $15,000 by the $75,000 cash distribution. Because this is a nonliquidating distribution, the basis in the noncash property is the lesser of $15,000 (remaining basis in the partnership interest) or the partnership’s $20,000 basis in the property. The basis in the property, therefore, is $15,000, and Wendy’s basis in the partnership interest is reduced to $0.


22. Carl receives a proportionate nonliquidating distribution when the basis of his partnership interest is $60,000. The distribution consists of $20,000 in cash and property with an adjusted basis to the partnership of $35,000 and a fair market value of $45,000. Carl’s basis in the noncash property and his remaining basis in the partnership interest are:a. $60,000; $0.b. $35,000; $0.c. $35,000; $5,000.d. $40,000; $0.e. None of the above.

ANS: CAfter reducing the basis of Carl’s partnership interest by the $20,000 cash received, his interest basis is $40,000 before considering the property distribution. The property takes the lesser of a substituted or carryover basis, or $35,000. Carl’s basis in the partnership interest is reduced to $5,000.


Partnerships 21-23

23. Martin is a partner in a continuing partnership. At the end of the current year, the partnership distributed to Martin in a proportionate, nonliquidating distribution cash of $20,000, inventory with a basis to the partnership of $6,000 and a fair market value of $12,000, and a parcel of land with a basis to the partnership of $20,000 and a fair market value of $15,000. Martin’s basis in the partnership interest was $100,000 before the distribution. What basis does Martin take in the inventory and land, and what is his basis in the partnership interest following the distribution?a. $6,000 basis in inventory; $15,000 basis in land; $59,000 basis in partnership.b. $6,000 basis in inventory; $20,000 basis in land; $54,000 basis in partnership.c. $12,000 basis in inventory; $15,000 basis in land; $53,000 basis in partnership.d. $12,000 basis in inventory; $20,000 basis in land; $48,000 basis in partnership.e. $12,000 basis in inventory; $68,000 basis in land; $0 basis in partnership.

ANS: BBasis of Martin’s interest $100,000 Less: Cash distribution (20,000)

Basis before property distributions $ 80,000 Less: Inventory distribution (6,000)*Less: Land distribution (20,000)*

Basis after property distributions $ 54,000

*Martin’s basis in the inventory and land equals the partnership’s basis in these properties. Whether the property is appreciated or depreciated does not matter.


24. Marty receives a proportionate nonliquidating distribution when the basis of her partnership interest is $50,000. The distribution consists of $60,000 cash and noninventory property (adjusted basis to the partnership of $20,000; fair market value of $23,000). How much gain or loss does Marty recognize, and what is her basis in the distributed property and in her partnership interest following the distribution?a. $0 gain or loss; $20,000 basis in property; $0 basis in partnership interest.b. $0 gain or loss; $23,000 basis in property; $2,000 basis in partnership interest.c. $10,000 capital gain; $0 basis in property; $0 basis in partnership interest.d. $10,000 capital gain; $20,000 basis in property; $0 basis in partnership interest.e. $10,000 ordinary income; $0 basis in property; $10,000 basis in partnership interest.

ANS: CBecause Marty received a cash distribution in excess of her basis in the partnership interest before the distribution, she must recognize a capital gain in the amount of that excess, or $10,000 ($60,000 distribution – $50,000 basis before distribution). Her basis in the property she received is limited to the amount of the basis in the partnership interest following the cash distribution, or $0. Her basis in the partnership interest following all distributions remains $0.



25. Linda’s basis in her partnership interest was $35,000, including her $40,000 share of partnership liabilities. The partnership decides to liquidate, and after repaying all liabilities, distributes all remaining assets proportionately to the partners. Linda receives $5,000 cash and accounts receivable with an $8,000 basis and fair market value to the partnership. What gain or loss does Linda recognize, and what is her basis in the accounts receivable?a. $0 gain; $8,000 basis.b. $10,000 gain; $0 basis.c. $22,000 loss; $0 basis.d. $10,000 gain; $8,000 basis.e. None of the above.

ANS: BThe partnership’s repayment of liabilities is treated as a cash distribution to Linda of $40,000. Combined with the $5,000 cash actually distributed, Linda is deemed to receive a cash distribution of $45,000, which exceeds her basis in her partnership interest by $10,000. Therefore, she must report a gain of $10,000. The accounts receivable will have a $0 substituted basis, since she has no remaining basis in her partnership interest to allocate to the receivables.


26. Beth has an outside basis of $60,000 in the BBDE Partnership as of December 31 of the current year. On that date the partnership liquidates and distributes to Beth a proportionate distribution of $20,000 cash and inventory with an inside basis to the partnership of $18,000 and a fair market value of $22,000. In addition, Beth receives a desk which has an inside basis and fair market value of $200 and $350, respectively. None of the distribution is for partnership goodwill. How much gain or loss will Beth recognize on the distribution, and what basis will she take in the desk?a. $21,800 loss; $200 basis.b. $21,650 loss; $350 basis.c. $0 loss; $200 basis.d. $0 loss; $22,000 basis.e. None of the above.

ANS: DThe cash and inventory are distributed first and take bases of $20,000 and $18,000, respectively. The partner cannot recognize a loss on the distribution because the desk is a § 1231 asset (depreciable property used in a trade or business). Only cash, inventory and receivables can be distributed if the partner is to recognize a loss. Therefore, the desk must take a substituted basis of $22,000 to the partner, which is the amount of the partner’s remaining outside basis when the desk is distributed.


Partnerships 21-25

27. Bill received $15,000 cash and a capital asset with a basis and fair market value of $35,000 in a proportionate liquidating distribution. His basis in his partnership interest was $65,000 prior to the distribution. How much gain or loss does Bill recognize, and what is his basis in the capital asset received in the distribution?a. $0 gain or loss; $35,000 basis.b. $15,000 loss; $35,000 basis.c. $15,000 gain; $35,000 basis.d. $15,000 gain; $50,000 basis.e. $0 gain or loss; $50,000 basis.

ANS: EBecause Bill has received property other than cash and unrealized receivables or inventory, no loss may be recognized on the liquidating distribution. The capital asset will take a substituted basis of $50,000, which was Bill’s remaining basis in his partnership interest after the cash distribution is considered.


28. Which of the following statements, if any, about an LLC is false?a. An LLC is usually taxed like a partnership.b. “Members” of an LLC generally have limited personal liability for debts of the LLC.c. “Members” of an LLC can participate in management of the LLC unless the member

agrees not to participate.d. An LLC can specially allocate income items, as long as the substantial economic effect

rules of § 704(b) are followed.e. None of the above statements is false.

ANS: EAll of these statements are true.

PTS: 1 REF: p. 21-47 | p. 21-48


MATCHING

Match each of the following statements with the terms below that provide the best definition.a. Organizational choice of many large accounting firms.b. Partner’s percentage allocation of current operating results.c. Might affect any two partners’ tax liabilities in different ways.d. Brokerage and registration fees incurred for promoting and marketing partnership

interests.e. Transfer of asset to partnership followed by immediate distribution of cash to partner.f. Must have at least one general partner.g. Theory treating the partner and partnership as separate economic units.h. Partner’s basis in partnership interest after tax-free contribution of asset to partnership.i. Partnership’s basis in asset after tax-free contribution of asset to partnership.j. Owners are “members.”k. Theory treating the partnership as a collection of taxpayers joined in an agency

relationship.l. Allows many unincorporated entities to select their Federal tax status.m. No correct match provided.

1. Limited partnership2. Check the box regulations3. Profits interest4. Limited liability partnership5. Aggregate concept6. Substituted7. Limited liability company8. Qualified nonrecourse debt9. Syndication costs10. Disguised sale11. Separately stated item12. Carryover13. Entity concept

1. ANS: F2. ANS: L3. ANS: B4. ANS: A5. ANS: K6. ANS: H7. ANS: J8. ANS: M9. ANS: D10. ANS: E11. ANS: C12. ANS: I13. ANS: G

Partnerships 21-27

Match each of the following statements with the terms below that provide the best definition.a. Operating expenses incurred after entity is formed but before it begins doing business.b. Each partner’s basis in the partnership.c. Tax accounting election made by partnership.d. Tax accounting calculation made by partnere. Tax accounting election made by partner.f. Designed to prevent excessive deferral of taxation of partnership income.g. Amount that may be received by partner for performance of services for the partnership.h. Adjusted basis of each partnership asset.i. Computation that determines the way recourse debt is shared.j. Will eventually be allocated to partner making tax-free property contribution to

partnership. k. Must be satisfied if a loss item is to be specially allocated to a partner.l. Justification for a tax year other than the required taxable year.m. No correct match is provided.

14. Organization costs15. Required taxable year16. Cost versus percentage depletion decision17. Inside basis18. Business purpose19. Start-up costs20. § 179 deduction21. Economic effect test22. Precontribution gain23. Domestic production activities deduction24. Outside basis25. Guaranteed payment26. Constructive liquidation scenario

14. ANS: M15. ANS: F16. ANS: E17. ANS: H18. ANS: L19. ANS: A20. ANS: C21. ANS: K22. ANS: J23. ANS: D24. ANS: B25. ANS: G26. ANS: I


ESSAY

1. The MOG Partnership reports ordinary income of $60,000, long-term capital gain of $12,000, and tax-exempt income of $12,000. The partnership agreement provides that Molly will receive all long-term capital gains and George will receive all tax-exempt interest income. Their allocation of ordinary income will be reduced accordingly, and Olivia will be allocated a proportionately greater share of ordinary income. (In other words, each partner will receive allocations totaling 1/3 of the total $84,000 of partnership income.) This allocation was agreed upon because Molly and George are in a high marginal tax bracket and Olivia is in a low marginal tax bracket.

a. Describe the elements that must be included in a partnership agreement in order for an allocation to have "economic effect."

b. Discuss whether or not the MOG allocation would be permitted and provide your reasoning.

ANS:a. For partnership allocations to meet the “economic effect” tests under the § 704(b) Regulations,

a partnership agreement should provide that (1) capital accounts will be maintained, (2) liquidating proceeds will be distributed according to capital account balances, and (3) any partner with a deficit capital account balance will contribute cash to the partnership to eliminate the deficit.

b. The MOG allocation will not be permitted. Though the partnership agreement may meet the “economic effect” tests under § 704, the allocation does not produce pre-tax economic consequences to Molly and George. Therefore, the allocations are not effective for tax purposes as they have no function other than the reduction of the partners’ combined tax liability.

PTS: 1 REF: p. 21-7 | p. 21-23 | p. 21-24 | Example 5 | Example 6

2. Harry and Sally are considering forming a partnership. Both taxpayers use the calendar year and are cash basis taxpayers. The partnership will not be a tax shelter. The partners are uncertain as to whether the partnership should use the cash or accrual method of accounting. Also, the idea of a tax deferral in the first year of operations has led them to consider using a June 30 fiscal year-end for the partnership.

As their tax adviser, identify the issues that must be considered in selecting an accounting method and tax year for the partnership.

ANS:Since neither partner is a Subchapter C corporation and the partnership is not a tax shelter, the partnership may select any accounting method: cash, accrual, or a hybrid of the two methods.

If the partnership uses the accrual method of accounting in determining its income, the partners will be taxed on partnership revenues from all “closed” transactions. In this regard, it does not matter whether cash has been received by the partnership and whether or not the partners use the accrual method on their individual tax returns. Thus, if the partnership adopts the accrual method for tax purposes, the partners may be faced with reporting and paying taxes on partnership income long before cash is available for distribution.

Partnerships 21-29

Regarding the July 1 to June 30 fiscal year, the desired tax deferral has little chance of success. Under § 706(b), the partnership must use the calendar year unless Harry and Sally can convince the IRS that a business purposes exists for a tax year other than the calendar year. Nothing in the fact pattern indicates a valid business purpose exists for a fiscal year. The partnership may also elect to use a tax year other than the required tax year if the deferral period is three months or less (e.g., October or November year-end), and if the partnership agrees to deposit tax on the deferred income at a specified tax rate. This election cannot be used in this situation to obtain a July 1 to June 30 fiscal year.

PTS: 1 REF: p. 21-17 to 21-18

3. Your client has operated a sole proprietorship for several years, and is now interested in raising capital for expansion. He is considering forming either a C corporation or an LLC.

a. Describe the treatment of an LLC and discuss any advantages the LLC offers over the C corporation.

b. Assume instead the client has previously operated as a C corporation. Describe the tax consequences of converting to an LLC.

ANS:a. The limited liability company (LLC) generally provides for Federal taxation under

Subchapter K (partnership taxation) and limited liability for all owners. Therefore, it provides for the same protection from personal liability as a C corporation while providing for taxation of LLC operations at the owner level. The C corporation tax does not apply to an LLC. Partnership provisions such as optional adjustments to basis, special allocations of income, gain, loss, deduction and credit, and inclusion of all LLC liabilities in outside basis are additional advantages of an LLC over a C corporation.

b. An existing C corporation should carefully weigh the consequences before converting to an LLC. The IRS has ruled that a C corporation must liquidate and re-form as an LLC. When a C corporation liquidates, any appreciation in corporate assets triggers a corporate level gain. This results in immediate double taxation of the gain (at the corporate level, then as a shareholder gain or loss on liquidation of the entity). A partnership, on the other hand, does not liquidate when it converts to an LLC, and any appreciation in partnership assets remains untaxed.

PTS: 1 REF: p. 21-47 | p. 21-48

federal taxation ii chapter 21 review questions

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