IRS Audit Guide Intro to Sec. 704(b) confirms flexibility of partnerships

Transcription

1 7-1 Determining the Partners Distributive Shares Chapter 7 1 IRS Audit Guide Intro to Sec. 704(b) confirms flexibility of partnerships 2

2 S Shareholders report pro-rata share of S corp. income. Partners report distributive share of partnership income. 3 First 7-4 Distributive share is determined by the partnership agreement 4

3 7-4 The partnership agreement is broadly defined. 5 To be respected, allocations, in the partnership agreement must have substantial economic effect (SEE test). If no agreement, or no SEE, then, the items are allocated in accordance with the partner s interest in the partnership (PIP Test) 6

4 PIP Test The partners' interests are determined by taking into account all facts and circumstances relating to the economic arrangement of the partners Holdner -- PIP Test Rebuttable presumption: partners are presumed to have equal per capita interests in the partnership

5 Substantial Economic Effect Determining substantial economic effect involves a two-part analysis: 1) The allocation must have economic effect within the meaning of Reg (b)(2)(ii). 2) Second, the economic effect of the allocation must be substantial within the meaning of Reg (b)(2)(iii) Primary Test 10

6 The Primary Economic Effect Test Three Parts The partnership agreement provides that: 1) Capital accounts be determined and maintained according to the rules of (b)(2)(iv); 7-6 2) Upon liquidation of a partner s interest, liquidating distributions are made in accordance with the partners positive capital account balances; and 11 The Primary Economic Effect Test 7-7 3)The partner must be unconditionally obligated to restore the deficit balance in the partner s capital account following the liquidation of the partner s partnership interest. 12

7 Capital Accounts ( Book ) Same as tax basis except for: 7-7 FMV of contributed property FMV of distributed property (deemed sale) 13 Contributions of property or services for a partnership interest. 7-7 Optional Revaluation of All Capital Accounts for All Property Distributions in consideration for a partnership interest. 14

8 7-7 GAAP mark to market rules when substantially all of the partnership property is stock, securities, commodities, readibly tradable on an established securities market. 15 Retroactive Allocations Are OK A partnership agreement includes any modifications made prior to, or at, the time prescribed for filing a partnership return (not including extensions) (IRC Sec. 761(c))

9 Example Primary Test Met 17 Example Primary Test Met 7-8 Building 1,000,000 Recourse Debt 900,000 Cap. Hal 50,000 Cap. Larry 50,000 Assets 1,000,000 Liabilities & Capital 1,000,000 18

10 The partnership agreement includes the three requirements for primary economic effect. 19 The SEE test is met. The $50,000 of depreciation to Hal in Years 1 and 2 has substantial economic effect. 20

11 End of Year 2 Building 900,000 Recourse Debt 900,000 Cap. Hal (50,000) Cap. Larry 50,000 Assets 900,000 Liabilities & Capital 900, Hal, by agreement and as a general partner, is required to restore the <$50,000> negative amount in his capital account at the end of Year 1. 22

12 Scenario A and B merely prove that the disproportionate allocation of depreciation to Hal has economic effect 23 Scenario A. Building purchased for $1,000,000. For two years, depreciation of <$50,000> to Hal. Sale for $1,100,000. Capital Hal Capital Larry Beginning (50,000) 50,000 Allocated Gain 100, ,000 Totals 50, ,000 24

13 If liquidated, Hal would receive $50,000 and Larry $100, What if Hal were allocated gain to the extent of prior cost recovery deductions? Capital Hal Capital Larry Beginning (50,000) 50,000 Allocated Gain 150,000 50,000 Totals 100, ,000 26

14 Scenario B. Sale for $800,000 following two years of <$50,000> losses all allocated to Hal. Capital Hal Capital Larry Beginning (50,000) 50,000 Allocated Loss (50,000) (50,000) Totals (100,000) 0 27 Example Primary Test Failed Same facts as 7-1 except Hal, who is allocated all $50K per year depreciation, is a limited partner. The primary test is failed no deficit restoration obligation. 28

15 Note: If the entity were an LLC (no partner liability), then absent a guarantee of the debt, the debt would be nonrecourse debt. No LLC member has a capital account deficit restoration obligation Alternate Economic Effect Test (useful for LPs and LLC members) 30

16 Alternate Economic Effect Test If no unlimited DRO, the allocation still has econonic effect if: 1) the loss is charged to the properly maintained capital account; and 2) the loss does not reduce the capital account below zero or in excess of a limited DRO 31 Ex. 7-2 Continued. LP Hal s capital account at the end of Year 1 Building 950,000 Recourse Debt 900,000 Cap. Hal 0 Cap. Larry 50,000 Assets 950,000 Liabilities & Capital 950,000 So in Year 1, the allocation of all $50,000 of depreciation to LP Hal has SEE under the alternate test. 32

17 Alternate Test 7-11 The partnership agreement must contain a qualified income offset. 33 Qualified Income Offset A qualified income offset 7-11 requires that, in the event of any unexpected event creating a capital account deficit, that an allocation of income and gain to the distributee must be made to eliminate the resulting capital account deficit as quickly as possible. 34

18 Year 2 allocation of 100% of $50,000 depreciation to LP Hal fails both the primary and alternate tests. Building 900,000 Recourse Debt 900,000 Cap. LP Hal 0 Cap. GP Larry Assets 900,000 Liabilities & 900,000 Capital Year 2 allocation per the PIP test--all $50K dep. to GP Larry and all to GP Larry in all future years Example 7-3 On Formation: A (GP) contributes $40,000 B (GP) contributes $40,000 No deficit restoration obligation (DRO) Allocation: odepreciation: 100% to A oeverything else: 50/50 Liquidation proceeds divided 50/50 Partnership purchases building odepreciation of $20,000 per year 36

19 Assets: Example 7-3 Beginning Balance Sheet: Tax and Book Basis Real Property $80,000 Total Assets $80,000 Liabilities: Bank Loan $0 Capital: A $40,000 $40,000 B $40,000 $40,000 Debt + Equity $80,000 Partner s Outside Basis 37 End of Year 1 Per Agreement: Tax and Book Basis Assets: Real Property $60,000 Total Assets $60,000 Liabilities: Bank Loan $0 Capital: A $20,000 $20,000 B $40,000 $40,000 Debt + Equity $60,000 Partner s Outside Basis 38

20 Conclusion In the hypothetical liquidation, at book basis, the proceeds are split 50/50: $30,000 to A $30,000 to B Therefore, the depreciation must be reallocated equally under the PIP Test. 39 End of Year 1 After Reallocation for Economic Effect: Tax and Book Basis Assets: Real Property $60,000 Total Assets $60,000 Liabilities: Bank Loan $0 Capital: A $30,000 $30,000 B $30,000 $30,000 Debt + Equity $60,000 Partner s Outside Basis 40

21 Example 7-4 Alternate EE On Formation: 7-7 A contributes $40,000 B contributes $40,000 No deficit restoration obligation (DRO) but a qualified income offset Allocation: odepreciation: 100% to A oeverything else: 50/50 Liquidation per positive capital account Depreciation of $20,000 per year 41 Assets: Example 7-4 Beginning Balance Sheet: Tax and Book Basis Real Property $80,000 Total Assets $80,000 Liabilities: Bank Loan $0 Capital: A $40,000 $40,000 B $40,000 $40,000 Debt + Equity $80,000 Partner s Outside Basis 42

22 End of Year 1 Per Agreement: Tax and Book Basis Assets: Partner s Outside Basis Real Property $60,000 Total Assets $60,000 Liabilities: Bank Loan $0 Capital: A $20,000 $20,000 (40,000 20,000 B $40,000 $40,000 Debt + Equity $60, The allocation of all $20,000 of depreciation to A meets the alternate economic effect test. 44

23 Example 7-5 Facts are the same as Example 7-4 but $20,000 Yr. 1 Depr. $25,000 Yr. 2 Depr. 45 Assets: Example 7-5 End of Year 1 Per Agreement: Tax and Book Basis Partner s Outside Basis Real Property $60,000 Total Assets $60,000 Liabilities: Bank Loan $0 Capital: A $20,000 $20,000 (40,000 20,000) B $40,000 $40,000 Debt + Equity $60,000 46

24 End of Year 2 Per Agreement: Tax and Book Basis Assets: Partner s Outside Basis Real Property $35,000 Total Assets $35,000 Liabilities: Bank Loan $0 Capital: A <$5,000> $0 ($20,000-25,000) B $40,000 $40,000 Debt + Equity $35, Year 2: Only $20,000 of Deprec. To A meets Alternate Test: Tax and Book Basis Assets: Partner s Outside Basis Real Property $35,000 Total Assets $35,000 Liabilities: Bank Loan $0 Capital: A $0 $0 ($20,000-20,000) B $35,000 $35,000 ($40,000 5,000) Debt + Equity $35,000 48

25 Example 7-6 Same as Example 7-5 but $20,000 of depreciation in Year 2. Also, a sale for $35,000 (adjusted basis $40,000) at the beginning of year 3, triggers <$5,000> loss divided 50/50 per the partnership agreement. 49 Example 7-6 A Capital B Capital Beginning $40,000 $40,000 Yr. 1 Loss (20,000) 0 Yr. 2 Loss (20,000) 0 Balance $0 $40,000 Yr. 3 Sale Loss ($5,000) Balance $0 $35,000 50

26 Example 7-7 Facts are the same as Example 7-5 but an unlimited DRO. $20,000 Yr. 1 Depr. $25,000 Yr. 2 Depr. 51 Assets: Example 7-7 End of Year 2 Per Agreement and Meets Primary Test: Tax and Book Basis Partner s Outside Basis Real Property $35,000 Total Assets $35,000 Liabilities: Bank Loan $0 Capital: A <$5,000> $0 ($20,000-25,000) B $40,000 $40,000 Debt + Equity $35,000 52

27 Conclusion The allocation of all $25,000 of depreciation to A, in Year 2, meets the primary economic effect test. In a hypothetical liquidation of the assets for $35,000, A would be required to pay $5,000 to B. 53 Example 7-8 Value = Basis Same facts as Example 7-5 but $20,000 Yr. 1 Depr. $20,000 Yr. 2 Depr. and a $5,000 distribution to A is expected in year 3. 54

28 Year 2 If All Depr. To A A Capital B Capital Yr. 2 Beg. $20,000 $40,000 Yr. 2 Expected Distribution (5,000) ($5,000) Yr. 2 Loss (20,000) 0 Balance ($5,000) $35, Value = Book Basis Even if the FMV of the property is $100,000, it is deemed to be worth its book basis of $40,000 (so zero gain on the anticipated sale). 56

29 Example 7-8 In Year 2, A can only be allocated $15,000 of depreciation because the $5,000 expected distribution reduces A s capital to zero. 57 Year 2 Correct Allocation A Capital B Capital Yr. 2 Beg. $20,000 $40,000 Yr. 2 Expected Distribution (5,000) ($5,000) Yr. 2 Loss (15,000) ($5,000) Balance $0 $30,000 58

30 Rev Rul The concepts in the ruling apply to a guarantee of debt by an LLC member or limited partner guarantee of limited partnership debt. 59 Ex. 7-9 On Formation: ogp contributes $100,000 olp contributes $100, Liquidate per positive capital account balances, but the GP has a DRO to creditors only (like an LLC member guarantor). The agreement contains a qualified income offset. 60

31 Ex. 7-9 Borrow $800,000 and purchase building for $1 Mil. o$200,000 of depreciation per year. Allocation: o Depreciation: 100% to GP o Gain to GP to the extent of depreciation. o Everything else: 50/50 61 Ex. 7-9 Think of GP as an LLC member who has guaranteed LLC debt that is otherwise nonrecourse debt. 62

32 Beginning Balance Sheet: Tax and Book Basis Assets: Partner s Outside Basis Real Property $1,000,000 Total Assets $1,000,000 Liabilities: Bank Loan $800,000 Capital: GP $100,000 $900,000 ($100, ,000) LP $100,000 $100,000 Debt + Equity $1,000, Can GP be allocated all $200,000 of the depreciation for Year 1? 64

33 End of Year 1 Per Agreement:: Tax and Book Basis Assets: Partner s Outside Basis Real Property $800,000 Total Assets $800,000 Liabilities: Bank Loan $800,000 Capital: GP <$100,000> $700,000 ($100, , ,000) LP $100,000 $100,000 Debt + Equity $800, Rev. Rule holding -- GP has no DRO at the end of Year 1 because the $800K debt does not exceed the $800K book basis (presumed FMV) of the property. Only $100,000 of the $200,000 of depreciation can be allocated to GP in Year 1. 66

34 Assets: Yr. 1 Conclusion Reallocate Depreciation 50/50in Year 1: Tax and Book Basis Partner s Outside Basis Real Property $800,000 Total Assets $800,000 Liabilities: Bank Loan $800,000 Capital: GP $0 $800,000 ($100, , ,000) LP $0 $0 ($100,000 - $100,000) Debt + Equity $800, Year 2? 68

35 Yr. 2 Conclusion GP has a $200,000 DRO at the end of Year 2 because the debt exceeds the book basis of the property by $200,000. All $200,000 of the $200,000 of depreciation can be allocated to GP in Year End of Year 2: GP Limited DRO of $200,000 Tax and Book Basis Assets: 7-18 Partner s Outside Basis Real Property $600,000 Total Assets $600,000 Liabilities: Bank Loan $800,000 Capital: GP <$200,000> $600,000 ($100,000 $800, ,000) LP $0 $0 Debt + Equity $600,000 70

36 Assets: 7-18 Partner s Outside Basis End of Year 5: GP Limited DRO of $800,000 Tax and Book Basis Real Property $0 Total Assets $0 Liabilities: Bank Loan $800,000 Capital: GP <$800,000> $0 ($600, ,000) LP $0 $0 Debt + Equity $0 71 Value = Book Basis The above results would be the same even if GP were confident that the potential gain on the sale of the property in any year would be sufficient to offset all of the depreciation. 72

37 7-19 Economic Effect Equivalence 73 Example 7-2 (Hal is LP) Assume no qualified income offset. The primary and alternate tests are flunked. Hal s Year 1 depreciation allocation meets the economic effect equivalence Dumb-but Lucky Test 74

38 Hal s capital account at the end of Year 1 Building 950,000 Recourse Debt 900,000 Cap. Hal 0 Cap. Larry 50,000 Assets 950,000 Liabilities & Capital 950, Substantiality 76

39 Substantiality The economic effect of the special allocation must be substantial. This requires a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Reg. Sec (b)(2)(iii)(a). 77 Shifting Allocations Capital account allocations equalize in the same tax year and the partners pay less income tax 78

40 Example 7-11 Shifting Allocation Partner A, a 25% partner, has $250,000 of unused capital loss carryovers. Partner B, a 75% partner, does not have any capital loss carryovers. The partnership earns ordinary operating income of $750,000 and a short-term capital gain of $250, If the partnership allocates only the $250,000 of STCG all to Partner A, that allocation has economic effect but it is NOT substantial. (It is shifting ). 79 Example 7-12 Shifting Allocation Assume the COD income constitutes 25% of partnership income in 2010 and Partner A, a 25% partner, is the only partner who is bankrupt or insolvent. An allocation of only the DDI to Partner A in 2010 has economic effect but it is not substantial. Compare Rev Rul in Chapter 11 80

41 Example Shifting Allocation Allocate W-2 wages to Partner A who is the only partner with Sec 199 DPGR and an offsetting amount of other expenses to the other partners. This allocation has economic effect, but it fails the substantiality test because it does not affect adversely any partner, yet it benefits the one partner with DPGR (by virtue of the increased Sec 199 deduction) after taxes. 81 Example 7-13 Shifting Allocation M, high bracket, wants the tax-exempt muni bond interest. D, with a large NOL, is OK with the ordinary income. The partnership agreement allocates all income from interest in the municipal bonds to M and an equal amount of income form DM s business operations to D. The remaining income from business operations is shared equally. 82

42 Example 7-13 Say the partnership has $100,000 of income: $30,000 Muni Bond Inc. $70,000 Operating Inc. 83 Example 7-13 Agreed Allocation M D Muni Bond Inc $30,000 Operating Inc. $30,000 Operating Inc. $20,000 $20,000 Totals $50,000 $50,000 84

43 Example 7-13 Substantial M D Muni Bond Inc $15,000 $15,000 Operating Inc. $35,000 $35,000 Totals $50,000 $50, Value Equals Basis Rule

44 Gain Chargeback 7-23 Assume that general partner Hal (in Ex. 7-1) is entitled to a gain allocation to the extent of his prior depreciation. Therefore, if, at the end of Year 2, the building is sold for $1,000,000, the entire $100,000 gain ($1,000,000 - $900,000) is allocated to Hal. 87 End of Year 2 GP Hal has an unlimited DRO Building 900,000 Recourse Debt 900,000 Cap. Hal (50,000) Cap. Larry 50,000 Assets 900,000 Liabilities & Capital 900,000 88

45 IRS Argument? Can IRS argue that because the building is in fact appreciated (assume an appraisal shows appreciation), that the depreciation allocation to Hal lacks substantiality? NO 89 Value Equals Basis Rule FMV is presumed to equal adjusted book basis

46 Protects Special Allocations of Depreciation from Failing the Substantiality Test Transitory 7-21 A special allocation with a strong likelihood that capital accounts will equalize within the next 5 years and the partners pay less income tax 92

47 Example Five Year Rule Not transitory if no strong likelihood of offset within 5 years 94

48 Example