SELECTED PARTNERSHIP & LLC TAX PROBLEMS

Transcription

1 SELECTED PARTNERSHIP & LLC TAX PROBLEMS All Rights Reserved Handouts pages. Slides begin on page 50. If printing for the purpose of taking notes, print only through slide 379 (page 320). Mark A. Vogel Tax Education Services Denver, Colorado

2 SELECTED PARTNERSHIP & LLC TAX PROBLEMS Administrative Matters 1. Schedule: a. Lunch Break in four hours, for one hour (12:30 1:30 p.m. Mountain Time) 2. Reference Materials: a. Download (within three days from your Personal Page): 1) Handouts file contains the PowerPoint presentation 3. Questions for the Instructor: a. LIVE Questions During the Seminar: 1) Voice: ) Typewritten: a) Click: On next to Live Course Link on your Personal Page b) Click: On the Speech Bubble in the bottom right corner of the seminar viewing screen b. Post-Seminar Questions: 1) OR 4. Computer Problems: a. Call the Office: VOGEL.SEM/SP&LPROB.18

3 SELECTED PARTNERSHIP & LLC TAX PROBLEMS Course Objectives 1. Formation a. Balance sheet b. Tax & book capital account c. Recourse & nonrecourse debt d. Rewarding a service person with an interest in the entity 2. Operations a. Filing Form 1065 b. Basis and at-risk for losses c. Maximum amount of loss that is deductible d. Discussion of special allocations and substantial economic effect e. Disguised sales (c) Issues, including a Reverse 704(c) Allocation 4. SE Problems 5. Transactions Between a Member and the LLC 6. Deduction under 199A of 20% of qualified business income (QBI) 7. Termination Issues 8. Sale of Interest a. With and without a 754 election 9. Payments to a Retiring Member for that Member s Interest in Unrealized Receivables and Goodwill VOGEL.SEM/SP&LPROB.18

4 Form 1065 Department of the Treasury Internal Revenue Service A Principal business activity U.S. Return of Partnership Income For calendar year 2017, or tax year beginning, 2017, ending, 20. Go to for instructions and the latest information. Name of partnership OMB No D Employer identification number B Principal product or service C Business code number Type or Print Number, street, and room or suite no. If a P.O. box, see the instructions. City or town, state or province, country, and ZIP or foreign postal code E Date business started F Total assets (see the instructions) $ G Check applicable boxes: (1) Initial return (2) Final return (3) Name change (4) Address change (5) Amended return (6) Technical termination - also check (1) or (2) H Check accounting method: (1) Cash (2) Accrual (3) Other (specify) I Number of Schedules K-1. Attach one for each person who was a partner at any time during the tax year J Check if Schedules C and M-3 are attached Caution. Include only trade or business income and expenses on lines 1a through 22 below. See the instructions for more information. Income Deductions (see the instructions for limitations) Sign Here 1a Gross receipts or sales a b Returns and allowances b c Balance. Subtract line 1b from line 1a c 2 Cost of goods sold (attach Form 1125-A) Gross profit. Subtract line 2 from line 1c Ordinary income (loss) from other partnerships, estates, and trusts (attach statement) Net farm profit (loss) (attach Schedule F (Form 1040)) Net gain (loss) from Form 4797, Part II, line 17 (attach Form 4797) Other income (loss) (attach statement) Total income (loss). Combine lines 3 through Salaries and wages (other than to partners) (less employment credits) Guaranteed payments to partners Repairs and maintenance Bad debts Rent Taxes and licenses Interest a Depreciation (if required, attach Form 4562) a b Less depreciation reported on Form 1125-A and elsewhere on return 16b 16c 17 Depletion (Do not deduct oil and gas depletion.) Retirement plans, etc Employee benefit programs Other deductions (attach statement) Total deductions. Add the amounts shown in the far right column for lines 9 through Ordinary business income (loss). Subtract line 21 from line Paid Preparer Use Only Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than partner or limited liability company member) is based on all information of which preparer has any knowledge. May the IRS discuss this return with the preparer shown below (see instructions)? Yes No Signature of partner or limited liability company member Date Print/Type preparer s name Preparer s signature Date PTIN Check if self-employed Firm s name Firm s EIN Firm s address Phone no. For Paperwork Reduction Act Notice, see separate instructions. Cat. No Z Form 1065 (2017)

5 Form 1065 (2017) Page 2 Schedule B Other Information 1 What type of entity is filing this return? Check the applicable box: Yes No a Domestic general partnership b Domestic limited partnership c Domestic limited liability company d Domestic limited liability partnership e Foreign partnership f Other 2 At any time during the tax year, was any partner in the partnership a disregarded entity, a partnership (including an entity treated as a partnership), a trust, an S corporation, an estate (other than an estate of a deceased partner), or a nominee or similar person? At the end of the tax year: a Did any foreign or domestic corporation, partnership (including any entity treated as a partnership), trust, or taxexempt organization, or any foreign government own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital of the partnership? For rules of constructive ownership, see instructions. If Yes, attach Schedule B-1, Information on Partners Owning 50% or More of the Partnership b Did any individual or estate own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital of the partnership? For rules of constructive ownership, see instructions. If Yes, attach Schedule B-1, Information on Partners Owning 50% or More of the Partnership At the end of the tax year, did the partnership: a Own directly 20% or more, or own, directly or indirectly, 50% or more of the total voting power of all classes of stock entitled to vote of any foreign or domestic corporation? For rules of constructive ownership, see instructions. If Yes, complete (i) through (iv) below (i) Name of Corporation (ii) Employer Identification Number (if any) (iii) Country of Incorporation (iv) Percentage Owned in Voting Stock b Own directly an interest of 20% or more, or own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital in any foreign or domestic partnership (including an entity treated as a partnership) or in the beneficial interest of a trust? For rules of constructive ownership, see instructions. If Yes, complete (i) through (v) below.. (i) Name of Entity (ii) Employer Identification Number (if any) (iii) Type of Entity (iv) Country of Organization (v) Maximum Percentage Owned in Profit, Loss, or Capital 5 Did the partnership file Form 8893, Election of Partnership Level Tax Treatment, or an election statement under section 6231(a)(1)(B)(ii) for partnership-level tax treatment, that is in effect for this tax year? See Form 8893 for more details Does the partnership satisfy all four of the following conditions? a The partnership s total receipts for the tax year were less than $250,000. b The partnership s total assets at the end of the tax year were less than $1 million. c Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return. d The partnership is not filing and is not required to file Schedule M If Yes, the partnership is not required to complete Schedules L, M-1, and M-2; Item F on page 1 of Form 1065; or Item L on Schedule K-1. 7 Is this partnership a publicly traded partnership as defined in section 469(k)(2)? During the tax year, did the partnership have any debt that was cancelled, was forgiven, or had the terms modified so as to reduce the principal amount of the debt? Has this partnership filed, or is it required to file, Form 8918, Material Advisor Disclosure Statement, to provide information on any reportable transaction? At any time during calendar year 2017, did the partnership have an interest in or a signature or other authority over a financial account in a foreign country (such as a bank account, securities account, or other financial account)? See the instructions for exceptions and filing requirements for FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR). If Yes, enter the name of the foreign country. Yes No Form 1065 (2017)

6 Form 1065 (2017) Page 3 Schedule B Other Information (continued) 11 At any time during the tax year, did the partnership receive a distribution from, or was it the grantor of, or transferor to, a foreign trust? If Yes, the partnership may have to file Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. See instructions a Is the partnership making, or had it previously made (and not revoked), a section 754 election? See instructions for details regarding a section 754 election. b Did the partnership make for this tax year an optional basis adjustment under section 743(b) or 734(b)? If Yes, attach a statement showing the computation and allocation of the basis adjustment. See instructions.... c Is the partnership required to adjust the basis of partnership assets under section 743(b) or 734(b) because of a substantial built-in loss (as defined under section 743(d)) or substantial basis reduction (as defined under section 734(d))? If Yes, attach a statement showing the computation and allocation of the basis adjustment. See instructions 13 Check this box if, during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (other than disregarded entities wholly owned by the partnership throughout the tax year) At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property? If the partnership is required to file Form 8858, Information Return of U.S. Persons With Respect To Foreign Disregarded Entities, enter the number of Forms 8858 attached. See instructions 16 Does the partnership have any foreign partners? If Yes, enter the number of Forms 8805, Foreign Partner s Information Statement of Section 1446 Withholding Tax, filed for this partnership. 17 Enter the number of Forms 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, attached to this return. 18 a Did you make any payments in 2017 that would require you to file Form(s) 1099? See instructions..... b If Yes, did you or will you file required Form(s) 1099? Enter the number of Form(s) 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, attached to this return. 20 Enter the number of partners that are foreign governments under section During the partnership s tax year, did the partnership make any payments that would require it to file Form 1042 and 1042-S under chapter 3 (sections 1441 through 1464) or chapter 4 (sections 1471 through 1474)? Was the partnership a specified domestic entity required to file Form 8938 for the tax year (See the Instructions for Form 8938)? Designation of Tax Matters Partner (see instructions) Enter below the general partner or member-manager designated as the tax matters partner (TMP) for the tax year of this return: Yes No Name of designated TMP Identifying number of TMP If the TMP is an entity, name of TMP representative Phone number of TMP Address of designated TMP Form 1065 (2017)

7 Form 1065 (2017) Page 4 Schedule K Partners Distributive Share Items Total amount 1 Ordinary business income (loss) (page 1, line 22) Net rental real estate income (loss) (attach Form 8825) a Other gross rental income (loss) a b Expenses from other rental activities (attach statement) 3b c Other net rental income (loss). Subtract line 3b from line 3a c 4 Guaranteed payments Interest income Dividends: a Ordinary dividends a b Qualified dividends b 7 Royalties Net short-term capital gain (loss) (attach Schedule D (Form 1065)) a Net long-term capital gain (loss) (attach Schedule D (Form 1065)) a b Collectibles (28%) gain (loss) b c Unrecaptured section 1250 gain (attach statement).. 9c 10 Net section 1231 gain (loss) (attach Form 4797) Other income (loss) (see instructions) Type Section 179 deduction (attach Form 4562) a Contributions a b Investment interest expense b c Section 59(e)(2) expenditures: (1) Type (2) Amount 13c(2) d Other deductions (see instructions) Type 13d 14a Net earnings (loss) from self-employment a b Gross farming or fishing income b c Gross nonfarm income c Income (Loss) Deductions Self- Employment Credits Foreign Transactions Alternative Minimum Tax (AMT) Items Other Information 15a Low-income housing credit (section 42(j)(5)) a b Low-income housing credit (other) b c Qualified rehabilitation expenditures (rental real estate) (attach Form 3468, if applicable) 15c d Other rental real estate credits (see instructions) Type 15d e Other rental credits (see instructions) Type 15e f Other credits (see instructions) Type 15f 16a Name of country or U.S. possession b Gross income from all sources b c Gross income sourced at partner level c Foreign gross income sourced at partnership level d Passive category e General category f Other 16f Deductions allocated and apportioned at partner level g Interest expense h Other h Deductions allocated and apportioned at partnership level to foreign source income i Passive category j General category k Other 16k l Total foreign taxes (check one): Paid Accrued l m Reduction in taxes available for credit (attach statement) m n Other foreign tax information (attach statement) a Post-1986 depreciation adjustment a b Adjusted gain or loss b c Depletion (other than oil and gas) c d Oil, gas, and geothermal properties gross income d e Oil, gas, and geothermal properties deductions e f Other AMT items (attach statement) f 18a Tax-exempt interest income a b Other tax-exempt income b c Nondeductible expenses c 19a Distributions of cash and marketable securities a b Distributions of other property b 20a Investment income a b Investment expenses b c Other items and amounts (attach statement) Form 1065 (2017)

8 Form 1065 (2017) Page 5 Analysis of Net Income (Loss) 1 Net income (loss). Combine Schedule K, lines 1 through 11. From the result, subtract the sum of Schedule K, lines 12 through 13d, and 16l Analysis by partner type: (i) Corporate (ii) Individual (active) (iii) Individual (passive) (iv) Partnership (v) Exempt Organization (vi) Nominee/Other a General partners b Limited partners Schedule L Balance Sheets per Books Beginning of tax year End of tax year Assets (a) (b) (c) (d) 1 Cash a Trade notes and accounts receivable... b Less allowance for bad debts Inventories U.S. government obligations Tax-exempt securities Other current assets (attach statement).. 7a Loans to partners (or persons related to partners) b Mortgage and real estate loans Other investments (attach statement)... 9a Buildings and other depreciable assets.. b Less accumulated depreciation a Depletable assets b Less accumulated depletion Land (net of any amortization) a Intangible assets (amortizable only)... b Less accumulated amortization Other assets (attach statement) Total assets Liabilities and Capital 15 Accounts payable Mortgages, notes, bonds payable in less than 1 year 17 Other current liabilities (attach statement). 18 All nonrecourse loans a Loans from partners (or persons related to partners) b Mortgages, notes, bonds payable in 1 year or more 20 Other liabilities (attach statement) Partners capital accounts Total liabilities and capital Schedule M-1 Reconciliation of Income (Loss) per Books With Income (Loss) per Return Note. The partnership may be required to file Schedule M-3 (see instructions). 1 Net income (loss) per books Income included on Schedule K, lines 1, 2, 3c, 5, 6a, 7, 8, 9a, 10, and 11, not recorded on books this year (itemize): 3 Guaranteed payments (other than health insurance) Expenses recorded on books this year not included on Schedule K, lines 1 through 13d, and 16l (itemize): a Depreciation $ b Travel and entertainment $ 5 Add lines 1 through Schedule M-2 1 Balance at beginning of year... 2 Capital contributed: a Cash... b Property.. 3 Net income (loss) per books Other increases (itemize): 5 Add lines 1 through Analysis of Partners Capital Accounts 6 Income recorded on books this year not included on Schedule K, lines 1 through 11 (itemize): a Tax-exempt interest $ 7 Deductions included on Schedule K, lines 1 through 13d, and 16l, not charged against book income this year (itemize): a Depreciation $ 8 Add lines 6 and Income (loss) (Analysis of Net Income (Loss), line 1). Subtract line 8 from line 5. 6 Distributions: a Cash b Property Other decreases (itemize): 8 Add lines 6 and Balance at end of year. Subtract line 8 from line 5 Form 1065 (2017)

9 SCHEDULE D (Form 1065) Capital Gains and Losses Attach to Form 1065 or Form Use Form 8949 to list your transactions for lines 1b, 2, 3, 8b, 9, and 10. Go to for instructions and the latest information. Department DRAFT of the Treasury AS OF Internal Revenue Service Name of partnership OMB No Employer identification number Part I Short-Term Capital Gains and Losses (See instructions) August 3, 2018 DO NOT FILE See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars. 1a Totals for all short-term transactions reported on Form 1099-B for which basis was reported to the IRS and for which you have no adjustments (see instructions). However, if you choose to report all these transactions on Form 8949, leave this line blank and go to line 1b. 1b Totals for all transactions reported on Form(s) 8949 with Box A checked Totals for all transactions reported on Form(s) 8949 with Box B checked Totals for all transactions reported on Form(s) 8949 with Box C checked (d) Proceeds (sales price) (e) Cost (or other basis) (g) Adjustments to gain or loss from Form(s) 8949, Part I, line 2, column (g) (h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g) 4 Short-term capital gain from installment sales from Form 6252, line 26 or Short-term capital gain or (loss) from like-kind exchanges from Form Partnership s share of net short-term capital gain (loss), including specially allocated short-term capital gains (losses), from other partnerships, estates, and trusts Net short-term capital gain or (loss). Combine lines 1a through 6 in column (h). Enter here and on Form 1065, Schedule K, line 8 or 11; or Form 8865, Schedule K, line 8 or Part II Long-Term Capital Gains and Losses (See instructions) See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars. 8a Totals for all long-term transactions reported on Form 1099-B for which basis was reported to the IRS and for which you have no adjustments (see instructions). However, if you choose to report all these transactions on Form 8949, leave this line blank and go to line 8b. 8b Totals for all transactions reported on Form(s) 8949 with Box D checked Totals for all transactions reported on Form(s) 8949 with Box E checked Totals for all transactions reported on Form(s) 8949 with Box F checked (d) Proceeds (sales price) (e) Cost (or other basis) (g) Adjustments to gain or loss from Form(s) 8949, Part II, line 2, column (g) 11 Long-term capital gain from installment sales from Form 6252, line 26 or Long-term capital gain or (loss) from like-kind exchanges from Form Partnership s share of net long-term capital gain (loss), including specially allocated long-term capital gains (losses), from other partnerships, estates, and trusts Capital gain distributions (see instructions) Net long-term capital gain or (loss). Combine lines 8a through 14 in column (h). Enter here and on Form 1065, Schedule K, line 9a or 11; or Form 8865, Schedule K, line 9a or (h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g) For Paperwork Reduction Act Notice, see the Instructions for Form Cat. No G Schedule D (Form 1065) 2018

10 Schedule K-1 (Form 1065) 2018 Department of the Treasury Internal Revenue Service For calendar year 2018, or tax year Part III Final K-1 Amended K OMB No Partner s Share of Current Year Income, Deductions, Credits, and Other Items 1 Ordinary business income (loss) 15 Credits beginning / / 2018 ending / / Partner s Share of Income, Deductions, Credits, etc. See back of form and separate instructions. A Part I DRAFT AS OF Information About the Partnership Partnership s employer identification number 2 Net rental real estate income (loss) 3 Other net rental income (loss) 4 Guaranteed payments 5 Interest income 16 Foreign transactions B Partnership s name, July address, city, state, and ZIP code 30, a 6b Ordinary dividends Qualified dividends C D E IRS Center where partnership filed return DO NOT FILE Part II Check if this is a publicly traded partnership (PTP) Information About the Partner Partner s identifying number 6c Dividend equivalents 7 Royalties 8 Net short-term capital gain (loss) 9a Net long-term capital gain (loss) 17 Alternative minimum tax (AMT) items F Partner s name, address, city, state, and ZIP code 9b Collectibles (28%) gain (loss) 9c Unrecaptured section 1250 gain 18 Tax-exempt income and nondeductible expenses G General partner or LLC member-manager Limited partner or other LLC member H Domestic partner Foreign partner 10 Net section 1231 gain (loss) 11 Other income (loss) I1 I2 What type of entity is this partner? If this partner is a retirement plan (IRA/SEP/Keogh/etc.), check here 19 Distributions J Partner s share of profit, loss, and capital (see instructions): Beginning Ending Profit % % Loss % % Capital % % 12 Section 179 deduction 13 Other deductions 20 Other information K Partner s share of liabilities: Beginning Ending L M Nonrecourse.. $ $ Qualified nonrecourse financing... $ $ Recourse... $ $ Partner s capital account analysis: Beginning capital account... $ Capital contributed during the year $ Current year increase (decrease). $ Withdrawals & distributions.. $ ( ) Ending capital account.... $ Tax basis GAAP Section 704(b) book Other (explain) Did the partner contribute property with a built-in gain or loss? Yes No If Yes, attach statement (see instructions) 14 Self-employment earnings (loss) *See attached statement for additional information. For IRS Use Only For Paperwork Reduction Act Notice, see Instructions for Form Cat. No R Schedule K-1 (Form 1065) 2018

11 Schedule K-1 (Form 1065) 2018 Page 2 This list identifies the codes used on Schedule K-1 for all partners and provides summarized reporting information for partners who file Form For detailed reporting and filing information, see the separate Partner s Instructions for Schedule K-1 and the instructions for your income tax return. 1. Ordinary business income (loss). Determine whether the income (loss) is Code Report on passive or nonpassive and enter on your return as follows. J Work opportunity credit Report on K Disabled access credit Passive loss See the Partner s Instructions L Empowerment zone Passive income Schedule E, line 28, column (h) employment credit M Credit for increasing research Nonpassive loss See the Partner s Instructions activities See the Partner s Instructions Nonpassive income Schedule E, line 28, column (k) N Credit for employer social 2. Net rental real estate income (loss) See the Partner s Instructions security and Medicare taxes 3. Other net rental income (loss) O Backup withholding Net income Schedule E, line 28, column (h) P Other credits Net loss See the Partner s Instructions 16. Foreign transactions 4. Guaranteed payments Schedule E, line 28, column (k) A Name of country or U.S. } 5. Interest income Form 1040, line 2b possession 6a. Ordinary dividends Form 1040, line 3b B Gross income from all sources Form 1116, Part I 6b. Qualified dividends Form 1040, line 3a C Gross income sourced at 6c. Dividend equivalents See the Partner s Instructions partner level 7. Royalties Schedule E, line 4 Foreign gross income sourced at partnership level 8. Net short-term capital gain (loss) Schedule D, line 5 D Section 951A category 9a. Net long-term capital gain (loss) Schedule D, line 12 E Foreign branch category 9b. Collectibles (28%) gain (loss) 28% Rate Gain Worksheet, line 4 F Passive category }Form 1116, Part I (Schedule D instructions) G General category 9c. Unrecaptured section 1250 gain See the Partner s Instructions H Other 10. Net section 1231 gain (loss) See the Partner s Instructions 11. Other income (loss) Code DRAFT AS OF July 30, 2018 DO NOT FILE A Other portfolio income (loss) See the Partner s Instructions B Involuntary conversions See the Partner s Instructions C Sec contracts & straddles Form 6781, line 1 D Mining exploration costs recapture See Pub. 535 E Cancellation of debt Schedule 1 (Form 1040), line 21 or Form 982 } F Section 951A income G Section 965(a) inclusion H Subpart F income other than See the Partner s Instructions sections 951A and 965 inclusion I Other income (loss) 12. Section 179 deduction See the Partner s Instructions 13. Other deductions A Cash contributions (60%) B Cash contributions (30%) C Noncash contributions (60%) D Noncash contributions (30%) }See the Partner s E Capital gain property to a 50% Instructions organization (30%) F Capital gain property (20%) G Contributions (100%) H Investment interest expense Form 4952, line 1 I Deductions royalty income Schedule E, line 19 J Section 59(e)(2) expenditures See the Partner s Instructions K Excess business interest expense See the Partner s Instructions L Deductions portfolio (other) Schedule A, line 13 M Amounts paid for medical insurance Schedule A, line 1 or Schedule 1 (Form 1040), line 29 N Educational assistance benefits See the Partner s Instructions O Dependent care benefits Form 2441, line 12 P Preproductive period expenses See the Partner s Instructions Q Commercial revitalization deduction from rental real estate activities See Form 8582 instructions R Pensions and IRAs See the Partner s Instructions S Reforestation expense deduction See the Partner s Instructions T through V Reserved for future use W Other deductions See the Partner s Instructions X Section 965(c) deduction See the Partner s Instructions 14. Self-employment earnings (loss) Note: If you have a section 179 deduction or any partner-level deductions, see the Partner s Instructions before completing Schedule SE. A Net earnings (loss) from self-employment B Gross farming or fishing income C Gross non-farm income } 15. Credits A Low-income housing credit (section 42(j)(5)) from pre-2008 buildings B Low-income housing credit (other) from pre-2008 buildings C Low-income housing credit (section 42(j)(5)) from post-2007 buildings See D Low-income housing credit (other) from post-2007 buildings E Qualified rehabilitation expenditures (rental real estate) F Other rental real estate credits G Other rental credits H Undistributed capital gains credit I Biofuel producer credit Schedule SE, Section A or B See the Partner s Instructions See the Partner s Instructions the Partner s Instructions Schedule 5 (Form 1040), line 74, box a See the Partner s Instructions } Deductions allocated and apportioned at partner level I Interest expense Form 1116, Part I J Other Form 1116, Part I Deductions allocated and apportioned at partnership level to foreign source income K Section 951A category L Foreign branch category M Passive category }Form 1116, Part I N General category O Other Other information P Total foreign taxes paid Form 1116, Part II Q Total foreign taxes accrued Form 1116, Part II R Reduction in taxes available for credit Form 1116, line 12 S Foreign trading gross receipts Form 8873 T Extraterritorial income exclusion Form 8873 U Section 951A(c)(1)(A) tested income } V Tested foreign income tax W Section 965 information X Other foreign transactions See the Partner s Instructions 17. Alternative minimum tax (AMT) items } A Post-1986 depreciation adjustment B Adjusted gain or loss See the Partner s C Depletion (other than oil & gas) Instructions and D Oil, gas, & geothermal gross income the Instructions for E Oil, gas, & geothermal deductions Form 6251 F Other AMT items 18. Tax-exempt income and nondeductible expenses A Tax-exempt interest income Form 1040, line 2a B Other tax-exempt income See the Partner s Instructions C Nondeductible expenses See the Partner s Instructions 19. Distributions A Cash and marketable securities B Distribution subject to section 737 C Other property } See the Partner s Instructions 20. Other information A Investment income Form 4952, line 4a B Investment expenses Form 4952, line 5 C Fuel tax credit information Form 4136 D Qualified rehabilitation expenditures See the Partner s Instructions (other than rental real estate) E Basis of energy property See the Partner s Instructions F Recapture of low-income housing Form 8611, line 8 credit (section 42(j)(5)) G Recapture of low-income housing credit (other) Form 8611, line 8 H Recapture of investment credit See Form 4255 I Recapture of other credits See the Partner s Instructions J Look-back interest completed See Form 8697 long-term contracts K Look-back interest income forecast } See Form 8866 method L Dispositions of property with section 179 deductions M Recapture of section 179 deduction N Interest expense for corporate partners O through Y Z Section 199A income AA Section 199A W-2 wages See the Partner s AB Section 199A unadjusted basis Instructions AC Section 199A REIT dividends AD Section 199A PTP income AE Excess taxable income AF Excess business interest income AG Gross receipts for section 59A(e) AH Other information

12 SAMPLE OPERATING AGREEMENT th THIS OPERATING AGREEMENT is made and entered into as of the 15 day of April, 2018 by and among the persons executing this Agreement as the initial Members of KBAR LLC, a Colorado limited liability company (the Company ), and any other person who subsequently agrees to be bound by the terms of this Agreement. I. DEFINITIONS. The following terms used in this Agreement shall have the following meanings (unless otherwise expressly provided herein): 1.1 Act means the Colorado Limited Liability Company Act and any successor statute thereto, as amended from time to time. 1.2 Adjusted Capital Account Deficit means, with respect to any Member, the deficit balance, if any, in such Member s Capital Account as of the end of the relevant taxable year after giving effect to the following adjustments: (a) Credit to such Capital Account any amounts that such Member is obligated to restore or is deemed to be obligated to restore pursuant to the penultimate sentences of Reg (g)(1) and Reg (i)(5); and (b) Debit to such Capital Account the items described in Reg (b)(2)(ii)(d)(4), Reg (b)(2)(ii)(d)(5) and Reg (b)(2)(ii)(d)(6). The foregoing definition of Adjusted Capital Account Deficit is intended to comply with the provisions of Reg (b)(2)(ii)(d) and shall be interpreted consistently therewith. 1.3 Agreement means this Operating Agreement. 1.4 Articles of Organization means the articles of organization of the Company, as amended from time to time. 1.5 Capital Account means, with respect to any Member, the capital account maintained for such Member in accordance with the following provisions: (a) To each Member s Capital Account there shall be credited such Member s Capital Contributions, such Member s distributive share of Profits and any items in the nature of income or gain which are specially allocated to such Member, and the amount of any Company liabilities assumed by such Member, or which are secured by any Company property distributed to such Member. (b) To each Member s Capital Account there shall be debited the amount of cash and the Gross Asset Value of any Company property distributed to such Member pursuant to any provision of this Agreement, such Member s distributive share of losses and any items in the nature of expenses or losses which are specially allocated to such Member, and the amount of any liabilities of such Member assumed by the Company or which are secured by any property contributed by such Member to the Company Page 1 of 18 VOGEL.SEM/SP&LPROB.18

13 (c) In the event units are transferred and the transferee becomes the owner of such units, the transferee shall succeed to the Capital Account of the transferor to the extent it relates to such units. (d) Capital Accounts shall otherwise be maintained as provided elsewhere in this Agreement and in Reg (b)(2)(iv). The foregoing provisions and the other provisions of this Agreement relating to the maintenance of Capital Accounts are intended to comply with Reg (b)(2)(iv) and shall be interpreted and applied in a manner consistent with such Regulations. In the event any of the provisions of this Agreement relating to the maintenance of Capital Accounts are deemed to be inconsistent with the requirements of Reg (b)(2)(iv), the manner in which the Capital Accounts are maintained may be modified to comply with such Regulations section, provided that such modification does not materially affect the amount distributable to any Member under the provisions of this Agreement relating to the dissolution of the Company. 1.6 Code means the Internal Revenue Code of 1986 or corresponding provisions of subsequent superseding federal revenue laws. 1.7 Company has the meaning set forth in the first paragraph of this Agreement. 1.8 Gross Asset Value means, with respect to any asset, the asset s adjusted basis for federal income tax purposes, except as follows: (a) The initial Gross Asset Value of any asset contributed by a Member to the Company shall be the gross fair market value of such asset; (b) The Gross Asset Values of all Company assets shall be adjusted to equal their respective gross fair market values (i) in connection with an acquisition of an interest in the Company by any new or existing Member in exchange for more than a de minimis Capital Contribution, or (ii) in connection with the liquidation of the Company or a distribution by the Company to a Member of more than a de minimis amount of Company property as consideration for an interest in the Company, provided, however, that the foregoing adjustments shall be made only if they are necessary or appropriate to reflect the relative economic interests of the Members in the Company; (c) The Gross Asset Value of any Company asset distributed to any Member shall be adjusted to equal the gross fair market value of such asset on the date of distribution; (d) The Gross Asset Values of Company assets shall be increased (or decreased) to reflect any adjustments to the Adjusted basis of such assets pursuant to 734(b) or 743(b), but only to the extent that such adjustments are taken into account in determining Capital Accounts pursuant to Reg (b)(2)(iv)(m); provided, however, that Gross Asset Values shall not be adjusted pursuant to this subsection to the extent that an adjustment is required pursuant to subsection (b) above in connection with a transaction that would otherwise result in an adjustment under this subsection (d); (e) The Gross Asset Value of any Company asset shall be adjusted to reflect any cost recovery deductions claimed with respect to such asset as described in the definition of Profits and Losses Page 2 of 18 VOGEL.SEM/SP&LPROB.18

14 1.9 Managers means the Managers of the Company. So long as there is a single Manager of the Company, any reference to Managers in this Agreement (or any plural pronouns referring to the Managers) shall be understood to refer to the sole Manager Member means each person listed on Schedule A as an initial member and each other person who is admitted as a Member pursuant to the terms and conditions of this Agreement. The term Member as used herein shall include a Manager to the extent he is a Member. A person must be a Member to be a Member Pro Rata means in proportion to the relevant Members ownership of units of any class, unless a specific class is specified Profits and Losses means for any taxable year or other accounting period an amount equal to the Company s taxable income or loss for such year or period, determined in accordance with 703(a) (for this purpose, all items of income, gain, loss, or deduction required to be stated separately pursuant to 703(a)(1) shall be included in taxable income or loss), with the following adjustments: (a) Any income of the Company that is exempt from federal income tax and not otherwise taken into account in computing Profits and Losses pursuant to this Section 1.12 shall be added to such taxable income or loss; (b) Any expenditures of the Company described in 705(a)(2)(B) or treated as 705(a)(2)(B) expenditures pursuant to Reg (b)(2)(iv)(i), and not otherwise taken into account in computing Profits or Losses pursuant to this Section 1.12 shall be subtracted from such taxable income or loss; (c) In the even the Gross Asset Value of any Company asset is adjusted as provided in subsections (b) or (c) of the definition of Gross Asset Value, the amount of such adjustment shall be taken into account as gain or loss from the disposition of such asset for purposes of computing Profits and Losses; (d) Gain or loss resulting from any disposition of Company property with respect to which gain or loss is recognized for federal income tax purposes shall be computed by reference to the Gross Asset Value of the property disposed of, notwithstanding that the adjusted tax basis of such property differs from its Gross Asset Value; (e) If the Gross Asset Value of an asset differs from its adjusted basis for federal income tax purposes at the beginning of a fiscal year, cost recovery deductions with respect to such asset shall be computed by reference to the asset s Gross Asset Value using the same method as is used to compute cost recovery deductions for federal income tax purposes, provided, however, that if the adjusted basis for federal income tax purposes of the asset at the beginning of such fiscal year is zero, cost recovery deductions shall be computed by reference to the asset s Gross Asset Value using any reasonable method; (f) Notwithstanding any other provision of this Section 1.12, any items of income, gain, loss, or deduction which are specially allocated to a Member shall not be taken into account in computing Profits or Losses Page 3 of 18 VOGEL.SEM/SP&LPROB.18

15 The amounts of the items of Company income, gain, loss or deduction available to be specially allocated under the provisions of this Agreement (if any) shall be determined by applying rules analogous to those set forth in Sections 1.12(a) through 1.12(e) above Regulations means the Income Tax Regulations, including Temporary Regulations, promulgated under the Code, as such regulations may be amended from time to time (including corresponding provisions of succeeding regulations) Transfer means, as a noun, any voluntary or involuntary transfer, sale, pledge, hypothecation, or other disposition and, as a verb, voluntarily or involuntarily to transfer, sell, pledge, hypothecate, or otherwise dispose of. II. THE COMPANY. 2.1 Formation. The Company has been organized as a Colorado limited liability company by the filing of the Articles of Organization under and pursuant to the Act and the issuance of a certificate of organization for the Company by the Secretary of State of the state of Colorado. The rights and liabilities of the Members shall be determined pursuant to the Act and this Agreement. To the extent that the rights or obligations of any Member are different by reason of any provision of this Agreement than they would be in the absence of such provision, this Agreement shall, to the extent permitted by the Act, control. 2.2 Name. The name of the Company is KBAR, LLC, and all Company business shall be conducted in that name or such other names that comply with applicable law as the Managers may select from time to time. 2.3 Term. The Company shall commence on the date the Articles of Organization are filed with the Secretary of State of the state of Colorado and shall continue in existence in accordance with the terms and provisions hereof. 2.4 Registered Agent; Principal Office in the United States; Other Offices. The registered agent of the Company in the state of Colorado shall be the initial registered agent named in the Articles of Organization or such other person or persons as the Managers may designate from time to time in the manner provided by law. The principal office of the Company in the United States shall be at such place as the Managers may designate from time to time, which need not be in the state of Colorado. The Company may have such other offices as the Managers may designate from time to time. 2.5 Purpose of the Company. The purpose of the Company shall be to engage in any activity in which a limited liability company may engage, as determined by the Members. 2.6 Title to Property. All real and personal property owned by the Company shall be owned by the Company as an entity, and no Member shall have any ownership interest in such property in his individual name or right, and each member s interest in the Company shall be personal property for all purposes. Except as otherwise provided in this Agreement, the Company shall hold all of its real and personal property in the name of the Company and not in the name of any Manager or Member Page 4 of 18 VOGEL.SEM/SP&LPROB.18

16 III. GENERAL PROVISIONS RELATING TO MEMBERS AND OTHER MEMBERS. 3.1 Initial Members. The names, addresses, initial Capital Contributions, and initial units of the initial Members are set forth on Schedule A. 3.2 Authority. Unless authorized to do so by this Agreement or by the Managers of the Company, no Member of the Company, in his capacity as a Member, shall have any power or authority to bind the Company in any way, to pledge its credit, or to render it liable for any purpose. 3.3 Limitation of Liability for Company Debts. Each Member s liability for the debts and obligations of the Company shall be limited as set forth in the Act and other applicable law. 3.4 Priority and Return of Capital. Except as expressly provided herein, no Member shall have priority over any other Member, either as to the return of Capital Contributions or as to allocations or distributions; provided that this Section 3.4 shall not apply to loans (as distinguished from Capital Contributions) that a Member has made to the Company. 3.5 Competing Activities. Members and their officers, directors, shareholders, partners, members, managers, agents, employees, and Affiliates may engage or invest in, independently or with others, any business activity of any type or description, including, without limitation, those that might be the same as or similar to the Company s business and that might be in direct or indirect competition with the Company. Further, neither the Company nor any Member shall have any right in or to such other ventures or activities or to the income or proceeds derived therefrom by virtue of this Agreement or the Member s status as a Member or other Member. The Members shall not be obligated to present any investment opportunity or prospective economic advantage for their own account or to recommend such opportunity to persons other than the Company or the Members. Each Member acknowledges that the other Members and their Affiliates may own and/or manage other businesses, including businesses that may compete with the Company and for the Members time. Each Member hereby waives any and all rights and claims which he may otherwise have against the other Members and their officers, directors, shareholders, partners, members, managers, agents, employees, and Affiliates as a result of any of such activities. 3.6 Creation and Issuance of Units and Other Interests. (a) The Managers are authorized to cause the issuance of additional units beyond those initially issued to the initial Members, including units in one or more classes, or one or more series of such classes, which classes or series shall have, subject to the provisions of applicable law, such designations, preferences and relative, participating, optional, or other special rights as shall be fixed by the Managers, including, without limitation, with respect to: (i) the Capital Contribution to be required by each such class or series; (ii) the allocation of Profits or Losses to each such class or series; (iii) the right of each such class or series to share in distributions; (iv) the rights of each such class or series upon dissolution and liquidation of the Company; (v) the price at which, and the terms and conditions upon which, each such class or series of units may be redeemed by the Company, if any such class or series is so redeemable; (vi) the rate at which, and the terms and conditions upon which, each such class or series may be converted into another class or series of units; and (vii) the right of each such class or series to vote on, or take action with respect to, Company matters, including matters relating to the relative rights, preferences, and privileges of such class or series, to the extent permitted by applicable law, if any such class or series is granted such voting rights Page 5 of 18 VOGEL.SEM/SP&LPROB.18

17 (b) In the event that the Managers exercise their right to issue additional units having special rights, (i) this Agreement shall be deemed to be amended as may be necessary to reflect the designations, preferences, and relative participating, optional, or other special rights of such units and (ii) any units having rights identical to those originally issued to the initial Members pursuant to this Agreement shall be referred to as Class A units and units carrying other rights shall be otherwise designated as the Managers determine. (c) The Company is authorized to cause the issuance of any other types of interest in the Company from time to time to Members or others persons on terms and conditions established by the Managers. Such interests may include, without limitation, unsecured and secured debt obligations of the Company, debt obligations of the Company convertible into units, and options, rights, or warrants to purchase any such units. IV. MEETINGS OF, AND ACTIONS BY, MEMBERS. 4.1 Actions by Members. Except as otherwise provided herein, all actions required or permitted to be taken by the Members shall only be taken at a meeting held in accordance with the provisions of this Agreement. Members holding, personally or by proxy, at least a majority of the total votes held by all Members shall constitute a quorum at any meeting of Members. If a quorum is present at such meeting, the affirmative vote of members holding a majority of the votes held by all members represented at such meeting, in person or by proxy, and entitled to vote on the subject matter shall be the act of the Members. Members may participate in any meeting by conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other, and participation by such means in such meeting shall constitute attendance and presence in person at such meeting. Unless otherwise agreed by the Members, the Managers shall preside over all meetings of the Members. 4.2 Voting Power. Each Member shall have one vote for each unit held by the Member, determined as of the relevant record date. 4.3 Action Without a Meeting. Action required or permitted to be taken by the Members as a group may be taken without a meeting if the action is evidenced by one or more written consents describing the action taken, signed by each Member entitled to vote and delivered to the Company for inclusion in the minutes or for filing with the Company records. Action taken pursuant to this Section 4.3 is effective when all Members entitled to vote have signed the consent unless the consent specifies a different effective date. The record date for determining Members entitled to take action without a meeting shall be the date the first Member signs a written consent. V. MANAGEMENT OF THE COMPANY. 5.1 Management of the Company by Managers. The business and affairs of the Company shall be managed by one or more Managers. The number of Managers of the Company shall be fixed from time to time by vote of the Members, but in no instance shall there be less than one Manager. 5.2 Term, Election, and Qualification of Managers. Each Manager shall hold office for such term as the Members may designate or until his successor shall have been elected and qualified. Managers shall be elected by the vote of the members pursuant to the provisions of Article IV Page 6 of 18 VOGEL.SEM/SP&LPROB.18

18 Cumulative voting for Managers shall not be permitted. The Managers may, but need not, be Members. 5.3 Resignation. Any Manager of the Company may resign at any time by giving written notice to the Company. The resignation of any Manager shall take effect upon receipt of notice thereof by the Company or at such later time as shall be specified in such notice. Unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. 5.4 Removal. All or any lesser number of Managers may be removed at any time, with or without cause, at a meeting called expressly for that purpose, by the affirmative vote of the Members then entitled to vote at an election of Managers. 5.5 Vacancies. Any vacancy occurring for any reason in the group of Managers may be filled by vote of the Members. A Manager chosen to fill a vacancy shall serve the unexpired term of his or her predecessor in office. Any Manager s position to be filled by reason of an increase in the number of Managers shall be filled by vote of the Members. A Manager chosen to fill a position resulting from an increase in the number of Managers shall hold office for such term as the Members may designate or until his successor has been elected and qualified. 5.6 Actions by the Managers. Any action that may be taken by the Managers shall require the consent of a majority of the Mangers, provided, however, that the Managers may delegate to one or more of their number the right and power to deal with any aspect of the Company s business and/or take any action that the Managers are authorized to take without the further consent of the other Managers. To the extent that circumstances reasonably permit, each Manager shall have a reasonable opportunity to participate in any management decision of the Managers unless the right and power to make that decision has been delegated to other Managers pursuant to the foregoing sentence. 5.7 Action Without a Meeting. Action required or permitted to be take by the Managers as a group may be taken without a meeting if the action is evidenced by one or more written consents describing the action taken, signed by each Manager and delivered to the Company for inclusion in the minutes or for filing with the Company records. Action taken pursuant to this Section 5.7 is effective when all Managers entitled to vote have signed the consent unless the consent specifies a different effective date. The record date for determining Managers entitled to take action without a meeting shall be the date the first Manager signs a written consent. 5.8 Time Devoted; Other Activities. The Managers shall be required to manage the Company as their primary business function and may not participate in any other business activity, provided, however, that nothing in this Section 5.8 shall be construed to prohibit a Manager from owning and managing essentially passive investments (including investments in enterprises that compete with the business of Company so long as the Manager and the Affiliates of the Manager do not collectively own more than 5% of the equity in such competing enterprises), to the extent that such ownership and management do not materially interfere with the Manager s duties of managing the business of the Company, and nothing in this Agreement shall be construed to give the Company or any Member an interest in such investments. 5.9 Standards of Care. Each Manager shall discharge his duties in good faith, in a manner he reasonably believes to be in the best interests of the Company Page 7 of 18 VOGEL.SEM/SP&LPROB.18

19 VI. CAPITAL. 6.1 Members Initial Capital Contributions. The amount of cash and the nature and agreed value of any property initially contributed or to be contributed to the Company by each initial Member are set forth on Schedule A hereto. 6.2 Additional Capital Contributions. The Members may contribute additional cash and property to the Company in such amounts and at such times as they shall determine No Obligation to Restore Negative or Deficit Capital Account Balances. Except as otherwise provided in the Agreement, no Member shall have any liability to restore all or any portion of the negative or deficit balance in the Member s Capital Account, and the negative or deficit balance of the member s Capital Account shall not be considered to be a debt owed by the Member to the Company or to any other person for any purpose whatsoever. This provision shall apply, without limitation, to a winding up, liquidation, and dissolution of the Company. 6.4 Interest On and Return of Capital Contributions. No Member shall be entitled to interest on the Member s Capital Contributions, except with the consent of the other Members or as provided by this Agreement. No Member shall be entitled to a return of the Member s Capital Contributions, as such, but only to such distributions as are provided for in this Agreement. VII. ALLOCATIONS. 7.1 General Allocation of Profits and Losses. Subject to the special allocations, limitations, and other provisions of this Article VII, the Profits and Losses of the Company will be allocated to and shared by the Members Pro Rata. 7.2 Special Allocations. The Company shall make the following special allocations: (a) Limitation on Allocation of Losses. Notwithstanding any other provision of this Agreement, no allocation of Losses, or any item in the nature of expenses or losses shall be made to a Member if such allocation would cause or increase an Adjusted Capital Account Deficit for such Member. The amount otherwise allocable to a Member but for the foregoing sentence shall instead be allocated to the other members in the manner, order, and priority set forth in this Agreement, subject again to the first sentence of this Section 7.2(a). (b) Qualified Income Offset. In the event a Member receives any adjustments, allocations, or distributions described in Reg (b)(2)(ii)(d)(4), (5), or (6) items of Company income and gain (consisting of a pro rata portion of each item of Company income, including gross income, and gain for such year) shall be specially allocated to that Member in an amount and manner sufficient to eliminate, to the extent required by the Regulations, and Adjusted Capital Account Deficit of that Member as quickly as possible, provided that an allocation pursuant to the Section 7.2(b) shall be made only if and to the extent that the Member would have an Adjusted Capital Account Deficit after all other allocations provided for in this Agreement have been tentatively made as if this Section 7.2(b) were not in this Agreement. The provisions of this Section 7.2(b) are intended to comply with the requirements of Reg (b)(2)(ii)(d) and shall be interpreted consistently therewith Page 8 of 18 VOGEL.SEM/SP&LPROB.18

20 (c) Special Provisions Applicable in the Event of Nonrecourse Borrowings. Capitalized terms used in this Section 7.2(c) and not otherwise defined shall have the meaning given them in Reg (1) Nonrecourse Deductions. Nonrecourse Deductions of the Company for any taxable year or other period shall be allocated among the Members Pro Rata. (2) Partner Nonrecourse Deductions. Any Partner Nonrecourse Deductions for any taxable year shall be specially allocated to the Member who bears the economic risk of loss with respect to the Partner Nonrecourse Debt to which such Partner Nonrecourse Deductions are attributable in accordance with Reg (i)(1). (3) Minimum Gain Chargeback. Except as otherwise provided in Reg (f), notwithstanding any other provision of this Article VII, if there is a net decrease in Partnership Minimum Gain during any Company fiscal year, each Member shall be specially allocated items of Company income and gain for such fiscal year (and, if necessary, subsequent fiscal years) in an amount equal to such Member s share of the net decrease in Partnership Minimum Gain, determined in accordance with Reg (g). Allocations pursuant to the previous sentence shall be made in proportion to the respective amounts required to be allocated to each member pursuant thereto. The items to be so allocated shall be determined in accordance with Reg (f)(6) and Reg (j)(2). This Section 7.1(d)(3) is intended to comply with the minimum gain chargeback requirement in Reg (f) and shall be interpreted consistently therewith. (4) Partner Minimum Gain Chargeback. Except as otherwise provided in Reg (i)(4), notwithstanding any other provision of this Article VII, if there is a net decrease in Partner Nonrecourse Debt Minimum Gain attributable to a Partner Nonrecourse Debt during any Company fiscal year, each Member who has a share of the Partner Nonrecourse Debt Minimum Gain attributable to such Partner Nonrecourse Debt, determined in accordance with Reg (i)(5), shall be specially allocated items of Company income and gain for such taxable year (and, if necessary, subsequent taxable years) in an amount equal to such Member s share of the net decrease in Partner Nonrecourse Debt Minimum Gain attributable to such Partner Nonrecourse Debt, determined in accordance with Reg (i)(4). Allocations pursuant to the previous sentence shall be made in proportion to the respective amounts required to be allocated to each Member pursuant thereto. The items to be so allocated shall be determined in accordance with Reg (i)(4) and Reg (j)(2). This Section 7.1(d)(4) is intended to comply with the minimum gain chargeback requirement in Reg (i)(4) and shall be interpreted consistently therewith. (5) Excess Nonrecourse Liabilities. Solely for purposes of determining a Member s proportionate share of the excess nonrecourse liabilities of the Company within the meaning of Reg (a)(3), the Members interest in the Company Profits are Pro Rata. (6) Distributions. To the extent permitted by Reg (h)(3), the Company shall endeavor to treat distributions of cash as having liability only to the extent that such distributions would cause or increase an Adjusted Capital Account Deficit for any Member Page 9 of 18 VOGEL.SEM/SP&LPROB.18

21 7.3 Curative Allocations. The allocations set forth in Section 7.2 (the Regulatory Allocations ) are intended to comply with certain requirements of the Regulations. It is the intent of the Unitholders that, to the extent possible, all Regulatory Allocations shall be offset either with other Regulatory Allocations or with special allocations of other items of Company income, gain, loss, or deduction pursuant to this Section 7.3. Therefore, notwithstanding any other provision of this Article VII (other than the Regulatory Allocations), to the extent possible offsetting special allocations of Company income, gain, loss, or deduction shall be made so that, after such offsetting allocations are made, each Unitholder s Capital Account balance is equal to the Capital Account balance such Unitholder would have had if the Regulatory Allocations were not part of this Agreement and all Company items were allocated pursuant to the other Sections of this Article VII. 7.4 Allocation in the Event of a Change in Interest. In the event that a Unitholder s interest in the Profits and Losses of the Company changes during any Fiscal Year, whether because of an initial or subsequent acquisition of Units, a Transfer of Units, a redemption of Units, or other reason, the Managers shall determine such Unitholder s distributive share of any item of income, gain, loss, deduction, or credit for such Fiscal Year by reference to this Agreement and by using any convention permitted by 706 and the Regulations thereunder, provided, however, that in no event shall a new Unitholder be entitled to any retroactive allocation of income, gain, loss, deduction or credit. 7.5 Tax Allocations: 704(c). (a) In accordance with 704(c) and the Regulations thereunder, income, gain, loss, and deduction with respect to any property contributed to the capital of the Company shall, solely for tax purposes, be allocated among the Members so as to take account of any variation between the adjusted basis of such property to the Company for federal income tax purposes and its initial Gross Asset Value, using any method authorized by Reg as determined by the Managers. (b) In the event the Gross Asset Value of any Company asset is adjusted pursuant to subsection (b) of the definition of Gross Asset Value, subsequent allocations of income, gain, loss, and deduction with respect to such asset shall take account of any variation between the adjusted basis of such asset for federal income tax purposes and its Gross Asset Value in the same manner as under 704(c), using any method described in Reg as determined by the Managers. 7.6 Curative Allocations Regarding Payments to Unitholders. To the extent that any compensation or guaranteed payment paid to a Unitholder or its Affiliate is ultimately not determined to be either a guaranteed payment under 707(c) or a payment to a Member other than his capacity as a Member under 707(a), such Unitholder shall be specially allocated gross income of the Company for the year in which such compensation or payment was made in an amount equal to the amount of such compensation or payment. If the Company s income for the year in which the compensation or payment was made is insufficient to satisfy this allocation, similar special allocations of income shall be made in subsequent years until the full amount of the allocation required by this Section 7.6 has been made. In the event that a distribution to a Member is ultimately recharacterized as a guaranteed payment under 707(c) or a payment to a Member other than in his capacity as a Member under 707(a), and if such recharacterization gives rise to a deduction, such deduction shall be allocated to the Member receiving the distribution Page 10 of 18 VOGEL.SEM/SP&LPROB.18

22 VIII. DISTRIBUTIONS. 8.1 Distributions. The Managers shall distribute the net Cash Flow of the Company not less than quarterly. For these purposes, the term Net Cash Flow for any period means (i) the Profits or Losses of the Company from operations (including investments of cash reserves), plus (ii) depreciation and other non-cash charges deducted in computing such Profits and Losses, less (iii) payments made in amortization of indebtedness of the Company, and less (iv) payments made to property replacement, contingency, capital expenditure, and other reserves as determined by the Managers. Except as otherwise provided in this Agreement, all distributions shall be made to the Members Pro Rata. 8.2 Tax Distributions. During each Taxable Year of the Company, and in any event no later than March 31 of the following Taxable Year, each Unitholders who has been allocated net taxable income of the Company (determined in accordance with 703(a)) for such Taxable Year shall be entitled to receive a cash distribution (or distributions) equal to his allocable share of such net taxable income multiplied by a percentage equal to the highest rate of tax imposed on individuals for federal income tax purposes for such Taxable Year (without regard to alternative minimum taxes or tax surcharges), plus five percent (a Tax Distribution ). Any Tax Distributions shall be deemed to be an advance distribution of amounts otherwise distributable to the Unitholders pursuant to Section 8.1, and will reduce the amounts that would subsequently otherwise be distributable to the Unitholders pursuant to Section 8.1 in the order distributions would otherwise have been made. The Company may distribute Tax Distributions in quarterly installments on an estimated basis prior to the end of a Taxable Year, but if the amounts distributed by the Company to a Unitholder as estimated quarterly Tax Distributions exceed the greater of (a) the amount of Tax Distributions to which such Unitholders entitled for such Taxable Year, or (b) the total amount of distributions to which such Unitholder is otherwise entitled in such Taxable Year, the Unitholder will, within fifteen (15) days after the tax return for such Taxable Year is filed, return such excess to the Company, and such excess shall be treated as a distribution to such Unitholder pursuant to Section 8.1 until it is returned (or if for any reason such excess is not returned, then such excess shall be set off against any future distributions to which such Unitholder otherwise would be entitled). 8.3 General Distribution Rules. (a) All amounts withheld pursuant to the Code or any provision of any state or local tax law with respect to any distribution shall be treated as amounts actually distributed to the Members. The Managers are authorized to withhold from distributions, or with respect to allocations, to the Members and to pay over to federal, state, or local government any amounts required to be so withheld pursuant to the Code or any provisions of any other federal, state, or local law and shall allocate such amounts to the Members with respect to which such amount was withheld. In the event that the Company is obligated to withhold in respect of an allocation to a Member, and such withholding obligation is in excess of the amount otherwise distributable to such Member, such excess withholding obligation shall be treated as an interest-free loan to the Member by the Company. Such loan shall be repaid out of future distributions frm the Company to the Member. If such distributions are insufficient to repay such loan, the Member shall be obligated to repay the remaining balance of such loan to the Company upon the withdrawal of the Member or upon dissolution of the Company, whichever comes first. (b) No distribution shall be made by the Company to the extent that, after giving effect to the distribution, the Company would not be able to pay its debts as they become due in the Page 11 of 18 VOGEL.SEM/SP&LPROB.18

23 usual course of business or the liabilities of the Company would exceed the fair market value of the Company s assets. IX. ADMINISTRATIVE MATTERS 9.1 Books and Records. At the expense of the Company, the Managers shall maintain at the principal place of business of the Company separate books and records of all operations and expenditures of the Company. The books and records of the Company shall be maintained using reasonable and proper accounting methods. 9.2 Returns and Elections. (a) The Managers shall cause the preparation and timely filing of all tax returns required to be filed by the Company pursuant to the Code and all other tax returns deemed necessary and required in each jurisdiction in which the Company does business. Copies of such returns, or pertinent information therefrom, shall be furnished to the Members within a reasonable time after the end of the Company s taxable year. (b) All elections permitted to be made by the Company under federal or state laws shall be made by the Managers in such manner as they deem appropriate and in the best interests of the Members. 9.3 Tax Matters Partner. The Managers shall select the tax matters partner as defined in 6231(a)(7) of the Code. The tax matters partner is authorized and required to represent the Company, at the Company s expense, in connection with all examinations of the Company s affairs by tax authorities, including resulting judicial and administrative proceedings, and to expend Company funds for professional services and costs associated therewith. 9.4 Transactions With Members and Managers. To the extent permitted by applicable law and except as otherwise provided in this Agreement, the Managers are hereby authorized to purchase property from, sell property to, borrow money from, or otherwise deal with any Member or Manager acting on its own behalf, or any Affiliate of any Member of Manager, provided that any such purchase, sale, loan, or other transaction shall be made on terms and conditions which are no less favorable to the Company than if the sale, purchase, loan, or other transaction had been entered into with an independent third party. X. TRANSFER OF INTERESTS General. Except as otherwise permitted or required by this Agreement a Unitholder shall not have the right or power to Transfer all or any part of his Units. In the event of a Transfer of Units, the transferee in all cases shall be bound by the terms of this Agreement, including, without limitation, the provisions of this Article X Permitted Transfers. Subject to the conditions and restrictions set forth in Section 10.3 hereof, a Unitholder may at any time Transfer all or any portion of its Units: (a) With the express written consent of the Managers, which consent may be withheld, or conditionally or unconditionally granted, as they shall determine in their absolute discretion; Page 12 of 18 VOGEL.SEM/SP&LPROB.18

24 (b) (c) To a Unitholder; To any members of such Unitholder s Immediate Family; (d) To a trust the current beneficiaries of which are solely the Unitholder or members of the Unitholder s Immediate Family, provided, however, that if any of the current beneficiaries are not the Unitholder or members of the Unitholder s Immediate Family, the trust shall be deemed to have withdrawn from the Company. (e) To an entity that is wholly owned by Persons to whom Units may be Transferred under the foregoing paragraphs of this Section 10.2, provided, however, that if such an interest in such entity ceases to be so owned, the entity shall be deemed to have withdrawn from the Company. (f) In the case of a trust or entity described in Section 10.2(d) or Section 10.2(e) that has not deemed to have withdrawn from the Company, to any beneficiary or owner of such trust or entity. (g) To the estate of the Unitholder, provided that under the terms of the estate the Units pass to, or are held for the benefit of, Persons to whom Units may have been Transferred directly by the Unitholder under foregoing paragraphs of this Section Any such Transfer is referred to in this Agreement as a Permitted Transfer Conditions to Permitted Transfers. A Transfer shall not be treated as a Permitted Transfer under Section 10.2 hereof unless and until the following conditions are satisfied; provided, however, that any such conditions may be waived in writing by the Company: (a) The transferor and transferee shall execute and deliver to the Company such documents and instruments of conveyance as may be necessary or appropriate in the opinion of counsel to the Company to effect or confirm such Transfer and to confirm the agreement of the transferee to be bound by the provisions of this Agreement. In all cases, the Company shall be reimbursed by the transferor and/or transferee for all costs and expenses that it reasonably incurs in connection with such Transfer including reasonable attorney s fees. (b) Except in the case of a Transfer involuntarily by operation of law, the transferor shall furnish to the Company an opinion of counsel, at the transferor s expense, which counsel and opinion shall be satisfactory to the Company, that the Transfer will not cause the Company to terminate for federal income tax purposes. (c) The transferor and transferee shall furnish the Company with the transferee s taxpayer identification number and any other information reasonably necessary to permit the Company to file all required federal, state, and local tax returns and other legally required information statements or returns. Without limiting the generality of the foregoing, the Company shall not be required to make any distribution otherwise provided for in this Agreement with respect to any Transferred Units until it has received such information. (d) Except in the case of a Transfer of Units involuntarily by operation of law, either (i) such Units shall be registered under the Securities Act of 1933, as amended, and any applicable state securities laws, or (ii) the transferor shall provide an opinion of counsel, at transferor s expense, which opinion and counsel shall be satisfactory to the Company, to the Page 13 of 18 VOGEL.SEM/SP&LPROB.18

25 effect that such Transfer is exempt from all applicable registration requirements and that such Transfer will not violate any applicable laws regulating the Transfer of securities Prohibited Transfers. Any purported Transfer of Units that is not a Permitted Transfer shall be null and void and of no effect whatsoever. In the case of a Transfer or attempted Transfer of Units that is not a Permitted Transfer, the parties engaging or attempting to engage in such Transfer shall be liable to indemnify and hold the Company and the other Unitholders harmless from all costs, liabilities, and damages that any of such indemnified Persons may incur (including, without limitation, incremental tax liability and attorneys fees and expenses) as a result of such Transfer or attempted Transfer and efforts to enforce the indemnity granted hereby. In the event that the Company is required to recognize a Transfer that is not a Permitted Transfer, the transferee of the Transferred Units shall be only a Unitholder Rights of Unadmitted Transferee. A person who acquires one or more Units through a Permitted Transfer shall be only a Unitholder and shall not have any of the rights of a Member under the Act or this Agreement (including, without limitation, any voting rights) unless such Person is admitted as a Member pursuant to the provisions of Article XI Rights and Duties of Transferor. Any Unitholder who has Transferred all of its Units (regardless of whether such Transfer was a Permitted Transfer) shall automatically cease to have any rights it held as a Member in the Company (if any) and, if applicable, shall be deemed to have resigned as a Manager, provided, however, that if the Company is not required to recognize such Transfer, such Transferor shall continue to be treated as a mere Unitholder. In no event will any Transfer relieve any Unitholder of any obligation or duty imposed by this Agreement, without the express consent of [all the other members] [a Required Interest of the Members] [the Managers]. st 10.7 Effective Date of Transfer. Any Transfer shall be deemed effective as of the 1 day of the calendar month in which the Transfer occurs. XI. ADDITIONAL MEMBERS Admission of New Members. From the date of the formation of the Company, any Person acceptable to the Managers may become a Member of the Company subject to the terms and conditions of this Agreement. No Person shall become a Member unless and until such Person has explicitly accepted, assumed, and agreed to be subject to and bound by all of the terms, obligations, and conditions of this Agreement, as the same may have been further amended Documentation of Admission. As a condition to the admission of a Person as an additional Member, the Managers may require the new member to execute, acknowledge and deliver to the Company such certificates, representations, and documents and to perform all such other acts that the Managers may deem necessary or desirable to (a) constitute such Person as an additional Member; (b) confirm that the person to be admitted as an additional Member has accepted, assumed and agreed to be subject and bound by all of the terms, obligations, and conditions of this Agreement, as the same may have been further amended; and (c) assure compliance with any applicable state and federal securities laws and regulations Page 14 of 18 VOGEL.SEM/SP&LPROB.18

26 XII. WITHDRAWAL Withdrawal. A Unitholder shall be deemed to have withdrawn from the Company upon the resignation, Bankruptcy, death, termination of existence, dissolution and commencement of winding-up, [or] incompetency (as determined by decree of a court of competent jurisdiction) [or expulsion (by a vote of a Required Interest of the Members)] of the Unitholder, or upon the occurrence of any other event that cause the Unitholder to be deemed to have withdrawn from the Company under the terms of this Agreement (an Event of Withdrawal ). Notwithstanding the foregoing, in no event shall an Event of Withdrawal be deemed to have occurred merely by reason of a Permitted Transfer by a Unitholder. A Unitholder who has withdrawn from the Company is referred to herein as a Withdrawing Unitholder Status of a Holder of Withdrawing Unitholder s Units. Any holder of a Withdrawing Unitholder s Units (including, without limitation, a Member who withdraws and continues to own Units) shall be treated as a Unitholder unless admitted to the Company as a Member under the provisions of Article XI. If a Withdrawing Unitholder is a Manager, he shall be deemed to have resigned as a Manager Economic Consequence of Withdrawal. In the event any Unitholder withdraws, the following provisions shall apply: (a) Within sixty (60) days following the date upon which the Company receives notice of an Event of Withdrawal, the Managers may elect to redeem all of the Units which were held by the Withdrawing Unitholder (regardless of the present owner of such Units), for an amount equal to the net amount that the Unitholder of such Units would have received if (i) all items of Company property (which, for this purpose, shall not be considered to include any goodwill or going concern value) were sold for fair market value as of the last day of the month in which the Event of Withdrawal occurred, (ii) the liabilities of the Company as of such date were paid, and (iii) the Company was liquidated in accordance with the provisions of Section For this purpose, the amount which would be realized pursuant to clause (1) of the foregoing sentence shall be determined by the Managers, which determination shall be binding provided it is reasonable and made in good faith. (b) The amount due the Unitholder whose Units are to be acquired under the provisions of Section 12.3(a) shall be paid in eight (8) semi-annual installments, without interest, with the first such payment due on the last day of the sixth month following the Event of Withdrawal, provided, however, that if the Company is subsequently dissolved pursuant to Section 13.1, all remaining amounts due to the Unitholder shall become due and payable upon the final distribution to the Company s Unitholders pursuant to Section 13.2 XIII. DISSOLUTION AND TERMINATION Dissolution. The Company shall be dissolved only upon the vote of a Majority in Interest of the Members or entry of a decree of involuntary dissolution by a court of competent jurisdiction (an Event of Dissolution ) Page 15 of 18 VOGEL.SEM/SP&LPROB.18

27 13.2 Winding Up, Liquidation, and Distribution of Property in Accordance With Capital Account Balances. (a) Following an Event of Dissolution, the Managers shall immediately proceed to wind up the affairs of the Company, sell or otherwise liquidate all of the Company property as promptly as practicable (except to the extent the Members may unanimously determine to distribute any items of property to the Members in kind), and discharge, or provide for the discharge of, all liabilities of the Company. If items of property are to be distributed in kind, the fair market value of such items as of the date of dissolution shall be determined by the Managers, which determination shall be binding if reasonable and made in good faith. Such items shall be deemed to have been sold as of the date of dissolution for their fair market value and the Capital Accounts of the Members shall be adjusted to reflect any Profit or Loss from such deemed sale. (b) Subject to Section 13.2(c), an amount equal to the positive balance of each Member s Capital Account, as determined after taking into account all Capital Account adjustments for the Company s fiscal year during which the liquidation occurs, shall be distributed to the Members, with any items of property distributed in kind being valued for this purpose at their fair market value, which distributions to the Members shall be made within the time limits prescribed by Reg (b)(2)(ii)(b)(2). If any Member has a deficit balance in his Capital Account, such Member shall have no obligation to make any contribution to the capital of the Company with respect to such deficit, and such deficit shall not be considered a debt owed to the Company or any other person for any purpose whatsoever. (c) In the discretion of the Managers, a pro rata portion of the distributions that would otherwise be made to the members pursuant to Section 13.2(b) may be: (1) Distributed to a trust established for the benefit of the Members for the purposes of liquidating Company assets, collecting amounts owed to the Company, and paying any contingent or unforeseen liabilities or obligations of the Company. The assets of any such trust shall be distributed to the Members from time to time, in the reasonable discretion of the Managers, in the same proportions as the amount distributed to such trust by the Company would otherwise have been distributed to the Members pursuant to Section 13.2(b) hereof; or (2) Withheld to provide a reasonable reserve for Company liabilities (contingent or otherwise) and to reflect the unrealized portion of any installment obligations owed to the Company provided that such withheld amounts shall be distributed to the members as soon as practicable Rights of Members. Except as otherwise provided in this Agreement, upon the Dissolution and winding up of the Company, (a) each Member shall look solely to the assets of the Company for the return of his Capital Contribution and shall have no right or power to demand or receive property other than cash from the Company, and (b) unless otherwise expressly provided herein, no Member(other than in its capacity as a creditor of the Company) shall have priority over any other Member as to the return of his Capital Contributions, distributions, or allocations Page 16 of 18 VOGEL.SEM/SP&LPROB.18

28 XIV. ELECTIONS Subchapter K. The Members have agreed in advance that they shall not elect to be excluded from Subchapter K of the Code, as provided in 761(a). The Manager(s) shall cause a complete tax return for both federal, state and local purposes to be prepared at the expenses of the Company Section 754 Election and Other Company Elections. The Manager(s) shall make any and all elections required of or for the benefit of the Company. Said elections shall be made in the Manager s sole and absolute discretion Election to Amortize Organizational Expenditures. The Company does hereby elect to ratably deduct amounts paid or incurred by the Company for its organization in accordance with 709, commencing with the effective date the Company begins. The Members shall make this election in the appropriate manner by requiring the accountants of the Company to perform all necessary acts and file all necessary returns and reports in the appropriate fashion. In the event that the Company is liquidated before the end of the amortization period of 709 of 180 months, any remaining organization expenses shall be deducted in the manner and to the extent as provided in 165. XV. GENERAL PROVISIONS Notices. Except as expressly set forth to the contrary in this Agreement, all notices, requests, or consents provided for or permitted to be given under this Agreement must be in writing and must be given (a) by depositing that writing in the United States mail, postage prepaid, (b) by delivering that writing to the recipient in person or by courier, or (c) by facsimile transmission. A notice, request, or consent given under this Agreement is effective only on proof of receipt by the person to receive it, unless mailed, in which case it shall be effective and deemed delivered three (3) days after being deposited in the United States mail. All notices, requests, and consents to be sent to a Member must be sent to or made at the address reflected for that Member on the Company s books, which address may be changed from time to time as that Member may specify by written notice to the Company. All notices, requests, or consents to be sent to the Company must be sent to the Company s principal place of business or, if the Company has no principal place of business, to its registered office addressed to its registered agent. Whenever any notice is required to be given, a written waiver thereof, signed by the person entitled to notice, whether before or after the time stated therein, shall be deemed equivalent to the giving of such notice. If three (3) successive notices mailed to the last-known address of any Member are returned as undeliverable, no further notices to such Member shall be necessary until another address for such Member is made known to the Company in writing Entire Agreement. This Agreement constitutes the entire agreement of the parties hereto relating to the Company and supersedes all prior contracts or agreements with respect to the Company, whether oral or written Construction. The headings in this Agreement are inserted for convenience only and are in no way intended to describe, interpret, define, or limit the scope, extent, or intent of this Agreement or any provision hereof. The words herein, hereof, and hereunder, when used in this Agreement, refer to this Agreement in its entirely. The word include and its derivatives mean by way of example and not by way of exclusion or limitation. Words in the singular include the plural and words in the plural, include the singular, according to the requirements of the context. Words importing a gender include all genders Page 17 of 18 VOGEL.SEM/SP&LPROB.18

29 15.4 Governing Law. This agreement is governed by and shall be construed in accordance with the law of the state of Colorado, excluding any conflict-of-laws rule or principle that might refer the governance or the construction of this Agreement to the law of another jurisdiction Further Assurances. In connection with this Agreement and the transactions contemplated hereby, each Member shall execute and deliver any additional documents and instruments and perform any additional acts that may be necessary or appropriate to effectuate and perform the provisions of this Agreement and those transactions Heirs, Successors, and Assigns. Each and all of the covenants, terms, provisions, and agreements herein contained shall be binding upon and inure to the benefit of the parties hereto and, to the extent permitted by this Agreement, their respective heirs, legal representatives, successors, and assigns. IN WITNESS WHEREOF, the Members have adopted this Operating Agreement as of the date first written above Page 18 of 18 VOGEL.SEM/SP&LPROB.18

30 PARTNERSHIP CODE SECTIONS

31 TITLE 26. INTERNAL REVENUE CODE SUBCHAPTER K PARTNERS AND PARTNERSHIPS PART I DETERMINATION OF TAX LIABILITY Current through P.L Effective: December 22, Section 701. Partners, Not Partnership, Subject to Tax A partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities. Section 702. Income and Credits of Partner (a) General Rule.--In determining his income tax, each partner shall take into account separately his distributive share of the partnership's-- (1) gains and losses from sales or exchanges of capital assets held for not more than 1 year, (2) gains and losses from sales or exchanges of capital assets held for more than 1 year, (3) gains and losses from sales or exchanges of property described in section 1231 (relating to certain property used in a trade or business and involuntary conversions), (4) charitable contributions (as defined in section 170(c)), (5) dividends with respect to which section 1(h)(11) or part VIII of subchapter B applies, purposes of this title, such amount shall include his distributive share of the gross income of the partnership. (d) Cross Reference.-- For rules relating to procedures for determining the tax treatment of partnership items see subchapter C of chapter 63 (section 6221 and following). Section 703. Partnership Computations (a) Income and Deductions.--The taxable income of a partnership shall be computed in the same manner as in the case of an individual except that-- (1) the items described in section 702(a) shall be separately stated, and (2) the following deductions shall not be allowed to the partnership: (A) the deductions for personal exemptions provided in section 151, (B) the deduction for taxes provided in section 164(a) with respect to taxes, described in section 901, paid or accrued to foreign countries and to possessions of the United States, (b) (6) taxes, described in section 901, paid or accrued to foreign countries and to possessions of the United States, (7) other items of income, gain, loss, deduction, or credit, to the extent provided by regulations prescribed by the Secretary, and (8) taxable income or loss, exclusive of items requiring separate computation under other paragraphs of this subsection. Character of Items Constituting Distributive Share.--The character of any item of income, gain, loss, deduction, or credit included in a partner's distributive share under paragraphs (1) through (7) of subsection (a) shall be determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership. (b) (C) the deduction for charitable contributions provided in section 170, (D) the net operating loss deduction provided in section 172, (E) the additional itemized deductions for individuals provided in part VII of subchapter B (sec. 211 and following), and (F) the deduction for depletion under section 611 with respect to oil and gas wells. Elections of the Partnership.--Any election affecting the computation of taxable income derived from a partnership shall be made by the partnership, except that any election under-- (1) subsection (b)(5) or (c)(3) of section 108 (relating to income from discharge of indebtedness), (c) Gross Income of a Partner.--In any case where it is necessary to determine the gross income of a partner for (2) section 617 (relating to deduction and recapture of certain mining exploration expenditures), or VOGEL.SEM/SP&LPROB.18

32 (3) section 901 (relating to taxes of foreign countries and possessions of the United States), shall be made by each partner separately. Section 704. Partner's Distributive Share partner's interest in the partnership and to the adjusted basis of the property distributed to reflect any gain or loss recognized under this subparagraph, and (C) if any property so contributed has a built-in loss-- (a) Effect of Partnership Agreement.--A partner's distributive share of income, gain, loss, deduction, or credit shall, except as otherwise provided in this chapter, be determined by the partnership agreement. (i) such built-in loss shall be taken into account only in determining the amount of items allocated to the contributing partner, and (b) Determination of Distributive Share.--A partner's distributive share of income, gain, loss, deduction, or credit (or item thereof) shall be determined in accordance with the partner's interest in the partnership (determined by taking into account all facts and circumstances), if-- (1) the partnership agreement does not provide as to the partner's distributive share of income, gain, loss, deduction, or credit (or item thereof), or (2) the allocation to a partner under the agreement of income, gain, loss, deduction, or credit (or item thereof) does not have substantial economic effect. (ii) except as provided in regulations, in determining the amount of items allocated to other partners, the basis of the contributed property in the hands of the partnership shall be treated as being equal to its fair market value at the time of contribution. For purposes of subparagraph (C), the term built-in loss means the excess of the adjusted basis of the property (determined without regard to subparagraph (C)(ii)) over its fair market value at the time of contribution. (c) Contributed Property.-- (1) In General.--Under regulations prescribed by the Secretary-- (A) income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair market value at the time of contribution, (B) if any property so contributed is distributed (directly or indirectly) by the partnership (other than to the contributing partner) within 7 years of being contributed-- (i) (ii) the contributing partner shall be treated as recognizing gain or loss (as the case may be) from the sale of such property in an amount equal to the gain or loss which would have been allocated to such partner under subparagraph (A) by reason of the variation described in subparagraph (A) if the property had been sold at its fair market value at the time of the distribution, the character of such gain or loss shall be determined by reference to the character of the gain or loss which would have resulted if such property had been sold by the partnership to the distributee, and (iii) appropriate adjustments shall be made to the adjusted basis of the contributing (2) Special Rule for Distributions Where Gain or Loss Would Not Be Recognized Outside Partnerships.- Under regulations prescribed by the Secretary, if-- (A) property contributed by a partner (hereinafter referred to as the contributing partner ) is distributed by the partnership to another partner, and (B) other property of a like kind (within the meaning of section 1031) is distributed by the partnership to the contributing partner not later than the earlier of-- (i) the 180th day after the date of the distribution described in subparagraph (A), or (ii) the due date (determined with regard to extensions) for the contributing partner's return of the tax imposed by this chapter for the taxable year in which the distribution described in subparagraph (A) occurs, then to the extent of the value of the property described in subparagraph (B), paragraph (1)(B) shall be applied as if the contributing partner had contributed to the partnership the property described in subparagraph (B). (3) Other Rules.--Under regulations prescribed by the Secretary, rules similar to the rules of paragraph (1) shall apply to contributions by a partner (using the cash receipts and disbursements method of accounting) of accounts payable and other accrued VOGEL.SEM/SP&LPROB.18

33 but unpaid items. Any reference in paragraph (1) or (2) to the contributing partner shall be treated as including a reference to any successor of such partner. (f) Cross Reference.-- For rules in the case of the sale, exchange, liquidation, or reduction of a partner's interest, see section 706(c)(2). (d) (e) Limitation on Allowance of Losses.-- (1) In General.--A partner's distributive share of partnership loss (including capital loss) shall be allowed only to the extent of the adjusted basis of such partner's interest in the partnership at the end of the partnership year in which such loss occurred. (2) Carryover.--Any excess of such loss over such basis shall be allowed as a deduction at the end of the partnership year in which such excess is repaid to the partnership. (3) Special Rules.-- (A) In General.--In determining the amount of any loss under paragraph (1), there shall be taken into account the partner's distributive share of amounts described in paragraphs (4) and (6) of section 702(a). (B) Exception.--In the case of a charitable contribution of property whose fair market value exceeds its adjusted basis, subparagraph (A) shall not apply to the extent of the partner's distributive share of such excess. Partnership Interests Created by Gift.-- (1) Distributive Share of Donee Includible in Gross Income.--In the case of any partnership interest created by gift, the distributive share of the donee under the partnership agreement shall be includible in his gross income, except to the extent that such share is determined without allowance of reasonable compensation for services rendered to the partnership by the donor, and except to the extent that the portion of such share attributable to donated capital is proportionately greater than the share of the donor attributable to the donor's capital. The distributive share of a partner in the earnings of the partnership shall not be diminished because of absence due to military service. (2) Purchase of Interest by Member of Family.--For purposes of this subsection, an interest purchased by one member of a family from another shall be considered to be created by gift from the seller, and the fair market value of the purchased interest shall be considered to be donated capital. The family of any individual shall include only his spouse, ancestors, and lineal descendants, and any trusts for the primary benefit of such persons. [(3) Redesignated (2)] Section 705. Determination of Basis of Partner's Interest (a) (b) General Rule.--The adjusted basis of a partner's interest in a partnership shall, except as provided in subsection (b), be the basis of such interest determined under section 722 (relating to contributions to a partnership) or section 742 (relating to transfers of partnership interests)-- (1) increased by the sum of his distributive share for the taxable year and prior taxable years of-- (A) taxable income of the partnership as determined under section 703(a), (B) income of the partnership exempt from tax under this title, and (C) the excess of the deductions for depletion over the basis of the property subject to depletion; (2) decreased (but not below zero) by distributions by the partnership as provided in section 733 and by the sum of his distributive share for the taxable year and prior taxable years of-- (A) losses of the partnership, and (B) expenditures of the partnership not deductible in computing its taxable income and not properly chargeable to capital account; and (3) decreased (but not below zero) by the amount of the partner's deduction for depletion for any partnership oil and gas property to the extent such deduction does not exceed the proportionate share of the adjusted basis of such property allocated to such partner under section 613A(c)(7)(D). Alternative Rule.--The Secretary shall prescribe by regulations the circumstances under which the adjusted basis of a partner's interest in a partnership may be determined by reference to his proportionate share of the adjusted basis of partnership property upon a termination of the partnership. Section 706. Taxable Years of Partner and Partnership (a) Year in Which Partnership Income Is Includible.--In computing the taxable income of a partner for a taxable year, the inclusions required by section 702 and section 707(c) with respect to a partnership shall be based on the income, gain, loss, deduction, or credit of the partnership for any taxable year of the partnership ending within or with the taxable year of the partner VOGEL.SEM/SP&LPROB.18

34 (b) Taxable Year.-- (1) Partnership's Taxable Year.-- (I) the 1st day of the partnership taxable year (determined without regard to clause (i)), or (A) Partnership Treated as Taxpayer.--The taxable year of a partnership shall be determined as though the partnership were a taxpayer. (II) the days during such representative period as the Secretary may prescribe. (B) Taxable Year Determined by Reference to Partners.--Except as provided in subparagraph (C), a partnership shall not have a taxable year other than-- (i) the majority interest taxable year (as defined in paragraph (4)), (ii) if there is no taxable year described in clause (i), the taxable year of all the principal partners of the partnership, or (iii) if there is no taxable year described in clause (i) or (ii), the calendar year unless the Secretary by regulations prescribes another period. (B) Further Change Not Required for 3 Years. Except as provided in regulations necessary to prevent the avoidance of this section, if, by reason of paragraph (1)(B)(i), the taxable year of a partnership is changed, such partnership shall not be required to change to another taxable year for either of the 2 taxable years following the year of change. (5) Application with Other Sections.--Except as provided in regulations, for purposes of determining the taxable year to which a partnership is required to change by reason of this subsection, changes in taxable years of other persons required by this subsection, section 441(i), section 584(h),1 section 644, or section 1378(a) shall be taken into account. (C) Business Purpose.--A partnership may have a taxable year not described in subparagraph (B) if it establishes, to the satisfaction of the Secretary, a business purpose therefor. For purposes of this subparagraph, any deferral of income to partners shall not be treated as a business purpose. (2) Partner's Taxable Year.--A partner may not change to a taxable year other than that of a partnership in which he is a principal partner unless he establishes, to the satisfaction of the Secretary, a business purpose therefor. (3) Principal Partner.--For the purpose of this subsection, a principal partner is a partner having an interest of 5 percent or more in partnership profits or capital. (c) Closing of Partnership Year.-- (1) General Rule.--Except in the case of a termination of a partnership and except as provided in paragraph (2) of this subsection, the taxable year of a partnership shall not close as the result of the death of a partner, the entry of a new partner, the liquidation of a partner's interest in the partnership, or the sale or exchange of a partner's interest in the partnership. (2) Treatment of Dispositions.-- (A) Disposition of Entire Interest.--The taxable year of a partnership shall close with respect to a partner whose entire interest in the partnership terminates (whether by reason of death, liquidation, or otherwise). (4) Majority Interest Taxable Year; Limitation on Required Changes.-- (A) Majority Interest Taxable Year Defined.--For purposes of paragraph (1)(B)(i)-- (i) In General.--The term majority interest taxable year means the taxable year (if any) which, on each testing day, constituted the taxable year of 1 or more partners having (on such day) an aggregate interest in partnership profits and capital of more than 50 percent. (ii) Testing Days.--The testing days shall be-- (B) Disposition of less than Entire Interest.--The taxable year of a partnership shall not close (other than at the end of a partnership's taxable year as determined under subsection (b)(1)) with respect to a partner who sells or exchanges less than his entire interest in the partnership or with respect to a partner whose interest is reduced (whether by entry of a new partner, partial liquidation of a partner's interest, gift, or otherwise). (d) Determination of Distributive Share When Partner's Interest Changes.-- (1) In General.--Except as provided in paragraphs (2) and (3), if during any taxable year of the partnership there is a change in any partner's interest in the partnership, each partner's distributive share of any item of income, gain, loss, deduction, or credit of VOGEL.SEM/SP&LPROB.18

35 the partnership for such taxable year shall be determined by the use of any method prescribed by the Secretary by regulations which takes into account the varying interests of the partners in the partnership during such taxable year. (2) Certain Cash Basis Items Prorated over Period to Which Attributable.-- (A) In General.--If during any taxable year of the partnership there is a change in any partner's interest in the partnership, then (except to the extent provided in regulations) each partner's distributive share of any allocable cash basis item shall be determined-- (i) (ii) by assigning the appropriate portion of such item to each day in the period to which it is attributable, and by allocating the portion assigned to any such day among the partners in proportion to their interests in the partnership at the close of such day. (B) Allocable Cash Basis Item.--For purposes of this paragraph, the term allocable cash basis item means any of the following items with respect to which the partnership uses the cash receipts and disbursements method of accounting: (i) (ii) Interest. Taxes. (iii) Payments for services or for the use of property. (iv) Any other item of a kind specified in regulations prescribed by the Secretary as being an item with respect to which the application of this paragraph is appropriate to avoid significant misstatements of the income of the partners. (C) Items Attributable to Periods Not Within Taxable Year.--If any portion of any allocable cash basis item is attributable to-- (i) (ii) any period before the beginning of the taxable year, such portion shall be assigned under subparagraph (A)(i) to the first day of the taxable year, or any period after the close of the taxable year, such portion shall be assigned under subparagraph (A)(i) to the last day of the taxable year. (D) Treatment of Deductible Items Attributable to Prior Periods.--If any portion of a deductible cash basis item is assigned under subparagraph (C)(i) to the first day of any taxable year-- (i) (ii) such portion shall be allocated among persons who are partners in the partnership during the period to which such portion is attributable in accordance with their varying interests in the partnership during such period, and any amount allocated under clause (i) to a person who is not a partner in the partnership on such first day shall be capitalized by the partnership and treated in the manner provided for in section 755. (3) Items Attributable to Interest in Lower Tier Partnership Prorated over Entire Taxable Year.--If-- (A) during any taxable year of the partnership there is a change in any partner's interest in the partnership (hereinafter in this paragraph referred to as the upper tier partnership ), and (B) such partnership is a partner in another partnership (hereinafter in this paragraph referred to as the lower tier partnership ), then (except to the extent provided in regulations) each partner's distributive share of any item of the upper tier partnership attributable to the lower tier partnership shall be determined by assigning the appropriate portion (determined by applying principles similar to the principles of subparagraphs (C) and (D) of paragraph (2)) of each such item to the appropriate days during which the upper tier partnership is a partner in the lower tier partnership and by allocating the portion assigned to any such day among the partners in proportion to their interests in the upper tier partnership at the close of such day. (4) Taxable Year Determined Without Regard to Subsection (c)(2)(a).--for purposes of this subsection, the taxable year of a partnership shall be determined without regard to subsection (c)(2)(a). Section 707. Transactions Between Partner and Partnership (a) Partner Not Acting in Capacity as Partner.-- (1) In General.--If a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner VOGEL.SEM/SP&LPROB.18

36 (2) Treatment of Payments to Partners for Property or Services.--Under regulations prescribed by the Secretary-- (A) Treatment of Certain Services and Transfers of Property.--If-- (i) a partner performs services for a partnership or transfers property to a partnership, (ii) there is a related direct or indirect allocation and distribution to such partner, and (iii) the performance of such services (or such transfer) and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership, such allocation and distribution shall be treated as a transaction described in paragraph (1). (B) Treatment of Certain Property Transfers.--If-- (i) there is a direct or indirect transfer of money or other property by a partner to a partnership, (ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and (iii) the transfers described in clauses (i) and (ii), when viewed together, are properly characterized as a sale or exchange of property, such transfers shall be treated either as a transaction described in paragraph (1) or as a transaction between 2 or more partners acting other than in their capacity as members of the partnership. (c) (B) two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests. In the case of a subsequent sale or exchange by a transferee described in this paragraph, section 267(d) shall be applicable as if the loss were disallowed under section 267(a)(1). For purposes of section 267(a)(2), partnerships described in subparagraph (B) of this paragraph shall be treated as persons specified in section 267(b). (2) Gains Treated as Ordinary Income.--In the case of a sale or exchange, directly or indirectly, of property, which in the hands of the transferee, is property other than a capital asset as defined in section (A) between a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or profits interest, in such partnership, or (B) between two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests, any gain recognized shall be considered as ordinary income. (3) Ownership of a Capital or Profits Interest.--For purposes of paragraphs (1) and (2) of this subsection, the ownership of a capital or profits interest in a partnership shall be determined in accordance with the rules for constructive ownership of stock provided in section 267(c) other than paragraph (3) of such section. Guaranteed Payments.--To the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses). (b) Certain Sales or Exchanges of Property with Respect to Controlled Partnerships.-- (1) Losses Disallowed.--No deduction shall be allowed in respect of losses from sales or exchanges of property (other than an interest in the partnership), directly or indirectly, between-- (A) a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership, or Section 708. Continuation of Partnership (a) General Rule.--For purposes of this subchapter, an existing partnership shall be considered as continuing if it is not terminated. (b) Termination.-- (1) General Rule.--For purposes of subsection (a), a partnership shall be considered as terminated only if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership VOGEL.SEM/SP&LPROB.18

37 (2) Special Rules.-- Section 709. (a) (b) (A) Merger or Consolidation.--In the case of the merger or consolidation of two or more partnerships, the resulting partnership shall, for purposes of this section, be considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership. (B) Division of a Partnership.--In the case of a division of a partnership into two or more partnerships, the resulting partnerships (other than any resulting partnership the members of which had an interest of 50 percent or less in the capital and profits of the prior partnership) shall, for purposes of this section, be considered a continuation of the prior partnership. Treatment of Organization and Syndication Fees General Rule.--Except as provided in subsection (b), no deduction shall be allowed under this chapter to the partnership or to any partner for any amounts paid or incurred to organize a partnership or to promote the sale of (or to sell) an interest in such partnership. Deduction of Organization Fees.-- (1) Allowance of Deduction.--If a partnership elects the application of this subsection (in accordance with regulations prescribed by the Secretary) with respect to any organizational expenses-- (A) the partnership shall be allowed a deduction for the taxable year in which the partnership begins business in an amount equal to the lesser of-- (B) (i) (ii) the amount of organizational expenses with respect to the partnership, or $5,000, reduced (but not below zero) by the amount by which such organizational expenses exceed $50,000, and the remainder of such organizational expenses shall be allowed as a deduction ratably over the 180-month period beginning with the month in which the partnership begins business. (2) Dispositions Before Close of Amortization Period. In any case in which a partnership is liquidated before the end of the period to which paragraph (1)(B) applies, any deferred expenses attributable to the partnership which were not allowed as a deduction by reason of this section may be deducted to the extent allowable under section 165. (3) Organizational Expenses Defined.--The organizational expenses to which paragraph (1) applies, are expenditures which-- (A) are incident to the creation of the partnership; (B) are chargeable to capital account; and (C) are of a character which, if expended incident to the creation of a partnership having an ascertainable life, would be amortized over such life. Section 721. Nonrecognition of Gain or Loss on Contribution (a) General Rule.--No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership. (b) Special Rule.--Subsection (a) shall not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (within the meaning of section 351) if the partnership were incorporated. (c) (d) Regulations Relating to Certain Transfers to Partnerships. The Secretary may provide by regulations that subsection (a) shall not apply to gain realized on the transfer of property to a partnership if such gain, when recognized, will be includible in the gross income of a person other than a United States person. Transfers of Intangibles.--For regulatory authority to treat intangibles transferred to a partnership as sold, see section 367(d)(3). Section 722. Basis of Contributing Partner's Interest The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721(b) to the contributing partner at such time. Section 723. Basis of Property Contributed to Partnership The basis of property contributed to a partnership by a partner shall be the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721(b) to the contributing partner at such time VOGEL.SEM/SP&LPROB.18

38 Section 724. (a) Character of Gain or Loss on Contributed Unrealized Receivables, Inventory Items, and Capital Loss Property Contributions of Unrealized Receivables.--In the case of any property which-- (1) was contributed to the partnership by a partner, and (2) was an unrealized receivable in the hands of such partner immediately before such contribution, nonrecognition transaction, the tax treatment which applies to such property under such subsection shall also apply to any substituted basis property resulting from such transaction. A similar rule shall also apply in the case of a series of non-recognition transactions. (B) Exception for Stock in C Corporation. Subparagraph (A) shall not apply to any stock in a C corporation received in an exchange described in section 351. any gain or loss recognized by the partnership on the disposition of such property shall be treated as ordinary income or ordinary loss, as the case may be. Section 731. Extent of Recognition of Gain or Loss on Distribution (b) Contributions of Inventory Items.--In the case of any property which-- (a) Partners.--In the case of a distribution by a partnership to a partner-- (1) was contributed to the partnership by a partner, and (2) was an inventory item in the hands of such partner immediately before such contribution, (1) gain shall not be recognized to such partner, except to the extent that any money distributed exceeds the adjusted basis of such partner's interest in the partnership immediately before the distribution, and (c) (d) any gain or loss recognized by the partnership on the disposition of such property during the 5-year period beginning on the date of such contribution shall be treated as ordinary income or ordinary loss, as the case may be. Contributions of Capital Loss Property.--In the case of any property which-- (1) was contributed by a partner to the partnership, and (2) was a capital asset in the hands of such partner immediately before such contribution, any loss recognized by the partnership on the disposition of such property during the 5-year period beginning on the date of such contribution shall be treated as a loss from the sale of a capital asset to the extent that, immediately before such contribution, the adjusted basis of such property in the hands of the partner exceeded the fair market value of such property. Definitions.--For purposes of this section-- (1) Unrealized Receivable.--The term unrealized receivable has the meaning given such term by section 751(c) (determined by treating any reference to the partnership as referring to the partner). (2) Inventory Item.--The term inventory item has the meaning given such term by section 751(d) (determined by treating any reference to the partnership as referring to the partner and by applying section 1231 without regard to any holding period therein provided). (3) Substituted Basis Property.-- (A) In General.--If any property described in subsection (a), (b), or (c) is disposed of in a (b) (c) (2) loss shall not be recognized to such partner, except that upon a distribution in liquidation of a partner's interest in a partnership where no property other than that described in subparagraph (A) or (B) is distributed to such partner, loss shall be recognized to the extent of the excess of the adjusted basis of such partner's interest in the partnership over the sum of-- (A) any money distributed, and (B) the basis to the distributee, as determined under section 732, of any unrealized receivables (as defined in section 751(c)) and inventory (as defined in section 751(d)). Any gain or loss recognized under this subsection shall be considered as gain or loss from the sale or exchange of the partnership interest of the distributee partner. Partnerships.--No gain or loss shall be recognized to a partnership on a distribution to a partner of property, including money. Treatment of Marketable Securities.-- (1) In General.--For purposes of subsection (a)(1) and section (A) the term money includes marketable securities, and (B) such securities shall be taken into account at their fair market value as of the date of the distribution. (2) Marketable Securities.--For purposes of this subsection: VOGEL.SEM/SP&LPROB.18

39 (A) In General.--The term marketable securities means financial instruments and foreign currencies which are, as of the date of the distribution, actively traded (within the meaning of section 1092(d)(1)). (B) Other Property.--Such term includes-- (i) (ii) any interest in-- (I) a common trust fund, or (II) a regulated investment company which is offering for sale or has outstanding any redeemable security (as defined in section 2(a)(32) of the Investment Company Act of 1940) of which it is the issuer, any financial instrument which, pursuant to its terms or any other arrangement, is readily convertible into, or exchangeable for, money or marketable securities, (iii) any financial instrument the value of which is determined substantially by reference to marketable securities, (iv) except to the extent provided in regulations prescribed by the Secretary, any interest in a precious metal which, as of the date of the distribution, is actively traded (within the meaning of section 1092(d)(1)) unless such metal was produced, used, or held in the active conduct of a trade or business by the partnership, (v) except as otherwise provided in regulations prescribed by the Secretary, interests in any entity if substantially all of the assets of such entity consist (directly or indirectly) of marketable securities, money, or both, and (vi) to the extent provided in regulations prescribed by the Secretary, any interest in an entity not described in clause (v) but only to the extent of the value of such interest which is attributable to marketable securities, money, or both. (C) Financial Instrument.--The term financial instrument includes stocks and other equity interests, evidences of indebtedness, options, forward or futures contracts, notional principal contracts, and derivatives. (3) Exceptions.-- (A) In General.--Paragraph (1) shall not apply to the distribution from a partnership of a marketable security to a partner if-- (i) the security was contributed to the partnership by such partner, except to the extent that the value of the distributed security is attributable to marketable securities or money contributed (directly or indirectly) to the entity to which the distributed security relates, (ii) to the extent provided in regulations prescribed by the Secretary, the property was not a marketable security when acquired by such partnership, or (iii) such partnership is an investment partnership and such partner is an eligible partner thereof. (B) Limitation on Gain Recognized.--In the case of a distribution of marketable securities to a partner, the amount taken into account under paragraph (1) shall be reduced (but not below zero) by the excess (if any) of-- (i) such partner's distributive share of the net gain which would be recognized if all of the marketable securities of the same class and issuer as the distributed securities held by the partnership were sold (immediately before the transaction to which the distribution relates) by the partnership for fair market value, over (ii) such partner's distributive share of the net gain which is attributable to the marketable securities of the same class and issuer as the distributed securities held by the partnership immediately after the transaction, determined by using the same fair market value as used under clause (i). Under regulations prescribed by the Secretary, all marketable securities held by the partnership may be treated as marketable securities of the same class and issuer as the distributed securities. (C) Definitions Relating to Investment Partnerships. For purposes of subparagraph (A)(iii): (i) Investment Partnership.--The term investment partnership means any partnership which has never been engaged in a trade or business and VOGEL.SEM/SP&LPROB.18

40 (ii) (iii) substantially all of the assets (by value) of which have always consisted of-- (I) money, (II) stock in a corporation, (III) notes, bonds, debentures, or other evidences of indebtedness, (IV) interest rate, currency, or equity notional principal contracts, (V) foreign currencies, (VI) interests in or derivative financial instruments (including options, forward or futures contracts, short positions, and similar financial instruments) in any asset described in any other subclause of this clause or in any commodity traded on or subject to the rules of a board of trade or commodity exchange, (VII) other assets specified in regulations prescribed by the Secretary, or (VIII) any combination of the foregoing. Exception for Certain Activities.--A partnership shall not be treated as engaged in a trade or business by reason of-- (I) any activity undertaken as an investor, trader, or dealer in any asset described in clause (i), or (II) any other activity specified in regulations prescribed by the Secretary. Eligible Partner.-- (I) In General.--The term eligible partner means any partner who, before the date of the distribution, did not contribute to the partnership any property other than assets described in clause (i). (II) Exception for Certain Nonrecognition Transactions.--The term eligible partner shall not include the transferor or transferee in a nonrecognition transaction involving a transfer of any portion of an interest in a partnership with respect to which the transferor was not an eligible partner. (iv) Look-Thru of Partnership Tiers.--Except as otherwise provided in regulations prescribed by the Secretary-- (I) a partnership shall be treated as engaged in any trade or business engaged in by, and as holding (instead of a partnership interest) a proportionate share of the assets of, any other partnership in which the partnership holds a partnership interest, and (II) a partner who contributes to a partnership an interest in another partnership shall be treated as contributing a proportionate share of the assets of the other partnership. (4) Basis of Securities Distributed.-- (A) If the preceding sentence does not apply under such regulations with respect to any interest held by a partnership in another partnership, the interest in such other partnership shall be treated as if it were specified in a subclause of clause (i). In General.--The basis of marketable securities with respect to which gain is recognized by reason of this subsection shall be-- (i) their basis determined under section 732, increased by (ii) the amount of such gain. (B) Allocation of Basis Increase.--Any increase in basis attributable to the gain described in subparagraph (A)(ii) shall be allocated to marketable securities in proportion to their respective amounts of unrealized appreciation before such increase. (5) Subsection Disregarded in Determining Basis of Partner's Interest in Partnership and of Basis of Partnership Property.--Sections 733 and 734 shall be applied as if no gain were recognized, and no adjustment were made to the basis of property, under this subsection. (6) Character of Gain Recognized.--In the case of a distribution of a marketable security which is an unrealized receivable (as defined in section 751(c)) or an inventory item (as defined in section 751(d)), any gain recognized under this subsection shall be treated as ordinary income to the extent of any increase in the basis of such security attributable to the gain described in paragraph (4)(A)(ii) VOGEL.SEM/SP&LPROB.18

41 (7) Regulations.--The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this subsection, including regulations to prevent the avoidance of such purposes. (d) Exceptions.--This section shall not apply to the extent otherwise provided by section 736 (relating to payments to a retiring partner or a deceased partner's successor in interest), section 751 (relating to unrealized receivables and inventory items), and section 737 (relating to recognition of precontribution gain in case of certain distributions). Section 732. Basis of Distributed Property Other than Money (a) Distributions Other than in Liquidation of a Partner's Interest.-- (b) (1) General Rule.--The basis of property (other than money) distributed by a partnership to a partner other than in liquidation of the partner's interest shall, except as provided in paragraph (2), be its adjusted basis to the partnership immediately before such distribution. (2) Limitation.--The basis to the distributee partner of property to which paragraph (1) is applicable shall not exceed the adjusted basis of such partner's interest in the partnership reduced by any money distributed in the same transaction. Distributions in Liquidation.--The basis of property (other than money) distributed by a partnership to a partner in liquidation of the partner's interest shall be an amount equal to the adjusted basis of such partner's interest in the partnership reduced by any money distributed in the same transaction. (B) to the extent of any basis remaining after the allocation under subparagraph (A), to other distributed properties-- (i) first by assigning to each such other property such other property's adjusted basis to the partnership, and (ii) then, to the extent any increase or decrease in basis is required in order to have the adjusted bases of such other distributed properties equal such remaining basis, in the manner provided in paragraph (2) or (3), whichever is appropriate. (2) Method of Allocating Increase.--Any increase required under paragraph (1)(B) shall be allocated among the properties-- (A) first to properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation before such increase (but only to the extent of each property's unrealized appreciation), and (B) then, to the extent such increase is not allocated under subparagraph (A), in proportion to their respective fair market values. (3) Method of Allocating Decrease.--Any decrease required under paragraph (1)(A) or (1)(B) shall be allocated-- (A) first to properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation before such decrease (but only to the extent of each property's unrealized depreciation), and (c) Allocation of Basis.-- (1) In General.--The basis of distributed properties to which subsection (a)(2) or (b) is applicable shall be allocated-- (A) (i) first to any unrealized receivables (as defined in section 751(c)) and inventory items (as defined in section 751(d)) in an amount equal to the adjusted basis of each such property to the partnership, and (ii) if the basis to be allocated is less than the sum of the adjusted bases of such properties to the partnership, then, to the extent any decrease is required in order to have the adjusted bases of such properties equal the basis to be allocated, in the manner provided in paragraph (3), and (d) (B) then, to the extent such decrease is not allocated under subparagraph (A), in proportion to their respective adjusted bases (as adjusted under subparagraph (A)). Special Partnership Basis to Transferee.--For purposes of subsections (a), (b), and (c), a partner who acquired all or a part of his interest by a transfer with respect to which the election provided in section 754 is not in effect, and to whom a distribution of property (other than money) is made with respect to the transferred interest within 2 years after such transfer, may elect, under regulations prescribed by the Secretary, to treat as the adjusted partnership basis of such property the adjusted basis such property would have if the adjustment provided in section 743(b) were in effect with respect to the partnership property. The Secretary may by regulations require the application of this subsection in the case of a distribution to a transferee partner, whether or not made within 2 years after the transfer, if at the time of the transfer the fair market value of the partnership property (other than VOGEL.SEM/SP&LPROB.18

42 (e) money) exceeded 110 percent of its adjusted basis to the partnership. Exception.--This section shall not apply to the extent that a distribution is treated as a sale or exchange of property under section 751(b) (relating to unrealized receivables and inventory items). (f) Corresponding Adjustment to Basis of Assets of a Distributed Corporation Controlled by a Corporate Partner.-- (1) In General.--If-- (A) a corporation (hereafter in this subsection referred to as the corporate partner ) receives a distribution from a partnership of stock in another corporation (hereafter in this subsection referred to as the distributed corporation ), (B) the corporate partner has control of the distributed corporation immediately after the distribution or at any time thereafter, and (C) the partnership's adjusted basis in such stock immediately before the distribution exceeded the corporate partner's adjusted basis in such stock immediately after the distribution, then an amount equal to such excess shall be applied to reduce (in accordance with subsection (c)) the basis of property held by the distributed corporation at such time (or, if the corporate partner does not control the distributed corporation at such time, at the time the corporate partner first has such control). (2) Exception for Certain Distributions Before Control Acquired.--Paragraph (1) shall not apply to any distribution of stock in the distributed corporation if-- (A) the corporate partner does not have control of such corporation immediately after such distribution, and (B) the corporate partner establishes to the satisfaction of the Secretary that such distribution was not part of a plan or arrangement to acquire control of the distributed corporation. (3) Limitations on Basis Reduction.-- (A) In General.--The amount of the reduction under paragraph (1) shall not exceed the amount by which the sum of the aggregate adjusted bases of the property and the amount of money of the distributed corporation exceeds the corporate partner's adjusted basis in the stock of the distributed corporation. (B) Reduction Not to Exceed Adjusted Basis of Property.--No reduction under paragraph (1) in the basis of any property shall exceed the adjusted basis of such property (determined without regard to such reduction). (4) Gain Recognition Where Reduction Limited.--If the amount of any reduction under paragraph (1) (determined after the application of paragraph (3)(A)) exceeds the aggregate adjusted bases of the property of the distributed corporation-- (A) such excess shall be recognized by the corporate partner as long-term capital gain, and (B) the corporate partner's adjusted basis in the stock of the distributed corporation shall be increased by such excess. (5) Control.--For purposes of this subsection, the term control means ownership of stock meeting the requirements of section 1504(a)(2). (6) Indirect Distributions.--For purposes of paragraph (1), if a corporation acquires (other than in a distribution from a partnership) stock the basis of which is determined (by reason of being distributed from a partnership) in whole or in part by reference to subsection (a)(2) or (b), the corporation shall be treated as receiving a distribution of such stock from a partnership. (7) Special Rule for Stock in Controlled Corporation. If the property held by a distributed corporation is stock in a corporation which the distributed corporation controls, this subsection shall be applied to reduce the basis of the property of such controlled corporation. This subsection shall be reapplied to any property of any controlled corporation which is stock in a corporation which it controls. (8) Regulations.--The Secretary shall prescribe such regulations as may be necessary to carry out the purposes of this subsection, including regulations to avoid double counting and to prevent the abuse of such purposes. Section 733. Basis of Distributee Partner's Interest In the case of a distribution by a partnership to a partner other than in liquidation of a partner's interest, the adjusted basis to such partner of his interest in the partnership shall be reduced (but not below zero) by-- (1) the amount of any money distributed to such partner, and (2) the amount of the basis to such partner of distributed property other than money, as determined under section VOGEL.SEM/SP&LPROB.18

43 Section 734. Adjustment to Basis of Undistributed Partnership Property Where Section 754 Election or Substantial Basis Reduction distribution if the sum of the amounts described in subparagraphs (A) and (B) of subsection (b)(2) exceeds $250,000. (a) (b) General Rule.--The basis of partnership property shall not be adjusted as the result of a distribution of property to a partner unless the election, provided in section 754 (relating to optional adjustment to basis of partnership property), is in effect with respect to such partnership or unless there is a substantial basis reduction with respect to such distribution. Method of Adjustment.--In the case of a distribution of property to a partner by a partnership with respect to which the election provided in section 754 is in effect or with respect to which there is a substantial basis reduction, the partnership shall-- (1) increase the adjusted basis of partnership property by-- (e) (2) Regulations.-- For regulations to carry out this subsection, see section 743(d)(2). Exception for Securitization Partnerships.--For purposes of this section, a securitization partnership (as defined in section 743(f)) shall not be treated as having a substantial basis reduction with respect to any distribution of property to a partner. Section 735. (a) Character of Gain or Loss on Disposition of Distributed Property Sale or Exchange of Certain Distributed Property.-- (A) the amount of any gain recognized to the distributee partner with respect to such distribution under section 731(a)(1), and (B) in the case of distributed property to which section 732(a)(2) or (b) applies, the excess of the adjusted basis of the distributed property to the partnership immediately before the distribution (as adjusted by section 732(d)) over the basis of the distributed property to the distributee, as determined under section 732, or (2) decrease the adjusted basis of partnership property by-- (A) the amount of any loss recognized to the distributee partner with respect to such distribution under section 731(a)(2), and (B) in the case of distributed property to which section 732(b) applies, the excess of the basis of the distributed property to the distributee, as determined under section 732, over the adjusted basis of the distributed property to the partnership immediately before such distribution (as adjusted by section 732(d)). Paragraph (1)(B) shall not apply to any distributed property which is an interest in another partnership with respect to which the election provided in section 754 is not in effect. (c) Allocation of Basis.--The allocation of basis among partnership properties where subsection (b) is applicable shall be made in accordance with the rules provided in section 755. (d) Substantial Basis Reduction.-- (b) (c) (1) Unrealized Receivables.--Gain or loss on the disposition by a distributee partner of unrealized receivables (as defined in section 751(c)) distributed by a partnership, shall be considered as ordinary income or as ordinary loss, as the case may be. (2) Inventory Items.--Gain or loss on the sale or exchange by a distributee partner of inventory items (as defined in section 751(d)) distributed by a partnership shall, if sold or exchanged within 5 years from the date of the distribution, be considered as ordinary income or as ordinary loss, as the case may be. Holding Period for Distributed Property.--In determining the period for which a partner has held property received in a distribution from a partnership (other than for purposes of subsection (a)(2)), there shall be included the holding period of the partnership, as determined under section 1223, with respect to such property. Special Rules.-- (1) Waiver of Holding Periods Contained in Section For purposes of this section, section 751(d) (defining inventory item) shall be applied without regard to any holding period in section 1231(b). (2) Substituted Basis Property.-- (A) In General.--If any property described in subsection (a) is disposed of in a nonrecognition transaction, the tax treatment which applies to such property under such subsection shall also apply to any substituted basis property resulting from such transaction. A similar rule shall also apply in the case of a series of nonrecognition transactions. (1) In General.--For purposes of this section, there is a substantial basis reduction with respect to a (B) Exception for Stock in C Corporation. Subparagraph (A) shall not apply to any stock VOGEL.SEM/SP&LPROB.18

44 Section 736. (a) in a C corporation received in an exchange described in section 351. Payments to a Retiring Partner or a Deceased Partner's Successor in Interest Payments Considered as Distributive Share or Guaranteed Payment.--Payments made in liquidation of the interest of a retiring partner or a deceased partner shall, except as provided in subsection (b), be considered-- (1) as a distributive share to the recipient of partnership income if the amount thereof is determined with regard to the income of the partnership, or (1) the excess (if any) of (A) the fair market value of property (other than money) received in the distribution over (B) the adjusted basis of such partner's interest in the partnership immediately before the distribution reduced (but not below zero) by the amount of money received in the distribution, or (2) the net precontribution gain of the partner. Gain recognized under the preceding sentence shall be in addition to any gain recognized under section 731. The character of such gain shall be determined by reference to the proportionate character of the net precontribution gain. (b) (2) as a guaranteed payment described in section 707(c) if the amount thereof is determined without regard to the income of the partnership. Payments for Interest in Partnership.-- (1) General Rule.--Payments made in liquidation of the interest of a retiring partner or a deceased partner shall, to the extent such payments (other than payments described in paragraph (2)) are determined, under regulations prescribed by the Secretary, to be made in exchange for the interest of such partner in partnership property, be considered as a distribution by the partnership and not as a distributive share or guaranteed payment under subsection (a). (b) (c) Net Precontribution Gain.--For purposes of this section, the term net precontribution gain means the net gain (if any) which would have been recognized by the distributee partner under section 704(c)(1)(B) if all property which-- (1) had been contributed to the partnership by the distributee partner within 7 years of the distribution, and (2) is held by such partnership immediately before the distribution, had been distributed by such partnership to another partner. Basis Rules.-- (2) Special Rules.--For purposes of this subsection, payments in exchange for an interest in partnership property shall not include amounts paid for-- (A) unrealized receivables of the partnership (as defined in section 751(c)), or (B) good will of the partnership, except to the extent that the partnership agreement provides for a payment with respect to good will. (3) Limitation on Application of Paragraph (2). Paragraph (2) shall apply only if-- (1) Partner's Interest.--The adjusted basis of a partner's interest in a partnership shall be increased by the amount of any gain recognized by such partner under subsection (a). For purposes of determining the basis of the distributed property (other than money), such increase shall be treated as occurring immediately before the distribution. (2) Partnership's Basis in Contributed Property. Appropriate adjustments shall be made to the adjusted basis of the partnership in the contributed property referred to in subsection (b) to reflect gain recognized under subsection (a). Section 737. (A) capital is not a material income-producing factor for the partnership, and (B) the retiring or deceased partner was a general partner in the partnership. Recognition of Precontribution Gain in Case of Certain Distributions to Contributing Partner (a) General Rule.--In the case of any distribution by a partnership to a partner, such partner shall be treated as recognizing gain in an amount equal to the lesser of-- (d) Exceptions.-- (1) Distributions of Previously Contributed Property. If any portion of the property distributed consists of property which had been contributed by the distributee partner to the partnership, such property shall not be taken into account under subsection (a)(1) and shall not be taken into account in determining the amount of the net precontribution gain. If the property distributed consists of an interest in an entity, the preceding sentence shall not apply to the extent that the value of such interest is attributable to property contributed to such entity after such interest had been contributed to the partnership VOGEL.SEM/SP&LPROB.18

45 (e) (2) Coordination with Section This section shall not apply to the extent section 751(b) applies to such distribution. Marketable Securities Treated as Money.-- For treatment of marketable securities as money for purposes of this section, see section 731(c). Section 741. Recognition and Character of Gain or Loss on Sale or Exchange In the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items). Section 742. Basis of Transferee Partner's Interest The basis of an interest in a partnership acquired other than by contribution shall be determined under part II of subchapter O (sec and following). the adjusted basis of partnership property shall be determined in accordance with his interest in partnership capital and, in the case of property contributed to the partnership by a partner, section 704(c) (relating to contributed property) shall apply in determining such share. In the case of an adjustment under this subsection to the basis of partnership property subject to depletion, any depletion allowable shall be determined separately for the transferee partner with respect to his interest in such property. (c) Allocation of Basis.--The allocation of basis among partnership properties where subsection (b) is applicable shall be made in accordance with the rules provided in section 755. (d) Substantial Built-In Loss.-- (1) In General.--For purposes of this section, a partnership has a substantial built-in loss with respect to a transfer of an interest in the partnership if-- (A) the partnership's adjusted basis in the partnership property exceeds by more than $250,000 the fair market value of such property, or Section 743. (a) (b) Special Rules Where 754 Election or Substantial Built-in Loss General Rule.--The basis of partnership property shall not be adjusted as the result of a transfer of an interest in a partnership by sale or exchange or on the death of a partner unless the election provided by section 754 (relating to optional adjustment to basis of partnership property) is in effect with respect to such partnership or unless the partnership has a substantial built-in loss immediately after such transfer. Adjustment to Basis of Partnership Property.--In the case of a transfer of an interest in a partnership by sale or exchange or upon the death of a partner, a partnership with respect to which the election provided in section 754 is in effect or which has a substantial built-in loss immediately after such transfer shall-- (1) increase the adjusted basis of the partnership property by the excess of the basis to the transferee partner of his interest in the partnership over his proportionate share of the adjusted basis of the partnership property, or (2) decrease the adjusted basis of the partnership property by the excess of the transferee partner's proportionate share of the adjusted basis of the partnership property over the basis of his interest in the partnership. Under regulations prescribed by the Secretary, such increase or decrease shall constitute an adjustment to the basis of partnership property with respect to the transferee partner only. A partner's proportionate share of (e) (B) the transferee partner would be allocated a loss of more than $250,000 if the partnership assets were sold for cash equal to their fair market value immediately after such transfer. (2) Regulations.--The Secretary shall prescribe such regulations as may be appropriate to carry out the purposes of paragraph (1) and section 734(d), including regulations aggregating related partnerships and disregarding property acquired by the partnership in an attempt to avoid such purposes. Alternative Rules for Electing Investment Partnerships.-- (1) No Adjustment of Partnership Basis.--For purposes of this section, an electing investment partnership shall not be treated as having a substantial built-in loss with respect to any transfer occurring while the election under paragraph (6)(A) is in effect. (2) Loss Deferral for Transferee Partner.--In the case of a transfer of an interest in an electing investment partnership, the transferee partner's distributive share of losses (without regard to gains) from the sale or exchange of partnership property shall not be allowed except to the extent that it is established that such losses exceed the loss (if any) recognized by the transferor (or any prior transferor to the extent not fully offset by a prior disallowance under this paragraph) on the transfer of the partnership interest. (3) No Reduction in Partnership Basis.--Losses disallowed under paragraph (2) shall not decrease VOGEL.SEM/SP&LPROB.18

46 the transferee partner's basis in the partnership interest. (4) Certain Basis Reductions Treated as Losses.--In the case of a transferee partner whose basis in property distributed by the partnership is reduced under section 732(a)(2), the amount of the loss recognized by the transferor on the transfer of the partnership interest which is taken into account under paragraph (2) shall be reduced by the amount of such basis reduction. (5) Electing Investment Partnership.--For purposes of this subsection, the term electing investment partnership means any partnership if-- (A) the partnership makes an election to have this subsection apply, (B) the partnership would be an investment company under section 3(a)(1)(A) of the Investment Company Act of 1940 but for an exemption under paragraph (1) or (7) of section 3(c) of such Act, (C) such partnership has never been engaged in a trade or business, (f) Exception for Securitization Partnerships.-- (1) No Adjustment of Partnership Basis.--For purposes of this section, a securitization partnership shall not be treated as having a substantial built-in loss with respect to any transfer. (2) Securitization Partnership.--For purposes of paragraph (1), the term securitization partnership means any partnership the sole business activity of which is to issue securities which provide for a fixed principal (or similar) amount and which are primarily serviced by the cash flows of a discrete pool (either fixed or revolving) of receivables or other financial assets that by their terms convert into cash in a finite period, but only if the sponsor of the pool reasonably believes that the receivables and other financial assets comprising the pool are not acquired so as to be disposed of. Section 751. Unrealized Receivables and Inventory Items (a) Sale or Exchange of Interest in Partnership.--The amount of any money, or the fair market value of any property, received by a transferor partner in exchange for all or a part of his interest in the partnership attributable to-- (D) substantially all of the assets of such partnership are held for investment, (E) at least 95 percent of the assets contributed to such partnership consist of money, (F) no assets contributed to such partnership had an adjusted basis in excess of fair market value at the time of contribution, (G) all partnership interests of such partnership are issued by such partnership pursuant to a private offering before the date which is 24 months after the date of the first capital contribution to such partnership, (H) the partnership agreement of such partnership has substantive restrictions on each partner's ability to cause a redemption of the partner's interest, and (I) the partnership agreement of such partnership provides for a term that is not in excess of 15 years. The election described in subparagraph (A), once made, shall be irrevocable except with the consent of the Secretary. (6) Regulations.--The Secretary shall prescribe such regulations as may be appropriate to carry out the purposes of this subsection, including regulations for applying this subsection to tiered partnerships. [(7) Redesignated (6).] (b) (1) unrealized receivables of the partnership, or (2) inventory items of the partnership, shall be considered as an amount realized from the sale or exchange of property other than a capital asset. Certain Distributions Treated as Sales or Exchanges.-- (1) General Rule.--To the extent a partner receives in a distribution-- (A) partnership property which is-- (i) (ii) unrealized receivables, or inventory items which have appreciated substantially in value, in exchange for all or a part of his interest in other partnership property (including money), or (B) partnership property (including money) other than property described in subparagraph (A)(i) or (ii) in exchange for all or a part of his interest in partnership property described in subparagraph (A)(i) or (ii), such transactions shall, under regulations prescribed by the Secretary, be considered as a sale or exchange of such property between the distributee and the partnership (as constituted after the distribution) VOGEL.SEM/SP&LPROB.18

47 (2) Exceptions.--Paragraph (1) shall not apply to-- (A) a distribution of property which the distributee contributed to the partnership, or (B) payments, described in section 736(a), to a retiring partner or successor in interest of a deceased partner. section 731, 732, or 741, as the case may be) such property had been sold by the partnership. (d) Inventory Items.--For purposes of this subchapter, the term inventory items means-- (1) property of the partnership of the kind described in section 1221(a)(1), (c) (3) Substantial Appreciation.--For purposes of paragraph (1)-- (A) In General.--Inventory items of the partnership shall be considered to have appreciated substantially in value if their fair market value exceeds 120 percent of the adjusted basis to the partnership of such property. (B) Certain Property Excluded.--For purposes of subparagraph (A), there shall be excluded any inventory property if a principal purpose for acquiring such property was to avoid the provisions of this subsection relating to inventory items. Unrealized Receivables.--For purposes of this subchapter, the term unrealized receivables includes, to the extent not previously includible in income under the method of accounting used by the partnership, any rights (contractual or otherwise) to payment for-- (1) goods delivered, or to be delivered, to the extent the proceeds therefrom would be treated as amounts received from the sale or exchange of property other than a capital asset, or (e) (f) (2) any other property of the partnership which, on sale or exchange by the partnership, would be considered property other than a capital asset and other than property described in section 1231, and (3) any other property held by the partnership which, if held by the selling or distributee partner, would be considered property of the type described in paragraph (1) or (2). Limitation on Tax Attributable to Deemed Sales of Section 1248 Stock.--For purposes of applying this section and sections 731 and 741 to any amount resulting from the reference to section 1248(a) in the second sentence of subsection (c), in the case of an individual, the tax attributable to such amount shall be limited in the manner provided by subsection (b) of section 1248 (relating to gain from certain sales or exchanges of stock in certain foreign corporation). Special Rules in the Case of Tiered Partnerships, Etc.--In determining whether property of a partnership is-- (1) an unrealized receivable, or (2) an inventory item, (2) services rendered, or to be rendered. For purposes of this section and,1 sections 731, 732, and 741 (but not for purposes of section 736), such term also includes mining property (as defined in section 617(f)(2)), stock in a DISC (as described in section 992(a)), section 1245 property (as defined in section 1245(a)(3)), stock in certain foreign corporations (as described in section 1248), section 1250 property (as defined in section 1250(c)), farm land (as defined in section 1252(a)), franchises, trademarks, or trade names (referred to in section 1253(a)), and an oil, gas, or geothermal property (described in section 1254) but only to the extent of the amount which would be treated as gain to which section 617(d)(1), 995(c), 1245(a), 1248(a), 1250(a), 1252(a), 1253(a), or 1254(a) would apply if (at the time of the transaction described in this section or section 731, 732, or 741, as the case may be) such property had been sold by the partnership at its fair market value. For purposes of this section and,1 sections 731, 732, and 741 (but not for purposes of section 736), such term also includes any market discount bond (as defined in section 1278) and any short-term obligation (as defined in section 1283) but only to the extent of the amount which would be treated as ordinary income if (at the time of the transaction described in this section or such partnership shall be treated as owning its proportionate share of the property of any other partnership in which it is a partner. Under regulations, rules similar to the rules of the preceding sentence shall also apply in the case of interests in trusts. Section 752. Treatment of Certain Liabilities (a) Increase in Partner's Liabilities.--Any increase in a partner's share of the liabilities of a partnership, or any increase in a partner's individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership. (b) Decrease in Partner's Liabilities.--Any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership. (c) Liability to Which Property Is Subject.--For purposes of this section, a liability to which property is subject shall, to the extent of the fair market value of such property, be considered as a liability of the owner of the property VOGEL.SEM/SP&LPROB.18

48 (d) Sale or Exchange of an Interest.--In the case of a sale or exchange of an interest in a partnership, liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships. Section 753. Partner Receiving Income in Respect of Decedent The amount includible in the gross income of a successor in interest of a deceased partner under section 736(a) shall be considered income in respect of a decedent under section 691. Section 754. Manner of Electing Optional Adjustment to Basis of Partnership Property (c) property shall not be reduced below zero. If, in the case of a distribution, the adjustment to basis of property described in paragraph (1) or (2) is prevented by the absence of such property or by insufficient adjusted basis for such property, such adjustment shall be applied to subsequently acquired property of a like character in accordance with regulations prescribed by the Secretary. No Allocation of Basis Decrease to Stock of Corporate Partner.--In making an allocation under subsection (a) of any decrease in the adjusted basis of partnership property under section 734(b)-- (1) no allocation may be made to stock in a corporation (or any person related (within the meaning of sections 267(b) and 707(b)(1)) to such corporation) which is a partner in the partnership, and If a partnership files an election, in accordance with regulations prescribed by the Secretary, the basis of partnership property shall be adjusted, in the case of a distribution of property, in the manner provided in section 734 and, in the case of a transfer of a partnership interest, in the manner provided in section 743. Such an election shall apply with respect to all distributions of property by the partnership and to all transfers of interests in the partnership during the taxable year with respect to which such election was filed and all subsequent taxable years. Such election may be revoked by the partnership, subject to such limitations as may be provided by regulations prescribed by the Secretary. Section 755. Rules for Allocation of Basis (a) (b) General Rule.--Any increase or decrease in the adjusted basis of partnership property under section 734(b) (relating to the optional adjustment to the basis of undistributed partnership property) or section 743(b) (relating to the optional adjustment to the basis of partnership property in the case of a transfer of an interest in a partnership) shall, except as provided in subsection (b), be allocated-- (1) in a manner which has the effect of reducing the difference between the fair market value and the adjusted basis of partnership properties, or (2) in any other manner permitted by regulations prescribed by the Secretary. Special Rule.--In applying the allocation rules provided in subsection (a), increases or decreases in the adjusted basis of partnership property arising from a distribution of, or a transfer of an interest attributable to, property consisting of-- (1) capital assets and property described in section 1231(b), or (2) any other property of the partnership, shall be allocated to partnership property of a like character except that the basis of any such partnership (2) any amount not allocable to stock by reason of paragraph (1) shall be allocated under subsection (a) to other partnership property. Gain shall be recognized to the partnership to the extent that the amount required to be allocated under paragraph (2) to other partnership property exceeds the aggregate adjusted basis of such other property immediately before the allocation required by paragraph (2). Section 761. Terms Defined (a) Partnership.--For purposes of this subtitle, the term partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate. Under regulations the Secretary may, at the election of all the members of an unincorporated organization, exclude such organization from the application of all or part of this subchapter, if it is availed of-- (b) (1) for investment purposes only and not for the active conduct of a business, (2) for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted, or (3) by dealers in securities for a short period for the purpose of underwriting, selling, or distributing a particular issue of securities, if the income of the members of the organization may be adequately determined without the computation of partnership taxable income. Partner.--For purposes of this subtitle, the term partner means a member of a partnership. In the case of a capital interest in a partnership in which capital is a material income-producing factor, whether a person is a partner with respect to such interest shall be determined without VOGEL.SEM/SP&LPROB.18

49 (c) (d) regard to whether such interest was derived by gift from any other person. Partnership Agreement.--For purposes of this subchapter, a partnership agreement includes any modifications of the partnership agreement made prior to, or at, the time prescribed by law for the filing of the partnership return for the taxable year (not including extensions) which are agreed to by all the partners, or which are adopted in such other manner as may be provided by the partnership agreement. Liquidation of a Partner's Interest.--For purposes of this subchapter, the term liquidation of a partner's interest means the termination of a partner's entire interest in a partnership by means of a distribution, or a series of distributions, to the partner by the partnership. (e) Distributions of Partnership Interests Treated as Exchanges.--Except as otherwise provided in regulations, for purposes of-- (1) section 708 (relating to continuation of partnership), (2) section 743 (relating to optional adjustment to basis of partnership property), and (3) any other provision of this subchapter specified in regulations prescribed by the Secretary, any distribution of an interest in a partnership (not otherwise treated as an exchange) shall be treated as an exchange. (g) return for the taxable year, for purposes of this title-- (A) such joint venture shall not be treated as a partnership, (B) all items of income, gain, loss, deduction, and credit shall be divided between the spouses in accordance with their respective interests in the venture, and (C) each spouse shall take into account such spouse's respective share of such items as if they were attributable to a trade or business conducted by such spouse as a sole proprietor. (2) Qualified Joint Venture.--For purposes of paragraph (1), the term qualified joint venture means any joint venture involving the conduct of a trade or business if-- (A) the only members of such joint venture are a husband and wife, (B) both spouses materially participate (within the meaning of section 469(h) without regard to paragraph (5) thereof) in such trade or business, and (C) both spouses elect the application of this subsection. Cross Reference.-- (f) Qualified Joint Venture.-- (1) In General.--In the case of a qualified joint venture conducted by a husband and wife who file a joint For rules in the case of the sale, exchange, liquidation, or reduction of a partner's interest, see sections 704(b) and 706(c)(2) VOGEL.SEM/SP&LPROB.18

50 Selected Partnership & LLC Tax Problems 2018 Mark A. Vogel Tax Education Services Denver, Colorado mvogel

51 Administrative Matters 1. Schedule: a. Lunch Break in four hours, for one hour (12:30 1:30 p.m. Mountain Time) 2. Reference Materials: a. Download (within three days from your Personal Page): g) 1) Handouts file contains the PowerPoint presentation If print Handouts file, print only to Slide Questions for the Instructor: a. LIVE Questions During the Seminar: 1) Voice: ) Typewritten: a) Click: On next to Live Course Link on your Personal Page b) Click: On the Speech Bubble in the bottom right corner of the seminar viewing screen b. Post-Seminar Questions: 1) OR 4. Computer Problems: a. Call the Office: SP&LPROB.18 2

52 Organization of Materials 1. Course Objectives. 2. Form 1065 & Schedules D and K-1 U. S. Return of Partnership Income. 3. Notes Pages To be used by participants for notes. 4. Table of Contents Sets forth the organization of materials. 5. Sample LLC Operating Agreement Represents a typical operating agreement, including terms that all practitioners should understand. 6. Partnership Code Sections. SP&LPROB.18 4 Organization of Materials 7. PowerPoint Slides To be used to structure the presentation of the Selected Partnership & LLC Tax Problems topics. Consists of 480 slides. SP&LPROB.18 5

53 Organization of Materials 10. Other materials: a. WGL - McKee, Nelson & Whitmire - Legal Approach (1976) b. WGL - Willis, Pennel & Postelwaite - Accounting Approach (1969) c. Nutshell on Partnership Taxation d. Google e. Tax Services CCH IntelliConnect, Checkpoint & Catalyst Series, Bloomberg & BNA Tax Management Portfolios, Parker Publishing SP&LPROB.18 6 Course Objectives Learn Something 1. Formation a. Balance sheet Tax, book & financial (See Schedule K-1, Line L.) b. Tax & book capital account c. Recourse & nonrecourse debt (See Schedule K-1, Line K.) d. Rewarding a service person with an interest in the entity (Notice ) 1) No capital interest, but profits-only interest. 2) TCJA Added new 1061 for individuals that receive a carried interest. But only applies to unique situations. SP&LPROB.18 7

54 Course Objectives 2. Operational Issues: a. Filing Form 1065 b. Basis How to keep track of basis 705(a) & 705(b) c. Maximum amount of loss that is deductible and whether the at-risk rules apply to an LLC? See 704(d) and 465. Last time used Form ) TCJA made a technical change that affects charitable contributions and foreign taxes. SP&LPROB.18 8 Course Objectives 2. Operational Issues: d. Disguised sale rules Form 8275 e. Difference between 707(a) and 707(c) payments Nonpartner vs. partner capacity f. Understanding of economic effect and alternate economic effect test 1) Would U prefer $100,000 of good deductions or $100,000 of ordinary income? g. Meaning of the term reverse 704(c) allocation (See P , No. 6.) SP&LPROB.18 9

55 Course Objectives (c) Issues, including a Reverse 704(c) Allocation a. Methods available See Reg & Reg (b)(2)(iv)(f). b. See Line M on Schedule K-1-704(c) 4. Section 199A New 20% deduction of qualified business income (QBI) from a qualified trade or business (QTB), including specified service business (SSB). Also added RPE & UBI. 5. Electing out of the new partnership audit rules that are effective for January 1, (4,000, s were filed in 2017 and how many had more than 100 partners?) SP&LPROB Course Objectives 6. SE Problems See Schedule K-1, Line G a. Is a member a general partner or a limited partner? b. Gregg, Garnett, Thompson, Hegarty & Newell Member = General Partner c. See Prop. Reg (e) d. Halibut, Time Bandit, Kilcher family & why are there less than ten crew members on fishing boats in the Deadliest Catch? e. Robucci, Renkemeyer, Hardy, Castigliola, CCA and CCA SP&LPROB.18 11

56 Course Objectives 7. Termination Issues May 9, 2018 (May 9, 2017 & May 9, 1997) a. 708(b) Technical terminations are repealed for taxable years beginning after December 31, b. Changed the rules as of May 9, 1997 & changed the rules again as of January 1, c. See also R.R U purchase A s interest LLC 40% 60% U A SP&LPROB Course Objectives 8. Sale of Interest See 751(a), (c) & (d) See a. With and without a 754 election SP&LPROB.18 13

57 Course Objectives 9. Payments to a Retiring Member for that Member s Interest in Unrealized Receivables and Goodwill National Law Firms and Accounting Firms a. Is the partner a general partner? Is a member the same as a general partner? b. Is capital a material income producing factor? c. See 736(b)(3) August 10, 1993 d. Poll: Restaurant: 1) Great food & lousy service or 2) Good food & great service SP&LPROB New Developments See Summary of New Developments which begin on Slide 379. If on-line and printing, and if want to save paper, print only to Slide 379. SP&LPROB.18 15

58 Operating Agreement 1. P.1 - Capital account Book and not tax a. U Cash $10,000 I Prop. FMV $10,000 A/B $6,000 b. Transfer to corporation How much now & how much in five years? c. Transfer to LLC How much now & how much in five years? d. See Schedule K-1, Line L Capital Account Book, Tax, GAAP 2. P.2 - Transfer of an interest Transferee takes transferor book & tax capital account 3. P.2-1.8(b) Reverse 704(c) allocation (See P , No. 6.) Reg (b)(2)(iv)(f) SP&LPROB Operating Agreement 4. P No obligation to restore deficit balance in its book capital account (No DRO) a. Will never apply unless no debt or debt is nonrecourse. 5. P Profitandlossratio U I % 50% % 45% % 60% SP&LPROB.18 17

59 Operating Agreement 6. P.8-7.2(a) Cannot create a deficit in Book Capital Account Does not apply unless no debt or debt is nonrecourse 7. P.8-7.2(b) Qualified Income Offset Does not apply unless no debt or debt is nonrecourse 8. P.9-7.2(c) Nonrecourse deductions Minimum gain N/A unless have Excess nonrecourse debt nonrecourse debt. Minimum gain chargeback SP&LPROB Operating Agreement 9. P (a) BIG/BIL of 704(c) and Reg KISS 10. P (b) Relates back to 1.8(b) on P.2 Reverse 704(c) allocation. (See Reg (b)(2)(iv)(f).) SP&LPROB.18 19

60 Operating Agreement 11. P (b) Liquidating distributions shall be made in accordance with positive balance in book capital account. Alternate Economic Effect Test Safe Harbor Test 1. Capital account maintenance 2. Liquidation distributions Pos. Bal. 3. No DRO 4. QIO a. Need to look for: 1) P&L ratio 2) Capital account maintenance 3) Liquidating distribution shall be made in accordance w/ Pos. Bal. in Book Capital SP&LPROB Operating Agreement 12. P Who makes the elections, including 754 election? Is it a good idea to allow the managing member the unilateral ability to make all elections? a. See Reg (a)-1(f) Demin. $2,500 b. See Reg (a)-3(h) 2% test c. 754 election Op. Bus. No; Real Estate and O&G Yes d. Election out of new partnership audit rules 13. P How to treat organization expenses under 709. SP&LPROB.18 21

61 Code Sections Operational Provisions Used to prepare Form to 709 Contributions of Property 721 to (a) & 752(b) Distributions of Cash and Property Current & Liquidating See Sch. K, Line 19(a) & 19(b). 731 to 737 SP&LPROB Miscellaneous Provisions Sales & Exchanges 741 to 743, including 751(a) 752(d) Miscellaneous Provisions 751(a) Ordinary Income/Loss 751(b) Disproportionate Distributions 751(c) Unrealized Receivables 751(d) Inventory SP&LPROB.18 23

62 Miscellaneous Provisions Miscellaneous Provisions 752 Debt Rules Uses the word money 753 IRD (See 1367(b)(4).) Election 755 Allocating basis adjustment if 754 election See regulations to Definitions, including definition of a tax partnership and last day to amend an operating agreement for 2018 ( ) SP&LPROB.18 24

63 Form 1065 Department of the Treasury Internal Revenue Service A Principal business activity U.S. Return of Partnership Income For calendar year 2017, or tax year beginning, 2017, ending, 20. Go to for instructions and the latest information. Name of partnership OMB No D Employer identification number B Principal product or service C Business code number Type or Print Number, street, and room or suite no. If a P.O. box, see the instructions. City or town, state or province, country, and ZIP or foreign postal code E Date business started F Total assets (see the instructions) $ G Check applicable boxes: (1) Initial return (2) Final return (3) Name change (4) Address change (5) Amended return (6) Technical termination - also check (1) or (2) H Check accounting method: (1) Cash (2) Accrual (3) Other (specify) I Number of Schedules K-1. Attach one for each person who was a partner at any time during the tax year J Check if Schedules C and M-3 are attached Caution. Include only trade or business income and expenses on lines 1a through 22 below. See the instructions for more information. Income Deductions (see the instructions for limitations) Sign Here 1a Gross receipts or sales a b Returns and allowances b c Balance. Subtract line 1b from line 1a c 2 Cost of goods sold (attach Form 1125-A) Gross profit. Subtract line 2 from line 1c Ordinary income (loss) from other partnerships, estates, and trusts (attach statement) Net farm profit (loss) (attach Schedule F (Form 1040)) Net gain (loss) from Form 4797, Part II, line 17 (attach Form 4797) Other income (loss) (attach statement) Total income (loss). Combine lines 3 through Salaries and wages (other than to partners) (less employment credits) Guaranteed payments to partners Repairs and maintenance Bad debts Rent Taxes and licenses Interest a Depreciation (if required, attach Form 4562) a b Less depreciation reported on Form 1125-A and elsewhere on return 16b 16c 17 Depletion (Do not deduct oil and gas depletion.) Retirement plans, etc Employee benefit programs Other deductions (attach statement) Total deductions. Add the amounts shown in the far right column for lines 9 through Ordinary business income (loss). Subtract line 21 from line Paid Preparer Use Only Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. Declaration of preparer (other than partner or limited liability company member) is based on all information of which preparer has any knowledge. May the IRS discuss this return with the preparer shown below (see instructions)? Yes No Signature of partner or limited liability company member Date Print/Type preparer s name Preparer s signature Date PTIN Check if self-employed Firm s name Firm s EIN Firm s address Phone no. For Paperwork Reduction Act Notice, see separate instructions. Cat. No Z Form 1065 (2017)

64 Form 1065 (2017) Page 2 Schedule B Other Information 1 What type of entity is filing this return? Check the applicable box: Yes No a Domestic general partnership b Domestic limited partnership c Domestic limited liability company d Domestic limited liability partnership e Foreign partnership f Other 2 At any time during the tax year, was any partner in the partnership a disregarded entity, a partnership (including an entity treated as a partnership), a trust, an S corporation, an estate (other than an estate of a deceased partner), or a nominee or similar person? At the end of the tax year: a Did any foreign or domestic corporation, partnership (including any entity treated as a partnership), trust, or taxexempt organization, or any foreign government own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital of the partnership? For rules of constructive ownership, see instructions. If Yes, attach Schedule B-1, Information on Partners Owning 50% or More of the Partnership b Did any individual or estate own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital of the partnership? For rules of constructive ownership, see instructions. If Yes, attach Schedule B-1, Information on Partners Owning 50% or More of the Partnership At the end of the tax year, did the partnership: a Own directly 20% or more, or own, directly or indirectly, 50% or more of the total voting power of all classes of stock entitled to vote of any foreign or domestic corporation? For rules of constructive ownership, see instructions. If Yes, complete (i) through (iv) below (i) Name of Corporation (ii) Employer Identification Number (if any) (iii) Country of Incorporation (iv) Percentage Owned in Voting Stock b Own directly an interest of 20% or more, or own, directly or indirectly, an interest of 50% or more in the profit, loss, or capital in any foreign or domestic partnership (including an entity treated as a partnership) or in the beneficial interest of a trust? For rules of constructive ownership, see instructions. If Yes, complete (i) through (v) below.. (i) Name of Entity (ii) Employer Identification Number (if any) (iii) Type of Entity (iv) Country of Organization (v) Maximum Percentage Owned in Profit, Loss, or Capital 5 Did the partnership file Form 8893, Election of Partnership Level Tax Treatment, or an election statement under section 6231(a)(1)(B)(ii) for partnership-level tax treatment, that is in effect for this tax year? See Form 8893 for more details Does the partnership satisfy all four of the following conditions? a The partnership s total receipts for the tax year were less than $250,000. b The partnership s total assets at the end of the tax year were less than $1 million. c Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return. d The partnership is not filing and is not required to file Schedule M If Yes, the partnership is not required to complete Schedules L, M-1, and M-2; Item F on page 1 of Form 1065; or Item L on Schedule K-1. 7 Is this partnership a publicly traded partnership as defined in section 469(k)(2)? During the tax year, did the partnership have any debt that was cancelled, was forgiven, or had the terms modified so as to reduce the principal amount of the debt? Has this partnership filed, or is it required to file, Form 8918, Material Advisor Disclosure Statement, to provide information on any reportable transaction? At any time during calendar year 2017, did the partnership have an interest in or a signature or other authority over a financial account in a foreign country (such as a bank account, securities account, or other financial account)? See the instructions for exceptions and filing requirements for FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR). If Yes, enter the name of the foreign country. Yes No Form 1065 (2017)

65 Form 1065 (2017) Page 3 Schedule B Other Information (continued) 11 At any time during the tax year, did the partnership receive a distribution from, or was it the grantor of, or transferor to, a foreign trust? If Yes, the partnership may have to file Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. See instructions a Is the partnership making, or had it previously made (and not revoked), a section 754 election? See instructions for details regarding a section 754 election. b Did the partnership make for this tax year an optional basis adjustment under section 743(b) or 734(b)? If Yes, attach a statement showing the computation and allocation of the basis adjustment. See instructions.... c Is the partnership required to adjust the basis of partnership assets under section 743(b) or 734(b) because of a substantial built-in loss (as defined under section 743(d)) or substantial basis reduction (as defined under section 734(d))? If Yes, attach a statement showing the computation and allocation of the basis adjustment. See instructions 13 Check this box if, during the current or prior tax year, the partnership distributed any property received in a like-kind exchange or contributed such property to another entity (other than disregarded entities wholly owned by the partnership throughout the tax year) At any time during the tax year, did the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property? If the partnership is required to file Form 8858, Information Return of U.S. Persons With Respect To Foreign Disregarded Entities, enter the number of Forms 8858 attached. See instructions 16 Does the partnership have any foreign partners? If Yes, enter the number of Forms 8805, Foreign Partner s Information Statement of Section 1446 Withholding Tax, filed for this partnership. 17 Enter the number of Forms 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, attached to this return. 18 a Did you make any payments in 2017 that would require you to file Form(s) 1099? See instructions..... b If Yes, did you or will you file required Form(s) 1099? Enter the number of Form(s) 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations, attached to this return. 20 Enter the number of partners that are foreign governments under section During the partnership s tax year, did the partnership make any payments that would require it to file Form 1042 and 1042-S under chapter 3 (sections 1441 through 1464) or chapter 4 (sections 1471 through 1474)? Was the partnership a specified domestic entity required to file Form 8938 for the tax year (See the Instructions for Form 8938)? Designation of Tax Matters Partner (see instructions) Enter below the general partner or member-manager designated as the tax matters partner (TMP) for the tax year of this return: Yes No Name of designated TMP Identifying number of TMP If the TMP is an entity, name of TMP representative Phone number of TMP Address of designated TMP Form 1065 (2017)

66 Form 1065 (2017) Page 4 Schedule K Partners Distributive Share Items Total amount 1 Ordinary business income (loss) (page 1, line 22) Net rental real estate income (loss) (attach Form 8825) a Other gross rental income (loss) a b Expenses from other rental activities (attach statement) 3b c Other net rental income (loss). Subtract line 3b from line 3a c 4 Guaranteed payments Interest income Dividends: a Ordinary dividends a b Qualified dividends b 7 Royalties Net short-term capital gain (loss) (attach Schedule D (Form 1065)) a Net long-term capital gain (loss) (attach Schedule D (Form 1065)) a b Collectibles (28%) gain (loss) b c Unrecaptured section 1250 gain (attach statement).. 9c 10 Net section 1231 gain (loss) (attach Form 4797) Other income (loss) (see instructions) Type Section 179 deduction (attach Form 4562) a Contributions a b Investment interest expense b c Section 59(e)(2) expenditures: (1) Type (2) Amount 13c(2) d Other deductions (see instructions) Type 13d 14a Net earnings (loss) from self-employment a b Gross farming or fishing income b c Gross nonfarm income c Income (Loss) Deductions Self- Employment Credits Foreign Transactions Alternative Minimum Tax (AMT) Items Other Information 15a Low-income housing credit (section 42(j)(5)) a b Low-income housing credit (other) b c Qualified rehabilitation expenditures (rental real estate) (attach Form 3468, if applicable) 15c d Other rental real estate credits (see instructions) Type 15d e Other rental credits (see instructions) Type 15e f Other credits (see instructions) Type 15f 16a Name of country or U.S. possession b Gross income from all sources b c Gross income sourced at partner level c Foreign gross income sourced at partnership level d Passive category e General category f Other 16f Deductions allocated and apportioned at partner level g Interest expense h Other h Deductions allocated and apportioned at partnership level to foreign source income i Passive category j General category k Other 16k l Total foreign taxes (check one): Paid Accrued l m Reduction in taxes available for credit (attach statement) m n Other foreign tax information (attach statement) a Post-1986 depreciation adjustment a b Adjusted gain or loss b c Depletion (other than oil and gas) c d Oil, gas, and geothermal properties gross income d e Oil, gas, and geothermal properties deductions e f Other AMT items (attach statement) f 18a Tax-exempt interest income a b Other tax-exempt income b c Nondeductible expenses c 19a Distributions of cash and marketable securities a b Distributions of other property b 20a Investment income a b Investment expenses b c Other items and amounts (attach statement) Form 1065 (2017)

67 Form 1065 (2017) Page 5 Analysis of Net Income (Loss) 1 Net income (loss). Combine Schedule K, lines 1 through 11. From the result, subtract the sum of Schedule K, lines 12 through 13d, and 16l Analysis by partner type: (i) Corporate (ii) Individual (active) (iii) Individual (passive) (iv) Partnership (v) Exempt Organization (vi) Nominee/Other a General partners b Limited partners Schedule L Balance Sheets per Books Beginning of tax year End of tax year Assets (a) (b) (c) (d) 1 Cash a Trade notes and accounts receivable... b Less allowance for bad debts Inventories U.S. government obligations Tax-exempt securities Other current assets (attach statement).. 7a Loans to partners (or persons related to partners) b Mortgage and real estate loans Other investments (attach statement)... 9a Buildings and other depreciable assets.. b Less accumulated depreciation a Depletable assets b Less accumulated depletion Land (net of any amortization) a Intangible assets (amortizable only)... b Less accumulated amortization Other assets (attach statement) Total assets Liabilities and Capital 15 Accounts payable Mortgages, notes, bonds payable in less than 1 year 17 Other current liabilities (attach statement). 18 All nonrecourse loans a Loans from partners (or persons related to partners) b Mortgages, notes, bonds payable in 1 year or more 20 Other liabilities (attach statement) Partners capital accounts Total liabilities and capital Schedule M-1 Reconciliation of Income (Loss) per Books With Income (Loss) per Return Note. The partnership may be required to file Schedule M-3 (see instructions). 1 Net income (loss) per books Income included on Schedule K, lines 1, 2, 3c, 5, 6a, 7, 8, 9a, 10, and 11, not recorded on books this year (itemize): 3 Guaranteed payments (other than health insurance) Expenses recorded on books this year not included on Schedule K, lines 1 through 13d, and 16l (itemize): a Depreciation $ b Travel and entertainment $ 5 Add lines 1 through Schedule M-2 1 Balance at beginning of year... 2 Capital contributed: a Cash... b Property.. 3 Net income (loss) per books Other increases (itemize): 5 Add lines 1 through Analysis of Partners Capital Accounts 6 Income recorded on books this year not included on Schedule K, lines 1 through 11 (itemize): a Tax-exempt interest $ 7 Deductions included on Schedule K, lines 1 through 13d, and 16l, not charged against book income this year (itemize): a Depreciation $ 8 Add lines 6 and Income (loss) (Analysis of Net Income (Loss), line 1). Subtract line 8 from line 5. 6 Distributions: a Cash b Property Other decreases (itemize): 8 Add lines 6 and Balance at end of year. Subtract line 8 from line 5 Form 1065 (2017)

68 SCHEDULE D (Form 1065) Capital Gains and Losses Attach to Form 1065 or Form Use Form 8949 to list your transactions for lines 1b, 2, 3, 8b, 9, and 10. Go to for instructions and the latest information. Department DRAFT of the Treasury AS OF Internal Revenue Service Name of partnership OMB No Employer identification number Part I Short-Term Capital Gains and Losses (See instructions) August 3, 2018 DO NOT FILE See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars. 1a Totals for all short-term transactions reported on Form 1099-B for which basis was reported to the IRS and for which you have no adjustments (see instructions). However, if you choose to report all these transactions on Form 8949, leave this line blank and go to line 1b. 1b Totals for all transactions reported on Form(s) 8949 with Box A checked Totals for all transactions reported on Form(s) 8949 with Box B checked Totals for all transactions reported on Form(s) 8949 with Box C checked (d) Proceeds (sales price) (e) Cost (or other basis) (g) Adjustments to gain or loss from Form(s) 8949, Part I, line 2, column (g) (h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g) 4 Short-term capital gain from installment sales from Form 6252, line 26 or Short-term capital gain or (loss) from like-kind exchanges from Form Partnership s share of net short-term capital gain (loss), including specially allocated short-term capital gains (losses), from other partnerships, estates, and trusts Net short-term capital gain or (loss). Combine lines 1a through 6 in column (h). Enter here and on Form 1065, Schedule K, line 8 or 11; or Form 8865, Schedule K, line 8 or Part II Long-Term Capital Gains and Losses (See instructions) See instructions for how to figure the amounts to enter on the lines below. This form may be easier to complete if you round off cents to whole dollars. 8a Totals for all long-term transactions reported on Form 1099-B for which basis was reported to the IRS and for which you have no adjustments (see instructions). However, if you choose to report all these transactions on Form 8949, leave this line blank and go to line 8b. 8b Totals for all transactions reported on Form(s) 8949 with Box D checked Totals for all transactions reported on Form(s) 8949 with Box E checked Totals for all transactions reported on Form(s) 8949 with Box F checked (d) Proceeds (sales price) (e) Cost (or other basis) (g) Adjustments to gain or loss from Form(s) 8949, Part II, line 2, column (g) 11 Long-term capital gain from installment sales from Form 6252, line 26 or Long-term capital gain or (loss) from like-kind exchanges from Form Partnership s share of net long-term capital gain (loss), including specially allocated long-term capital gains (losses), from other partnerships, estates, and trusts Capital gain distributions (see instructions) Net long-term capital gain or (loss). Combine lines 8a through 14 in column (h). Enter here and on Form 1065, Schedule K, line 9a or 11; or Form 8865, Schedule K, line 9a or (h) Gain or (loss) Subtract column (e) from column (d) and combine the result with column (g) For Paperwork Reduction Act Notice, see the Instructions for Form Cat. No G Schedule D (Form 1065) 2018

69 Schedule K-1 (Form 1065) 2018 Department of the Treasury Internal Revenue Service For calendar year 2018, or tax year Part III Final K-1 Amended K OMB No Partner s Share of Current Year Income, Deductions, Credits, and Other Items 1 Ordinary business income (loss) 15 Credits beginning / / 2018 ending / / Partner s Share of Income, Deductions, Credits, etc. See back of form and separate instructions. A Part I DRAFT AS OF Information About the Partnership Partnership s employer identification number 2 Net rental real estate income (loss) 3 Other net rental income (loss) 4 Guaranteed payments 5 Interest income 16 Foreign transactions B Partnership s name, July address, city, state, and ZIP code 30, a 6b Ordinary dividends Qualified dividends C D E IRS Center where partnership filed return DO NOT FILE Part II Check if this is a publicly traded partnership (PTP) Information About the Partner Partner s identifying number 6c Dividend equivalents 7 Royalties 8 Net short-term capital gain (loss) 9a Net long-term capital gain (loss) 17 Alternative minimum tax (AMT) items F Partner s name, address, city, state, and ZIP code 9b Collectibles (28%) gain (loss) 9c Unrecaptured section 1250 gain 18 Tax-exempt income and nondeductible expenses G General partner or LLC member-manager Limited partner or other LLC member H Domestic partner Foreign partner 10 Net section 1231 gain (loss) 11 Other income (loss) I1 I2 What type of entity is this partner? If this partner is a retirement plan (IRA/SEP/Keogh/etc.), check here 19 Distributions J Partner s share of profit, loss, and capital (see instructions): Beginning Ending Profit % % Loss % % Capital % % 12 Section 179 deduction 13 Other deductions 20 Other information K Partner s share of liabilities: Beginning Ending L M Nonrecourse.. $ $ Qualified nonrecourse financing... $ $ Recourse... $ $ Partner s capital account analysis: Beginning capital account... $ Capital contributed during the year $ Current year increase (decrease). $ Withdrawals & distributions.. $ ( ) Ending capital account.... $ Tax basis GAAP Section 704(b) book Other (explain) Did the partner contribute property with a built-in gain or loss? Yes No If Yes, attach statement (see instructions) 14 Self-employment earnings (loss) *See attached statement for additional information. For IRS Use Only For Paperwork Reduction Act Notice, see Instructions for Form Cat. No R Schedule K-1 (Form 1065) 2018

70 Schedule K-1 (Form 1065) 2018 Page 2 This list identifies the codes used on Schedule K-1 for all partners and provides summarized reporting information for partners who file Form For detailed reporting and filing information, see the separate Partner s Instructions for Schedule K-1 and the instructions for your income tax return. 1. Ordinary business income (loss). Determine whether the income (loss) is Code Report on passive or nonpassive and enter on your return as follows. J Work opportunity credit Report on K Disabled access credit Passive loss See the Partner s Instructions L Empowerment zone Passive income Schedule E, line 28, column (h) employment credit M Credit for increasing research Nonpassive loss See the Partner s Instructions activities See the Partner s Instructions Nonpassive income Schedule E, line 28, column (k) N Credit for employer social 2. Net rental real estate income (loss) See the Partner s Instructions security and Medicare taxes 3. Other net rental income (loss) O Backup withholding Net income Schedule E, line 28, column (h) P Other credits Net loss See the Partner s Instructions 16. Foreign transactions 4. Guaranteed payments Schedule E, line 28, column (k) A Name of country or U.S. } 5. Interest income Form 1040, line 2b possession 6a. Ordinary dividends Form 1040, line 3b B Gross income from all sources Form 1116, Part I 6b. Qualified dividends Form 1040, line 3a C Gross income sourced at 6c. Dividend equivalents See the Partner s Instructions partner level 7. Royalties Schedule E, line 4 Foreign gross income sourced at partnership level 8. Net short-term capital gain (loss) Schedule D, line 5 D Section 951A category 9a. Net long-term capital gain (loss) Schedule D, line 12 E Foreign branch category 9b. Collectibles (28%) gain (loss) 28% Rate Gain Worksheet, line 4 F Passive category }Form 1116, Part I (Schedule D instructions) G General category 9c. Unrecaptured section 1250 gain See the Partner s Instructions H Other 10. Net section 1231 gain (loss) See the Partner s Instructions 11. Other income (loss) Code DRAFT AS OF July 30, 2018 DO NOT FILE A Other portfolio income (loss) See the Partner s Instructions B Involuntary conversions See the Partner s Instructions C Sec contracts & straddles Form 6781, line 1 D Mining exploration costs recapture See Pub. 535 E Cancellation of debt Schedule 1 (Form 1040), line 21 or Form 982 } F Section 951A income G Section 965(a) inclusion H Subpart F income other than See the Partner s Instructions sections 951A and 965 inclusion I Other income (loss) 12. Section 179 deduction See the Partner s Instructions 13. Other deductions A Cash contributions (60%) B Cash contributions (30%) C Noncash contributions (60%) D Noncash contributions (30%) }See the Partner s E Capital gain property to a 50% Instructions organization (30%) F Capital gain property (20%) G Contributions (100%) H Investment interest expense Form 4952, line 1 I Deductions royalty income Schedule E, line 19 J Section 59(e)(2) expenditures See the Partner s Instructions K Excess business interest expense See the Partner s Instructions L Deductions portfolio (other) Schedule A, line 13 M Amounts paid for medical insurance Schedule A, line 1 or Schedule 1 (Form 1040), line 29 N Educational assistance benefits See the Partner s Instructions O Dependent care benefits Form 2441, line 12 P Preproductive period expenses See the Partner s Instructions Q Commercial revitalization deduction from rental real estate activities See Form 8582 instructions R Pensions and IRAs See the Partner s Instructions S Reforestation expense deduction See the Partner s Instructions T through V Reserved for future use W Other deductions See the Partner s Instructions X Section 965(c) deduction See the Partner s Instructions 14. Self-employment earnings (loss) Note: If you have a section 179 deduction or any partner-level deductions, see the Partner s Instructions before completing Schedule SE. A Net earnings (loss) from self-employment B Gross farming or fishing income C Gross non-farm income } 15. Credits A Low-income housing credit (section 42(j)(5)) from pre-2008 buildings B Low-income housing credit (other) from pre-2008 buildings C Low-income housing credit (section 42(j)(5)) from post-2007 buildings See D Low-income housing credit (other) from post-2007 buildings E Qualified rehabilitation expenditures (rental real estate) F Other rental real estate credits G Other rental credits H Undistributed capital gains credit I Biofuel producer credit Schedule SE, Section A or B See the Partner s Instructions See the Partner s Instructions the Partner s Instructions Schedule 5 (Form 1040), line 74, box a See the Partner s Instructions } Deductions allocated and apportioned at partner level I Interest expense Form 1116, Part I J Other Form 1116, Part I Deductions allocated and apportioned at partnership level to foreign source income K Section 951A category L Foreign branch category M Passive category }Form 1116, Part I N General category O Other Other information P Total foreign taxes paid Form 1116, Part II Q Total foreign taxes accrued Form 1116, Part II R Reduction in taxes available for credit Form 1116, line 12 S Foreign trading gross receipts Form 8873 T Extraterritorial income exclusion Form 8873 U Section 951A(c)(1)(A) tested income } V Tested foreign income tax W Section 965 information X Other foreign transactions See the Partner s Instructions 17. Alternative minimum tax (AMT) items } A Post-1986 depreciation adjustment B Adjusted gain or loss See the Partner s C Depletion (other than oil & gas) Instructions and D Oil, gas, & geothermal gross income the Instructions for E Oil, gas, & geothermal deductions Form 6251 F Other AMT items 18. Tax-exempt income and nondeductible expenses A Tax-exempt interest income Form 1040, line 2a B Other tax-exempt income See the Partner s Instructions C Nondeductible expenses See the Partner s Instructions 19. Distributions A Cash and marketable securities B Distribution subject to section 737 C Other property } See the Partner s Instructions 20. Other information A Investment income Form 4952, line 4a B Investment expenses Form 4952, line 5 C Fuel tax credit information Form 4136 D Qualified rehabilitation expenditures See the Partner s Instructions (other than rental real estate) E Basis of energy property See the Partner s Instructions F Recapture of low-income housing Form 8611, line 8 credit (section 42(j)(5)) G Recapture of low-income housing credit (other) Form 8611, line 8 H Recapture of investment credit See Form 4255 I Recapture of other credits See the Partner s Instructions J Look-back interest completed See Form 8697 long-term contracts K Look-back interest income forecast } See Form 8866 method L Dispositions of property with section 179 deductions M Recapture of section 179 deduction N Interest expense for corporate partners O through Y Z Section 199A income AA Section 199A W-2 wages See the Partner s AB Section 199A unadjusted basis Instructions AC Section 199A REIT dividends AD Section 199A PTP income AE Excess taxable income AF Excess business interest income AG Gross receipts for section 59A(e) AH Other information

71 Formation of Partnership (Yes) FACTS: A Cash $100,000 50% Yes U Idea that will make us money while we sleep 45% FMV $90,000 Yes I Draft Operating Agreement 5% FMV $10,000 No Which of the above have contributed property? (Gerald Ford & Beaver Creek) SP&LPROB Code Sections: Formation of the Partnership (Yes) 721 No Gain or Loss But property must be contributed. 722 Partner s Basis in Interest 723 Partnership s Basis in Contributed Property (UBIA) 724 Holding Period to the Partnership of Contributed Capital Loss & Inventory Property 752(a) Proportionate Share of Debt is Money Contribution Recourse Debt Loss Ratio & Nonrecourse Debt Profits Ratio 752(b) Debt on the Contributed Property is a Money Distribution SP&LPROB.18 26

72 Formation of the Partnership (Yes) What are the exceptions to 721? SP&LPROB Formation of the Partnership (Yes) What are the exceptions to 721? Investment company 721(b) & 351(e) Debt in excess of basis 731(a)(1) Capital interest for services Profits interest for services See Notice & (c)(1)(B) Distribution of contributed property within seven years 737 Receive property as a distribution within seven years Disguised sale under 707(a)(2)(B) Otey Transaction Preferred distribution w/in two years See Form 8275 SP&LPROB.18 28

73 Formation of the Partnership (Yes) What is the definition of Property? (See Stafford) See 936(h)(3)(B) U has an idea (45%), I will draft Operating Agreement (5%) and A will contribute cash (50%). Are commitments from the following considered as property: Tenant Architect Received a capital interest Contractor in LLC FMV $200,000 Lender SP&LPROB Formation of the Partnership (Yes) 1. What result for book purposes when appreciated property is contributed to a partnership in exchange for an interest in the partnership? Assume, for example, that the following parties contribute various property for a one-third interest in partnership capital, profits and losses of the ABC partnership. (See Form 1065, Schedule K-1, Item L for different capital accounts (tax, 704(b) Book or GAAP), and 721, 722, 723, 724 and 752(a) & (b).) A/B FMV A Cash $100,000 $100,000 B Property (Real) 150, ,000 C Property (Equip) 30, ,000 SP&LPROB.18 30

74 Formation of the Partnership (Yes) 2. What is meant by the term partner s capital account for book purposes? (See Operating Agreement.) Net FMV of property contributed 3. What is meant by the term partner s capital account for tax purposes? Tax capital is a Debit = Credits number SP&LPROB Formation of the Partnership Tax Balance Sheet A/B Cash $100 Debt $0 B Prop 150 Tax Cap. Acct: CProp 30 A 100 $280 B 150 C 30 $280 SP&LPROB.18 32

75 Formation of the Partnership Book Balance Sheet FMV Cash $100 Debt $0 B Prop 100 (A/B $150) Book Cap. Acct: C Prop 100 (A/B $30) A 100 $300 B 100 C 100 $300 Operating Agreement See P (a) - 704(c) SP&LPROB Formation of the Partnership (Yes) 4. What is the difference between a partner s capital account for tax purposes and a partner s adjusted basis? No Debt Tax capital = A/B If Debt Tax capital & proportionate share of all debt = A/B 5. What balance sheet would you recommend using on Schedule L of Form 1065 Book, Tax, or Financial? a. What is UBIA and why do U care? SP&LPROB.18 34

76 Formation of the Partnership (Yes) 6. If the B and C property is depreciable property, what depreciation method is available to the tax partnership on the contributed property? (See 168(i)(7).) Do the short-year depreciation methods of Rev. Proc apply? (See also 708(b)(1)(B).) a. Assume that the B and C properties are transferred to the LLC on January 1, 2018 and LLC selects tax year end. What is the partnership s depreciation deduction on the B & C property? (See 168(i)(7) and UBIA.) b. Now assume that the LLC was organized in May 2018 and that the LLC purchased, five-year MACRS property on June 20, 2018 for $100,000. Assume no 179 election and no bonus depreciation. If all property is depreciable property, how does the LLC calculate depreciation on the property? SP&LPROB Formation of the Partnership (Yes) 6. If the B and C property is depreciable property, what depreciation method is available to the tax partnership on the contributed property? (See 168(i)(7).) Do the short-year depreciation methods of Rev. Proc apply? (See also 708(b)(1)(B).) c. What is the depreciation deduction on the property acquired on June 20, 2018? $20,000 or $13,300? SP&LPROB.18 36

77 Formation of the Partnership See 168(i)(7) Step into basis, step into depreciation schedule and A/B at the time of contribution is UBIA for wage limitforthe 199A deduction of 20% of QBI. If form LLC in May 2018: $20, = (1/5 x 2) x (1/2) x $100, $13,300 = (1/5 x 2) x (4/12) x $100,000 SP&LPROB Formation of the Partnership (No) 7. What Code Section determines the period of time that a partner is considered to have held its partnership interest where the partner received its interest as a result of the contribution of property? (See 1223(1) and Reg ) What Code Section determines the length of time that a partnership is considered to have held property contributed to the partnership? (See 724, 1223(2) and Rev. Rul ) a. What result if A who has been a member of an LLC for ten years contributes tibt additional money to the partnership? Is A s hldi holding period affected by the additional capital contribution? b. Assume that A contributes cash of $1,000 and a Capital Asset, FMV of $1,000, A/B $400 for an interest in the partnership. What is her basis in her interest and her holding period? SP&LPROB.18 38

78 Formation of the Partnership (No) U Contribute: Cash $10,000 Capital lassetfmv $10, (A/B $6,000) Sell UR interest 9 months later for $40,000. What is the character of gain? How much is ST gain and how much is LT gain? Total ST LT A/R $40,000 A/R $20,000 A/R $20,000 A/B 16,000 A/B 8,000 A/B 8,000 Gain $24,000 ST $12,000 LT $12,000 Does this make sense? SP&LPROB Formation of the Partnership (No) 8. Of what importance is 724? How long must the partnership hold contributed inventory property before it can recognize capital gain and how long must the partnership hold contributed capital loss property before it can recognize an ordinary loss? Is there a similar requirement imposed on an S corporation? a. For example, in No. 1 above, assume that the B property was a capital asset (FMV $100,000 & A/B $150,000) in the hands of B and that the C property was an inventory asset to C (FMV $100, & A/B $300,000). 000) The ABC Partnership intends to hold the B property as inventory and the C property as a capital asset. How long must the ABC Partnership hold both the B property and C property before it can recognize an ordinary loss and capital gain? (See 704(c) & BIG & BIL.) SP&LPROB.18 40

79 Formation of the Partnership (No) Before 724: Using 704(c), had the ability to legitimately: Convert O.I. into LTCG C - LT Gain $70,000 AND Convert a C.L. into O.L. B - O.L. ($50,000) Now five-year holding period under 724. SP&LPROB Code Sections: Formation of the Partnership (Yes) 721 No Gain or Loss if Property is Contributed 722 Partner s Basis in Interest 723 Partnership s Basis in Contributed Property (UBIA) 724 Holding Period of Contributed Property 752(a) Proportionate Share of Debt is Money Contribution 752(b) Debt on Property Transferred is Money Distribution (See 731(a)(1).) SP&LPROB.18 42

80 Formation of the Partnership (Yes) Code Sections: Definition of Debt or Liability Reg (a)(4) (See 357(c)(3).) Creates or increases basis, or results in cash. Gives rise to an immediate deduction. Gives rise to an expense that is not deductible in computing taxable income and is not properly chargeable to capital. SP&LPROB Formation of the Partnership (Yes) Which of the following is considered as a debt? Cash Accrual 1. Borrow $800,000 to purchase property which costs $1,000,000 Yes Yes 2. Unpaid rent on of $30,000 No Yes 3. Unpaid meal (& entertainment) expenses on of $10,000 No Yes SP&LPROB.18 44

81 Recourse & Nonrecourse Debt Are trade payables considered as debt to an accrual basis partnership? ANS:Yes Are trade payables considered as debt to a cash basis partnership? ANS:No SP&LPROB Recourse & Nonrecourse Debt (Yes) An island in the middle of the Pacific Ocean cost $100,000 and was paid foras follows: Cash Down $ 10,000 Mortgage 90,000 Cost $100,000 Recourse Debt Nonrecourse Debt What options available to lender? What options available to lender? May pursue borrower w/ May only look to property to deficiency judgment satisfy debt OR May not pursue borrower Send borrower Form 1099-C Point? Point? Who bears the risk of loss? Who bears the risk of loss? SP&LPROB.18 46

82 ISLAND SINKS Recourse & Nonrecourse Debt (Yes) 18 months later, the island sinks. What difference, if any, if the debt secured by the island is: Recourse debt? (See Reg ) Loss Ratio Nonrecourse debt? (See Reg ) Profits Ratio What do AZ, CA, FL & NV have in common? (Why did O.J. Simpson move from CA to FL?) Mention Silverado Savings & Neil Bush SP&LPROB Recourse & Nonrecourse Debt (Yes) Mention Cesar Fabian from Kauai who I met in December Cesar was a cab driver whose house was sold in a foreclosure sale and he received a Form 1099C from the bank. (See CCA Deals with whether debt is recourse or nonrecourse.) House: Cost $500,000 (A/B $445,000) Debt $450,000 Sold in Foreclosure Sale for $300,000 Form 1099-C for $150,000 What difference, if any, if the debt is recourse vs. nonrecourse and what difference if principal residence vs. rental property? SP&LPROB.18 48

83 Recourse & Nonrecourse Debt If Recourse Form 1099-C $150,000 If Nonrecourse (See Crane & Tufts) Form 4797: A/R $300,000 A/R $450,000 A/B 445,000 A/B 445, ($145,000) 1231 $ 5,000 SP&LPROB Formation of the Partnership (Yes) Assume that A, B and C contributed the following properties in exchange for an interest in the partnership: Adjusted Basis FMV A - Cash $100,000 $100,000 B - Property 60, ,000 Recourse Debt 90,000 90,000 C - Property 70, ,000 Recourse Debt 150, ,000 The partnership agreement provides that each partner is liable for its proportionate share of the recourse debt on the properties contributed by B and C. What tax effect if formed a corporation and made an S election? Choice of Entity. SP&LPROB.18 50

84 Formation of the Partnership A B A/B $100,000 A/B $60, Prop. Share Prop. Share of Debt 80,000 of Debt 80,000 A/B $180,000 Debt on Prop. Trans (90,000) A/B $50,000 SP&LPROB Formation of the Partnership C A/B $ 70, Prop. Share of Debt 80,000 Debt on Prop. Trans (150,000) A/B $0 But 731(a)(1) Tax Gain $ 0 No money distribution in excess of basis SP&LPROB.18 52

85 Formation of the Partnership Book Balance Sheet FMV Cash $100 Debt $240 B Prop 190 Book Cap. Acct: C Prop 250 A 100 $540 B 100 C 100 $540 SP&LPROB Formation of the Partnership Tax Balance Sheet FMV Cash $100 Debt $240 B Prop 60 Tax Cap. Acct: CProp 70 A 100 $230 B (30) C (80) $230 SP&LPROB.18 54

86 Interest for Services (Yes) How to reward a favored EE with ownership interest? What tax effect if a partner receives only a profit s interest in return for its services rendered to the partnership? Is a profit s interest property? When does an item become property for purposes of 721? (See Sol Diamond (AJA ), Campbell (Hap Shasby Chief Counsel), St. Johns, Henzel Phelps, Rev. Proc , Rev. Proc , and Notice optional reading. See also Reg (b)(1) & Reg (b)(2) To whom were the services rendered & 409A?) See also Reg (e) & If receive a capital interest in exchange for services, 721 does not apply. Have a taxable event. If receive only a profits interest (and no capital interest) for services, 721 does apply. Not a taxable event. (See 1061 which applies to raising capital, investing in or developing specified assets, securities, real estate, options or derivatives.) SP&LPROB Interest for Services (Yes) What result if a corporation issues stock in exchange for services? How much Gain/Loss is the corporation required to recognize when it sells or issues it own stock? (See 1032.) Corporation Service Person 1. Sale of stock by corporation 1. Received cash for services for cash No G/L G.I. 2. Distributed cash to service 2. Then purchased stock for person Ded. 162 cash & basis is FMV SP&LPROB.18 56

87 Notice VOGEL.SEM/SP&LPROB.18

88 Notice Released: May 20, 2005 Published: June 13, 2005 Purpose This notice addresses the taxation of a transfer of a partnership interest in connection with the performance of services. In conjunction with this notice, the Treasury Department and the Internal Revenue Service are proposing regulations under 83 of the Internal Revenue Code. The proposed regulations grant the Commissioner authority to issue guidance of general applicability related to the taxation of the transfer of a partnership interest in connection with the performance of services. This notice includes a proposed revenue procedure under that authority. The proposed revenue procedure provides additional rules for the elective safe harbor under proposed (l) for a partnership's transfers of interests in the partnership in connection with the performance of services for that partnership. The safe harbor is intended to simplify the application of 83 to partnership interests and to coordinate the provisions of 83 with the principles of partnership taxation. Upon the finalization of the proposed revenue procedure, Rev. Proc , C.B. 343, and Rev. Proc , C.B. 191, (described below) will be obsoleted. Until that occurs, taxpayers may not rely upon the safe harbor set forth in the proposed revenue procedure, but taxpayers may continue to rely upon current law, including Rev. Proc , C.B. 343, and Rev. Proc , C.B Effective Date The Treasury Department and the Service intend for the revenue procedure proposed in this notice to be finalized and made effective in conjunction with the finalization of the related proposed regulations under 83 and subchapter K of chapter 1 of the Internal Revenue Code (subchapter K). Request for Comments Comments are requested on the proposed revenue procedure in this notice. Although the Treasury Department and the Service request comments on all aspects of the proposed revenue procedure, comments are requested specifically on the following: 1. Whether additional guidance is needed to address the transfer of an interest in a partnership to a person who is not rendering services directly to such partnership (for example, an upper-tier partnership transfers an interest in a lower-tier partnership to a person for services rendered to the upper-tier partnership). 2. Whether election of the safe harbor described in proposed (l) and the proposed revenue procedure should be permitted on Form 1065, U.S. Return of Partnership Income, and whether continued use of the safe harbor should be reported annually on Form 1065 and Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. Comments may be submitted on or before August 22, 2005 to Internal Revenue Service, PO Box 7604, Washington, DC 20044, Attn: CC:PA:LPD:PR (Notice ), Room Submissions may also be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to the Courier's Desk at 1111 Constitution Avenue, NW, Washington DC 20224, Attn: CC:PA:LPD:PR (Notice ), Room Submissions may also be sent electronically via the internet to the following address: Notice.comments@irscounsel. treas.gov. Include the notice number (Notice ) in the subject line. Drafting Information The principal authors of this notice are Stephen Tackney of the Office of Associate Chief Counsel (Tax Exempt and Government Entities); and Audrey Ellis and Demetri Yatrakis of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this notice and the application of 83, contact Stephen Tackney at (202) (not a toll-free call). For further information regarding this notice and the application of the rules contained in subchapter K, contact Audrey Ellis or Demetri Yatrakis at (202) (not a toll-free call). PROPOSED REVENUE PROCEDURE SECTION 1. PURPOSE Proposed (l) of the Income Tax Regulations allows taxpayers to elect to apply special rules (the Safe Harbor) to a partnership's transfers of interests in the partnership in connection with the performance of services for the partnership. The Treasury Department and the Internal Revenue Service intend for the Safe Harbor to simplify the application of 83 of the Internal Revenue Code to partnership interests transferred in connection with the performance of services and to coordinate the principles of 83 with the principles of partnership taxation. This revenue procedure sets forth additional rules for the elective safe harbor under proposed (l) for a partnership's transfer of interests in the partnership in connection with the performance of services for that partnership VOGEL.SEM/SP&LPROB.18

89 SECTION 2. LAW AND DISCUSSION Section 83(a) provides that if, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of (1) the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over (2) the amount (if any) paid for such property, is included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. Section (e) provides that, for purposes of 83 and the regulations thereunder, the term property includes real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future. For these purposes, under proposed (e) property includes a partnership interest. Generally, a mere right to allocations or distributions described in 707(a)(2)(A) is not a partnership interest. Proposed (e) also provides that, in the case of a transfer of a partnership interest in connection with the performance of services, the Commissioner may prescribe generally applicable administrative rules to address the application of 83 to the transfer. Section 83(b) provides that a service provider may elect to include in his or her gross income, for the taxable year in which substantially nonvested property is transferred, the excess of (1) the fair market value of the property at the time of the transfer (determined without regard to any restriction other than a restriction which by its terms will never lapse), over (2) the amount (if any) paid for the property. If such an election is made, 83(a) does not apply with respect to the transfer of the property upon vesting and, if the property is subsequently forfeited, no deduction is allowed to the service provider in respect of the forfeiture. Section (b) provides that an election under 83(b) must be filed not later than 30 days after the date the property was transferred and may be filed prior to the date of the transfer. Section (c) provides that the election is made by filing one copy of a written statement with the Internal Revenue Service Center with which the service provider files his or her return. In addition, one copy of such statement must be submitted with the service provider's income tax return for the taxable year in which the property was transferred. Section (a) provides that, unless an election under 83(b) is made, the transferor is regarded as the owner of substantially nonvested property transferred in connection with the performance of services until such property becomes substantially vested, and any income from such property received by the service provider (or beneficiary thereof), or the right to the use of such property by the service provider, constitutes additional compensation and is included in the gross income of the service provider for the taxable year in which the income is received or the use is made available. Under this rule, a partnership must treat as unissued any substantially nonvested partnership interest transferred in connection with the performance of services for which an election under 83(b) has not been made. If the service provider who holds such an interest receives distributions from the partnership with respect to that interest while the interest is substantially nonvested, the distributions are treated as compensation in the capacity in which the service provider performed the services. For example, if a service provider that is not a pre-existing partner holds a substantially nonvested partnership interest that the service provider received in connection with the performance of services and the service provider did not make an election under 83(b) with respect to that interest, then any distributions made to the service provider on account of such interest are treated as additional compensation and not partnership distributions. If, instead, the service provider who receives a substantially nonvested partnership interest in connection with the performance of services makes a valid election under 83(b), then the service provider is treated as the owner of the property. See Rev. Rul , C.B. 17. The service provider is treated as a partner with respect to such an interest, and the partnership must allocate partnership items to the service provider as if the partnership interest were substantially vested. Section (b) provides that property is substantially nonvested for 83 purposes when it is subject to a substantial risk of forfeiture and is nontransferable. Property is substantially vested for 83 purposes when it is either transferable or not subject to a substantial risk of forfeiture. Section (c) provides that, for 83 purposes, whether a risk of forfeiture is substantial or not depends upon the facts and circumstances. A substantial risk of forfeiture exists where rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if such condition is not satisfied. Section (d) provides that, for 83 purposes, the rights of a person in property are transferable if such person can transfer any interest in the property to any person other than the transferor of the property, but only if the rights in such property of such transferee are not subject to a substantial risk of forfeiture. Proposed (l) provides that, subject to such additional conditions, rules, and procedures that the Commissioner may VOGEL.SEM/SP&LPROB.18

90 prescribe in regulations, revenue rulings, notices, or other guidance published in the Internal Revenue Bulletin, a partnership and all of its partners may elect a safe harbor under which the fair market value of a partnership interest that is transferred in connection with the performance of services is treated as being equal to the liquidation value of that interest for transfers on or after the date final regulations are published in the Federal Register if the following conditions are satisfied: (1) the partnership must prepare a document, executed by a partner who has responsibility for federal income tax reporting by the partnership, stating that the partnership is electing, on behalf of the partnership and each of its partners, to have the safe harbor apply irrevocably as of the stated effective date with respect to all partnership interests transferred in connection with the performance of services while the safe harbor election remains in effect and attach the document to the tax return for the partnership for the taxable year that includes the effective date of the election; (2) except as provided below, the partnership agreement must contain provisions that are legally binding on all of the partners stating that (a) the partnership is authorized and directed to elect the safe harbor, and (b) the partnership and each of its partners (including any person to whom a partnership interest is transferred in connection with the performance of services) agrees to comply with all requirements of the safe harbor with respect to all partnership interests transferred in connection with the performance of services while the election remains effective; and (3) if the partnership agreement does not contain the provisions described in clause (2) of this sentence, or the provisions are not legally binding on all of the partners of the partnership, then each partner in a partnership that transfers a partnership interest in connection with the performance of services must execute a document containing provisions that are legally binding on that partner stating that (a) the partnership is authorized and directed to elect the safe harbor, and (b) the partner agrees to comply with all requirements of the safe harbor with respect to all partnership interests transferred in connection with the performance of services while the election remains effective. The specified effective date of the safe harbor election may not be prior to the date that the safe harbor election is executed. Proposed (l) provides that the partnership must retain such records as may be necessary to indicate that an effective election has been made and remains in effect, including a copy of the partnership's election statement under this paragraph (1), and, if applicable, the original of each document submitted to the partnership by a partner under this paragraph (1). If the partnership is unable to produce a record of a particular document, the election will be treated as not made, generally resulting in termination of the election. The safe harbor election also may be terminated by the partnership preparing a document, executed by a partner who has responsibility for federal income tax reporting by the partnership, which states that the partnership, on behalf of the partnership and each of its partners, is revoking the safe harbor election on the stated effective date, and attaching the document to the tax return for the partnership for the taxable year that includes the effective date of the revocation. Section 83(h) provides that, in the case of a transfer of property in connection with the performance of services or a cancellation of a restriction described in 83(d), there is allowed as a deduction under 162, to the person for whom the services were performed (the service recipient), an amount equal to the amount included under 83(a), (b), or (d)(2) in the gross income of the service provider. The deduction is allowed for the taxable year of the service recipient in which or with which ends the taxable year in which such amount is included in the gross income of the service provider. Under (a)(3), if property is substantially vested upon the transfer, the deduction is allowed to the service recipient in accordance with its method of accounting (in conformity with 446 and 461). Section (c) provides that if, under 83(h) and (a), a deduction, an increase in basis, or a reduction of gross income was allowable (disregarding the reasonableness of the amount of compensation) in respect of a transfer of property and such property is subsequently forfeited, the amount of such deduction, increase in basis, or reduction of gross income shall be includable in the gross income of the person to whom it was allowable for the taxable year of the forfeiture. The basis of such property in the hands of the person to whom it is forfeited shall include any such amount includable in the gross income of such person, as well as any amount such person pays upon forfeiture. Section 704(b) requires that a partner's distributive share of income, gain, loss, deduction, or credit (or item thereof) be determined in accordance with the partner's interest in the partnership, determined by taking into account all facts and circumstances, if (1) the partnership agreement does not provide otherwise as to the partner's distributive share, or (2) the allocation to a partner under the agreement does not have substantial economic effect. Proposed (b)(2)(iv)(b)(l) provides that a partner's capital account includes the amount contributed by that partner to the partnership, and, in the case of a compensatory partnership interest that is transferred on or after the date final regulations are published in the Federal Register, the amount included on or after that date as the partner's compensation income under 83(a), (b), or (d)(2). For these purposes, a compensatory partnership interest is an interest in the transferring partnership that is transferred in connection with the performance of services for that partnership (either before or after the formation of the partnership), including an interest that is transferred on the exercise of a compensatory partnership option. A compensatory partnership option is an option to acquire an interest in the issuing partnership that is granted in connection with the performance of services for VOGEL.SEM/SP&LPROB.18

91 that partnership (either before or after the formation of the partnership). See proposed (b)(4). Proposed (b)(4)(xii)(a) provides that if a 83(b) election has been made with respect to a substantially nonvested interest, allocations of partnership items while the interest is substantially nonvested cannot have economic effect. Proposed (b)(4)(xii)(b) provides that allocations of partnership items to a holder of a substantially nonvested interest for which a 83(b) election has been made will be deemed to be in accordance with the partners' interests in the partnership if the partnership agreement requires that: (1) in the event that the interest for which the 83(b) election is made is later forfeited, the partnership shall make forfeiture allocations in the year of the forfeiture; and (2) all material allocations and capital account adjustments under the partnership agreement not pertaining to substantially nonvested partnership interests for which a 83(b) election has been made are recognized under 704(b). Proposed (b)(4)(xii)(e) provides that proposed (b)(4)(xii)(b) does not apply to allocations of partnership items made with respect to a substantially nonvested interest for which the holder has made a 83(b) election if, at the time of the 83(b) election, there is a plan that the interest will be forfeited. In determining whether there is a plan that the interest will be forfeited, the Commissioner will consider all of the facts and circumstances (including the tax status of the holder of the forfeitable compensatory partnership interest). Proposed (b)(4)(xii)(c) defines forfeiture allocations as allocations to the service provider (consisting of a pro rata portion of each item) of gross income and gain or gross deduction and loss (to the extent such items are available) for the taxable year of the forfeiture in a positive or negative amount equal to (1) the excess (not less than zero) of (a) the amount of the distributions (including deemed distributions under 752(b) and the adjusted tax basis of any property so distributed) to the partner with respect to the forfeited partnership interest (to the extent such distributions are not taxable under 731), over (b) the amounts paid for the interest and the adjusted tax basis of property contributed by the partner (including deemed contributions under 752(a)) to the partnership with respect to the forfeited partnership interest, minus (2) the cumulative net income (or loss) allocated to the partner with respect to the forfeited partnership interest. Proposed (b)(4)(xii)(d) provides that for purposes of proposed (b)(4)(xii)(c), items of income and gain are reflected as positive amounts, and items of deduction and loss are reflected as negative amounts. Section 721(a) provides that no gain or loss is recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership. Proposed l(b)(l) provides that 721 generally does not apply to the transfer of a partnership interest in connection with the performance of services. Such a transfer constitutes a transfer of property to which 83 and the regulations thereunder apply. However, under proposed (b)(2), except as provided in 83(h) or (c), no gain or loss is recognized by a partnership upon: (i) the transfer or substantial vesting of a compensatory partnership interest, or (ii) the forfeiture of a compensatory partnership interest. Proposed (b) provides that if a partnership interest is transferred in connection with the performance of services, and that partnership interest is substantially nonvested (within the meaning of (b)), then the holder of the partnership interest is not treated as a partner solely by reason of holding the interest, unless the holder makes an election with respect to the interest under 83(b). Rev. Proc , C.B. 343, provides generally that if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of becoming a partner, the Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership. The revenue procedure does not apply if (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high- quality debt securities or a high-quality net lease; (2) within two years of receipt, the partner disposes of the profits interest; or (3) the profits interest is a limited partnership interest in a "publicly traded partnership" within the meaning of 7704(b). Rev. Proc , C.B. 191, clarifies Rev. Proc and provides that, for purposes of Rev. Proc , if a partnership grants a substantially nonvested profits interest in the partnership to a service provider, the service provider will be treated as receiving the interest on the date of its grant, provided that: (1) the partnership and the service provider treat the service provider as the owner of the partnership interest from the date of its grant and the service provider takes into account the distributive share of partnership income, gain, loss, deduction and credit associated with that interest in computing the service provider's income tax liability for the entire period during which the service provider has the interest; (2) upon the grant of the interest or at the time that the interest becomes substantially vested, neither the partnership nor any of the partners deducts any amount (as wages, compensation, or otherwise) for the fair market value of the interest; and (3) all other conditions of Rev. Proc are satisfied VOGEL.SEM/SP&LPROB.18

92 SECTION 3. SCOPE.01 In General. The Safe Harbor in section 4 of this revenue procedure applies to any Safe Harbor Partnership Interest transferred by a partnership if the transfer is made during the period in which the Safe Harbor Election is in effect (whether or not the Safe Harbor Partnership Interest is substantially vested on the date of transfer). Thus, for example, sections 4.02 through 4.04 of this revenue procedure apply to a Safe Harbor Partnership Interest that is transferred during the period in which the Safe Harbor Election is in effect, even if that Safe Harbor Partnership Interest does not become substantially vested until after the Safe Harbor Election is terminated, a 83(b) election is made after the Safe Harbor Election is terminated, or that Safe Harbor Partnership Interest is forfeited after the Safe Harbor Election is terminated. Further, a Safe Harbor Election is binding on the partnership, all of its partners, and the service provider. The Safe Harbor includes all of the rules set forth in section 4 of this revenue procedure, and a partnership, its partners, and the service provider may not choose to apply only certain of the rules in section 4 of this revenue procedure or to apply the Safe Harbor only to certain partners, service providers, or partnership interests..02 Safe Harbor Partnership Interest. (1) Except as otherwise provided in section 3.02(2) of this revenue procedure, a Safe Harbor Partnership Interest is any interest in a partnership that is transferred to a service provider by such partnership in connection with services provided to the partnership (either before or after the formation of the partnership), provided that the interest is not (a) related to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, (b) transferred in anticipation of a subsequent disposition, or (c) an interest in a publicly traded partnership within the meaning of 7704(b). Unless it is established by clear and convincing evidence that the partnership interest was not transferred in anticipation of a subsequent disposition, a partnership interest is presumed to be transferred in anticipation of a subsequent disposition for purposes of the preceding clause (b) if the partnership interest is sold or disposed of within two years of the date of receipt of the partnership interest (other than a sale or disposition by reason of death or disability of the service provider) or is the subject, at any time within two years of the date of receipt, of a right to buy or sell regardless of when the right is exercisable (other than a right to buy or sell arising by reason of the death or disability of the service provider). For the purposes of this revenue procedure, "disability" means a condition which causes a service provider to be unable to engage in any substantial gainful activity by reason of a medically determinable physical or mental impairment expected to result in death or to last for a continuous period of not less than 12 months. (2) An interest in a partnership is not a Safe Harbor Partnership Interest unless at the date of transfer the requirements of section 3.03 of this revenue procedure are satisfied and a Safe Harbor Election has not terminated pursuant to section 3.04 of this revenue procedure. For the first taxable year that a partnership is subject to a Safe Harbor Election, a partnership interest may be a Safe Harbor Partnership Interest if a Safe Harbor Election is attached to the partnership tax return for the taxable year including the date of transfer, provided that the other requirements of section 3.03 of this revenue procedure are satisfied on or before the date of such transfer..03 Required Conditions for Safe Harbor Election. In order to effect and maintain a valid Safe Harbor Election, the following conditions must be satisfied: (1) The partnership must prepare a document, executed by a partner who has responsibility for federal income tax reporting by the partnership, stating that the partnership is electing, on behalf of the partnership and each of its partners, to have the Safe Harbor described in Rev. Proc. 200X-XX apply irrevocably with respect to all partnership interests transferred in connection with the performance of services while the Safe Harbor Election remains in effect. The Safe Harbor Election must specify the effective date of the Safe Harbor Election, and the effective date for the Safe Harbor Election may not be prior to the date that the Safe Harbor Election is executed. The Safe Harbor Election must be attached to the tax return for the partnership for the taxable year that includes the effective date of the Safe Harbor Election. (2) Except as provided in section 3.03(3) of this revenue procedure, the partnership agreement must contain provisions that are legally binding on all of the partners stating that (a) the partnership is authorized and directed to elect the Safe Harbor described in this revenue procedure, and (b) the partnership and each of its partners (including any person to whom a partnership interest is transferred in connection with the performance of services) agrees to comply with all requirements of the Safe Harbor described in this revenue procedure with respect to all partnership interests transferred in connection with the performance of VOGEL.SEM/SP&LPROB.18

93 services while the election remains effective. If a partner that is bound by these provisions transfers a partnership interest to another person, the requirement that each partner be bound by these provisions is satisfied only if the person to whom the interest is transferred assumes the transferring partner's obligations under the partnership agreement. If an amendment to the partnership agreement is required, the amendment must be effective before the date on which a transfer occurs for the Safe Harbor to be applied to such transfer. (3) If the partnership agreement does not contain the provisions described in section 3.03(2) of this revenue procedure, or the provisions are not legally binding on all of the partners of the partnership, then each partner in a partnership that transfers a partnership interest in connection with the performance of services must execute a document containing provisions that are legally binding on each partner stating that (a) the partnership is authorized and directed to elect the Safe Harbor described in this revenue procedure, and (b) the partner agrees to comply with all requirements of the Safe Harbor described in this revenue procedure with respect to all partnership interests transferred in connection with the performance of services while the election remains effective. Each person classified as a partner must execute the document required by this paragraph (3), and the document must be effective, before the date on which a transfer occurs, for the Safe Harbor to be applied to such transfer. If a partner who has submitted the required document transfers a partnership interest to another person, the condition that each partner submit the necessary document is satisfied only if the person to whom the interest is transferred either submits the required document or assumes the transferring partner's obligations under a document required by this paragraph that was previously submitted with respect to the transferred interest..04 Termination of Safe Harbor Election. A Safe Harbor Election continues in effect until terminated. A Safe Harbor Election terminates automatically on the date that a partnership fails to satisfy the conditions and requirements described in sections 3.02 and 3.03 of this revenue procedure. A Safe Harbor Election also terminates automatically in the event that the partnership, a partner, or service provider reports income tax effects of a Safe Harbor Partnership Interest in a manner inconsistent with the requirements of this revenue procedure, including a failure to provide appropriate information returns. A partnership may affirmatively terminate a Safe Harbor Election by preparing a document, executed by a partner who has responsibility for federal income tax reporting by the partnership, indicating that the partnership, on behalf of the partnership and each of its partners, is revoking its Safe Harbor Election under Rev. Proc. 200X-XX and the effective date of the revocation, provided that the effective date may not be prior to the date the election to terminate is executed. Such termination election must be attached to the tax return for the partnership for the taxable year that includes the effective date of the election. The rules of the Safe Harbor in section 4 of this revenue procedure do not apply to any partnership interests transferred on or after the date of a termination of the Safe Harbor Election under this paragraph but continue to apply to any Safe Harbor Partnership Interests transferred while the Safe Harbor Election was in effect..05 Election After Termination. If a partnership has made a Safe Harbor Election and if such Safe Harbor Election has been terminated under section 3.04 of this revenue procedure, then, absent the consent of the Commissioner, the partnership (and any successor partnerships) are not eligible to make a Safe Harbor Election for any taxable year that begins before the fifth calendar year after the calendar year during which such termination occurs. For purposes of this paragraph, a successor partnership is any partnership that (1) on the date of termination, is related (within the meaning of 267(b) or 707(b)) to the partnership whose Safe Harbor Election has terminated (or, if the partnership whose Safe Harbor Election has terminated does not exist on the date of termination would be related if it existed on such date), and (2) acquires (either directly or indirectly) a substantial portion of the assets of the partnership whose Safe Harbor Election has terminated..06 Recordkeeping Requirement. Under proposed (1), the partnership is required to keep as records: (1) a copy of the Safe Harbor Election submitted by the partnership to the Service under section 3.03(1) of this revenue procedure, and (2) if applicable, the original of each document submitted to the partnership by a partner under section 3.03(3) of this revenue procedure. If the partnership is unable to produce a record of a particular document, the election will be treated as not made, generally resulting in termination of the Safe Harbor Election under section 3.04 of this revenue procedure. SECTION 4. SAFE HARBOR.01 Safe Harbor. For purposes of 83, the rules in sections 4.02 through 4.04 of this revenue procedure apply to any Safe Harbor Partnership Interest for which a Safe Harbor Election is in effect VOGEL.SEM/SP&LPROB.18

94 .02 Liquidation Value. Under the Safe Harbor, the fair market value of a Safe Harbor Partnership Interest is treated as being equal to the liquidation value of that interest. For this purpose, liquidation value is determined without regard to any lapse restriction (as defined at (i)) and means the amount of cash that the recipient of the Safe Harbor Partnership Interest would receive if, immediately after the transfer, the partnership sold all of its assets (including goodwill, going concern value, and any other intangibles associated with the partnership's operations) for cash equal to the fair market value of those assets and then liquidated..03 Vesting. Under the Safe Harbor, a Safe Harbor Partnership Interest is treated as substantially vested if the right to the associated capital account balance equivalent is not subject to a substantial risk of forfeiture or the interest is transferable. A Safe Harbor Partnership Interest is treated as substantially nonvested only if, under the terms of the interest at the time of the transfer, the interest terminates and the holder may be required to forfeit the capital account balance equivalent credited to the holder under conditions that would constitute a substantial risk of forfeiture, and the interest is not transferable. For these purposes, the capital account balance equivalent is the amount of cash that the recipient of the Safe Harbor Partnership Interest would receive if, immediately prior to the forfeiture, the interest vested and the partnership sold all of its assets (including goodwill, going concern value, or any other intangibles associated with the partnership's operations) for cash equal to the fair market value of those assets and then liquidated. Notwithstanding the previous sentence, a Safe Harbor Partnership Interest will not be considered substantially nonvested if the sole portion of the capital account balance equivalent forfeited is the excess of the capital account balance equivalent at the date of termination of services over the capital account balance equivalent at the end of the prior partnership tax year or any later date before the date of termination of services..04 Forfeiture Subsequent to 83(b) Election. If a Safe Harbor Partnership Interest with respect to which a 83(b) election has been made is forfeited, the service provider must include as ordinary income in the taxable year of the forfeiture an amount equal to the excess, if any, of (1) the amount of income or gain that the partnership would be required to allocate to the service provider under proposed (b)(4)(xii) if the partnership had unlimited items of gross income and gain, over (2) the amount of income or gain that the partnership actually allocated to the service provider under proposed (b)(4)(xii). SECTION 5. APPLICATION OF SAFE HARBOR TO SERVICE PROVIDER AND SERVICE RECIPIENT.01 Application of Safe Harbor to the Service Provider. Under the Safe Harbor, the service provider recognizes compensation income upon the transfer of a substantially vested Safe Harbor Partnership Interest in an amount equal to the liquidation value of the interest, less any amount paid for the interest. If the service provider receives a Safe Harbor Partnership Interest that is substantially nonvested, does not make an election under 83(b), and holds the interest until it substantially vests, the service provider recognizes compensation income in an amount equal to the liquidation value of the interest on the date the interest substantially vests, less any amount paid for the interest. If the service provider receives a Safe Harbor Partnership Interest that is substantially nonvested and makes an election under 83(b), the service provider recognizes compensation income on the date of transfer equal to the liquidation value of the interest, determined as if the interest were substantially vested, pursuant to the rules of 83(b) and , less any amount paid for the interest..02 Application of Safe Harbor to the Service Recipient. Under 83(h), the service recipient generally is entitled to a deduction equal to the amount included as compensation in the gross income of the service provider under 83(a), (b), or (d)(2), but only to the extent the amount meets the requirements of 162 or 212. Under the Safe Harbor, the amount included in the service provider's gross income in accordance with section 4.02 of this revenue procedure is considered the amount included as compensation in the gross income of the service provider under 83(a) or (b) for purposes of 83(h). The deduction generally is allowed for the taxable year of the partnership in which or with which ends the taxable year of the service provider in which the amount is included in gross income as compensation. However, in accordance with (a)(3), where the deduction relates to the transfer of substantially vested property, the deduction is available in accordance with the service recipient's method of accounting. SECTION 6. EXAMPLES The following facts apply for all of the examples below: SP is an individual with a calendar year taxable year. PRS is a partnership with a calendar year taxable year. Except as otherwise stated, PRS's partnership agreement provides for all partnership items to be allocated to the partners in proportion to the partners' interests in the partnership. PRS's partnership agreement provides that the partners' capital accounts will be determined and maintained in accordance with (b)(2)(iv), that liquidation proceeds will be VOGEL.SEM/SP&LPROB.18

95 distributed in accordance with the partners' positive capital account balances, and that any partner with a deficit balance in the partner's capital account following the liquidation of the partner's interest must restore that deficit to the partnership. All allocations and distributions to all parties are not recast under 707(a)(2), and 751(b) does not apply to any distribution. The partnership, its members, and the service providers elect the Safe Harbor provided in section 4 of this revenue procedure and file all affected returns consistent with the Safe Harbor, and each partnership interest transferred constitutes a Safe Harbor Partnership Interest under section 3.02 of this revenue procedure. The issuance of the partnership interest in each example is not required to be capitalized under the rules of 263 or other applicable provision of the Code. In examples in which the partnership interest transferred to the service provider is not substantially vested, there is not a plan that the service provider will forfeit the partnership interest. (1) Example 1: Substantially Vested Profits Interest Facts: PRS has two partners, A and B, each with a 50% interest in PRS. On March 1, 2005, SP agrees to perform services for the partnership in exchange for a partnership interest. Under the terms of the partnership agreement, SP is entitled to 10% of the future profits and losses of PRS, but is not entitled to any of the partnership's capital as of the date of transfer. Although SP must surrender the partnership interest upon termination of services to the partnership, SP will not surrender any share of the profits accumulated through the end of the partnership taxable year preceding the partnership taxable year in which SP terminates services. Conclusion: Under section 4.03 of this revenue procedure, SP's interest in PRS is treated as substantially vested at the time of transfer. Under section 4.02 of this revenue procedure, the fair market value of the interest for purposes of 83 is treated as being equal to its liquidation value (zero). Therefore, SP does not recognize compensation income under 83(a) as a result of the transfer, PRS is not entitled to a deduction, and SP is not entitled to a capital account balance. (2) Example 2: Substantially Vested Interest Facts: PRS has two partners, A and B, each with a 50% interest in PRS. On March 1, 2005, SP pays the partnership $10 and agrees to perform services for the partnership in exchange for a 10% partnership interest that is treated as substantially vested under section 4.03 of this revenue procedure. Immediately before SP's $10 payment to PRS and the transfer of the partnership interest to SP in connection with the performance of services, the value of the partnership's assets (including goodwill, going concern value, and any other intangibles associated with the partnership's operations) is $990. Conclusion: Under section 4.02 of this revenue procedure, the fair market value of SP's interest in PRS at the time the interest becomes substantially vested is treated as being equal to its liquidation value at that time for purposes of 83. Therefore, in 2005, SP includes $90 ($100 liquidation value less $10 amount paid for the interest) as compensation income under 83(a), PRS is entitled to a deduction of $90 under 83(h), and SP's initial capital account is $100 ($90 included in income plus $10 amount paid for the interest). (3) Example 3: Substantially Nonvested Interest; No 83(b) Election; Pre-Existing Partner Facts: PRS has two partners, A and SP, each with a 50% interest in PRS. On December 31, 2004, SP agrees to perform services for the partnership in exchange for a 10% increase in SP's interest in the partnership from 50% to 60%. SP is not required to pay any amount in exchange for the additional 10% interest. Under the terms of the partnership agreement, if SP terminates services on or before January 1, 2008, SP forfeits any right to any share of accumulated, undistributed profits with respect to the additional 10% interest. The partnership interest transferred to SP is not transferable and no election is made under 83(b). SP continues performing services through January 1, PRS has taxable income of $500 in 2005 and $1,000 in each of 2006 and No distributions are made to A or SP during such period. On January 1, 2008, the value of the partnership's assets (including goodwill, going concern value, and any other intangibles associated with the partnership's operations) is $3,500. Conclusion: Under section 4.03 of this revenue procedure, the 10% partnership interest transferred to SP on December 31, 2004, is treated as substantially nonvested at the time of transfer. Because a 83(b) election is not made, SP does not include any amount as compensation income attributable to the transfer, and correspondingly, PRS is not entitled to a deduction under 83(h). In accordance with the partnership agreement, PRS's taxable income for 2005 is allocated $250 to A and $250 to SP, and PRS's taxable income for each of 2006 and 2007 is allocated $500 to A and $500 to SP. On January 1, 2008, SP's additional 10% interest in PRS is treated as becoming substantially vested under section 4.03 of this revenue procedure. At that time, the additional 10% interest in the partnership has a liquidation value of $350 (10% of $3,500). Under VOGEL.SEM/SP&LPROB.18

96 section 4.02 of this revenue procedure, the fair market value of the interest at the time it becomes substantially vested is treated as being equal to its liquidation value at that time for purposes of 83. Therefore, in 2008, SP includes $350 as compensation income under 83(a), PRS is entitled to a deduction of $350 under 83(h), and SP's capital account is increased by $350. (4) Example 4: Substantially Nonvested Interest; No 83(b) Election Facts: PRS has two partners, A and B, each with a 50% interest in PRS. On December 31, 2004, SP pays the partnership $10 and agrees to perform services for the partnership in exchange for a 10% partnership interest. Under the terms of the partnership agreement, if SP terminates services on or before January 1, 2008, SP forfeits any rights to any share of accumulated, undistributed profits, but is entitled to a return of SP's $10 initial contribution. SP's partnership interest is not transferable and no election is made under 83(b). SP continues performing services through January 1, PRS earns $500 of taxable income in 2005, and $1,000 in each of 2006 and A and B each receive distributions of $225 in 2005, but neither A nor B receive distributions in 2006 and PRS transfers $50 to SP in 2005, but does not make any transfers to SP in 2006 or On January 1, 2008, SP's partnership interest has a liquidation value of $300 (taking into account the unpaid partnership income credited to SP through that date). Conclusion: Under section 4.03 of this revenue procedure, SP's partnership interest is treated as substantially nonvested at the time of transfer. Because a 83(b) election is not made, SP does not include any amount as compensation income attributable to the transfer and, correspondingly, PRS is not entitled to a deduction under 83(h). Under proposed (b), SP is not a partner in PRS; therefore, none of PRS's taxable income for the years in which SP's interest is substantially nonvested may be allocated to SP. Rather, PRS's taxable income is allocated exclusively to A and B. In addition, the $50 paid by PRS to SP in 2005 is compensation income to SP, and PRS is entitled to a deduction of $50 under 162 in accordance with its method of accounting. On January 1, 2008, SP's interest in PRS is treated as becoming substantially vested under section 4.03 of this revenue procedure. Under section 4.02 of this revenue procedure, the fair market value of the interest at the time the interest becomes substantially vested is treated as being equal to its liquidation value at that time for 83 purposes. Therefore, in 2008, SP includes $290 ($300 liquidation value less $10 amount paid for the interest) as compensation income under 83(a), PRS is entitled to a $290 deduction, and SP's capital account is increased to $300 ($290 included in income plus $10 amount paid for the interest). (5) Example 5: Substantially Nonvested Interest; 83(b) Election Facts: The facts are the same as in Example 4, except that SP makes an election under 83(b) with respect to SP's interest in PRS. The liquidation value of the interest is $100 at the time the interest in PRS is transferred to SP. SP continues performing services through January 1, Conclusion: Under section 4.02 of this revenue procedure, the fair market value (disregarding lapse restrictions) of SP's interest in PRS at the time of transfer is treated as being equal to its liquidation value (disregarding lapse restrictions) at that time for 83 purposes. Because a 83(b) election is made, in 2004 SP includes $90 ($100 liquidation value less $10 amount paid for the interest) as compensation income, PRS is entitled to a $90 deduction, and SP's initial capital account is $100 ($90 included in SP's income plus $10 amount paid for the interest). Under proposed (b), as a result of SP's election under 83(b), SP is treated as a partner starting from the date of the transfer of the interest to SP. Accordingly, SP includes in 2005 taxable income SP's $50 distributive share of PRS income, and the $50 payment to SP by PRS in 2005 is a partnership distribution under 731. SP includes in 2006 and 2007 taxable income SP's $100 distributive shares of PRS income for those years. (6) Example 6: Substantially Nonvested Interest; 83(b) Election; Forfeiture; Net Profit Facts: The facts are the same as in Example 5, except that SP terminates services on September 30, 2007, and is repaid the $10 that SP paid for the PRS interest in The partnership agreement provides that if SP's partnership interest is forfeited, SP's distributive share of all partnership items (other than forfeiture allocations) will be zero with respect to the interest for the taxable year of the partnership in which the interest is forfeited. Conclusion: The tax consequences for 2004 through 2006 are the same as in Example (5). As a result of the forfeiture in 2007, PRS is required under (c) to include in gross income $90 (the amount of the allowable deduction on the transfer of the interest to SP). In accordance with the partnership agreement, PRS also makes forfeiture allocations in 2007 to offset partnership income and loss that was allocated to SP and partnership distributions to SP prior to the forfeiture VOGEL.SEM/SP&LPROB.18

97 Cumulative net income of $150 was allocated to SP prior to the forfeiture ($50 in 2005 and $100 in 2006) and SP received a total of $60 of distributions from PRS ($50 in 2005 and $10 in 2007 (the repayment of SP's initial contribution to PRS)). Under proposed (b)(4)(xii), the total forfeiture allocations to SP is $100 of partnership loss and deduction, the difference between $50 ($60 of distributions to SP less $10 of contributions to PRS by SP) and $150 (cumulative net income allocated to SP). Pursuant to the partnership agreement, none of the partnership income for the year 2007 is allocated to SP. In accordance with 83(b)(1) (last sentence), SP does not receive a deduction or capital loss for the amount ($90) that was included as SP's compensation income as a result of the election under 83(b). (7) Example 7: Substantially Nonvested Interest; 83(b) Election; Forfeiture; Net Loss Facts: PRS has two partners, A and B, each with a 50% interest in PRS. On December 31, 2004, SP pays the partnership $10 and agrees to perform services for the partnership in exchange for a 10% partnership interest. Under the terms of the partnership agreement, if SP terminates services before January 1, 2008, SP forfeits any right to any share of accumulated, undistributed profits, but is entitled to a return of SP's $10 initial contribution. SP's partnership interest is not transferable. The partnership agreement provides that if SP's partnership interest is forfeited, SP's distributive share of all partnership items (other than forfeiture allocations) will be zero with respect to the interest for the taxable year of the partnership in which the interest is forfeited. At the time of the transfer, the liquidation value of the 10% partnership interest is $100, and SP makes an election under 83(b) with respect to the interest. In 2005, PRS earns $500 of taxable income, which is allocated and distributed $225 to each of A and B and $50 to SP. In 2006, PRS has net taxable loss of $1,000, $100 of which is allocated to SP. PRS does not make any distributions in PRS has no items of income, gain, loss, or deduction in 2007, other than gross income recognized under (c). SP terminates services on September 30, 2007, and is repaid the $10 that SP paid for the PRS interest in PRS does not make any distributions in 2007, other than the return of SP's $10 contribution. value less $10 amount paid for the interest), PRS is entitled to a $90 deduction under 83(h), and SP's initial capital account is $100 ($90 compensation income plus $10 amount paid for the interest). Under proposed (b), as a result of SP's election under 83(b), SP is treated as a partner starting from the date of the transfer of the interest to SP. Accordingly, SP includes in 2005 taxable income SP's $50 distributive share of PRS's income, and the $50 payment to SP in 2005 is a partnership distribution under 731. SP includes in computing 2006 taxable income SP's $100 distributive share of PRS's loss. As a result of the forfeiture in 2007, PRS is required under (c) to include in gross income $90 (the amount of the allowable deduction on the transfer of the interest to SP). In accordance with the partnership agreement, PRS also makes forfeiture allocations in 2007 to offset partnership income and loss that was allocated to SP and partnership distributions to SP prior to the forfeiture. Cumulative net loss of $50 was allocated to SP prior to the forfeiture ($50 of income in 2005 and $100 of loss in 2006) and SP received a total of $60 of partnership distributions ($50 in 2005 and $10 in 2007 (the repayment of SP's initial contribution to PRS)). If PRS had unlimited items of gross income and gain, the total forfeiture allocations to SP under proposed (b)(4)(xii) would be $100 of partnership income and gain, the difference between $50 ($60 distributions to SP less $10 of contributions to PRS by SP) and -$50 (cumulative net loss allocated to SP). However, PRS's only income in 2007 is the $90 of income recognized by PRS under (c), all of which must be used to make forfeiture allocations to SP. Under section 4.04 of this revenue procedure, in 2007, SP must include in ordinary income $10 (the difference between the forfeiture allocations that would be required under proposed (b)(4)(xii) if PRS had an unlimited amount of gross income and gain, $100, and the actual forfeiture allocations to SP, $90). PRS is not entitled to a deduction for the amount ($10) that SP is required to include in income under section 4.04 of this revenue procedure. SECTION 7. EFFECT ON OTHER DOCUMENTS Rev. Proc , C.B. 343, and Rev. Proc , C.B. 191, are obsoleted. Conclusion: Under section 4.02 of this revenue procedure, the fair market value (disregarding lapse restrictions) of SP's interest in PRS at the time of transfer is treated as being equal to its liquidation value (disregarding lapse restrictions) at that time for purposes of 83. Because a 83(b) election is made, SP includes as compensation income in 2004 $90 ($100 liquidation VOGEL.SEM/SP&LPROB.18

98 Interest for Services (Yes) Assume that the Balance Sheet for the LLC is as follows (000 s are omitted): Adj. Basis FMV Assets $6,000 $9,000 Liabilities $2,400 $2,400 Capital Accounts: A 1,800 3,300 B 1,800 3,300 SP&LPROB $6,000 $9,000 Interest for Services Without applying any discounts, based on Balance Sheet on the previous slide, what is a one-third interest in the tax partnership worth? (See Prop. regulations on 2704 (Min & Mkt Discounts) which were issued in August 2016, in December 2016 Treasury declined to finalize and in October 2017, regulations were withdrawn.) ANS: $2,200,000 (1/3 x $6,600,000) SP&LPROB.18 58

99 Interest for Services (Yes) The LLC has finally agreed to give U a one-third interest in the LLC in exchange foryour long and devoted service to the business About time!! Would U graciously accept this most generous offer or politely decline? SP&LPROB Interest for Services (Yes) Assume that the Balance Sheet for the LLC is as follows: Adj. Basis FMV Assets $6,000 $9,000 Liabilities $2,400 $2,400 Capital Accounts: A 1,800 3,300 B 1,800 3,300 $6,000 $9,000 a. What tax effect if the LLC transfers a 1/3 interest in partnership capital and profits to U in exchange for services (see Notice )? SP&LPROB.18 60

100 Capital Interest for Services (Yes) P/S U Service Person 1. No G/L 1. G.I. $2,200,000 (Form 1099 Box 7) 2. Deduct $2,200, Tax & Book Cap. Acct. $2,200,000 (A&B) Would U graciously accept or politely decline? SP&LPROB Interest for Services (Yes) Assume that the Balance Sheet for the LLC is as follows: Adj. Basis FMV Assets $6,000 $9,000 Liabilities $2,400 $2,400 Capital Accounts: A 1,800 3,300 B 1,800 3, $6,000 $9,000 b. Same as a above, except the LLC transfers only a 1/3 interest in profits to U in exchange for services (see Notice )? SP&LPROB.18 62

101 Profits Interest for Services (Yes) P/S U 1. No G/L 1. No G.I. Why? 2. No Deduct 2. Tax & Book Cap. Acct. $0 Would U graciously accept or politely decline? Mention reverse 704(c) allocation Only income activity is collection of zero basis receivables. See P.2 of Operating Agreement 1.8(b) Reverse 704(c) allocation. (See P , No. 6.) How much of income from the collection of the receivable of $3,000 would be allocated to U All, Some or None? SP&LPROB Interest for Services (No) (Skip to Slide 87.) Assume that the Balance Sheet for the LLC is as follows: Adj. Basis FMV Assets $6,000 $9,000 Liabilities $2,400 $2,400 Capital Accounts: A 1,800 3,300 B 1,800 3,300 $6,000 $9,000 c. Same as a above (capital interest for services), except that C s interest is subject to a substantial risk of forfeiture, i.e., U is required to perform services for the next five years. SP&LPROB.18 64

102 Capital Subject to Substantial Risk of Forfeiture If U did accept and did not make 83(b) election: P/S Nothing & if U is entitled to 1/3 of the profits for next five years, the profits pass out as compensation for services U What happens at the end of five years when the substantial risk of forfeiture lapses? U recognize O.I. SP&LPROB Interest for Services (No) Assume that the Balance Sheet for the LLC is as follows: Adj. Basis FMV Assets $6,000 $9,000 Liabilities $2,400 $2,400 Capital Accounts: A 1,800 3,300 B 1,800 3, $6,000 $9,000 d. Same as c above (capital interest for services & subject to a substantial risk of forfeiture), except that U makes a 83(b) election. SP&LPROB.18 66

103 Capital and 83(b) Election Would you graciously accept, or politely decline? If U made 83(b) Election: Today P/S U 1. No G/L Inc. $2,200, Ded $2,200, Book & Tax Capital lacct $2,200, (Recognized as partner today) 5 Years SRF Lapses Nothing SP&LPROB Interest for Services (No) Assume that the Balance Sheet for the LLC is as follows: Adj. Basis FMV Assets $6,000 $9,000 Liabilities $2,400 $2,400 Capital Accounts: A 1,800 3,300 B 1,800 3,300 $6,000 $9,000 e. Same as d above (capital interest for services, subject to a substantial risk of forfeiture & 83(b) election), except that U forfeits her interest when the value of her capital account is: 1) $2,200 SP&LPROB.18 68

104 Capital Interest for Services and 83(b) Election Year of Forfeiture P/S U Income $2,200,000 No Ded for $2,200,000 Why? Previously included in G.I. SP&LPROB Interest for Services (No) Assume that the Balance Sheet for the LLC is as follows: Adj.Basis FMV Assets $6,000 $9,000 Liabilities $2,400 $2,400 Capital Accounts: A 1,800 3,300 B 1,800 3,300 $6,000 $9,000 e. Same as d above (capital interest for services, subject to a substantial risk of forfeiture & 83(b) election), except that U forfeits her interest when the value of her capital account is: 2) $2,500 SP&LPROB.18 70

105 Capital Interest for Services and 83(b) Election Year of Forfeiture P/S Income $2,200,000 U No Ded for forfeit interest But: Capital Acct Now $2,500,000 Was $2,200,000 Difference: $300,000 Notice : Forfeiture allocations of $300,000 of expenses and losses to U Why? SP&LPROB Interest for Services (No) Assume that the Balance Sheet for the LLC is as follows: Adj. Basis FMV Assets $6,000 $9,000 Liabilities $2,400 $2,400 Capital Accounts: A 1,800 3,300 B 1,800 3,300 $6,000 $9,000 e. Same as d above (capital interest for services, subject to a substantial risk of forfeiture & 83(b) election), except that U forfeits her interest when the value of her capital account is: 3) $1,800 SP&LPROB.18 72

106 Capital Interest for Services and 83(b) Election Year of Forfeiture P/S Income $2,200,000 U No Ded for forfeit interest But: Capital Acct Now $1,800,000 Was $2,200,000 Difference: $400,000 Notice : Forfeiture allocations of $400,000 of income and gain to U Why? SP&LPROB Interest for Services (No) Assume that the Balance Sheet for the LLC is as follows: Adj. Basis FMV Assets $6,000 $9,000 Liabilities $2,400 $2,400 Capital Accounts: A 1,800 3,300 B 1,800 3,300 $6,000 $9,000 f. Same as b above, i.e., the partnership transfers only a 1/3 interest in profits to C in exchange for services, but U s interest is subject to a substantial risk of forfeiture. (No 83(b) election.) SP&LPROB.18 74

107 Profits Interest for Services No 83(b) Election & Profits Only P/S Nothing Today U Nothing Allocate % of profits to C Treated as compensationforservices P/S No G/L SRF Lapses U No G/L SP&LPROB Interest for Services (No) Assume that the Balance Sheet for the LLC is as follows: Adj. Basis FMV Assets $6,000 $9,000 Liabilities $2,400 $2,400 Capital Accounts: A 1,800 3,300 B 1,800 3,300 $6,000 $9,000 g. Same as f above, (i.e., the partnership transfers only a 1/3 interest in profits to C in exchange for services, but U s interest is subject to a substantial risk of forfeiture), except that C makes a 83(b) election. SP&LPROB.18 76

108 Profits Interest for Services Yes 83(b) Election & Profits Only P/S No G/L Today U No income, but Book & Tax Cap. Acct. - $0 (Recognized as partner today) P/S Nothing SRF Lapses U Nothing SP&LPROB Review Problem (Yes) 1. A, B, C, D and E decide to form a partnership in which they will each have an equal share of capital, profits and losses. Each contributes the following property: p Partner Property Basis FMV A Cash $100 $100 B Land (subject to mortgage of $50) Goodwill (from business to be continued) 0 60 C Building (subject to mortgage of $100) Cash D Equipment ($40 of 1245 recapture) E Inventory Installment note receivable Account receivable for services rendered for E to a third party 0 40 SP&LPROB Total: $300 $650

109 Partner s Basis (Yes) A A/B $100 + Prop. Share of Debt 752(a) (1/5 x $150) 30 A/B $130 SP&LPROB Partner s Basis (Yes) A/B $ 50 + Prop. Share of Debt 752(a) (1/5 x $150) 30 - Debt on Prop. Trans. 752(b) (50) B A/B $ 30 SP&LPROB.18 80

110 Partner s Basis (Yes) C A/B $ 50 + Prop. Share of Debt 752(a) (1/5 x $150) 30 - Debt on Prop. Trans. 752(b) (100) A/B $ 0 Tax Gain $ 20 See 731(a)(1) SP&LPROB Partner s Basis (Yes) D A/B $60 + Prop. Share of Debt 752(a) (1/5 x $150) 30 A/B $90 SP&LPROB.18 82

111 Partner s Basis (Yes) E A/B $40 + Prop. Share of Debt 752(a) (1/5 x $150) 30 A/B $70 SP&LPROB Schedule L 1065, 1120, 1120S (Yes) What Balance Sheet (Book, Tax, or Financial) SP&LPROB.18 84

112 A/B Liabilities $150 Assets $300 Tax Cap. Acct. Tax Balance Sheet (Yes) A $100 B 0 C (50) D 60 E 40 $300 SP&LPROB Tax Balance Sheet (Yes) A/B Liabilities $ (b) Alt. Rule Assets $300 Tax Prop. Share Partner Cap. Acct. + ofdebt = Basis A $100 + $30 = $130 B = 30 C (50) + 30 = 0 D = 90 E = 70 $300 $320 SP&LPROB.18 86

113 Partnership Operations (Yes) Overview of Applicable Code Sections Sections deal with the Code Sections that determine the income of a partnership and how that income isto be allocated among the partners.these code sections are the primary code sections used in preparing a Form Special Allocations: 704(b) Substantial Economic Effect (Traditional (Waterfall Class A & Class B owners) & Targeted Allocations O&G) 704(c) BIG / BIL & Reverse 704(c) allocation 706(d) Varying Interest ( ) If U had your druthers, would U prefer $100,000 of good deductions or $100,000 of ordinary income? SP&LPROB Partnership Operations (Yes) Section 701 A partnership is not a taxable entity, but each partner is required to include his distributive ib ti share of the partnership income on his own tax return and pay the tax thereon. This is true regardless of whether the partner receives an advance against his distributive share which is greater than or less than his distributive share. No Federal income tax Still have employment, excise taxes & sin taxes Some states have a fee that is required. CA LLC - $800 IL Replacement Tax TX Gross Receipts Tax SP&LPROB.18 88

114 Partnership Operations (Yes) Section 702(a) Commonly referred to as the variable effect or separately stated items. These are the items listed on the Schedule K and K-1. Section 702(a)(1) to (6) items include capital gains and losses, 1231 gains and losses, dividends and charitable contributions. Other items are also included if their tax treatment would vary from partner to partner. Section 702(a)(7) includes all special ilallocations under 704(c) dealing with ih the difference between fair market value and adjusted basis of contributed property, 704(b)(2) - special allocation of items of income, loss, deduction, or credit, and 706(d) dealing with the allocation of items of income, gain, loss, deduction, or credit where a partner's interest in the partnership varies or changes during the taxable year. SP&LPROB Partnership Operations (Yes) Section 702(b) Generally, the character of an item of income, gain, loss, or dd deduction is dt determined dat thepartnership's level. l In other words, if the character of the gain to the partnership is a long-term capital gain, each partner's distributive share is also a long-term capital gain. Hedge Fund Manager & Carried Interest (Both Mrs. Clinton & President Trump made mention of this in presidential debate Now 1061.) Fix and Flips See Podell. (Dealer (O.I.) or Investment (LT)) U is an investor and I is a contractor. Purchase a piece of property, rehab the property and 18 months later sell the property at a gain. What is the character? SP&LPROB.18 90

115 Example of Carried interest (Yes) U InvestintaxP/S U agree to manage account of P/S for 5% of net profits of P/S (providing management services exclusively for P/S) Profits LT $140,000,000 x 5% = $7,000, Is $7,000,000 a guaranteed payment? No. Why? 707(c) Not w/o regard to income 2. Is this a payment made to U in a non-partner capacity? No. Not 707(a) payment Not offering same services to 3 rd party. 3. Distributive share LT $7,000,000 Converted O.I. into LTCG 4. Now 1061 Converts the O.I. into STCG if a specified asset such as a security mandates that the security must have been held for more than three years. SP&LPROB Partnership Operations (Yes) Section 703(a) - The income of a partnership is calculated in the same manner as that of an individual. Certain deductions, however, are not taken into account. Such deductions include the deduction for personal exemptions under 151, the charitable contribution deduction under 170, the net operating loss deduction under 172, and the additional itemized deductions for individuals such as the medical expense deduction of 213, the moving expense deduction of 217, the alimony deduction under 215, and the contribution to individual retirement accounts under 219. SP&LPROB.18 92

116 Partnership Operations (Yes) Section 703(b) - Any election affecting the taxable income is generally required to be made by the partnership. Such elections include 179 expensing in lieu of depreciation, the method of depreciation, inventory method, method of accounting, etc. See Reg (a)-1(f) De Minimis See Reg (a)-3(h) 2% Test Electing out of audit rules SP&LPROB Partnership Operations (Yes) Section 704(a) - A partner's distributive share of the income or loss is to be determined by the partnership agreement. Section 704(b)(1) - If the partnership agreement does not otherwise provide, each partner's distributive share of income, gain, loss, deduction, or credit is to be determined by taking into account all the facts and circumstances. (PIP test) Section 704(b)(2) - Special allocations will be allowed as long as the allocation has substantial economic effect. SP&LPROB.18 94

117 Partnership Operations (Yes) Assume that U puts in $300 and I puts in $100 into an LLC. The LLC purchases property for $400 and later sells the property for $1,000. Two Questions for TRP: 1. How should U and I allocate the profit of $600? 2. How should the LLC distribute the $1,000 in liquidation? Assume: 1. No agreement Facts & Circumstances Test. (PIP test) SP&LPROB Partnership Operations (Yes) Assume that U puts in $300 and I puts in $100 into an LLC. The LLC purchases property for $400 and later sells thepropertyt for $1,000. Two Questions for TRP: 1. How should U and I allocate the profit of $600? 2. How should the LLC distribute the $1,000 in liquidation? Assume: 2. Agreement All profits 50/50 and all liquidating distributions in accordance with positive balance in capital accounts. Most likely. (Mention targeted allocations.) SP&LPROB.18 96

118 Partnership Operations Most important items in Operating Agreement: 1. P&L ratio 2. Capital account maintenance 3. Liquidating distributions shall be made in accordance with positive balance in BookCapital laccount SP&LPROB Partnership Operations (Yes) Assume that U puts in $300 and I puts in $100 into an LLC. The LLC purchases property for $400 and later sells the property for $1,000. Two Questions for TRP: 1. How should U and I allocate the profit of $600? 2. How should the LLC distribute the $1,000 in liquidation? Assume: 3. Agreement All profits 50/50 and all liquidating distributions 75% to U and 25% to I. Liquidating distributions trump the P&L ratio. SP&LPROB.18 98

119 Partnership Operations (Yes) U I Initial contribution $300 $100 Profit $ $600 $400 Cash $1,000 $750 $250 Liquidating distributions trump the P&L ratio. SP&LPROB Substantial Economic Effect (No) Targeted Allocations The agreement states that when the LLC is liquidated, the first $500 shall be distributed to I and the remaining amount to U. The property is sold for: $1,000 U I A/R $1,000 $300 $100 A/B (400) Gain $ $500 $500 SP&LPROB

120 Substantial Economic Effect (No) Targeted Allocations The agreement states that when the LLC is liquidated, the first $500 shall be distributed to I and the remaining amount to U. The property is sold for: $1,200 U I A/R $1,200 $300 $100 A/B (400) Gain $ $700 $500 SP&LPROB Substantial Economic Effect (No) Targeted Allocations The agreement states that when the LLC is liquidated, the first $500 shall be distributed to I and the remaining amount to U. The property is sold for: $700 U I A/R $700 $300 $100 A/B (400) Gain $300?? $200 $500 SP&LPROB

121 Partnership Operations (Yes) Section 704(c) Any income, gain, loss, or deduction with respect to property contributed by a partner to the partnership shall be shared among the partners in order to take into account the difference between the fair market value and adjusted basis with respect to such property determined as of the time of the contribution. In addition, 704(c) provides that if the contributed property is distributed to another partner within seven years from the date of contribution, the contributing partner is required to recognize gain or loss. (See 704(c)(1)(B) and 737.) (See Page (a).) (See P ) Methods under 704(c): Traditional Method Traditional Method with Curative Allocation Remedial Allocation Method Small Disparity SP&LPROB Partnership Operations (Yes) Section 704(d) Subject to 465, the at-risk rules, and 469, the passive activity rules, each partner's distributive share of partnership loss shall be allocated to each partner to the extent of his basis in the partnership. If a partner's distributive share of such partnership loss exceeds his adjusted basis, such loss shall be carried forward and allowed in that year in which the partner has a sufficient basis to absorb the loss. Pre-2018 losses limited by basis rules do not affect QBI for current year (see also 465, 469 and special rules for 461(l)). SP&LPROB

122 Partnership Operations (Yes) Section 705(a) A partner's basis in his partnership interest is initially determined by the way he acquired such interest. For example, a partner's basis acquired by the contribution of property is determined under 722; a partner's basis acquired by gift is determined under 1015; a partner's basis acquired from a decedent is determined under 1014; and a partner's basis acquired by a transfer between spouses or former spouses is determined under Long Hand Method How did the TRP make the basis calculation in 1990? SP&LPROB Partnership Operations (Yes) Section 705(b) Deals with the alternative rule in determining a partner's basis in his partnership interest. Under the alternative rule, a partner's basis in his partnership interest is equal to the adjusted basis of the partnership property which would be distributed to such partner in the event that the partnership was liquidated. Generally, such amount equals the partner's tax capital account plus the partner's proportionate share of the partnership debt. Short Cut Tax Capital Account plus proportionate share of all debt (nonrecourse debt, qualified nonrecourse financing and recourse debt). Can U think of an everyday example of nonrecourse debt? SP&LPROB

123 Partnership Operations (Yes) Section 706(a) A partner is required to include his distributive share of partnership income, gain, loss, deduction, or credit and any guaranteed payments in his taxable income for the partnership taxable year ending within or with his taxable year. Ending within means that the partnership and partner have different taxable years, while ending with means that the partnership and partner have the same taxable year end. Bring U two Schedule K-1 s and each has a TYE of: How much on 2018 Form 1040? (RPE with a fiscal year ending within 2018 is eligible for 199A deduction and should be eligible for 199 deduction.) SP&LPROB Partnership Operations (Yes) Section 706(b) Under the general rule, a partnership cannot adopt a taxable year of other than that of the partners owning amajority interest in partnership capital and profits unless it establishes a business purpose and receives consent of the Secretary or unless the partnership makes such payments as are required by If all members of an LLC are individuals, what taxable year end is the LLC restricted to? ANS: Why? SP&LPROB

124 Partnership Operations (Yes) Section 706(c) The taxable year of a partnership shall not close as the result of the death of a partner, the entry of a new partner, the liquidation of a partner, or the sale or exchange of a partner's interest in the partnership. If a partner, however, disposes of his entire interest in a partnership or if the partner dies during the year, the taxable year of the partnership shall close with respect to such partner. If a partner died on , 18 andhis/her i/ estate succeeds to the interest, how many Schedule K-1 s for the year of death? ANS: Atleasttwo. SP&LPROB Partnership Operations (Yes) Section 706(d) As added by DRA 1984, if during any taxable year of the partnership there is achange in any partner's interest t in the partnership, each partner's distributive share of any item of income, gain, loss, deduction, or credit shall be determined by taking into account the varying interests of the partners in the partnership during the year. With respect to certain cash-basis items and allocating such cash-basis items to each partner to take into account a partner's varying interest, such cash basis items are to be allocated to the period in which they are economically attributable. (Final Regulations issued in 2015.) A sells her 1/3 interest to D on July 1, How to allocate income in year of sale Close or no close books? What is the default if the contract does not otherwise provide? SP&LPROB

125 Close or No Close Facts: From January 1, 2018 to June 30, 2018, the LLC generates ordinary income of $300 and from July 1, 2018 to December 31, 2018, the LLC generates ordinary income of $1,500. No close Proportionate TYE 12/31/18 L.22 O.I. $1,800 x 1/3 = $600 (A - $300; D - $300) If close: 1/1/18 to 6/30/18 O.I. $300 x 1/3 = $100 to A 7/1/18 to 12/31/18 O.I. $1,500 x 1/3 = $500 to D What is the default if the purchase agreement is silent? ANS: Close. SP&LPROB Partnership Operations (Yes) Section 707(a) Under 707(a), a partner can deal with his partnership in a capacity other than as a member of such partnership. In other words, a partner can deal with his partnership in an arm's-length transaction. As enacted by TRA 1984, there are, however, certain restrictions which apply. For example, 267(e) disallows any 707(a) payment as a deduction to the partnership until such amount is actually paid; and 707(a) has also been changed to deal with special allocations of income which are properly capital expenditures, and certain transfers of property followed by a distribution of money (referred to as Otey transactions). Subject to 267(e) Payments to a partner in nonpartner capacity Loan of money, rental of property, sale of property or performance of services. SP&LPROB

126 Partnership Operations (Yes) Section 707(b) In certain situations, when a partner or related party deals with apartnership in anarm's-length transaction, ti losses on the sale or exchange of property will be disallowed and gains on such sales or exchanges will be converted into ordinary income (See also 1239). If someone who is not a partner in a partnership deals with a partnership in which one of the partners is related under the attribution rules of 267, that person is treated as if he were dealing directly with each partner in the partnership and consequently a portion of the loss on such sale or exchange would be disallowed under 267. Sale of property at a gain or loss. (Gain on sale may be recharacterized as O.I. and loss disallowed if own more than a 50% interest in capital or profits.) Concept of Land Banking. Bramlette / Bradshaw SP&LPROB Partnership Operations (Yes) Section 707(c) When a partnership pays a partner a guaranteed payment for services or for the use of capital, such guaranteed payment is deductible by the partnership and included with the guaranteed partner's gross income. Such guaranteed payment is always included as ordinary income to the guaranteed partners in the year in which the partnership properly deducts such amount in the calculation of its taxable income as determined by its method of accounting. Not subject to 267(e). () Payments made to a partner in a partner capacity Either for services (SE) or for the use of property (not SE). (See Prop. Reg. to 1411.) SP&LPROB

127 Partnership Operations (Yes) Section 708(a) A partnership continues in existence unless it is terminated. SP&LPROB Partnership Operations (Yes) Section 708(b) Technical Termination A partnership shall terminate for federal income tax purposes if no part of any business is being conducted by partners in a partnership. (For sales or exchanges before January 1, 2018, if there is a sale or exchange of a 50 percent or more interest in partnership capital and profits within a 12-month period (referred to as a Technical Termination)). Just because a partnership terminates for state law purposes does not mean that such partnership terminates for tax purposes. Sell MB business which is owned by U & I for $3,000,000 cash and bury the 30,000 in $100 bills in U s backyard. Does the LLC terminate? What was the most significant tax effect that occurred if a partnership terminated by reason of a sale or exchange, i.e., a Technical Termination All tax attributes disappeared and 168(i)(7) did not apply. SP&LPROB

128 Partnership Operations (Yes) Section 709(a) No deduction shall be allowed to the partnership or to any partner for any amounts paid or incurred to organize a partnership or to promote the sale of an interest in a partnership. (Butno deductionon a technical termination.) Section 709(b) Amounts paid or incurred to organize the partnership may, at the election of the partnership, be deducted in an amount equal to the lesser of the amount paid to organize the partnership or $5,000, reduced by the amount of such organizational expenses which exceed $50,000 and the remainder of such organizational expenses may be deducted ratably over 180 months, beginning with the month in which the partnership begins business. Section 709 is similar to 248, which deals with the amortization of organizational expenses for a corporation, and 195, which deals with the amortization of start-up expenses. SP&LPROB Partnership Operations (Yes) Other Code Sections that impact the operating provisions: Section 199A Deduction for 20% of QBI. Section 465 For partnerships engaged in an activity of other than real estate, the maximum amount that a partner can deduct in any one taxable year is limited to the amount that he has at-risk. (See Form 6198.) Section 469 If a partner does not materially participate in the activity of the partnership, there is a limit on the amount of any partnership loss that may be dd deducted tdby the partner in thecalculation l ti of his taxable income. Section 752 A partner's basis in his partnership interest can be increased or decreased, with either an increase in partnership debt or a decrease in partnership debt. Section 1411(c) 3.8% tax on NII. SP&LPROB

129 Basis (Yes) Significance of Basis. No entry on Sch. K-1, Line L. Do you care and, if so, when and why? Can you easily reconstruct a partner s basis in its partnership interest? Assume that your client has been a partner for the last 28 years and individual does not have any idea as to what its basis is in the partnership. If the client offers to pay you $25,000 to reconstruct its basis, how long will it take you? Do the tax software programs have an ability to track apartner sbasis?(see Schedule B, Page 2, Line 6 of Form 1065.) (My software PB-1 & PB-2.) How long have L.19(a) & L.19(b) appeared as a line item on Sch. K? (Since 1994 GATT Agreement) SP&LPROB

130 BASIS FOR PARTNER'S INTEREST Initial basis is the sum of the following: Amount of money contributed Partner's adjusted basis in property contributed Increase in partner's liabilities (in connection with contribution) xxxx xxxx xxxx Total xxxx Decrease in partner's liabilities (in connection with contribution) (xxx) Initial basis of partner's interest xxxx* Annual adjustment: Increase in basis: Distributable share of the following: Taxable income xxx Tax-exempt income xxx Percentage of depletion in excess of cost depletion basis xxx Contributions to capital xxx Increase in partner's liabilities xxx Total adjustment increasing basis xxxx Decrease in basis: Distributable share of the following: Taxable losses, even if not deductible Separately stated items: additional first year depreciation - Charitable contributions, but only adjusted basis of property contributed - Investment interest - Investment expenses - Foreign taxes xxx xxx VOGEL.SEM/SP&LPROB.18

131 Items not deductible in calculating taxable income and not properly chargeable to a capital account: - Disallowed meal, entertainment and club dues - Expenses incurred in earning of income exempt from tax, including expenses under 265 related to earning of tax exempt income and life insurance premiums under Losses disallowed under both 267(b) and 707(b) - Nondeductible bribes, fines and penalties xxx Nonliquidation distributions: Money ** xxx Decrease in partner's liabilities xxx Property (Generally, partnership's adjusted basis, but see limitation and exceptions)*** xxx Total adjustment decreasing basis Year end basis in a partnership interest xxxx xxxx * If contributing partner exchanges services for partnership interest, see Reg which describes the effect on the partner's basis. ** Basis in partnership interest cannot be reduced below zero. Thus, a distribution of money, which includes marketable securities in some situations under 731(c), in excess of basis in a partnership interest represents a gain to the partner ( 731(a)). *** Liquidating distributions decrease basis to zero ( 732(b)) VOGEL.SEM/SP&LPROB.18

132 Basis When Partner Owns More than One Interest in the Partnership (Yes) For example, assume that A purchased a 10% interest in an LLC in 2015, another 10% interest in 2016, and a third 10% interest in As of January 1, 2018, each 10% interest has a basis as follows: 2015 $15, , ,000 Total $81,000 If A sells a 10% interest in 2018 for $45,000, how much gain is taxable? (See Rev. Rul One basis and one capital account. A/B is $27,000 or 1/3 of $81,000.) SP&LPROB Basis When Partner Owns More than One Interest in the Partnership (Yes) For example, assume that A purchased a 10% interest in an LLC in 2015, another 10% interest in 2016, and a third 10% interest in As of January 1, 2018, each 10% interest has a basis as follows: 2015 $15, , ,000 Total $81,000 If A s allocable share of the loss for the year is $75,000, how much of the loss is deductible by her? (One basis and one capital account. All $75,000 of the loss is deductible.) SP&LPROB

133 Maximum Amount of Loss Deductible (Yes) Assume at the end of partnership taxable year 2018, partner C has the following distributive share of partnership items described in 702(a): LTCL ($9,000) STCL (6,000) 1231 (2,000) Investment interest (1,000) Odi Ordinary Income 3,000 C s adjusted basis in his interest at the end of 2018, before adjustment for any of the above items, is $6,000. What tax consequences? SP&LPROB Maximum Amount of Loss Deductible Losses Ded. C.F. A/B $6,000 LT ($9,000) ($4,500) ($4,500) + O.I. 3,000 ST (6,000) (3,000) (3,000) 704(d) Basis $9, (2,000) (1,000) (1,000) 163(d) (1,000) (500) (500) $18,000 $9,000 ($9,000) Software will keep track of this. If the member sells its interest on the first day of the next taxable year, how much of the loss suspended under basis may offset the gain? ANS:None. SP&LPROB

134 Maximum Amount of Loss Deductible (Yes) Assume at the end of partnership taxable year 2018, partner C has the following distributive share of partnership items described in 702(a): LTCL ($9,000) STCL (6,000) 1231 (2,000) Investment interest (1,000) Odi Ordinary Income 3,000 What result if C (whose adjusted basis is $6,000) also received a money distribution of $6,000. Which is taken into account first - the money distribution or the losses? See Rev.Rul SP&LPROB Maximum Amount of Loss Deductible Rev. Rul A/B $6,000 + O.I. 3,000 Money (6,000) 704(d) Basis for losses $3,000 Losses are limited under 704(d) to $3,000. SP&LPROB

135 Maximum Amount of Loss Deductible (Yes) What result if both property and money is distributed? For example, assume that A has an adjusted basis in her partnership interest of $30,000 and the partnership distributes property FMV $30,000 and A/B of $25,000 in March and it distributes cash of $22,000 in November. Which is taken into account first? (See 733 & See Schedule K, Line 19(a) & 19(b).) ANS:Money SP&LPROB Maximum Amount of Loss Deductible A/B $30,000 Less Money (22,000) Basis $ 8,000 Basis in Dist. Prop. ($8,000) (But LLC Basis was $25,000) A/B $0 SP&LPROB

136 Maximum Amount of Loss Deductible (Yes) Same as above, except now assume that partner C's distributive share of the items described in 702(a) is: Cash 170 $15,000 What tax consequences if C s adjusted basis is $6,000? (See also 1366(d) and 704(d).) For taxable years beginning after December 31, 2017, the maximum amount of the charitable contribution that is deductible is limited to $6,000. SP&LPROB Maximum Amount of Loss Deductible Point: Charitable contribution is deductible and is not limited by 704(d) basis since it is not a loss item. See Notice : Listed Transaction 1. A receives promotional materials that offer prospective investors in an LLC the possibility of a charitable contribution deduction that equals or exceeds an amount that is two and one-half times the amount of A s investment. A purchases an interest in the LLC through entity that holds real property. A pays $40,000 for her interest. The LLC that holds the real property contributes a conservation easement encumbering the property to a taxexempt entity and allocates a charitable contribution deduction of $150,000 to A (A/B $10,000). Following that contribution, A reports on her federal income tax return a charitable contribution deduction of $150,000 with respect to the conservation easement. Going one step further, after the contribution, A s interest in the LLC is terminated. See Rev. Rul Also gives A an ordinary loss of say $39,000. Huh? 2. Notice defines the above factual situation as a listed transaction. Would you invest $40,000 for a charitable contribution of $150,000? SP&LPROB

137 Maximum Amount of Loss Deductible (Yes) What difference, if any, if the partnership contributed appreciated property to a qualified charitable organization? C's distributive share of the fair market value is $30,000, his distributive share of the adjusted basis is $14,000 and his adjusted basis in his partnership interest before the contribution is $20,000. (See Rev. Rul and after, the PATH Act, the same rules apply to an S corporation See 1366(d)(4).) SP&LPROB Maximum Amount of Loss Deductible A/B $20,000 Less A/B of prop. contributed A/B $ 6,000 (14,000) But then can take a 170 deduction for $30,000 Think of distribution out and then donate the property to the charity. Same result for an S corporation. SP&LPROB

138 At Risk (Yes) When are you likely to encounter at risk? In LLC where member has a deficit balance in its tax capital account. See Form 6198 Is it likely that the at-risk rules will ever apply to an LLC? Will the at-risk rules apply to a PTP? SP&LPROB At Risk (Yes) Guarantees of an amount borrowed by another person (the primary obligor) for uses in an activity shall not increase the guarantor s amount at risk, unless the guarantee is paid and the guarantor has no remaining legal rights against the primary obligor (Prop. Reg (d)). In FSA , the IRS ruled that if a member of an LLC guarantees the debt of the LLC, the member is at-risk with respect to such amount except to the extent the member has a right of reimbursement against the remaining members. (See also CCA and CCA ) SP&LPROB

139 At Risk (Yes) If member of LLC guarantees the debt of the LLC: The debt is recourse debt to the guarantor. Creates basis. Allows for a deficit balance in book capital account. At-risk rules are not applicable. SP&LPROB At Risk (Yes) Assume A s Schedule K-1 reflects the following: Line K: Nonrecourse debt $ 70,000 Qualified nonrecourse financing 40,000 Recourse debt 30,000 Line L: Tax Capital account on $ 20,000 Less: Distributive share of operating loss (110,000) Tax Capital account on ($90,000) How much of the $110,000 loss allocated to A is deductible by her? SP&LPROB

140 At Risk Can U give me an everyday example of a debt which is a straight-up nonrecourse debt? What about: 1. O/S trade payable by a cash basis taxpayer No 2. O/S trade payable by an accrual basis partnership No / Maybe 3. Line of credit which is secured by equipment or inventory Yes 4. Capitalized or leveraged lease under Rev. Rul , Rev. Proc and Rev. Proc Purchase even though described as a lease Yes SP&LPROB Allocations Under 704(c) (Yes) How is the BIG/BIL on contributed property allocated? If the contributed property is depreciable property, which partner receives the first dollar s worth of tax depreciation? (See Page and Operating Agreement Page (a).) First dollar of gain or loss to contributing partner First dollar of tax depreciation to noncontributing partners SP&LPROB

141 Allocations Under 704(c) (Yes) What is the purpose of 704(c)? To ensure that the tax amount matches the book amount to the noncontributing partner. SP&LPROB Allocations Under 704(c) (Yes) When does 704(c) apply? (See Page No. 5.) What is BIG/BIL? (See Page ) What is a reverse 704(c) allocation? (See Page No. 6.) (See Reg (b)(2)(iv)(f) & See Page 2, 1.8(b) & 7.5(b) of the Operating Agreement.) SP&LPROB

142 Allocations Under 704(c) (Yes) Increased accounting costs. Who will pay U to do this correctly? How long will it take U to figure out the calculations? ANS:6to8hours If make a mistake, who will point out the mistake? ANS: Advisor for another partner SP&LPROB Allocations Under 704(c) (Yes) How to avoid 704(c) problem Not practical, but value of property contributed A Cash $100,000 B Prop - FMV $100,000 A/B $ 40, BIG $60,000 SP&LPROB

143 Allocations Under 704(c) (Yes) Methods for allocating BIG/BIL: Traditional Method Page years ( ) Traditional Method with Curative Allocation (Page 171-6). (To steal 1994) What is the ceiling rule? Not sufficient tax amount to match book amount to noncontributing partner. Remedial Allocation Method (Page ). (To create 1995) Small Disparity (Page ). SP&LPROB Allocations Under 704(c) (Yes) Who should select the method for allocating BIG/BIL under 704(c)? Which method would you recommend? (KISS) How many members have read the Operating Agreement? How many attorneys who drafted the Operating Agreement could put pencil to paper to figure out the calculations? Of the members that have read the Operating Agreement, how many understand its terms? SP&LPROB

144 Allocations Under 704(c) (Yes) A - Cash $100,000 B - Property FMV $100,000 A/B 40,000 LLC sells the B property 18 months later for $120,000 or $76,000 and the LLC has income from operations of $60,000. How is the resulting gain or loss allocated between A and B if the LLC has elected to use the traditional method, the traditional method with the curative allocation or the remedial allocation method. (Total proceeds to distribute $280,000 or $236,000.) SP&LPROB Allocations Under 704(c) (Yes) Capital Accounts A B Book Tax Book Tax SP&LPROB

145 Allocations Under 704(c) Remember Tax Capital Account is equal to Adjusted Basis if there is no debt. SP&LPROB Sale for $120,000: (Yes) Book Tax A/R $120,000 A/R $120,000 Less Net Book Value 100,000 A/B 40,000 Book Gain $ 20,000 Tax Gain $ 80,000 $10,000 $10,000 BIG $60,000 A B SP&LPROB

146 Sale for $120,000: (Yes) Capital Accounts A B Book Tax Book Tax $100,000 $100,000 $100,000 $ 40,000 O.I. Opns: $60,000 30,000 30,000 30,000 30,000 Book Gain: $20,000 10,000 10,000 Tax Gain: $80,000 10,000 70,000 $140,000 $140,000 $140,000 $140,000 SP&LPROB Sale for $76,000: Ceiling Rule (Yes) Book Sell B s Property A/R $ 76,000 A/R $76,000 Less Net Book Value (100,000) A/B 40,000 Book Loss ($ 24,000) Tax Gain $36,000 ($12,000) ($12,000) If using Traditional Method all gain of $36,000 allocated A B tob SP&LPROB

147 Sale for $76,000: (Yes) (Skip to Slide 154.) Capital Accounts A B Book Tax Book Tax $100,000 $100,000 $100,000 $ 40,000 O.I. Opns: Traditional $60,000 30,000 30,000 30,000 30,000 Method with Curative Allocation Book Loss: Steal $12,000 ($24,000) (12,000) (12,000) of Deduction Tax Gain: Traditional $36, ,000 Method $118,000 $130,000 $118,000 $106,000 SP&LPROB Sale for $76,000: Traditional Method w/ Curative Allocation (No) Capital Accounts A B Book Tax Book Tax $100,000 $100,000 $100,000 $ 40,000 O.I. Opns: Traditional $60,000 30,000 30,000 30,000 30,000 Method with Curative Allocation Book Loss: Steal $12,000 ($24,000) (12,000) (12,000) of Deduction Tax Gain: Traditional $36, ,000 Method $118,000 $130,000 $118,000 $106,000 SP&LPROB

148 Sale for $76,000: Traditional Method w/ Curative Allocation (See Page ) Assume the operating income is determined as follows: A B O.I. $140,000 $70,000 $70,000 Exp (80,000) 40,000 40,000 L.22 O.I. $ 60,000 $30,000 $30,000 SP&LPROB Sale for $76,000: Remedial Allocation Method (See Page ) (No) Capital Accounts A B Book Tax Book Tax $100,000 $100,000 $100,000 $ 40,000 O.I. Opns: Traditional $60,000 30,000 30,000 30,000 30,000 Method with Curative Allocation Book Loss: Steal $12,000 ($24,000) (12,000) (12,000) of Deduction Tax Gain: Traditional $36, ,000 Method $118,000 $130,000 $118,000 $106,000 SP&LPROB

149 Allocations Under 704(c) (See Page ) (Yes) A - Cash $100,000 Capital Accounts: Tax-$8,000 B - Depreciable Property 704(b) Book - $20,000 FMV $100,000 GAAP - $10,000 A/B 40,000 B used straight line depreciation and the property has five years left of its original recovery period of 10 years. How to allocate the net income from the partnership if: Ordinary income from operations $60,000 Tax depreciation on B property ( 168(i)(7)) (8,000) Net income $52,000 SP&LPROB Allocations Under 704(c) (Yes) How to allocate the net income from the partnership if: Ordinary income from operations $60,000 Tax depreciation on B property ( 168(i)(7)) (8,000) Net income $52,000 A B (Not correct) - a. $26,000 $26,000 (Traditional Method) - b. 22,000 30,000 (Traditional Method) (w/ curative) - c. 20,000 32,000 (Remedial Method) - d. 23,000 29,000 SP&LPROB

150 Reg (b)(2)(iv)(g)(3): (See Page & Reg (d)(2).) Book Depreciation For: Traditional Method Traditional Method with Curative Allocation Book Depreciation Tax Depreciation Net Book Value = Tax A/B Book Depreciation $8,000 $100,000 = $40,000 Book Depreciation = $20,000 SP&LPROB Reg (b)(2)(iv)(g)(3): (Yes) A B Book Depreciation $20,000 $10,000 $10,000 Difference (12,000) (2,000) (10,000) Tax Depreciation $ 8,000 $8,000 $ 0 Does the Ceiling Rule apply? SP&LPROB

151 Allocations Under 704(c) (Yes) (Skip to Slide 165.) How to allocate the net income from the partnership if: Ordinary income from operations $60,000 Tax depreciation on B property ( 168(i)(7)) (8,000) Net income $52,000 A B (Not correct) - a. $26,000 $26,000 (Traditional Method) - b. 22,000 30,000 (Traditional Method) (w/ curative) - c. 20,000 32,000 (Remedial Method) - d. 23,000 29,000 SP&LPROB Remedial Allocation Method Reg (d)(2) (See Page ) (No) Book Depreciation for Years 1-5: Tax Dep ($40,000 5 years) $8,000 + BIG Depreciation based on Original Recovery Periods ($60, years) 6,000 A B Book Depreciation $14,000 $7,000 $7,000 Difference (6,000) (6,000) Tax Depreciation $ 8,000 $7,000 $1,000 SP&LPROB

152 Remedial Allocation Method Reg (d)(2) (See Page ) (No) Book Depreciation for Years 6-10: Tax Dep ($40,000 5 years) $0 + BIG Depreciation based on Original Recovery Periods ($60, years) 6,000 A B Book Depreciation ($6,000) ($3,000) ($3,000) Difference 6, ,000 Tax Depreciation $ 0 ($3,000) $3,000 Create: Deduction of $3,000 to A and income of $3,000 to B. SP&LPROB Allocations Under 704(c) (No) How to allocate the net income from the partnership if: Ordinary income from operations $60,000 Tax depreciation on B property ( 168(i)(7)) (8,000) Net income $52,000 A B (Not correct) - a. $26,000 $26,000 (Traditional Method) - b. 22,000 30,000 (Traditional Method) (w/ curative) - c. 20,000 32,000 (Remedial Method) - d. 23,000 29,000 SP&LPROB

153 Remedial Allocation Method Reg (d) (See Page ) (No) How much tax depreciation is allocated to A over five years if the remedial allocation method is used, or if the traditional method is used? ($35,000 vs. $40,000) What is the point? SP&LPROB Allocations Under 704(c) Reg (d) (No) What result if the property is sold at the beginning of the third year for $65,000: a. Traditional Method 1) What is the net book value and A/B at the end of Year 2? ($60,000 & $24,000) b. Remedial Allocation Method 1) What is the net book value and A/B at the end of Year 2? ($72,000 & $24,000) SP&LPROB

154 Sell Property at Begin of Year 3 for $65,000: (No) Traditional Remedial Tax A/R $65,000 A/R $65,000 A/R $65,000 Net Book Net Book Value 60,000 Value (72,000) A/B 24,000 ($40 - $16) Book Gain $ 5,000 Book Loss $ (7,000) Tax Gain $41,000 SP&LPROB Reverse 704(c) Allocations (See Page ) (Yes) A/B FMV Acc. Rec. $ 0 $900 Other Assets 900 1,500 $900 $2,400 Debt $600 $600 Capital Acct A Capital Acct B $900 $2,400 Assume that C is admitted to the tax partnership. C alternatively: 1. Contributes cash of $900 for a 1/3 interest in capital and profits, or 2. Receives a 1/3 interest in partnership capital FMV $600 in exchange for services, or 3. Receives a 1/3 interest in the future profits in exchange for services. Question: How much of the income from the collection of the Accounts Receivables is allocated to C and who receives the first dollar s worth of depreciation? All Some None SP&LPROB

155 Reverse 704(c) Allocations (See Page ) (Yes) Acc. Rec. A/R $900 Net Book Value 900 A B C Book Gain 0 $ 0 $ 0 $0 Tax Gain Tax Gain $900 $450 $450 $0 Purpose of 704(c) is to ensure that the tax amount matches the book amount to the non-contributing partner who is C in this situation. SP&LPROB Reverse 704(c) Allocations (See Page ) Other Assets: Assume that the other assets are depreciable assets and that the tax depreciation is $90 ($900 10) and the book deprecation is $150 ($1,500 10). A B C Book Depreciation $150 $50 $50 $50 Diff 1 (60) (30) (30) 0 Tax Dep. $ 90 $20 $20 $50 Point: C, the incoming member, receives the first dollar of tax depreciation. SP&LPROB

156 Reverse 704(c) and 751(b) Do U think that 751(b) applies in the following situation: A/B FMV Cash $600 $600 Acc. Rec Other Assets $1,050 $1,800 Cap. Acct.: A $350 $600 B C $1,050 $1,800 A sold interest for $600 A sold ½ interest for $300 P/S distributes $600 to A The LLC distributes $300 to A and A s interest in the LLC is reduced from a 1/3 interest to a 20% interest in the LLC. What is A s Prop. Share of the interest in the receivable? Before $100. After?? SP&LPROB Allocation Under 704(c) (No) Assume that A contributes five-year property acquired in 2017 to a partnership in exchange for a one-third interest in partnership profits, losses, and capital. The date of contribution is January 1, 2018 and A elected to use MACRS. The property is worth $100, has an adjusted basis of $80 on the date of contribution and originally cost $100. If A, B, and C each have a one-third interest in the partnership, how is the depreciation for 2018 and 2019 to be allocated among A, B, and C, using only the traditional method? Tax Depreciation $20, , ,200 SP&LPROB

157 Allocation Under 704(c) Traditional Method 2018 (No) Book Depreciation = Tax Depreciation Net Book Value Tax A/B Book Depreciation = $32,000 $100,000 $80,000 A B C Book Dep. $40,000 $13,300 $13,300 $13,300 Difference ( 8,000) ( 8,000) 0 0 Tax Dep. $32,000 $5,300 $13,300 $13,300 SP&LPROB Allocation Under 704(c) Traditional Method 2019 (No) Book Depreciation = $19,200 $60,000 $48,000 A B C Book Dep. $24,000 $8,000 $8,000 $8,000 Difference ( 4,800) ( 4,800) 0 0 Tax Dep. $19,200 $3,200 $8,000 $8,000 SP&LPROB

158 Reg Contributed Property VOGEL.SEM/SP&LPROB.18

159 Reg Contributed Property A. In General. 1. General Principles. The purpose of 704(c) is to prevent the shifting of tax consequences among partners with respect to precontribution gain or loss. Under 704(c), a partnership must allocate income, gain, loss, and deduction with respect to property contributed by a partner to the partnership so as to take into account any variation between the adjusted tax basis of the property and its fair market value at the time of contribution. Notwithstanding any other provision of this section, the allocations must be made using a reasonable method that is consistent with the purpose of 704(c). For this purpose, an allocation method includes the application of all of the rules of this section (e.g., aggregation rules). An allocation method is not necessarily unreasonable merely because another allocation method would result in a higher aggregate tax liability. Paragraphs (b), (c), and (d) of this section describe allocation methods that are generally reasonable. Other methods may be reasonable in appropriate circumstances. Nevertheless, in the absence of specific published guidance, it is not reasonable to use an allocation method in which the basis of property contributed to the partnership is increased (or decreased) to reflect built-in gain (or loss), or a method under which the partnership creates tax allocations of income, gain, loss, or deduction independent of allocations affecting book capital accounts. See Reg (d). Paragraph (e) of this section contains special rules and exceptions. 2. Operating Rules. Except as provided in paragraphs (e)(2) and (e)(3) of this section, 704(c) and this section apply on a property-by-property basis. Therefore, in determining whether there is a disparity between adjusted tax basis and fair market value, the built-in gains and built-in losses on items of contributed property cannot be aggregated. A partnership may use different methods with respect to different items of contributed property, provided that the partnership and the partners consistently apply a single reasonable method for each item of contributed property and that the overall method or combination of methods are reasonable based on the facts and circumstances and consistent with the purpose of 704(c). It may be unreasonable to use one method for appreciated property and another method for depreciated property. Similarly, it may be unreasonable to use the traditional method for built-in gain property contributed by a partner with a high marginal tax rate while using curative allocations for built-in gain property contributed by a partner with a low marginal tax rate. 3. Definitions. a. Section 704(c) Property. Property contributed to a partnership is 704(c) property if at the time of contribution its book value differs from the contributing partner's adjusted tax basis. For purposes of this section, book value is determined as contemplated by Reg (b). Therefore, book value is equal to fair market value at the time of contribution and is subsequently adjusted for cost recovery and other events that affect the basis of the property. For a partnership that maintains capital accounts in accordance with Reg (b)(2)(iv), the book value of property is initially the value used in determining the contributing partner's capital account under Reg (b)(2)(iv)(d), and is appropriately adjusted thereafter (e.g., for book cost recovery under Reg (b)(2)(iv)(g)(3) and (d)(2) and other events that affect the basis of the property). A partnership that does not maintain capital accounts under Reg (b)(2)(iv) must comply with this section using a book capital account based on the same principles (i.e., a book capital account that reflects the fair market value of property at the time of contribution and that is subsequently adjusted for cost recovery and other events that affect the basis of the property). b. Built-In Gain and Built-In Loss. The built-in gain on 704(c) property is the excess of the property's book value over the contributing partner's adjusted tax basis upon contribution. The built-in gain is thereafter reduced by decreases in the difference between the property's book value and adjusted tax basis. The built-in loss on 704(c) property is the excess of the VOGEL.SEM/SP&LPROB.18

160 contributing partner's adjusted tax basis over the property's book value upon contribution. The built-in loss is thereafter reduced by decreases in the difference between the property's adjusted tax basis and book value. 4. Accounts Payable and Other Accrued but Unpaid Items. Accounts payable and other accrued but unpaid items contributed by a partner using the cash receipts and disbursements method of accounting are treated as 704(c) property for purposes of applying the rules of this section. 5. Other Provisions of the Internal Revenue Code. Section 704(c) and this section apply to a contribution of property to the partnership only if the contribution is governed by 721, taking into account other provisions of the Internal Revenue Code. For example, to the extent that a transfer of property to a partnership is a sale under 707, the transfer is not a contribution of property to which 704(c) applies. 6. Other Applications of 704(c) Principles. a. Revaluations under 704(b). The principles of this section apply to allocations with respect to property for which differences between book value and adjusted tax basis are created when a partnership revalues partnership property pursuant to Reg (b)(2)(iv)(f) (reverse 704(c) allocations). Partnerships are not required to use the same allocation method for reverse 704(c) allocations as for contributed property, even if at the time of revaluation the property is already subject to 704(c) and paragraph (a) of this section. In addition, partnerships are not required to use the same allocation method for reverse 704(c) allocations each time the partnership revalues its property. A partnership that makes allocations with respect to revalued property must use a reasonable method that is consistent with the purposes of 704(b) and (c). b. Basis Adjustments. A partnership making adjustments under Reg (b) or Reg (a)(2) must account for built-in gain or loss under 704(c) in accordance with the principles of this section. 7. Transfers of a Partnership Interest. If a contributing partner transfers a partnership interest, built-in gain or loss must be allocated to the transferee partner as it would have been allocated to the transferor partner. If the contributing partner transfers a portion of the partnership interest, the share of built-in gain or loss proportionate to the interest transferred must be allocated to the transferee partner. 8. Disposition of Property in Nonrecognition Transaction. If a partnership disposes of 704(c) property in a nonrecognition transaction in which no gain or loss is recognized, the substituted basis property (within the meaning of 7701(a)(42)) is treated as 704(c) property with the same amount of built-in gain or loss as the 704(c) property disposed of by the partnership. If gain or loss is recognized in such a transaction, appropriate adjustments must be made. The allocation method for the substituted basis property must be consistent with the allocation method chosen for the original property. If a partnership transfers an item of 704(c) property together with other property to a corporation under 351, in order to preserve that item's built-in gain or loss, the basis in the stock received in exchange for the 704(c) property is determined as if each item of 704(c) property had been the only property transferred to the corporation by the partnership. 9. Tiered Partnerships. If a partnership contributes 704(c) property to a second partnership (the lower-tier partnership), or if a partner that has contributed 704(c) property to a partnership contributes that partnership interest to a second partnership (the upper-tier partnership), the upper-tier partnership must allocate its distributive share of lower-tier partnership items with respect to that 704(c) property in a manner that takes into account the contributing partner's remaining built-in gain or loss. Allocations made under this paragraph will be considered to be made in a manner that meets the requirements of Reg (b)(2)(iv)(q) (relating to capital account adjustments where guidance is lacking) VOGEL.SEM/SP&LPROB.18

161 10. Anti-Abuse Rule. An allocation method (or combination of methods) is not reasonable if the contribution of property (or event that results in reverse 704(c) allocations) and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value of the partners' aggregate tax liability. B. Traditional Method. 1. In General. This paragraph (1) describes the traditional method of making 704(c) allocations. In general, the traditional method requires that when the partnership has income, gain, loss, or deduction attributable to 704(c) property, it must make appropriate allocations to the partners to avoid shifting the tax consequences of the built-in gain or loss. Under this rule, if the partnership sells 704(c) property and recognizes gain or loss, built-in gain or loss on the property is allocated to the contributing partner. If the partnership sells a portion of, or an interest in, 704(c) property, a proportionate part of the built-in gain or loss is allocated to the contributing partner. For 704(c) property subject to amortization, depletion, depreciation, or other cost recovery, the allocation of deductions attributable to these items takes into account built-in gain or loss on the property. For example, tax allocations to the noncontributing partners of cost recovery deductions with respect to 704(c) property generally must, to the extent possible, equal book allocations to those partners. However, the total income, gain, loss, or deduction allocated to the partners for a taxable year with respect to a property cannot exceed the total partnership income, gain, loss, or deduction with respect to that property for the taxable year (the ceiling rule). If a partnership has no property the allocations from which are limited by the ceiling rule, the traditional method is reasonable when used for all contributed property. 2. Examples. The following examples illustrate the principles of the traditional method. Example 1 - Operation of the traditional method: (i) Calculation of Built-In Gain on Contribution. A and B form partnership AB and agree that each will be allocated a 50 percent share of all partnership items and that AB will make allocations under 704(c) using the traditional method under paragraph (b) of this section. A contributes depreciable property with an adjusted tax basis of $4,000 and a book value of $10,000, and B contributes $10,000 cash. Under paragraph (a)(3) of this section, A has built-in gain of $6,000, the excess of the partnership's book value for the property ($10,000) over A's adjusted tax basis in the property at the time of contribution ($4,000). (ii) Allocation of Tax Depreciation. The property is depreciated using the straight-line method over a 10-year recovery period. Because the property depreciates at an annual rate of 10 percent, B would have been entitled to a depreciation deduction of $500 per year for both book and tax purposes if the adjusted tax basis of the property equalled its fair market value at the time of contribution. Although each partner is allocated $500 of book depreciation per year, the partnership is allowed a tax depreciation deduction of only $400 per year (10 percent of $4,000). The partnership can allocate only $400 of tax depreciation under the ceiling rule of paragraph (b)(1) of this section, and it must be allocated entirely to B. In AB's first year, the proceeds generated by the equipment exactly equal AB's operating expenses. At the end of that year, the book value of the property is $9,000 ($10,000 less the $1,000 book depreciation deduction), and the adjusted tax basis is $3,600 ($4,000 less the $400 tax depreciation deduction). A's built-in gain with respect to the property decreases to $5,400 ($9,000 book value less $3,600 adjusted tax basis). Also, at the end of AB's first year, A has a $9,500 book capital account and a $4,000 tax basis in A's partnership interest. B has a $9,500 book capital account and a $9,600 adjusted tax basis in B's partnership interest. (iii) Sale of the Property. If AB sells the property at the beginning of AB's second year for $9,000, AB realizes tax gain of $5,400 ($9,000, the amount realized, less the adjusted tax basis of $3,600). Under paragraph (b)(1) of this section, the entire $5,400 gain must be allocated to A because the property A contributed has that much built-in gain remaining. If AB sells the property at the VOGEL.SEM/SP&LPROB.18

162 beginning of AB's second year for $10,000, AB realizes tax gain of $6,400 ($10,000, the amount realized, less the adjusted tax basis of $3,600). Under paragraph (b)(1) of this section, only $5,400 of gain must be allocated to A to account for A's built-in gain. The remaining $1,000 of gain is allocated equally between A and B in accordance with the partnership agreement. If AB sells the property for less than the $9,000 book value, AB realizes tax gain of less than $5,400, and the entire gain must be allocated to A. (iv) Termination and Liquidation of Partnership. If AB sells the property at the beginning of AB's second year for $9,000, and AB engages in no other transactions that year, A will recognize a gain of $5,400, and B will recognize no income or loss. A's adjusted tax basis for A's interest in AB will then be $9,400 ($4,000, A's original tax basis, increased by the gain of $5,400). B's adjusted tax basis for B's interest in AB will be $9,600 ($10,000, B's original tax basis, less the $400 depreciation deduction in the first partnership year). If the partnership then terminates and distributes its assets ($19,000 in cash) to A and B in proportion to their capital account balances, A will recognize a capital gain of $100 ($9,500, the amount distributed to A, less $9,400, the adjusted tax basis of A's interest). B will recognize a capital loss of $100 (the excess of B's adjusted tax basis, $9,600, over the amount received, $9,500). Example 2 - Unreasonable Use of the Traditional Method Facts: (i) Facts. C and D form partnership CD and agree that each will be allocated a 50 percent share of all partnership items and that CD will make allocations under 704(c) using the traditional method under paragraph (b) of this section. C contributes equipment with an adjusted tax basis of $1,000 and a book value of $10,000, with a view to taking advantage of the fact that the equipment has only one year remaining on its cost recovery schedule although its remaining economic life is significantly longer. At the time of contribution, C has a built-in gain of $9,000 and the equipment is 704(c) property. D contributes $10,000 of cash, which CD uses to buy securities. D has substantial net operating loss carryforwards that D anticipates will otherwise expire unused. Under Reg (b)(2)(iv)(g)(3), the partnership must allocate the $10,000 of book depreciation to the partners in the first year of the partnership. Thus, there is $10,000 of book depreciation and $1,000 of tax depreciation in the partnership's first year. CD sells the equipment during the second year for $10,000 and recognizes a $10,000 gain ($10,000, the amount realized, less the adjusted tax basis of $0). (ii) Unreasonable Use of Method. a. At the beginning of the second year, both the book value and adjusted tax basis of the equipment are $0. Therefore, there is no remaining built-in gain. The $10,000 gain on the sale of the equipment in the second year is allocated $5,000 each to C and D. The interaction of the partnership's one-year write-off of the entire book value of the equipment and the use of the traditional method results in a shift of $4,000 of the precontribution gain in the equipment from C to D (D's $5,000 share of CD's $10,000 gain, less the $1,000 tax depreciation deduction previously allocated to D). b. The traditional method is not reasonable under paragraph (a)(10) of this section because the contribution of property is made, and the traditional method is used, with a view to shifting a significant amount of taxable income to a partner with a low marginal tax rate and away from a partner with a high marginal tax rate. c. Under these facts, if the partnership agreement in effect for the year of contribution had provided that tax gain from the sale of the property (if any) would always be allocated first to C to offset the effect of the ceiling rule limitation, the allocation method would not violate the anti-abuse rule of paragraph (a)(10) of this section. See paragraph (c)(3) of this section. Under other facts, (for example, if the partnership holds multiple 704(c) properties and either uses multiple allocation methods or uses a single allocation method VOGEL.SEM/SP&LPROB.18

163 where one or more of the properties are subject to the ceiling rule) the allocation to C may not be reasonable. C. Traditional Method with Curative Allocations. 1. In General. To correct distortions created by the ceiling rule, a partnership using the traditional method under paragraph (b) of this section may make reasonable curative allocations to reduce or eliminate disparities between book and tax items of noncontributing partners. A curative allocation is an allocation of income, gain, loss, or deduction for tax purposes that differs from the partnership's allocation of the corresponding book item. For example, if a noncontributing partner is allocated less tax depreciation than book depreciation with respect to an item of 704(c) property, the partnership may make a curative allocation to that partner of tax depreciation from another item of partnership property to make up the difference, notwithstanding that the corresponding book depreciation is allocated to the contributing partner. A partnership may limit its curative allocations to allocations of one or more particular tax items (e.g., only depreciation from a specific property or properties) even if the allocation of those available items does not offset fully the effect of the ceiling rule. 2. Consistency. A partnership must be consistent in its application of curative allocations with respect to each item of 704(c) property from year to year. 3. Reasonable Curative Allocations. a. Amount. A curative allocation is not reasonable to the extent it exceeds the amount necessary to offset the effect of the ceiling rule for the current taxable year or, in the case of a curative allocation upon disposition of the property, for prior taxable years. b. Timing. The period of time over which the curative allocations are made is a factor in determining whether the allocations are reasonable. Notwithstanding paragraph (c)(3)(i) of this section, a partnership may make curative allocations in a taxable year to offset the effect of the ceiling rule for a prior taxable year if those allocations are made over a reasonable period of time, such as over the property's economic life, and are provided for under the partnership agreement in effect for the year of contribution. See paragraph (c)(4) Example 3(ii)(C) of this section. c. Type. 1) In General. To be reasonable, a curative allocation of income, gain, loss, or deduction must be expected to have substantially the same effect on each partner's tax liability as the tax item limited by the ceiling rule. The expectation must exist at the time the 704(c) property is obligated to be (or is) contributed to the partnership and the allocation with respect to that property becomes part of the partnership agreement. However, the expectation is tested at the time the allocation with respect to that property is actually made if the partnership agreement is not sufficiently specific as to the precise manner in which allocations are to be made with respect to that property. Under this paragraph (c), if the item limited by the ceiling rule is loss from the sale of property, a curative allocation of gain must be expected to have substantially the same effect as would an allocation to that partner of gain with respect to the sale of the property. If the item limited by the ceiling rule is depreciation or other cost recovery, a curative allocation of income to the contributing partner must be expected to have substantially the same effect as would an allocation to that partner of partnership income with respect to the contributed property. For example, if depreciation deductions with respect to leased equipment contributed by a tax-exempt partner are limited by the ceiling rule, a curative allocation of dividend or interest income to that partner generally is not reasonable, although a curative allocation of depreciation deductions from other leased equipment to the noncontributing partner is reasonable. Similarly, under this rule, if depreciation deductions apportioned to foreign source income in a particular statutory VOGEL.SEM/SP&LPROB.18

164 grouping under 904(d) are limited by the ceiling rule, a curative allocation of income from another statutory grouping to the contributing partner generally is not reasonable, although a curative allocation of income from the same statutory grouping and of the same character is reasonable. 2) Exception for Allocation from Disposition of Contributed Property. If cost recovery has been limited by the ceiling rule, the general limitation on character does not apply to income from the disposition of contributed property subject to the ceiling rule, but only if properly provided for in the partnership agreement in effect for the year of contribution or revaluation. For example, if allocations of depreciation deductions to a noncontributing partner have been limited by the ceiling rule, a curative allocation to the contributing partner of gain from the sale of that property, if properly provided for in the partnership agreement, is reasonable for purposes of paragraph (c)(3)(iii)(a) of this section even if not of the same character. 4. Examples. The following examples illustrate the principles of this paragraph (c). Example 1. Reasonable and Unreasonable Curative Allocations. (i) Facts. E and F form partnership EF and agree that each will be allocated a 50 percent share of all partnership items and that EF will make allocations under 704(c) using the traditional method with curative allocations under paragraph (c) of this section. E contributes equipment with an adjusted tax basis of $4,000 and a book value of $10,000. The equipment has 10 years remaining on its cost recovery schedule and is depreciable using the straight- line method. At the time of contribution, E has a built-in gain of $6,000, and therefore, the equipment is 704(c) property. F contributes $10,000 of cash, which EF uses to buy inventory for resale. In EF's first year, the revenue generated by the equipment equals EF's operating expenses. The equipment generates $1,000 of book depreciation and $400 of tax depreciation for each of 10 years. At the end of the first year EF sells all the inventory for $10,700, recognizing $700 of income. The partners anticipate that the inventory income will have substantially the same effect on their tax liabilities as income from E's contributed equipment. Under the traditional method of paragraph (b) of this section, E and F would each be allocated $350 of income from the sale of inventory for book and tax purposes and $500 of depreciation for book purposes. The $400 of tax depreciation would all be allocated to F. Thus, at the end of the first year, E and F's book and tax capital accounts would be as follows: E Book Tax Book Tax $10,000 $4,000 $10,000 $10,000 Initial contribution <500> <0> <500> <400> Depreciation Sales income $ 9,850 $4,350 $ 9,850 $ 9,950 (ii) Reasonable Curative Allocation. Because the ceiling rule would cause a disparity of $100 between F's book and tax capital accounts, EF may properly allocate to E under paragraph (c) of this section an additional $100 of income from the sale of inventory for tax purposes. This allocation results in capital accounts at the end of EF's first year as follows: E Book Tax Book Tax $10,000 $4,000 $10,000 $10,000 Initial contribution <500> <0> <500> <400> Depreciation Sales income $ 9,850 $4,450 $ 9,850 $ 9,850 F F VOGEL.SEM/SP&LPROB.18

165 (iii) Unreasonable curative allocation. a. The facts are the same as in paragraphs (i) and (ii) of this Example 1, except that E and F choose to allocate all the income from the sale of the inventory to E for tax purposes, although they share it equally for book purposes. This allocation results in capital accounts at the end of EF's first year as follows: E Book Tax Book Tax $10,000 $4,000 $10,000 $10,000 Initial contribution <500> <0> <500> <400> Depreciation Sales income $ 9,850 $4,700 $ 9,850 $ 9,600 b. This curative allocation is not reasonable under paragraph (c)(3)(i) of this section because the allocation exceeds the amount necessary to offset the disparity caused by the ceiling rule. Example 2. Curative Allocations Limited to Depreciation (i) Facts. G and H form partnership GH and agree that each will be allocated a 50 percent share of all partnership items and that GH will make allocations under 704(c) using the traditional method with curative allocations under paragraph (c) of this section, but only to the extent that the partnership has sufficient tax depreciation deductions. G contributes property G1, with an adjusted tax basis of $3,000 and a fair market value of $10,000, and H contributes property H1, with an adjusted tax basis of $6,000 and a fair market value of $10,000. Both properties have 5 years remaining on their cost recovery schedules and are depreciable using the straight-line method. At the time of contribution, G1 has a built-in gain of $7,000 and H1 has a built-in gain of $4,000, and therefore, both properties are 704(c) property. G1 generates $600 of tax depreciation and $2,000 of book depreciation for each of seven years. H1 generates $1,200 of tax depreciation and $2,000 of book depreciation for each of 5 years. In addition, the properties each generate $500 of operating income annually. G and H are each allocated $1,000 of book depreciation for each property. Under the traditional method of paragraph (b) of this section, G would be allocated $0 of tax depreciation for G1 and $1,000 for H1, and H would be allocated $600 of tax depreciation for G1 and $200 for H1. Thus, at the end of the first year, G and H's book and tax capital accounts would be as follows: G Book Tax Book Tax $10,000 $3,000 $10,000 $6,000 Initial contribution <1,000> <0> <1,000> <600> G1 depreciation <1,000> <1,000> <1,000> <200> H1 depreciation Operating income $ 8,500 $2,500 $ 8,500 $5,700 (ii) Curative Allocations. Under the traditional method, G is allocated more depreciation deductions than H, even though H contributed property with a smaller disparity reflected on GH's book and tax capital accounts. GH makes curative allocations to H of an additional $400 of tax depreciation each year, which reduces the disparities between G and H's book and tax capital accounts ratably each year. These allocations are reasonable provided the allocations meet the other requirements of this section. As a result of their agreement, at the end of the first year, G and H's capital accounts are as follows: H F VOGEL.SEM/SP&LPROB.18

166 G Book Tax Book Tax $10,000 $3,000 $10,000 $6,000 Initial contribution <1,000> <0> <1,000> <600> G1 depreciation <1,000> <600> <1,000> <600> H1 depreciation Operating income $ 8,500 $2,900 $ 8,500 $5,300 Example 3. Unreasonable Use of Curative Allocations (i) Facts. J and K form partnership JK and agree that each will receive a 50 percent share of all partnership items and that JK will make allocations under 704(c) using the traditional method with curative allocations under paragraph (c) of this section. J contributes equipment with an adjusted tax basis of $1,000 and a book value of $10,000, with a view to taking advantage of the fact that the equipment has only one year remaining on its cost recovery schedule although it has an estimated remaining economic life of 10 years. J has substantial net operating loss carryforwards that J anticipates will otherwise expire unused. At the time of contribution, J has a built-in gain of $9,000, and therefore, the equipment is 704(c) property. K contributes $10,000 of cash, which JK uses to buy inventory for resale. In JK's first year, the revenues generated by the equipment exactly equal JK's operating expenses. Under Reg (b)(2)(iv)(g)(3), the partnership must allocate the $10,000 of book depreciation to the partners in the first year of the partnership. Thus, there is $10,000 of book depreciation and $1,000 of tax depreciation in the partnership's first year. In addition, at the end of the first year JK sells all of the inventory for $18,000, recognizing $8,000 of income. The partners anticipate that the inventory income will have substantially the same effect on their tax liabilities as income from J's contributed equipment. Under the traditional method of paragraph (b) of this section, J and K's book and tax capital accounts at the end of the first year would be as follows: J Book Tax Book Tax $10,000 $1,000 $10,000 $10,000 Initial contribution <5,000> <0> <5,000> <1,000> Depreciation 4,000 4,000 4,000 4,000 Sales income $ 9,000 $5,000 $ 9,000 $13,000 (ii) Unreasonable use of method. a. The use of curative allocations under these facts to offset immediately the full effect of the ceiling rule would result in the following book and tax capital accounts at the end of JK's first year: J Book Tax Book Tax $10,000 $1,000 $10,000 $10,000 Initial contribution <5,000> <0> <5,000> <1,000> Depreciation 4,000 8,000 4,000 0 Sales income $ 9,000 $9,000 $ 9,000 $ 9,000 b. This curative allocation is not reasonable under paragraph (a)(10) of this section because the contribution of property is made and the curative allocation method is used with a view to shifting a significant amount of partnership taxable income to a partner with a low marginal tax H K K VOGEL.SEM/SP&LPROB.18

167 rate and away from a partner with a high marginal tax rate, within a period of time significantly shorter than the economic life of the property. c. The property has only one year remaining on its cost recovery schedule even though its economic life is considerably longer. Under these facts, if the partnership agreement had provided for curative allocations over a reasonable period of time, such as over the property's economic life, rather than over its remaining cost recovery period, the allocations would have been reasonable. See paragraph (c)(3)(ii) of this section. Thus, in this example, JK would make a curative allocation of $400 of sales income to J in the partnership's first year (10 percent of $4,000). J and K's book and tax capital accounts at the end of the first year would be as follows: D. Remedial Allocation Method. J Book Tax Book Tax $10,000 $1,000 $10,000 $10,000 Initial contribution <5,000> <0> <5,000> <1,000> Depreciation 4,000 4,400 4,000 3,600 Sales income $ 9,000 $5,400 $ 9,000 $12, In General. A partnership may adopt the remedial allocation method described in this paragraph to eliminate distortions caused by the ceiling rule. A partnership adopting the remedial allocation method eliminates those distortions by creating remedial items and allocating those items to its partners. Under the remedial allocation method, the partnership first determines the amount of book items under paragraph (d)(2) of this section and the partners' distributive shares of these items under 704(b). The partnership then allocates the corresponding tax items recognized by the partnership, if any, using the traditional method described in paragraph (b)(1) of this section. If the ceiling rule (as defined in paragraph (b)(1) of this section) causes the book allocation of an item to a noncontributing partner to differ from the tax allocation of the same item to the noncontributing partner, the partnership creates a remedial item of income, gain, loss, or deduction equal to the full amount of the difference and allocates it to the noncontributing partner. The partnership simultaneously creates an offsetting remedial item in an identical amount and allocates it to the contributing partner. 2. Determining the Amount of Book Items. Under the remedial allocation method, a partnership determines the amount of book items attributable to contributed property in the following manner rather than under the rules of Reg (b)(2)(iv)(g)(3). The portion of the partnership's book basis in the property equal to the adjusted tax basis in the property at the time of contribution is recovered in the same manner as the adjusted tax basis in the property is recovered (generally, over the property's remaining recovery period under 168(i)(7) or other applicable Internal Revenue Code section). The remainder of the partnership's book basis in the property (the amount by which book basis exceeds adjusted tax basis) is recovered using any recovery period and depreciation (or other cost recovery) method (including first-year conventions) available to the partnership for newly purchased property (of the same type as the contributed property) that is placed in service at the time of contribution. 3. Type. Remedial allocations of income, gain, loss, or deduction to the noncontributing partner have the same tax attributes as the tax item limited by the ceiling rule. The tax attributes of offsetting remedial allocations of income, gain, loss, or deduction to the contributing partner are determined by reference to the item limited by the ceiling rule. Thus, for example, if the ceiling rule limited item is loss from the sale of contributed property, the offsetting remedial allocation to the contributing partner must be gain from the sale of that property. Conversely, if the ceiling rule limited item is gain from the sale of contributed property, the offsetting remedial allocation to the contributing partner must be loss from the sale of that property. If the ceiling rule limited item is depreciation or other K VOGEL.SEM/SP&LPROB.18

168 cost recovery from the contributed property, the offsetting remedial allocation to the contributing partner must be income of the type produced (directly or indirectly) by that property. Any partner level tax attributes are determined at the partner level. For example, if the ceiling rule limited item is depreciation from property used in a rental activity, the remedial allocation to the noncontributing partner is depreciation from property used in a rental activity and the offsetting remedial allocation to the contributing partner is ordinary income from that rental activity. Each partner then applies 469 to the allocations as appropriate. 4. Effect of Remedial Items. a. Effect on Partnership. Remedial items do not affect the partnership's computation of its taxable income under 703 and do not affect the partnership's adjusted tax basis in partnership property. b. Effect on Partners. Remedial items are notional tax items created by the partnership solely for tax purposes and do not affect the partners' book capital accounts. Remedial items have the same effect as actual tax items on a partner's tax liability and on the partner's adjusted tax basis in the partnership interest. 5. Limitations on Use of Methods Involving Remedial Allocations. a. Limitation on Taxpayers. In the absence of published guidance, the remedial allocation method described in this paragraph (d) is the only reasonable 704(c) method permitting the creation of notional tax items. b. Limitation on Internal Revenue Service. In exercising its authority under paragraph (a)(10) of this section to make adjustments if a partnership's allocation method is not reasonable, the Internal Revenue Service will not require a partnership to use the remedial allocation method described in this paragraph (d) or any other method involving the creation of notional tax items. 6. Adjustments to Application of Method. The Commissioner may, by published guidance, prescribe adjustments to the remedial allocation method under this paragraph (d) as necessary or appropriate. This guidance may, for example, prescribe adjustments to the remedial allocation method to prevent the duplication or omission of items of income or deduction or to reflect more clearly the partners' income or the income of a transferee of a partner. 7. Examples. The following examples illustrate the principles of this paragraph (d). Example 1. Remedial allocation method. (i) Facts. On January 1, L and M form partnership LM and agree that each will be allocated a 50 percent share of all partnership items. The partnership agreement provides that LM will make allocations under 704(c) using the remedial allocation method under this paragraph (d) and that the straight-line method will be used to recover excess book basis. L contributes depreciable property with an adjusted tax basis of $4,000 and a fair market value of $10,000. The property is depreciated using the straight-line method with a 10-year recovery period and has 4 years remaining on its recovery period. M contributes $10,000, which the partnership uses to purchase land. Except for the depreciation deductions, LM's expenses equal its income in each year of the 10 years commencing with the year the partnership is formed. (ii ) Years 1 through 4. Under the remedial allocation method of this paragraph (d), LM has book depreciation for each of its first 4 years of $1,600 [$1,000 ($4,000 adjusted tax basis divided by the 4-year remaining recovery period) plus $600 ($6,000 excess of book value over tax basis, divided by the new 10-year recovery period)]. (For the purpose of simplifying the example, the partnership's book depreciation is determined without regard to any first-year depreciation conventions.) Under the partnership agreement, L and M are each allocated 50 percent ($800) of the book depreciation VOGEL.SEM/SP&LPROB.18

169 M is allocated $800 of tax depreciation and L is allocated the remaining $200 of tax depreciation ($1,000-$800). See paragraph (d)(1) of this section. No remedial allocations are made because the ceiling rule does not result in a book allocation of depreciation to M different from the tax allocation. The allocations result in capital accounts at the end of LM's first 4 years as follows: (ii) Subsequent years. L Book Tax Book Tax $10,000 $4,000 $10,000 $10,000 Initial contribution <3,200> <800> <3,200> <3,200> Depreciation $ 6,800 $3,200 $ 6,800 $ 6,800 a. For each of years 5 through 10, LM has $600 of book depreciation ($6,000 excess of initial book value over adjusted tax basis divided by the 10-year recovery period that commented in year 1), but no tax depreciation. Under the partnership agreement, the $600 of book depreciation is allocated equally to L and M. Because of the application of the ceiling rule in year 5, M would be allotted $300 of book depreciation, but no tax depreciation. Thus, at the end of LM's fifth year L's and M's book and tax capital accounts would be as follows: L M Book Tax Book Tax $6,800 $3,200 $6,800 $6,800 End of year 4 <300> <300> Depreciation 300 <300> Remedial allocations $6,500 $3,200 $6,500 $6,800 b. Because the ceiling rule would cause an annual disparity of $300 between M's allocations of book and tax depreciation, LM must make remedial allocations of $300 of tax depreciation deductions to M under the remedial allocation method for each of years 5 through 10. LM must also make an offsetting remedial allocation to L of $300 of taxable income, which must be of the same type as income produced by the property. At the end of year 5, LM's capital accounts are as follows: L M Book Tax Book Tax $6,800 $3,200 $6,800 $6,800 End of year 4 <300> <300> Depreciation 300 <300> Remedial allocations $6,500 $3,500 $6,500 $6,500 c. At the end of year 10, LM's capital accounts are as follows: L M Book Tax Book Tax $6,500 $3,500 $6,500 $6,500 End of year 4 <1,500> <1,500> Depreciation 1,500 <1,500> Remedial allocations $5,000 $5,000 $5,000 $5,000 Example 2. Remedial Allocations on Sale. (i) Facts. N and P form partnership NP and agree that each will be allocated a 50 percent share of all partnership items. The partnership agreement provides that NP will make allocations under 704(c) using the remedial allocation method under this paragraph (d). N contributes Blackacre M VOGEL.SEM/SP&LPROB.18

170 (land) with an adjusted tax basis of $4,000 and a fair market value of $10,000. Because N has a built-in gain of $6,000, Blackacre is 704(c) property. P contributes Whiteacre (land) with an adjusted tax basis and fair market value of $10,000. At the end of NP's first year, NP sells Blackacre to Q for $9,000 and recognizes a capital gain of $5,000 ($9,000 amount realized less $4,000 adjusted tax basis) and a book loss of $1,000 ($9,000 amount realized less $10,000 book basis). NP has no other items of income, gain, loss, or deduction. If the ceiling rule were applied, N would be allocated the entire $5,000 of tax gain and N and P would each be allocated $500 of book loss. Thus, at the end of NP's first year N's and P's book and tax capital accounts would be as follows: N P Book Tax Book Tax $10,000 $4,000 $10,000 $10,000 Initial contribution <500> 5,000 <500> Sale of Blackacre $ 9,500 $9,000 $ 9,500 $10,000 (ii) Remedial Allocation. Because the ceiling rule would cause a disparity of $500 between P's allocation of book and tax loss, NP must make a remedial allocation of $500 of capital loss to P and an offsetting remedial allocation to N of an additional $500 of capital gain. These allocations result in capital accounts at the end of NP's first year as follows: N P Book Tax Book Tax $10,000 $4,000 $10,000 $10,000 Initial contribution <500> 5,000 <500> Sale of Blackacre 500 <500> Remedial allocations $ 9,500 $9,500 $ 9,500 $ 9,500 Example 3. Remedial Allocation Where Built-In Gain Property Sold for Book and Tax Loss. (i) Facts. The facts are the same as in Example 2, except that at the end of NP's first year, NP sells Blackacre to Q for $3,000 and recognizes a capital loss of $1,000 ($3,000 amount realized less $4,000 adjusted tax basis) and a book loss of $7,000 ($3,000 amount realized less $10,000 book basis). If the ceiling rule were applied, P would be allocated the entire $1,000 of tax loss and N and P would each be allocated $3,500 of book loss. Thus, at the end of NP's first year, N's and P's book and tax capital accounts would be as follows: N P Book Tax Book Tax $10,000 $4,000 $10,000 $10,000 Initial contribution <3,500> 0 <500> Sale of Blackacre $ 6,000 $4,000 $ 6,500 $ 9,000 (ii) Remedial Allocation. Because the ceiling rule would cause a disparity of $2,500 between P's allocation of book and tax loss on the sale of Blackacre, NP must make a remedial allocation of $2,500 of capital loss to P and an offsetting remedial allocation to N of $2,500 of capital gain. These allocations result in capital accounts at the end of NP's first year as follows: N P Book Tax Book Tax $10,000 $4,000 $10,000 $10,000 Initial contribution <3,500> 0 <3,500> <1,000> Sale of Blackacre 500 <500> Remedial allocations $ 6,500 $6,500 $ 6,500 $ 6, VOGEL.SEM/SP&LPROB.18

171 E. Exceptions and Special Rules. 1. Small disparities. a. General Rule. If a partner contributes one or more items of property to a partnership within a single taxable year of the partnership, and the disparity between the book value of the property and the contributing partner's adjusted tax basis in the property is a small disparity, the partnership may-- 1) Use a reasonable 704(c) method; 2) Disregard the application of 704(c) to the property; or 3) Defer the application of 704(c) to the property until the disposition of the property. b. Definition of Small Disparity. A disparity between book value and adjusted tax basis is a small disparity if the book value of all properties contributed by one partner during the partnership taxable year does not differ from the adjusted tax basis by more than 15 percent of the adjusted tax basis, and the total gross disparity does not exceed $20, Aggregation. Each of the following types of property may be aggregated for purposes of making allocations under 704(c) and this section if contributed by one partner during the partnership taxable year. a. Depreciable Property. All property, other than real property, that is included in the same general asset account of the contributing partner and the partnership under 168. b. Zero-Basis Property. All property with a basis equal to zero, other than real property. c. Inventory. For partnerships that do not use a specific identification method of accounting, each item of inventory, other than qualified financial assets (as defined in paragraph (e)(3)(ii) of this section). 3. Special Aggregation Rule for Securities Partnerships. a. General Rule. For purposes of making reverse 704(c) allocations, a securities partnership may aggregate gains and losses from qualified financial assets using any reasonable approach that is consistent with the purpose of 704(c). Notwithstanding paragraphs (a)(2) and (a)(6)(i) of this section, once a partnership adopts an aggregate approach, that partnership must apply the same aggregate approach to all of its qualified financial assets for all taxable years in which the partnership qualifies as a securities partnership. Paragraphs (e)(3)(iv) and (e)(3)(v) of this section describe approaches for aggregating reverse 704(c) gains and losses that are generally reasonable. Other approaches may be reasonable in appropriate circumstances. See, however, paragraph (a)(10) of this section, which describes the circumstances under which 704(c) methods, including the aggregate approaches described in this paragraph (e)(3), are not reasonable. A partnership using an aggregate approach must separately account for any builtin gain or loss from contributed property. b. Qualified Financial Assets. 1) In General. A qualified financial asset is any personal property (including stock) that is actively traded. Actively traded means actively traded as defined in Reg (d)-1 (defining actively traded property for purposes of the straddle rules). 2) Management Companies. For a management company, qualified financial assets also include the following, even if not actively traded: shares of stock in a corporation; notes, VOGEL.SEM/SP&LPROB.18

172 bonds, debentures, or other evidences of indebtedness; interest rate, currency, or equity notional principal contracts; evidences of an interest in, or derivative financial instruments in, any security, currency, or commodity, including any option, forward or futures contract, or short position; or any similar financial instrument. 3) Partnership Interests. An interest in a partnership is not a qualified financial asset for purposes of this paragraph (e)(3)(ii). However, for purposes of this paragraph (e)(3), a partnership (upper-tier partnership) that holds an interest in a securities partnership (lower-tier partnership) must take into account the lower-tier partnership's assets and qualified financial assets as follows: a) In determining whether the upper-tier partnership qualifies as an investment partnership, the upper-tier partnership must treat its proportionate share of the lower-tier securities partnership's assets as assets of the upper- tier partnership; and b) If the upper-tier partnership adopts an aggregate approach under this paragraph (e)(3), the upper-tier partnership must aggregate the gains and losses from its directly held qualified financial assets with its distributive share of the gains and losses from the qualified financial assets of the lower- tier securities partnership. c. Securities Partnership. 1) In General. A partnership is a securities partnership if the partnership is either a management company or an investment partnership, and the partnership makes all of its book allocations in proportion to the partners' relative book capital accounts (except for reasonable special allocations to a partner that provides management services or investment advisory services to the partnership). 2) Definitions. a) Management Company. A partnership is a management company if it is registered with the Securities and Exchange Commission as a management company under the Investment Company Act of 1940, as amended (15 U.S.C. 80a). b) Investment Partnership. A partnership is an investment partnership if: (i) (ii) On the date of each capital account restatement, the partnership holds qualified financial assets that constitute at least 90 percent of the fair market value of the partnership's non-cash assets; and The partnership reasonably expects, as of the end of the first taxable year in which the partnership adopts an aggregate approach under this paragraph (e)(3), to make revaluations at least annually. d. Partial Netting Approach. This paragraph (e)(3)(iv) describes the partial netting approach of making reverse 704(c) allocations. See Example 1 of paragraph (e)(3)(ix) of this section for an illustration of the partial netting approach. To use the partial netting approach, the partnership must establish appropriate accounts for each partner for the purpose of taking into account each partner's share of the book gains and losses and determining each partner's share of the tax gains and losses. Under the partial netting approach, on the date of each capital account restatement, the partnership: 1) Nets its book gains and book losses from qualified financial assets since the last capital account restatement and allocates the net amount to its partners; VOGEL.SEM/SP&LPROB.18

173 2) Separately aggregates all tax gains and all tax losses from qualified financial assets since the last capital account restatement; and 3) Separately allocates the aggregate tax gain and aggregate tax loss to the partners in a manner that reduces the disparity between the book capital account balances and the tax capital account balances (book-tax disparities) of the individual partners. e. Full Netting Approach. This paragraph (e)(3)(v) describes the full netting approach of making reverse 704(c) allocations on an aggregate basis. See Example 2 of paragraph (e)(3)(ix) of this section for an illustration of the full netting approach. To use the full netting approach, the partnership must establish appropriate accounts for each partner for the purpose of taking into account each partner's share of the book gains and losses and determining each partner's share of the tax gains and losses. Under the full netting approach, on the date of each capital account restatement, the partnership: 1) Nets its book gains and book losses from qualified financial assets since the last capital account restatement and allocates the net amount to its partners; 2) Nets tax gains and tax losses from qualified financial assets since the last capital account restatement; and 3) Allocates the net tax gain (or net tax loss) to the partners in a manner that reduces the book-tax disparities of the individual partners. f. Type of Tax Gain or Loss. The character and other tax attributes of gain or loss allocated to the partners under this paragraph (e)(3) must: 1) Preserve the tax attributes of each item of gain or loss realized by the partnership; 2) Be determined under an approach that is consistently applied; and 3) Not be determined with a view to reducing substantially the present value of the partners' aggregate tax liability. g. Disqualified Securities Partnerships. A securities partnership that adopts an aggregate approach under this paragraph (e)(3) and subsequently fails to qualify as a securities partnership must make reverse 704(c) allocations on an asset-by-asset basis after the date of disqualification. The partnership, however, is not required to disaggregate the book gain or book loss from qualified asset revaluations before the date of disqualification when making reverse 704(c) allocations on or after the date of disqualification. h. Transitional Rule for Qualified Financial Assets Revalued after Effective Date. A securities partnership revaluing its qualified financial assets pursuant to Reg (b)(2)(iv)(f) on or after the effective date of this section may use any reasonable approach to coordinate with revaluations that occurred prior to the effective date of this section. i. Examples. The following examples illustrate the principles of this paragraph (e)(3). Example 1. Operation of the Partial Netting Approach (i) Facts. Two regulated investment companies, X and Y, each contribute $150,000 in cash to form PRS, a partnership that registers as a management company. The partnership agreement provides that book items will be allocated in accordance with the partners' relative book capital accounts, that book capital accounts will be adjusted to reflect daily revaluations of property pursuant to Reg (b)(2)(iv)(f)(5)(iii), and that reverse 704(c) allocations will be made using the partial netting approach described in paragraph (e)(3)(iv) of this section VOGEL.SEM/SP&LPROB.18

174 X and Y each have an initial book capital account of $150,000. In addition, the partnership establishes for each of X and Y a revaluation account with a beginning balance of $0. On Day 1, PRS buys Stock 1, Stock 2, and Stock 3 for $100,000 each. On Day 2, Stock 1 increases in value from $100,000 to $102,000, Stock 2 increases in value from $100,000 to $105,000, and Stock 3 declines in value from $100,000 to $98,000. At the end of Day 2, Z, a regulated investment company, joins PRS by contributing $152,500 in cash for a one-third interest in the partnership [$152,500 divided by $300,000 (initial values of stock) + $5,000 (net gain at end of Day 2) + $152,500]. PRS uses this cash to purchase Stock 4. PRS establishes a revaluation account for Z with a $0 beginning balance. As of the close of Day 3, Stock 1 increases in value from $102,000 to $105,000, and Stocks 2, 3, and 4 decrease in value from $105,000 to $102,000, from $98,000 to $96,000, and from $152,500 to $151,500, respectively. At the end of Day 3, PRS sells Stocks 2 and 3. (ii) Book allocations--day 2. At the end of Day 2, PRS revalues the partnership's qualified financial assets and increases X's and Y's book capital accounts by each partner's 50 percent share of the $5,000 ($2,000 + $5,000 - $2,000) net increase in the value of the partnership's assets during Day 2. PRS increases X's and Y's respective revaluation account balances by $2,500 each to reflect the amount by which each partner's book capital account increased on Day 2. Z's capital account is not affected because Z did not join PRS until the end of Day 2. At the beginning of Day 3, the partnership's accounts are as follows: Stock 1 Stock 2 Stock 3 Stock 4 $100,000 $100,000 $100, Opening Balance 2,000 5,000 (2,000) Day 2 Adjustment $102,000 $105,000 $ 98,000 $152,500 Total X Book Tax Revaluation Account $150,000 $150,000 $ 0 Opening Balance 2, ,500 Day 2 Adjustment $152,500 $150,000 $2,500 Closing Balance Y Book Tax Revaluation Account $150,000 $150,000 $ 0 Opening Balance 2, ,500 Day 2 Adjustment $152,500 $150,000 $2,500 Closing Balance Z Book Tax Revaluation Account Opening Balance Day 2 Adjustment $152,500 $152,500 $ 0 Closing Balance (iii) Book and tax allocations--day 3. At the end of Day 3, PRS decreases the book capital accounts of X, Y, and Z by $1,000 to reflect each partner's share of the $3,000 ($3,000--$3,000--$2,000--$1,000) net decrease in the value of the partnership's qualified financial assets. PRS also reduces each partner's revaluation account balance by $1, VOGEL.SEM/SP&LPROB.18

175 Accordingly, X's and Y's revaluation account balances are reduced to $1,500 each and Z's revaluation account balance is ($1,000). PRS then separately allocates the tax gain from the sale of Stock 2 and the tax loss from the sale of Stock 3. The $2,000 of tax gain recognized on the sale of Stock 2 ($102,000 - $100,000) is allocated among the partners with positive revaluation account balances in accordance with the relative balances of those revaluation accounts. X's and Y's revaluation accounts have equal positive balances; thus, PRS allocates $1,000 of the gain from the sale of Stock 2 to X and $1,000 of that gain to Y. PRS allocates none of the gain from the sale to Z because Z's revaluation account balance is negative. The $4,000 of tax loss recognized from the sale of Stock 3 ($96,000 - $100,000) is allocated first to the partners with negative revaluation account balances to the extent of those balances. Because Z is the only partner with a negative revaluation account balance, the tax loss is allocated first to Z to the extent of Z's ($1,000) balance. The remaining $3,000 of tax loss is allocated among the partners in accordance with their distributive shares of the loss. Accordingly, PRS allocates $1,000 of tax loss from the sale of Stock 3 to each of X and Y. PRS also allocates an additional $1,000 of the tax loss to Z, so that Z's total share of the tax loss from the sale of Stock 3 is $2,000. PRS then reduces each partner's revaluation account balance by the amount of any tax gain allocated to that partner and increases each partner's revaluation account balance by the amount of any tax loss allocated to that partner. At the beginning of Day 4, the partnership's accounts are as follows: Stock 1 Stock 2 Stock 3 Stock 4 $100,000 $100,000 $100,000 $152,500 Opening Balance 2,000 5,000 (2,000) Day 2 Adjustment 3,000 (3,000) (2,000) (1,000) Day 3 Adjustment $105,000 $102,000 $ 96,000 $151,500 Total X and Y Book Tax Revaluation Account $150,000 $150,000 $ 0 Opening Balance 2, ,500 Day 2 Adjustment (1,000) 0 (1,000) Day 3 Adjustment $151,500 $150,000 $1,500 Total 0 1,000 (1,000) Gain from Stock 2 0 (1,000) 1,000 Loss from Stock 3 $151,500 $150,000 $1,500 Closing Balance Z Book Tax Revaluation Account $152,500 $152,500 $ 0 Opening Balance (1,000) 0 (1,000) Day 3 Adjustment $151,500 $152,500 (1,000) Total Gain from Stock 2 0 (2,000) 2,000 Loss from Stock 3 $151,500 $150,500 $1,000 Closing Balance VOGEL.SEM/SP&LPROB.18

176 Example 2. Operation of the Full Netting Approach (i) Facts. The facts are the same as in Example 1, except that the partnership agreement provides that PRS will make reverse 704(c) allocations using the full netting approach described in paragraph (e)(3)(v) of this section. (ii) Book allocations--days 2 and 3. PRS allocates its book gains and losses in the manner described in paragraphs (ii) and (iii) of Example 1 (the partial netting approach). Thus, at the end of Day 2, PRS increases the book capital accounts of X and Y by $2,500 to reflect the appreciation in the partnership's assets from the close of Day 1 to the close of Day 2 and records that increase in the revaluation account created for each partner. At the end of Day 3, PRS decreases the book capital accounts of X, Y, and Z by $1,000 to reflect each partner's share of the decline in value of the partnership's assets from Day 2 to Day 3 and reduces each partner's revaluation account by a corresponding amount. (iii) Tax allocations--day 3. After making the book adjustments described in the previous paragraph, PRS allocates its net tax gain (or net tax loss) from its sales of qualified financial assets during Day 3. To do so, PRS first determines its net tax gain (or net tax loss) recognized from its sales of qualified financial assets for the day. There is a $2,000 net tax loss ($2,000 gain from the sale of Stock 2 less $4,000 loss from the sale of Stock 3) on the sale of PRS's qualified financial assets. Because Z is the only partner with a negative revaluation account balance, the partnership's net tax loss is allocated first to Z to the extent of Z's ($1,000) revaluation account balance. The remaining net tax loss is allocated among the partners in accordance with their distributive shares of loss. Thus, PRS allocates $ of the $2,000 net tax loss to each of X and Y. PRS also allocates an additional $ of the net tax loss to Z, so that the total net tax loss allocation to Z is $1, PRS then increases each partner's revaluation account balance by the amount of net tax loss allocated to that partner. At the beginning of Day 4, the partnership's accounts are as follows: Stock 1 Stock 2 Stock 3 Stock 4 $100,000 $100,000 $100,000 $152,000 Opening Balance 2,000 5,000 (2,000) Day 2 Adjustment 3,000 (3,000) (2,000) (1,000) Day 3 Adjustment $105,000 $102,000 $ 96,000 $151,500 Total X and Y Book Tax Revaluation Account $150,000 $150,000 $ 0 Opening Balance 2, ,500 Day 2 Adjustment (1,000) 0 (1,000) Day 3 Adjustment $151,500 $150,000 1,500 Total 0 (333) (333) Net Tax Loss-Stocks 2 & 3 $151,500 $149,667 $1,833 Closing Balance VOGEL.SEM/SP&LPROB.18

177 Z Book Tax Revaluation Account $152,500 $152,500 $ 0 Opening Balance (1,000) 0 (1,000) Day 3 Adjustment $151,500 $152,500 (1,500) Total 0 (1,333) 1,333 Net Tax Loss-Stocks 2 & 3 $151,500 $151,167 $ 333 Closing Balance 4. Aggregation as Permitted by the Commissioner. The Commissioner may, by published guidance or by letter ruling, permit: a. Aggregation of properties other than those described in paragraphs (e)(2) and (e)(3) of this section; b. Partnerships and partners not described in paragraph (e)(3) of this section to aggregate gain and loss from qualified financial assets; and c. Aggregation of qualified financial assets for purposes of making 704(c) allocations in the same manner as that described in paragraph (e)(3) of this section. 5. Effective date. This section applies to property contributed to a partnership and to restatements pursuant to Reg (b)(2)(iv)(f) on or after December 21, VOGEL.SEM/SP&LPROB.18

178 PAL Rules and Material Participation (Yes) Remember one can only materially participate in a trade or business activity. One cannot materially participate in a rental activity. The only exception is a REP may materially participate in a rental real estate activity. Definitions: Trade or Business APCU 7 days Rental Activity APCU > 7 days (and may not materially participate in a rental activity unless REP and underlying activity is a rental real estate activity) SP&LPROB PAL Rules What Qualifies as Material Participation? (Yes) For purposes of the passive loss rules (including the special relief provision for real estate professionals), a taxpayer is normally consider to materially participate in an activity if any of the following tests are met (Temp. Reg T(a)): 1. The taxpayer participates in the activity for more than 500 hours during the year. Proof 2. The taxpayer's participation in the activity for the tax year constitutes substantially all of the participation by all individuals in the activity. 3. The taxpayer's participation is more than 100 hours during the tax year, and no other individual id participates i t more hours than the taxpayer. (See Ll Leland, T.C. Memo attorney and wild hogs.) 4. The activity is a significant participation activity for the taxpayer for the tax year and the taxpayer's participation in all significant participation activities for the tax year is more than 500 hours. (A significant participation activity is basically one in which the taxpayer participates for more than 100 hours during the tax year.) SP&LPROB

179 PAL Rules What Qualifies as Material Participation? (Yes) For purposes of the passive loss rules (including the special relief provision for real estate professionals), a taxpayer is normally consider to materially participate in an activity if any of the following tests are met (Temp. Reg T(a)): 5. The taxpayer materially participated for any five tax years during the ten immediately preceding tax years. Purpose Retire from a business but retain an ownership interest. 6. If the activity in question is a personal service activity, the taxpayer materially participated in the activity for any three tax years preceding the current tax year. (Personal service includes the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.) Retire from a law firm, an accounting firm or a medical practice. SP&LPROB PAL Rules What Qualifies as Material Participation? (Yes) For purposes of the passive loss rules (including the special relief provision for real estate tt professionals), a taxpayer is normally consider to materially participate i t in an activity if any of the following tests are met (Temp. Reg T(a)): 7. Basedonallthefactsandcircumstances, the taxpayer participates on a regular, continuous, and substantial basis during the year. Future regulations are to provide further guidance for this test. However, the temporary regulations indicate that if an individual participates in an activity for 100 hours or less during the year, the facts and circumstances test is not available to qualify for material participation. Also, services in the management of the activity are not to be taken into account for this test unless no person (other than the taxpayer) who performs services in connection with the management of the activity receives fees or compensation for such services, and no individual performs management services that exceed (by hours) the amount of management services performed by the individual (Temp. Reg T(b)(2)). (See Wade, T.C. Memo , and Hailstock, T.C. Memo ) SP&LPROB

180 PAL Rules What Qualifies as Material Participation? (Yes) Limited partners have a tougher standard for determining if they materially participate in the partnership's activities. Instead of satisfying one of the seven tests listed above, they must satisfy either test 1, 5 or 6. However, in the case of rental real estate activities, only tests 1 and 5 are effectively available for limited partners because rental real estate is not a personal service activity. According to the IRS audit manual, a member of an LLC is treated as a limited partner for purposes of applying the PAL rules. (But see Gregg v. Comm r, USTC 50,169 (D.C. Ore. 2000), Garnett, Thompson, Hegarty, & Newell (all 2010 cases), where a member was treated as a general partner for purposes of applying the PAL rules.) (See also Prop. Reg (e) for the definition of a limited partner.) Point: Member of LLC = G.P. and may materially participate using any of the seven tests. SP&LPROB Self-Employment Income H & W own a retail business as general partners in a partnership. W is active and H is not active. If each partner s distributive share of the earnings is $80,000, how much of the income is subject to SE tax? Same as above, except the business is an LLC. SP&LPROB

181 SE Income (Yes) Is a partner s distributive share of $100,000 of operating income considered as SE income? General Partner Homer, Alaska See old 1348 & 30% test Time Bandit on the Deadliest Catch Is it a relatively big boat or a small boat? Where is its home port? Why are there less than ten crew members on each of the fishing vessels in the Deadliest Catch and how far do the Kilcher s live from a real city? See singer by name of Jewel Huh? Is it true that a halibut s sex changes from male to female at about lbs.? SP&LPROB SE Income (Yes) Is a partner s distributive share of $100,000 of operating income considered as SE income? How much is subject to the 3.8% tax on NII? Limited Partner (not SE) (See TRA 1997 & Newt Gingrich.) Not L.P. if: Participate > 500 hours May contractually bind entity Personally liable for any debt Prop. Reg (e) Only a limited partner if do not have ability to make management decisions under state law and the operating agreement. (December 2011) SP&LPROB

182 SE Income (Yes) Is an S corporation shareholder s distributive share of $100,000 of operating income considered as SE income? How much is subject to the 3.8% tax on NII? Shareholder in S corporation Not SE SP&LPROB SE Income (Yes) Is a partner s distributive share of $100,000 of operating income considered as SE income? How much is subject to the 3.8%tax on NII? Member of LLP Service business (SE income) Renkemeyer, CCA , CCA & Castigliola See Prop. Reg (e) SP&LPROB

183 SE Income (Yes) (Skip to Slide 205.) Is a partner s distributive share of $100,000 of operating income considered d as SE income? How much is subject to the 3.8% tax on NII? Member of LLC Member Manager or Member but not Manager Pay managing members a guaranteed payment for services. (But see CCA and Hardy.) W-2 Can you issue a W-2 to Member of an LLC? (See 199A.) Bifurcated interest Make left hand the managing member and right hand the member, but not manager. (See Robucci.) SP&LPROB Self-Employment Tax and Limited Partners Recent Case Causes a Stir (No) Background: (a) defines net earnings from self-employment to include a partner s distributive share from a partnership. a. 1402(a)(13), however, excludes the distributive share of any item of income or loss of a limited partner, as such, other than certain guaranteed payments. b. This was enacted prior to common use of limited liability partnerships (LLPs) and limited liability companies (LLCs) under more recent State statutes. c. But see Prop. Reg SP&LPROB

184 Self-Employment Tax and Limited Partners (No) Background: 1. Prop. Reg (a)-1(h) (1997) provides that a partner is treated as a limited partner unless that individual: a. Has personal liability for the debts of or claims against the partnership by reason of being a partner; b. Has authority under local law to contract on behalf of the partnership; or c. Participates in the partnership s business for more than 500 hours during the partnership s taxable year. 2. But a service partner in a service partnership may not be a limited partner (unless provides de minimis services). SP&LPROB Self-Employment Tax and Limited Partners (No) Background: 1. Congressional response to Prop. Reg (a)-1(h) (1997): a. TRA 1997 provided that no temporary or final regulations with respect to the definition of a limited partner under 1402 could be issued before 7/1/98. b. Senate passed a non-binding resolution reflecting the sense of the Senate that Congress rather than the IRS or Treasury Department e t should determine the law in this area. c. Congress has done nothing since d. IRS and Treasury have done nothing since 1997, but state that taxpayers may rely on the proposed regulations. SP&LPROB

185 Self-Employment Tax and Limited Partners (No) As a result, rules are not clear for LLPs and LLCs. 1. IRS most strict position is in PLR : LLC member is not eligible for the limited partner exception in 1402(a)(13) because he/she is not an actual limited partner under State partnership law. a. Aggressive practitioners: The exception applies to all owners in entities treated as partnerships for Federal tax purposes if they have limited liability. b. Recent 469 cases: Members of an LLC are not limited partners to apply the material participation rules because even though they have limited liability, they are allowed to participate in management and are more like general partners. (But see Prop. Reg ) SP&LPROB Proposed Regulations under 469 Material Participation By Limited Partners (No) Background: (h)(2): Except as provided in regulations, no interest in a limited partnership as a limited partner (LP) shall be treated as an interest with respect to which a taxpayer materially participates. 2. Reg T(a): provides seven ways a taxpayer is treated as materially participating in an activity. 3. Reg T(e)(2): allows an LP to establish material participation only under thee of the seven ways, primarily the 500- hour rule. 4. Reg T(e)(3): an interest is an LP interest if the liability of the holder for obligations of the partnership is limited under State law. SP&LPROB

186 Proposed Regulations under 469 Material Participation By Limited Partners (No) Problem: how does one treat a member of an LLC? 1. Recent cases: a member of an LLC is not a limited partner for purposes of the material participation rules. 2. Why? Members of an LLC are like general partners in that they are allowed to participate in the activity. a. Their hi limitedi liability is not an appropriate basis totreatthem as limitedi partners for purposes of the material participation rules under 469. b. Also, LLC members are not limited partners under a State partnership statute. SP&LPROB Proposed Regulations under 469 Material Participation By Limited Partners (No) Prop. Reg (e): 1. An interest in an entity shall be treated as an interest in a limited partnership as a limited partner if: a. The entity in which such interest is held is classified as a partnership for Federal income purposes; and b. The holder of such interest does not have rights to manage the entity at all times during theentity s taxable yearunder the law of the jurisdiction in which the entity is organized and under the governing agreement. 2. In short: regulations shift from a limited liability principle to a right to manage principle. But language is ambiguous. SP&LPROB

187 Proposed Regulations under 469 Material Participation By Limited Partners (No) Commentators: 1. What does the second prong mean? A member of an LLC will not be treated as a LP in a state that gives members the right to manage, even if the member agreement does not allow particular members to participate in management of the entity? 2. Both the N.Y. State Bar Association Tax Section and the ABA Section of Taxation have weighed in on the proposed regulations. Both ask for clarity on the definition of rights to manage and whether a member agreement of an LLC trumps state law. SP&LPROB Self-Employment Tax and Limited Partners (Yes) In Renkemeyer, Campbell & Weaver LLP v. Comm r, 136TC.No.7 (2011): 1. In 2004, three lawyers practiced law through an LLP organized under Kansas law. They were partners in the LLP, as was an S corporation that was wholly owned by an ESOP of which the three lawyers were the beneficiaries. a. About 99% of the LLP s income was due to lawyers services. b. One issue in the case was whether a special allocation to the S corporation in 2004 was valid. The Court held it was not. c. Real issue: The three attorneys treated none of their distributive share of LLC income as subject to SE taxes. SP&LPROB

188 Self-Employment Tax and Limited Partners (No) In Renkemeyer, Campbell & Weaver LLP v. Comm r, 136TC.No.7 (2011): 1. The attorneys argued that the 1402(a)(13) limited partnership exception applied to them because: a. Their interests in the LLP were designated as limited partnership interests in the LLP s organization documents; and b. Their interests in the firm enjoy limited liability under Kansas law governing LLPs. SP&LPROB Self-Employment Tax and Limited Partners (No) In Renkemeyer, Campbell & Weaver LLP v. Comm r, 136TC.No.7 (2011): 1. Court rejected the attorneys argument because: a. The key difference between general partners (GPs) and limited partners (LPs) is that GPs have management power and unlimited liability, while LPs lack management power but enjoy immunity from liability for debts of the partnership. Thus the interest of a LP is generally akin to that of a passive investor. b. All partners in an LLP enjoy limited liability, but may have management powers. An LLP essentially is a general partnership that affords a form of limited liability for all partners. SP&LPROB

189 Self-Employment Tax and Limited Partners (No) In Renkemeyer, Campbell & Weaver LLP v. Comm r, 136TC.No.7 (2011): 1. Court rejects the attorneys arguments: c. Since the 1997 proposed regulations were never finalized, the Court must apply accepted principles of statutory construction to determine the meaning of the term limited partner under Legislative history is relevant. d. Legislative history: The limited partner exclusion is to exclude for coverage purposes certain earnings which are basically of an investment nature. Thus persons who merely invest in a partnership and who are not actively participating in the business are excluded from SE tax. SP&LPROB Self-Employment Tax and Limited Partners (No) In Renkemeyer, Campbell & Weaver LLP v. Comm r, 136TC.No.7 (2011): 1. Court rejects the attorneys arguments: e. The legislative history does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes. f. Here 99% of the LLP s income came from the attorneys services performed in their capacities as partners. Therefore it was clear that no partner was a mere investor. Exclusion does not apply to income from services performed in the capacity of a partner. SP&LPROB

190 Self-Employment Tax and Limited Partners (No) In Renkemeyer, Campbell & Weaver LLP v. Comm r, 136TC.No.7 (2011): 1. One view of the case: The Court in a roundabout way simply held that a partner in a LLP is not subject to the exclusion because he/she is not an actual limited partner under a traditional State partnership statute, but rather a specialized type of partner who typically participates in management with some limited liability. 2. Another view: The label l of limitedit partner and limitedit liability is irrelevant; because partners/members of an LLP or LLC may participate in the business, all are subject to SE tax if they provide services to the entity in their capacity as partners/members. 3. The old problem: Where is the line? SP&LPROB Self-Employment Tax and Limited Partners (No) In Renkemeyer, Campbell & Weaver LLP v. Comm r, 136TC.No.7 (2011): 1. Questions: a. How does one balance the significance of a partner/member s investment in the entity with the services that person provides in his/her capacity as a partner /member? b. What if in a two-member LLC one member contributes $50,000 and is the managing member who works at least 40 hours per week, and the other contributes $500,000 and provides services 300 hours per year? c. If an LLP or LLC is a service business, is there any room for a partner/member to claim limited partner status for SE purposes unless that person provides no more than de minimis services? Where is the line for de minimis services? SP&LPROB

191 Avoiding SE Tax Using Hollow Corporations Does Not Work (No) In Robucci v. Comm r, T.C. Memo : 1. Psychiatrist T practiced as sole proprietor and took CPA/lawyer s advice to restructure: (Arlene French Mark Carson Matt Houtsma) a. Formed LLC through which the practice was conducted. b. LLC owned by T (95%) and a professional corporation (P.C.) wholly owned by T (5%). Taxed as partnership. c. Wholly owned side corporation W to serve as business and management advisor, and reimburse employee expenses. d. T s 95% interest in LLC treated as 85% limited partnership interest (for contributed goodwill) and 10% general partnership interest (for medical services). SP&LPROB Avoiding SE Tax Using Hollow Corporations Does Not Work (No) In Robucci v. Comm r, T.C. Memo : 1. Purpose: Avoid SE tax and reduce earnings potentially subject to SE tax by deducting management fees funneled through corporations. a. In T received distributive share from LLC of $24,000 for his 10% interest and $200,000 for his 85% interest. Only the $24,000 was treated as being subject to SE tax. b. LLC also claimed $95,000 of deductions for management fees, although not clear what the fees were for or if paid to W or to P.C. c. Nothing changed in T s practice. P.C. and W had no employees or contracts with T. LLC had no employment contract with T. SP&LPROB

192 Avoiding SE Tax Using Hollow Corporations Does Not Work (No) In Robucci v. Comm r, T.C. Memo : 1. IRS: Ignore P.C. and W, and LLC is a single-member LLC owned by T and a disregarded entity. All income is subject to SE tax. 2. The Court applied Moline Properties, Inc. v. Comm r, 319 U.S. 436 (1943): Ignore a corporation for Federal tax purposes unless (a) purpose is the equivalent of a business activity; and (b) incorporation is followed by carrying on an actual business. a. Here neither P.C. nor W met either prong under Moline Properties. b. Neither did anything. They were hollow, shell companies. T s practice did not change and he did everything as before. SP&LPROB Avoiding SE Tax Using Hollow Corporations Does Not Work (No) In Robucci v. Comm r, T.C. Memo : 1. Court: The corporations (P.C. and W) must be ignored for Federal tax purposes. a. Therefore LLC was a single-member LLC owned by T. b. No check-the-box election was made, so LLC is a disregarded entity. c. All earnings of the LLC are SE income for T. 2. Note: Court did not apply economic substance doctrine. IRS: Do not take that to mean that the economic substance doctrine does not apply to entity formation or entity structure. SP&LPROB

193 Self-Employment Taxes Limited Partners (No) ILM : Partners of an investment management services partnership are not limited partners within the meaning of the exclusion for SE taxes under 1402(a)(13). 1. An investment management company (MC) organized as an LLC and taxed as a partnership serves as the investment manager for a family of investment funds. a. MC has full responsibility to manage and control the funds and does all the typical services work of a fund manager. b. MC partners work full time in providing the wide range of professional services including investment research and advice, legal and accounting services, and trading services. SP&LPROB ILM : Self-Employment Taxes Limited Partners (No) 1. Each partner of MC received a Form W-2 for the two tax years in issue, apparently in an amount that was less than his or her full distributive share of MC income. 2. MC treated all of its partners as limited partners not subject to SE tax on their distributive share of income. 3. MC previously was organized as an S corporation, at which time it paid wage amounts that represented reasonable compensation to each employee who later became a partner when MC restructured as an LLC taxed as a partnership. SP&LPROB

194 ILM : Self-Employment Taxes Limited Partners (No) 1. MC: Because it has the same role and business as the S corporation it succeeded, it can continue to apply the reasonable compensation wage rules applicable to corporations. Also, the partners (members of the LLC) are limited partners exempt from SE tax. 2. IRS: Relying on and quoting from Renkemeyer (three lawyers working full time for their LLP are not limited partners), concluded that active service providers providing a partnership with service in their capacity as partners are not limited partners. The limited partner exception in 1402(a)(13) is intended to cover passive investors, not service providers. SP&LPROB ILM : Self-Employment Taxes Limited Partners (Yes) 1. IRS: Also reviewed Riether v. U.S., 919 F.Supp.2d 1140 (D. N.Mex. 2012), where the court held that spouses who owned an LLC taxed as a partnership could not pay wages to themselves and treat distributions of profits from the LLC as unearned income that was not subject to SE tax. Partners cannot be treated as employees of a partnership. a. May an individual be paid on a W-2, if the individual owns an interest in a PTP and is employed on a full-time basis by the PTP? (See Rev. Rul ) 2. IRS: Here, like Renkemeyer, the earnings of each partner from MC are a direct result of services rendered. Here, like Riether, MC cannot change the character of its partners distributive shares by paying portions of those shares in amounts mislabeled as wages. Reasonable compensation rules do not apply. SP&LPROB

195 ILM Another issue: Self-Employment Taxes Limited Partners (Yes) 1. Rev. Rul and Riether stated that a partner may not be an employee of the partnership. 2. IRS: Has heard that at least one Big Four accounting firm is taking the position that if a partnership creates a wholly owned disregarded entity, partners may be employees of the disregarded entity, which gets its own EIN and is subject to Form W-2 withholding. This could affect benefit plans. 3. Also: Buried among the 317 listed projects in the IRS priority guidance plan is a project: Guidance on the application of 1402(a)(13) to LLCs. Stay tuned. SP&LPROB Discussion Question (Yes) Assume these facts: 1. Taxpayer T owned and operated a chain of restaurants through his LLC, which was taxed as a partnership. T owned a majority interest and his wife owned a minority interest. Only T participated in the business, and he had total control over business operations and worked more than 40 hours per week at the LLC. (See also Hardy Member owns interest in surgery center Not SE and may be passive income.) 2. T had the LLC pay him $60, in guaranteed payments that he believes are reasonable compensation. T included the guaranteed payments in SE income, but treated the rest of his distributive share ($240,000) as earnings from invested capital, and excluded it from SE income. 3. Would you sign a return taking that position? SP&LPROB

196 In CCA : Limited Partners and SE Tax More IRS Guidance (Yes) (Skip to Slide 221.) 1. IRS: Restaurant franchisee operating through an LLC taxed as a partnership was not a limited partner within the meaning of 1402(a)(13), and therefore was subject to self-employment ( SE ) tax on his entire distributive share from the LLC. a. Individual F purchased franchise restaurants and contributed them to an LLC (P) that is treated as a partnership for tax purposes. F owns a majority interest in P, and the remaining interests are owned by F s wife and her irrevocable trust. b. Neither the wife nor the trust were involved with P s business operations, and their status as limited partners in P for SE tax purposes was not in issue. SP&LPROB Limited Partners and SE Tax More IRS Guidance (No) In CCA : 2. F s franchise agreements with company C required him to personally devote full-time and best-efforts work to the operation of the restaurants. a. F is P s Operating Manager, President, and CEO. He manages P and makes all significant operating decisions. b. F also oversees all employees of P, and oversees the executive management team that handles many of P s day-to-day business affairs. c. F received guaranteed payments in the three years at issue. P treated F as a limited partner for purposes of SE taxes and included only the guaranteed payments in F s SE income. SP&LPROB

197 Limited Partners and SE Tax More IRS Guidance (No) In CCA : 3. Section 1402(a)(13) excludes from net earnings from self-employment the distributive share of any item of income or loss of a limited partner, as such, other than specified guaranteed payments. 4. F and P: F s income from P should be bifurcated for SE tax purposes between F s (a) income attributable to capital invested or the efforts of others, which is not subject to SE tax; and (b) compensation for services rendered, which is subject to SE tax. a. F claimed that the restaurant operations were capital intensive and involved many employees, and not all his income from P was for his personal services. SP&LPROB Limited Partners and SE Tax More IRS Guidance (No) In CCA : 5. F argued that he had a reasonable expectation for a return on his capital investment, and the guaranteed payments represented reasonable compensation for F s services and the rest of his earnings were of an investment nature. 6. F relied on the recent Brinks case where a law firm organized as a professional corporation was faulted for zeroing out its taxable income through bonuses paid to shareholder employees. There the Tax Court found that such shareholders were entitled to a return on investment, and part of the firm s distributed income had to be treated as dividends. SP&LPROB

198 Limited Partners and SE Tax More IRS Guidance (No) In CCA : 7. IRS: F and P are misguided and conflating employment tax rules for corporations and partnerships. a. First, cases such as Cokes and Methvin (discussed above) demonstrate that individual partners who are not limited partners are subject to SE tax regardless of their participation in the partnership business or the capital-intensive nature of the partnership business. b. Second, Renkemeyer, Campbell and Weaver LLP v. Comm r, 136T.C. 137 (2011), demonstrates the 1402(a)(13) exception to SE income was intended to apply only to those who merely invested in a partnership rather than those who actively participate and perform services in their capacity as partners. SP&LPROB Limited Partners and SE Tax More IRS Guidance (No) In CCA : 7. IRS: F and P are misguided and conflating employment tax rules for corporations and partnerships. c. Third, Reither v. U.S., 919 F.Supp.2d 1140 (D. N.M. 2012), held that a husband and wife were subject to SE tax on their entire distributive shares from an LLC taxed as a partnership, rejecting the arguments that: 1) They were employees of the LLC and not self-employed because the LLC issued Forms W-2 to them; and 2) Income from the LLC other than their Form W-2 wages was unearned income not subject to SE tax. SP&LPROB

199 Limited Partners and SE Tax More IRS Guidance (No) In CCA : 8. IRS: Under the above authorities it is clear that members of a partnership are not employees of the partnership for SE tax purposes. a. Unless F in fact was a limited partner, he was subject to SE tax on all of his income received from P, notwithstanding the capital investments made, the capital-intensive nature of the business, or the fact that P had many employees. b. F was not a limited partner under Renkemeyer and Reither. F actively participated and performed services for P in his capacity as a partner. He had sole authority to manage P, and was the only partner involved in the business who was not a mere investor. SP&LPROB Limited Partners and SE Tax More IRS Guidance (No) In CCA : 9. IRS: Rejected a substance over form argument that a different analysis should apply to LLC members who derive their income from the sale of products, have made substantial capital investments, and have delegated significant management responsibilities to executive-level employees. 10. IRS: That argument is really that the rules for such LLCs are identical to employment tax rules for corporate shareholder employees, and only reasonable compensation is subject to employment tax. SP&LPROB

200 Limited Partners and SE Tax More IRS Guidance (No) In CCA : 11. IRS: F s argument ignores the separate statutory SE tax rules for partners and the statutory employment tax rules for corporate shareholder employees. a. Section 1402(a)(13) provides an exclusion for limited partners, not for a reasonable return on capital, and does not indicate that a partner s status as a limited partner depends on the presence of a guaranteed payment or the capital-intensive nature of the partnership s s business. b. Here P could not change the character of F s distributive share by paying F guaranteed payments. P was not a corporation and the wage and reasonable compensation rules do not apply. SP&LPROB Lawyers in PLLC Taxed as Partnership: Cannot Exclude Part of Income from SE Income (Yes) In Castigliola v. Comm r, T.C. Memo : 1. Held: Three member managers in a law practice that operated as a professional limited liability company (PLLC) were not limited partners that could exclude a portion of their distributive shares from self-employment (SE) income under 1402(a)(13). 2. Result is similar to Renkemeyer, Campbell & Weaver LLP v. Comm r, 136 T.C. 137 (2011), but the Court in Castigliola based its decision on the fact thatt the lawyers participated i t in the control of the law practice, not on a distinction between personal service income and investment income. 3. Case follows pattern that an owner who is not a general partner under local, non-tax law can be a general partner (or at least not a limited partner) for federal tax purposes. SP&LPROB

201 Lawyers in PLLC Taxed as Partnership: Cannot Exclude Part of Income from SE Income In Castigliola v. Comm r, T.C. Memo : 4. Facts: Three lawyers initially practiced law through a Mississippi general partnership, but in 2001 reorganized their firm as a PLLC that was taxed as a partnership for federal tax purposes. a. For each of 2008 through 2010, the lawyers each received guaranteed payments ranging from $125,000 to $150,000. These payments were commensurate with local legal salaries. Any net profits of the firm in excess of the guaranteed payments were distributed ib t d to the members in accordance with the PLLC agreement. b. Following a CPA s advice, the members reported all guaranteed payments as SE income, but did not pay SE tax on the excess distributions. This resulted in alleged underpayment of SE tax by the three members of about $53,000 over three years. SP&LPROB Lawyers in PLLC Taxed as Partnership: Cannot Exclude Part of Income from SE Income In Castigliola v. Comm r, T.C. Memo : 5. Section 1402: SE income includes the distributive share of a member s income from any T/B carried on by a partnership, except for income of a limited partner, as such, other than guaranteed payments 6. IRS: The three members were not limited partners under the statute. 7. Court: The term limited partner is not defined in the statute, and under Renkemeyer the Court must follow congressional intent. The meaning of limited partnership is not necessarily confined solely to the limited partnership context. First issue is whether each of the three members of the PLLC is functionally equivalent to a limited partner in a limited partnership. SP&LPROB

202 Lawyers in PLLC Taxed as Partnership: Cannot Exclude Part of Income from SE Income Court analysis: 8. Here, under the Revised Uniform Limited Partnership Act adopted by Mississippi, a person is not a limited partner with limited liability if he or she participates in the control of the business (subject to certain exceptions). a. Common to the definitions of a limited partner are the primary characteristics of limited liability and lack of control of the business. b. Here each of the three members participated in the control of the PLLC, which had no written operating agreement. Therefore they were not limited partners under 1402(a)(13), and could exclude no part of their distributive shares from SE income. SP&LPROB Another Question to Ponder (Yes) Schedule C - ($70,000) - Resultsin NOLC.F Schedule C - $130,000 What is AGI and SE income for 2018? What happens in 2019? AGI $60,000 SE $130,000 SP&LPROB

203 Another Question to Ponder (Yes) Assume that for 2018, A has the following: Schedule C $130,000 What is AGI and SE income? Schedule K-1 from a (See Reg , Ex. 2.) passive activity: AGI $130,000 O.L. (70,000) SE $60,000 SE (70,000) What is A s income from self-employment if the Schedule C activity is a trade or business? (See Decrescenzo, T.C. Memo , where an NOL CF could not offset the taxpayer s self-employment income for the current year.) SP&LPROB Another Question to Ponder (Yes) Schedule K-1 from Form 1065 to which is a passive activity O.I. $40,000 Form 1120S 179 ($18,000) O.I. $40,000 SE $0 or Blank 179 ($18,000) How much of the 179 amount is deductible? To take a 179 deduction for a member of an LLC, does the income have to be subject to SE income? (But see instructions to Form 4562 Must meaningfully participate.) SP&LPROB

204 Transactions Between Partners and Partnerships (Yes) 707(c) 707(a) Guaranteed Payment Non-Partner Capacity in Partner Capacity (Issue Form 1099) (Issue Schedule K-1) 1. Lease of Property 1. Perform Services Subject to 267(e) 2. Loan of $ 2. Use of Capital Not SE (See 267(e)(4)) 3. Perform Services 4. Sale of Property More than 50% interest required: 707(b)(2) a. Gain Convert Gain into O.I b. Loss - 707(b)(1) Disallowance of Loss SP&LPROB Guaranteed Payments (Yes) 1. Assume for the following questions that Ralph owns a one-third interest in the capital profits and losses of the RST partnership (S & T also each have a one-third interest). Ralph and the partnership use the cash method of accounting and both, unless otherwise indicated, are calendar-year taxpayers. How much is Ralph required to include in the current year if: a. The partnership pays Ralph $24,000 a year for services rendered to the partnership and the partnership has ordinary income of $60, bf before taking into account the payments to Ralph? SP&LPROB

205 Guaranteed Payments R S T O.I. $60, (c) (24,000) $24,000 $ 0 $ 0 L.22 O.I. $36,000 $12,000 $12,000 $12,000 SP&LPROB Guaranteed Payments 1. Assume for the following questions that Ralph owns a one-third interest in the capital profits and losses of the RST partnership (S & T also each have a one-third interest). Ralph and the partnership use the cash method of accounting and both, unless otherwise indicated, are calendar-year taxpayers. How much is Ralph required to include in the current year if: b. Same as a except that the partnership has ordinary income of $15,000 before taking into account the payments to Ralph. SP&LPROB

206 Guaranteed Payments R S T O.I. $15, (c) (24,000) $24,000 $ 0 $ 0 L.22 O.L. ($ 9,000) ($3,000) ($3,000) ($3,000) SP&LPROB Guaranteed Payments 1. Assume for the following questions that Ralph owns a one-third interest in the capital profits and losses of the RST partnership (S & T also each have a one-third interest). Ralph and the partnership use the cash method of accounting and both, unless otherwise indicated, are calendar-year taxpayers. How much is Ralph required to include in the current year if: c. Same as b except that in addition to the ordinary income of $15,000, the partnership has a short-term capital gain of $36,000. SP&LPROB

207 Guaranteed Payments R S T O.I. $15, (c) (24,000) $24,000 $ 0 $ 0 L.22 O.L. ($ 9,000) ($3,000) $3,000 $3,000 ST $36,000 $12,000 $12,000 $12,000 SP&LPROB Guaranteed Payments (Old CPA Exam) Assume that Ralph has a one-third interest, but that he is a calendar-year taxpayer and the partnership is a fiscal-year taxpayer with an April 30 year end. For the fiscal year ending April 30, the partnership has the following ordinary income after deducting the guaranteed payment to Ralph of: 2017 $60, $75, $90,000 In addition, Ralph receives a guaranteed payment of the following during the calendar year: 2017 $ 3,000/month 2018 $ 4,000/month 2019 $ 5,000/month How much is Ralph required to report as his distributive share of the ordinary income from the partnership for 2018? ANS: $73,000 or $65,000 SP&LPROB

208 Guaranteed Payment SP&LPROB Transactions Between Partner and Partnership Assume that Able has a 60% interest in the partnership capital and profits of the AB partnership. Able proposes to sell property in which he has an adjusted basis of $120,000 to the AB partnership for cash of $300,000. What result to Able if the partnership intends to hold the property as: a. Depreciable capital assets? (See also 453(g), 1239 & 707(b)(2) O.I. & no installment sale treatment SP&LPROB

209 Transactions Between Partner and Partnership Assume that Able has a 60% interest in the partnership capital and profits of the AB partnership. Able proposes to sell property in which he has an adjusted basis of $120,000 to the AB partnership for cash of $300,000. What result to Able if the partnership intends to hold the property as: b. Non-depreciable capital asset? LT $80,000 & 453 SP&LPROB Transactions Between Partner and Partnership Assume that Able has a 60% interest in the partnership capital and profits of the AB partnership. Able proposes to sell property in which he has an adjusted basis of $120,000 to the AB partnership for cash of $300,000. What result to Able if the partnership intends to hold the property as: c. Non-depreciable trade or business property under 1231? (Parking lot See 707(b)(2).) 1239 N/A 707(b)(2) O.I. $180, Do not know SP&LPROB

210 Transactions Between Partner and Partnership Assume that Able has a 60% interest in the partnership capital and profits of the AB partnership. Able proposes to sell property in which he has an adjusted basis of $120,000 to the AB partnership for cash of $300,000. What result to Able if the partnership intends to hold the property as: d. Item of inventory? 1239 N/A 707(b)(2) O.I. $180, ? SP&LPROB Transactions Between Partner and Partnership (Yes) Assume that Able has a 60% interest in the partnership capital and profits of the AB partnership. Able proposes to sell property in which he has an adjusted basis of $120,000 to the AB partnership for cash of $300,000. What result to Able if the partnership intends to hold the property as: e. What difference in a to d above if Able sold the property to the partnership for cash of $100,000 and a note for $200,000 (assume that the note bears an adequate rate of interest under 1274). Which qualify for installment sale treatment under 453? SP&LPROB

211 Disguised Sale Rules (Yes) 707(a)(2)(B) Otey Transaction Disguised Sale Rules If receive preferential distribution within two years of time of transfer, transfer will be recast as part-sale/part-contribution (See Form 8275.) A FMV - $1,000,000 A/B - 300,000 B Has $500,000 cash Objective: A wants $500,000 tax free & needs the money today SP&LPROB Disguised Sale Rules (Yes) 707(a)(2)(B) Otey Transaction A FMV - $1,000,000 A/B - 300,000 B Has $500,000 cash Objective: A wants $500,000 tax free Options: 1. Sale of 50% Interest to B SP&LPROB

212 Disguised Sale Rules (Yes) 707(a)(2)(B) Otey Transaction A FMV - $1,000,000 A/B - 300,000 B Has $500,000 cash Objective: A wants $500,000 tax free Options: 2. Contribution is to corporation Receive back boot of $500,000 SP&LPROB Disguised Sale Rules (Yes) 707(a)(2)(B) Otey Transaction A FMV - $1,000,000 A/B - 300,000 B Has $500,000 cash Objective: A wants $500,000 tax free Options: 3. Have A place Midnight Mortgage on Property of $500,000 before transfer to corporation. SP&LPROB

213 Disguised Sale Rules (Yes) 707(a)(2)(B) Otey Transaction A FMV - $1,000,000 A/B - 300,000 B Has $500,000 cash Objective: A wants $500,000 tax free Options: 4. Transfer to partnership - Have partnership borrow $500,000 - Have partnership distribute $500,000 to A SP&LPROB Disguised Sale Rules (Yes) 707(a)(2)(B) Otey Transaction A FMV - $1,000,000 A/B - 300,000 B Has $500,000 cash Objective: A wants $500,000 tax free Options: 5. Have A place Midnight Mortgage on Property in the amount of $500,000 and then the property is transferred to a tax partnership. SP&LPROB

214 Disguised Sale Rules SP&LPROB Termination of Partnership (Yes) Under 708(a), a partnership continues if it is not otherwise terminated. A partnership terminates for tax purposes only if no part of any business, financial operation or venture continues to be carried on by any of its partners in the partnership ( 708(b)(1)(A)) (or, for sales before January 1, 2018, within a 12-month period, there is a sale or exchange of 50% or more of the total interest in partnership capital and profits ( 708(b)(1)(B) Called a Technical Termination)). U & I have a MB which was sold for 30,000 $100 bills or $3,000,000. U & I were operating the MB as an LLC. U & I take the $3,000,000 and bury the money in U s backyard. Will the LLC terminate? If the answer is no, will the partnership be subject to a penalty for not filing a 1065 $200/mos. for 2018 return filed in 2019? SP&LPROB

215 Termination of Partnership (Yes) If the partnership terminates for tax purposes, the partnership's taxable year closes for all of its partners on the date of the tax termination (Reg (b)(1)(iii)). (5-7-18) However, just because the partnership terminates under state law does not also mean that the partnership terminates for tax purposes (See Neubecker v. Comm'r, 65 T.C. 577 (1975); Panero v. Comm'r, 48 T.C. 147 (1967)). Common examples of items thatt terminate t the partnership under state tt law which do not necessarily terminate a partnership for tax purposes include a partner's death, retirement, bankruptcy, insolvency, insanity, admission of a new partner, or the sale of a partnership interest. Will the death of a member of an LLC cause the LLC to terminate under state law? (Mention Technical Termination See Rev. Rul ) SP&LPROB Termination Questions Example (Yes) LLC On , A dies. What tax effect if: 60% 40% 1. A s Estate succeeds to A s interest? A U 2. LLC required to redeem A s interest? 3. U are required to purchase A s interest? See Rev. Rul SP&LPROB

216 Termination Questions Example (Yes) LLC On , A dies. What tax effect if: 60% 20% 20% 1. A s Estate succeeds to A s interest? A B C 2. LLC required to redeem A s interest? B & C pay an attorney $3,000 to redraft the Operating Agreement. Deductible or not? 3. B & C are required to purchase A s interest? B & C pay $3,000 to an attorney to redraft the Operating Agreement. Deductible or not? SP&LPROB RPE UBIA Section 199A Deduction QBI SSB QTB See: Sch. E Note BoxA&BoxB See 179 T/B SP&LPROB

217 SCHEDULE E (Form 1040) Department of the Treasury Internal Revenue Service (99) Name(s) shown on return Supplemental Income and Loss (From rental real estate, royalties, partnerships, S corporations, estates, trusts, REMICs, etc.) Attach to Form 1040, 1040NR, or Form Go to for instructions and the latest information. OMB No Attachment Sequence No. 13 Your social security number Part I Income or Loss From Rental Real Estate and Royalties Note: If you are in the business of renting personal property, use Schedule C or C-EZ (see instructions). If you are an individual, report farm rental income or loss from Form 4835 on page 2, line 40. DRAFT AS OF July 16, 2018 DO NOT FILE A Did you make any payments in 2018 that would require you to file Form(s) 1099? (see instructions)..... Yes No B If Yes, did you or will you file required Forms 1099? Yes No 1a Physical address of each property (street, city, state, ZIP code) A B C 1b 2 For each rental real estate property listed Fair Rental A B C Type of Property (from list below) Type of Property: 1 Single Family Residence 2 Multi-Family Residence above, report the number of fair rental and personal use days. Check the QJV box only if you meet the requirements to file as a qualified joint venture. See instructions. A B C Days Personal Use Days 3 Vacation/Short-Term Rental 4 Commercial 5 Land 6 Royalties 7 Self-Rental 8 Other (describe) Income: Properties: A B C 3 Rents received Royalties received Expenses: 5 Advertising Auto and travel (see instructions) Cleaning and maintenance Commissions Insurance Legal and other professional fees Management fees Mortgage interest paid to banks, etc. (see instructions) Other interest Repairs Supplies Taxes Utilities Depreciation expense or depletion Other (list) Total expenses. Add lines 5 through Subtract line 20 from line 3 (rents) and/or 4 (royalties). If result is a (loss), see instructions to find out if you must file Form Deductible rental real estate loss after limitation, if any, on Form 8582 (see instructions) ( ) ( ) ( ) 23a Total of all amounts reported on line 3 for all rental properties a b Total of all amounts reported on line 4 for all royalty properties b c Total of all amounts reported on line 12 for all properties c d Total of all amounts reported on line 18 for all properties d e Total of all amounts reported on line 20 for all properties e 24 Income. Add positive amounts shown on line 21. Do not include any losses Losses. Add royalty losses from line 21 and rental real estate losses from line 22. Enter total losses here. 25 ( ) 26 Total rental real estate and royalty income or (loss). Combine lines 24 and 25. Enter the result here. If Parts II, III, IV, and line 40 on page 2 do not apply to you, also enter this amount on Schedule 1 (Form 1040), line 17, or Form 1040NR, line 18. Otherwise, include this amount in the total on line 41 on page For Paperwork Reduction Act Notice, see the separate instructions. Cat. No L Schedule E (Form 1040) 2018 QJV

218 Schedule E (Form 1040) 2018 Attachment Sequence No. 13 Page 2 Name(s) shown on return. Do not enter name and social security number if shown on other side. Your social security number Caution: The IRS compares amounts reported on your tax return with amounts shown on Schedule(s) K-1. Part II Income or Loss From Partnerships and S Corporations Note: If you report a loss, receive a distribution, dispose of stock, or receive a loan repayment from an S corporation, you must check the box in column (e) on line 28 and attach the required basis computation. If you report a loss from an at-risk activity for which any amount is not at risk, you must check the box in column (f) on line 28 and attach Form 6198 (see instructions). DRAFT AS OF July 16, 2018 DO NOT FILE 27 Are you reporting any loss not allowed in a prior year due to the at-risk, excess farm loss, or basis limitations, a prior year unallowed loss from a passive activity (if that loss was not reported on Form 8582), or unreimbursed partnership expenses? If you answered Yes, see instructions before completing this section Yes No 28 (a) Name A B C D Passive Income and Loss (g) Passive loss allowed (attach Form 8582 if required) (h) Passive income from Schedule K-1 (b) Enter P for partnership; S for S corporation (c) Check if foreign partnership (i) Nonpassive loss from Schedule K-1 (d) Employer identification number (e) Check if basis computation is required Nonpassive Income and Loss (j) Section 179 expense deduction from Form 4562 (f) Check if any amount is not at risk (k) Nonpassive income from Schedule K-1 A B C D 29a Totals b Totals 30 Add columns (h) and (k) of line 29a Add columns (g), (i), and (j) of line 29b ( ) 32 Total partnership and S corporation income or (loss). Combine lines 30 and Part III Income or Loss From Estates and Trusts 33 (a) Name A B Passive Income and Loss (c) Passive deduction or loss allowed (attach Form 8582 if required) (d) Passive income from Schedule K-1 (b) Employer identification number Nonpassive Income and Loss (e) Deduction or loss from Schedule K-1 (f) Other income from Schedule K-1 A B 34a Totals b Totals 35 Add columns (d) and (f) of line 34a Add columns (c) and (e) of line 34b ( ) 37 Total estate and trust income or (loss). Combine lines 35 and Part IV Income or Loss From Real Estate Mortgage Investment Conduits (REMICs) Residual Holder 38 (a) Name (b) Employer identification number (c) Excess inclusion from Schedules Q, line 2c (see instructions) (d) Taxable income (net loss) from Schedules Q, line 1b 39 Combine columns (d) and (e) only. Enter the result here and include in the total on line 41 below 39 Part V Summary 40 Net farm rental income or (loss) from Form Also, complete line 42 below Total income or (loss). Combine lines 26, 32, 37, 39, and 40. Enter the result here and on Schedule 1 (Form 1040), line 17, or Form 1040NR, line Reconciliation of farming and fishing income. Enter your gross farming and fishing income reported on Form 4835, line 7; Schedule K-1 (Form 1065), box 14, code B; Schedule K-1 (Form 1120S), box 17, code AC; and Schedule K-1 (Form 1041), box 14, code F (see instructions) Reconciliation for real estate professionals. If you were a real estate professional (see instructions), enter the net income or (loss) you reported anywhere on Form 1040 or Form 1040NR from all rental real estate activities in which you materially participated under the passive activity loss rules.. 43 (e) Income from Schedules Q, line 3b Schedule E (Form 1040) 2018

219 Proposed Regulations on 199A On August 8, 2018, the IRS released proposed regulations on the 199A qualified business income deduction. The proposed rules, which are 184 pages of large print, address many issues that had been of concern to practitioners, such as the definition of a specified trade or business, the calculation of qualified business income flowing through to multiple entities, the treatment of wages paid to employees through third parties, and the definition of reputation or skill. The rules allow for grouping of related trades or businesses for purposes of applying 199A and provide for narrow applicability of 199A s reputation or skill clause. The IRS separately issued a proposed revenue procedure addressing the calculation of W-2 wages for purposes of the W-2 wage limitation on the deduction. See Notice SP&LPROB Proposed Regulations on 199A Some of the more significant provisions in the proposed regulations include: Uses the 162 definition for a trade or business. Allowing taxpayers to aggregate trades or businesses, other than a specified service business, for purposes of applying 199A. Allowing a business that pays wages to a common law employee through a third-party to count such wages as being paid by the business in applying the W-2 wage limitation (PEO). For purposes of determining whether a trade or business is a specified service trade or business (SSB), providing performance of service in the field of consulting means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems. SP&LPROB

220 Proposed Regulations on 199A Some of the more significant provisions in the proposed regulations include: Stating that a real estate broker or agent is allowed the deduction. Limiting the meaning of the reputation or skill clause to fact patterns in which the individual or relevant passthrough entity (RPE) is engaged in the trade or business of: (1) receiving income for endorsing products or services, including an individual s distributive share of income or distribution from an RPE for which the individual provides endorsement services; (2) licensing or receiving income for the use of an individual s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual s identity, including an individual s distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual s image; or (3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players). SP&LPROB Proposed Regulations on 199A Some of the more significant provisions in the proposed regulations include: Providing a de minimis rule for a specified service trade or business (SSB) so that it is not considered a SSB, and is thus eligible for the deduction, if gross receipts are $25 million or less and less than ten percent of gross receipts of the trade or business is attributable to the performance of services in an SSB. Allows a fiscal-year RPE to qualify for the deduction. Allows the rental of property to a commonly controlled entity to qualify as a QTB. (See Prop. Reg A-1(b)(13) and may also be aggregated with the commonly controlled entity. See also Prop. Reg A-4(b).) SP&LPROB

221 Proposed Regulations on 199A Prop. Reg A-1 contains the operational rules, including how to determine the deduction for taxpayers with incomes at or below the threshold amounts and for those with incomes above the thresholds. It also contains definitions of the following terms: aggregated trade or business, applicable percentage, phase-in range, qualified business income, QBI component, qualified PTP income, qualified REIT dividends, reduction amount, relevant passthrough entity (RPE), specified service trade or business (SSB), threshold amount, total QBI amount, unadjusted basis immediately after acquisition (UBIA) of qualified property, and W-2 wages. SP&LPROB Proposed Regulations on 199A Prop. Reg A-1 also contains the definition of a trade or business. The IRS decided to apply the definition of trade or business contained in 162(a) because the definition of trade or business under 162 is derived from a large amount of case law and administrative guidance interpreting the meaning of trade or business in the context of a broad range of industries. This will provide for administrable rules that are appropriate for the purposes of 199A and that taxpayers py have experience applying, and the IRS believes it will reduce compliance costs, burden, and administrative complexity. Rental to a commonly controlled entity is a trade or business under Reg A-1(b)(13) and may also be aggregated with the commonly controlled entity See Reg A-4(b). SP&LPROB

222 Proposed Regulations on 199A Prop. Reg A-2 contains rules for determining W-2 wages and the UBIA of qualified property, both of which are components in calculating limitations on the deduction. The rules for determining W- 2 wages are based on the rules under the repealed 199 deduction for qualified domestic production activities, except, unlike 199, the 199A W-2 wages are determined separately for each trade or business. Prop Reg A-3199A-3 restates the definitions in 199A(c) (QBI) and provides additional guidance on the determination of QBI, qualified REIT dividends, and qualified PTP income. Gain under 751 is QBI. SP&LPROB Proposed Regulations on 199A Prop. Reg A-4 contains aggregation rules allowing separate trades or businesses to be grouped when applying the 199A rules. The IRS rejected comments suggesting the application of the grouping rules under 469, the passive loss provision, and instead proposed a flexible method that looks into common ownership, shared services, and other commonality, but specifically excludes SSBs from being aggregated under the rules. The regulations impose a duty of consistency that requires that once multiple trades or businesses are aggregated into a single aggregated trade or business under 199A, taxpayers must consistently report the aggregated group in subsequent tax years. Aggregation allows for ease of administration. SP&LPROB

223 Proposed Regulations on 199A Prop. Reg A-5 defines specified service trades or businesses and the trade or business of performing services as an employee. The regulations include an anti-abuse rule designed to prevent taxpayers from separating out parts of what otherwise would be an integrated SSB, such as the administrative functions, in an attempt to qualify those separated parts for the 199A deduction. Prop. Reg A-6 contains special rules for RPEs, PTPs, trusts, and estates that these entities may need to follow for purposes of computing the entities or their owners 199A deductions. SP&LPROB Proposed Regulations on 199A Prop. Reg (f)-1 addresses concerns regarding the abusive use of multiple trusts by confirming the applicability of 643(f). Section 643(f) permits the IRS to issue regulations to prevent taxpayers from establishing multiple nongrantor trusts or contributing additional capital to multiple existing nongrantor trusts in order to avoid federal income tax. Notice , issued contemporaneously with the proposed regulations, contains a proposed revenue procedure with three methods for calculating W-2 wages (1) for purposes of the limitation based on W-2 wages to the amount of the deduction for qualified business income under 199A; and (2) for purposes of the reduction to the 199A deduction based on W-2 wages for certain specified agricultural and horticultural cooperative patrons. SP&LPROB

224 How to Calculate Taxable Income for an Individual in G.I. Inclusions- 71to 90 Exclusions to DFORAGI(BusinessrelatedandL.23toL.35 Sch.C,Sch.D, Sch. E, Sch. F, Form 4797, Form 4835) 63 AGI Line37 Less $0 for self, spouse, and qualifying child (QC) or qualifying relative (QR) 151 & 152 Less greater of I.D. (Schedule A) or standard deduction ($24,000, $18,000 & $12,000) Taxable Income Before 199A Deduction Less: NOLs from 2018 Less, if qualify, deduction for QBI under 199A Form 8905 Taxable Income (The same amount deductible under 199A is also deductible in computing AMTI.) SP&LPROB

225 Section 199A Qualified Business Income Current through P.L Also includes P.L to Title 26 includes updates from P.L , Divisions M, T, and U (Titles I through III). (a) Allowance of Deduction.--In the case of a taxpayer other than a corporation, there shall be allowed as a deduction for any taxable year an amount equal to the lesser of-- (1) the combined qualified business income amount of the taxpayer, or (2) an amount equal to 20 percent of the excess (if any) of-- (A) the taxable income of the taxpayer for the taxable year, over (B) the net capital gain (as defined in section 1(h)) of the taxpayer for such taxable year. (b) Combined Qualified Business Income Amount.--For purposes of this section-- (1) In General.--The term combined qualified business income amount means, with respect to any taxable year, an amount equal to-- (A) the sum of the amounts determined under paragraph (2) for each qualified trade or business carried on by the taxpayer, plus (B) 20 percent of the aggregate amount of the qualified REIT dividends and qualified publicly traded partnership income of the taxpayer for the taxable year. (2) Determination of Deductible Amount for Each Trade or Business.--The amount determined under this paragraph with respect to any qualified trade or business is the lesser of-- (A) 20 percent of the taxpayer's qualified business income with respect to the qualified trade or business, or (B) the greater of-- (i) (ii) 50 percent of the W-2 wages with respect to the qualified trade or business, or the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property. (3) Modifications to Limit Based on Taxable Income.-- (A) Exception from limit.--in the case of any taxpayer whose taxable income for the taxable year does not exceed the threshold amount, paragraph (2) shall be applied without regard to subparagraph (B) VOGEL.SEM/SP&LPROB.18

226 (B) Phase-In of Limit for Certain Taxpayers.-- (i) In General.--If-- (I) the taxable income of a taxpayer for any taxable year exceeds the threshold amount, but does not exceed the sum of the threshold amount plus $50,000 ($100,000 in the case of a joint return), and (II) the amount determined under paragraph (2)(B) (determined without regard to this subparagraph) with respect to any qualified trade or business carried on by the taxpayer is less than the amount determined under paragraph (2)(A) with respect such trade or business, then paragraph (2) shall be applied with respect to such trade or business without regard to subparagraph (B) thereof and by reducing the amount determined under subparagraph (A) thereof by the amount determined under clause (ii). (ii) Amount of Reduction.--The amount determined under this subparagraph is the amount which bears the same ratio to the excess amount as-- (I) the amount by which the taxpayer's taxable income for the taxable year exceeds the threshold amount, bears to (4) Wages, Etc.-- (II) $50,000 ($100,000 in the case of a joint return). (iii) Excess Amount.--For purposes of clause (ii), the excess amount is the excess of-- (I) the amount determined under paragraph (2)(A) (determined without regard to this paragraph), over (II) the amount determined under paragraph (2)(B) (determined without regard to this paragraph). (A) In General.--The term W-2 wages means, with respect to any person for any taxable year of such person, the amounts described in paragraphs (3) and (8) of section 6051(a) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year. (B) Limitation to Wages Attributable to Qualified Business Income.--Such term shall not include any amount which is not properly allocable to qualified business income for purposes of subsection (c)(1). (C) Return Requirement.--Such term shall not include any amount which is not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for such return VOGEL.SEM/SP&LPROB.18

227 (5) Acquisitions, Dispositions, and Short Taxable Years.--The Secretary shall provide for the application of this subsection in cases of a short taxable year or where the taxpayer acquires, or disposes of, the major portion of a trade or business or the major portion of a separate unit of a trade or business during the taxable year. (6) Qualified Property.--For purposes of this section: (A) In General.--The term qualified property means, with respect to any qualified trade or business for a taxable year, tangible property of a character subject to the allowance for depreciation under section (i) which is held by, and available for use in, the qualified trade or business at the close of the taxable year, (ii) which is used at any point during the taxable year in the production of qualified business income, and (iii) the depreciable period for which has not ended before the close of the taxable year. (B) Depreciable Period.--The term depreciable period means, with respect to qualified property of a taxpayer, the period beginning on the date the property was first placed in service by the taxpayer and ending on the later of-- (i) the date that is 10 years after such date, or (ii) the last day of the last full year in the applicable recovery period that would apply to the property under section 168 (determined without regard to subsection (g) thereof). (7) Special Rule with Respect to Income Received from Cooperatives.--In the case of any qualified trade or business of a patron of a specified agricultural or horticultural cooperative, the amount determined under paragraph (2) with respect to such trade or business shall be reduced by the lesser of-- (A) 9 percent of so much of the qualified business income with respect to such trade or business as is properly allocable to qualified payments received from such cooperative, or (B) 50 percent of so much of the W-2 wages with respect to such trade or business as are so allocable. (c) Qualified Business Income.--For purposes of this section-- (1) In General.--The term qualified business income means, for any taxable year, the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. Such term shall not include any qualified REIT dividends or qualified publicly traded partnership income. (2) Carryover of Losses.--If the net amount of qualified income, gain, deduction, and loss with respect to qualified trades or businesses of the taxpayer for any taxable VOGEL.SEM/SP&LPROB.18

228 year is less than zero, such amount shall be treated as a loss from a qualified trade or business in the succeeding taxable year. (3) Qualified Items of Income, Gain, Deduction, and Loss.--For purposes of this subsection-- (A) In General.--The term qualified items of income, gain, deduction, and loss means items of income, gain, deduction, and loss to the extent such items are-- (i) effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864(c), determined by substituting qualified trade or business (within the meaning of section 199A) for nonresident alien individual or a foreign corporation or for a foreign corporation each place it appears), and (ii) included or allowed in determining taxable income for the taxable year. (B) Exceptions.--The following items shall not be taken into account as a qualified item of income, gain, deduction, or loss: (i) Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss. (ii) Any dividend, income equivalent to a dividend, or payment in lieu of dividends described in section 954(c)(1)(G). Any amount described in section 1385(a)(1) shall not be treated as described in this clause. (iii) Any interest income other than interest income which is properly allocable to a trade or business. (iv) Any item of gain or loss described in subparagraph (C) or (D) of section 954(c)(1) (applied by substituting qualified trade or business for controlled foreign corporation ). (v) Any item of income, gain, deduction, or loss taken into account under section 954(c)(1)(F) (determined without regard to clause (ii) thereof and other than items attributable to notional principal contracts entered into in transactions qualifying under section 1221(a)(7)). (vi) Any amount received from an annuity which is not received in connection with the trade or business. (vii) Any item of deduction or loss properly allocable to an amount described in any of the preceding clauses. (4) Treatment of Reasonable Compensation and Guaranteed Payments.--Qualified business income shall not include-- (A) reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business, VOGEL.SEM/SP&LPROB.18

229 (B) any guaranteed payment described in section 707(c) paid to a partner for services rendered with respect to the trade or business, and (C) to the extent provided in regulations, any payment described in section 707(a) to a partner for services rendered with respect to the trade or business. (d) Qualified Trade or Business.--For purposes of this section-- (1) In General.--The term qualified trade or business means any trade or business other than-- (A) a specified service trade or business, or (B) the trade or business of performing services as an employee. (2) Specified Service Trade or Business.--The term specified service trade or business means any trade or business-- (A) which is described in section 1202(e)(3)(A) (applied without regard to the words engineering, architecture, ) or which would be so described if the term employees or owners were substituted for employees therein, or (B) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)). (3) Exception for Specified Service Businesses Based on Taxpayer's Income.-- (A) In General.--If, for any taxable year, the taxable income of any taxpayer is less than the sum of the threshold amount plus $50,000 ($100,000 in the case of a joint return), then-- (i) any specified service trade or business of the taxpayer shall not fail to be treated as a qualified trade or business due to paragraph (1)(A), but (ii) only the applicable percentage of qualified items of income, gain, deduction, or loss, and the W-2 wages and the unadjusted basis immediately after acquisition of qualified property, of the taxpayer allocable to such specified service trade or business shall be taken into account in computing the qualified business income, W-2 wages, and the unadjusted basis immediately after acquisition of qualified property of the taxpayer for the taxable year for purposes of applying this section. (B) Applicable Percentage.--For purposes of subparagraph (A), the term applicable percentage means, with respect to any taxable year, 100 percent reduced (not below zero) by the percentage equal to the ratio of-- (i) the taxable income of the taxpayer for the taxable year in excess of the threshold amount, bears to VOGEL.SEM/SP&LPROB.18

230 (ii) $50,000 ($100,000 in the case of a joint return). (e) Other Definitions.--For purposes of this section-- (1) Taxable Income.--Except as otherwise provided in subsection (g)(2)(b), taxable income shall be computed without regard to any deduction allowable under this section. (2) Threshold Amount.-- (A) In General.--The term threshold amount means $157,500 (200 percent of such amount in the case of a joint return). (B) Inflation Adjustment.--In the case of any taxable year beginning after 2018, the dollar amount in subparagraph (A) shall be increased by an amount equal to-- (i) such dollar amount, multiplied by (ii) the cost-of-living adjustment determined under section 1(f)(3) for the calendar year in which the taxable year begins, determined by substituting calendar year 2017 for calendar year 2016 in subparagraph (A)(ii) thereof. The amount of any increase under the preceding sentence shall be rounded as provided in section 1(f)(7). (3) Qualified REIT Dividend.--The term qualified REIT dividend means any dividend from a real estate investment trust received during the taxable year which-- (A) is not a capital gain dividend, as defined in section 857(b)(3), and (B) is not qualified dividend income, as defined in section 1(h)(11). (4) Qualified Publicly Traded Partnership Income.--The term qualified publicly traded partnership income means, with respect to any qualified trade or business of a taxpayer, the sum of-- (A) the net amount of such taxpayer's allocable share of each qualified item of income, gain, deduction, and loss (as defined in subsection (c)(3) and determined after the application of subsection (c)(4)) from a publicly traded partnership (as defined in section 7704(a)) which is not treated as a corporation under section 7704(c), plus (B) any gain recognized by such taxpayer upon disposition of its interest in such partnership to the extent such gain is treated as an amount realized from the sale or exchange of property other than a capital asset under section 751(a). [(5) Redesignated (4)] VOGEL.SEM/SP&LPROB.18

231 (f) Special Rules.-- (1) Application to Partnerships and S Corporations.-- (A) In General.--In the case of a partnership or S corporation-- (i) this section shall be applied at the partner or shareholder level, (ii) each partner or shareholder shall take into account such person's allocable share of each qualified item of income, gain, deduction, and loss, and (iii) each partner or shareholder shall be treated for purposes of subsection (b) as having W-2 wages and unadjusted basis immediately after acquisition of qualified property for the taxable year in an amount equal to such person's allocable share of the W-2 wages and the unadjusted basis immediately after acquisition of qualified property of the partnership or S corporation for the taxable year (as determined under regulations prescribed by the Secretary). For purposes of clause (iii), a partner's or shareholder's allocable share of W-2 wages shall be determined in the same manner as the partner's or shareholder's allocable share of wage expenses. For purposes of such clause, partner's or shareholder's allocable share of the unadjusted basis immediately after acquisition of qualified property shall be determined in the same manner as the partner's or shareholder's allocable share of depreciation. For purposes of this subparagraph, in the case of an S corporation, an allocable share shall be the shareholder's pro rata share of an item. (B) Application to Trusts and Estates.--Rules similar to the rules under section 199(d)(1)(B)(i) (as in effect on December 1, 2017) for the apportionment of W-2 wages shall apply to the apportionment of W-2 wages and the apportionment of unadjusted basis immediately after acquisition of qualified property under this section. (C) Treatment of Trades or Business in Puerto Rico.-- (i) In General.--In the case of any taxpayer with qualified business income from sources within the commonwealth of Puerto Rico, if all such income is taxable under section 1 for such taxable year, then for purposes of determining the qualified business income of such taxpayer for such taxable year, the term United States shall include the Commonwealth of Puerto Rico. (ii) Special Rule for Applying Limit.--In the case of any taxpayer described in clause (i), the determination of W-2 wages of such taxpayer with respect to any qualified trade or business conducted in Puerto Rico shall be made without regard to any exclusion under section 3401(a)(8) for remuneration paid for services in Puerto Rico VOGEL.SEM/SP&LPROB.18

232 (2) Coordination with Minimum Tax.--For purposes of determining alternative minimum taxable income under section 55, qualified business income shall be determined without regard to any adjustments under sections 56 through 59. (3) Deduction Limited to Income Taxes.--The deduction under subsection (a) shall only be allowed for purposes of this chapter. (4) Regulations.--The Secretary shall prescribe such regulations as are necessary to carry out the purposes of this section, including regulations-- (A) for requiring or restricting the allocation of items and wages under this section and such reporting requirements as the Secretary determines appropriate, and (B) for the application of this section in the case of tiered entities. (g) Deduction for Income Attributable to Domestic Production Activities of Specified Agricultural or Horticultural Cooperatives.-- (1) Allowance of Deduction.-- (A) In General.--In the case of a taxpayer which is a specified agricultural or horticultural cooperative, there shall be allowed as a deduction an amount equal to 9 percent of the lesser of-- (i) the qualified production activities income of the taxpayer for the taxable year, or (ii) the taxable income of the taxpayer for the taxable year. (B) Limitation.-- (i) In General.--The deduction allowable under subparagraph (A) for any taxable year shall not exceed 50 percent of the W-2 wages of the taxpayer for the taxable year. (ii) W-2 Wages.--For purposes of this subparagraph, the W-2 wages of the taxpayer shall be determined in the same manner as under subsection (b)(4) (without regard to subparagraph (B) thereof and after application of subsection (b)(5)), except that such wages shall not include any amount which is not properly allocable to domestic production gross receipts for purposes of paragraph (3)(A). (C) Taxable Income of Cooperatives Determined Without Regard to Certain Deductions.--For purposes of this subsection, the taxable income of a specified agricultural or horticultural cooperative shall be computed without regard to any deduction allowable under subsection (b) or (c) of section 1382 (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions) VOGEL.SEM/SP&LPROB.18

233 (2) Deduction Allowed to Patrons.-- (A) In General.--In the case of any eligible taxpayer who receives a qualified payment from a specified agricultural or horticultural cooperative, there shall be allowed as a deduction for the taxable year in which such payment is received an amount equal to the portion of the deduction allowed under paragraph (1) to such cooperative which is-- (i) allowed with respect to the portion of the qualified production activities income to which such payment is attributable, and (ii) identified by such cooperative in a written notice mailed to such taxpayer during the payment period described in section 1382(d). (B) Limitation Based on Taxable Income.--The deduction allowed to any taxpayer under this paragraph shall not exceed the taxable income of the taxpayer determined without regard to the deduction allowed under this paragraph and after taking into account any deduction allowed to the taxpayer under subsection (a) for the taxable year. (C) Cooperative Denied Deduction for Portion of Qualified Payments.--The taxable income of a specified agricultural or horticultural cooperative shall not be reduced under section 1382 by reason of that portion of any qualified payment as does not exceed the deduction allowable under subparagraph (A) with respect to such payment. (D) Eligible Taxpayer.--For purposes of this paragraph, the term eligible taxpayer means-- (i) a taxpayer other than a corporation, or (ii) a specified agricultural or horticultural cooperative. (E) Qualified Payment.--For purposes of this section, the term qualified payment means, with respect to any eligible taxpayer, any amount which-- (i) is described in paragraph (1) or (3) of section 1385(a), (ii) is received by such taxpayer from a specified agricultural or horticultural cooperative, and (iii) is attributable to qualified production activities income with respect to which a deduction is allowed to such cooperative under paragraph (1). (3) Qualified Production Activities Income.--For purposes of this subsection-- (A) In General.--The term qualified production activities income for any taxable year means an amount equal to the excess (if any) of-- (i) the taxpayer's domestic production gross receipts for such taxable year, over VOGEL.SEM/SP&LPROB.18

234 (ii) the sum of-- (I) the cost of goods sold that are allocable to such receipts, and (II) other expenses, losses, or deductions (other than the deduction allowed under this subsection), which are properly allocable to such receipts. (B) Allocation Method.--The Secretary shall prescribe rules for the proper allocation of items described in subparagraph (A) for purposes of determining qualified production activities income. Such rules shall provide for the proper allocation of items whether or not such items are directly allocable to domestic production gross receipts. (C) Special Rules for Determining Costs.-- (i) In General.--For purposes of determining costs under subclause (I) of subparagraph (A)(ii), any item or service brought into the United States shall be treated as acquired by purchase, and its cost shall be treated as not less than its value immediately after it entered the United States. A similar rule shall apply in determining the adjusted basis of leased or rented property where the lease or rental gives rise to domestic production gross receipts. (ii) Exports for Further Manufacture.--In the case of any property described in clause (i) that had been exported by the taxpayer for further manufacture, the increase in cost or adjusted basis under clause (i) shall not exceed the difference between the value of the property when exported and the value of the property when brought back into the United States after the further manufacture. (D) Domestic Production Gross Receipts.-- (i) In General.--The term domestic production gross receipts means the gross receipts of the taxpayer which are derived from any lease, rental, license, sale, exchange, or other disposition of any agricultural or horticultural product which was manufactured, produced, grown, or extracted by the taxpayer (determined after the application of paragraph (4)(B)) in whole or significant part within the United States. Such term shall not include gross receipts of the taxpayer which are derived from the lease, rental, license, sale, exchange, or other disposition of land. (ii) Related Persons.-- (I) In General.--The term domestic production gross receipts shall not include any gross receipts of the taxpayer derived from property leased, licensed, or rented by the taxpayer for use by any related person. (II) Related Person.--For purposes of subclause (I), a person shall be treated as related to another person if such persons are treated as a single employer under subsection (a) or (b) of section 52 or subsection (m) or (o) of section 414, except that determinations under subsections (a) and (b) of section 52 shall be made without regard to section 1563(b) VOGEL.SEM/SP&LPROB.18

235 (4) Specified Agricultural or Horticultural Cooperative.--For purposes of this section-- (A) In General.--The term specified agricultural or horticultural cooperative means an organization to which part I of subchapter T applies which is engaged-- (i) in the manufacturing, production, growth, or extraction in whole or significant part of any agricultural or horticultural product, or (ii) in the marketing of agricultural or horticultural products. (B) Application to Marketing Cooperatives.--A specified agricultural or horticultural cooperative described in subparagraph (A)(ii) shall be treated as having manufactured, produced, grown, or extracted in whole or significant part any agricultural or horticultural product marketed by the specified agricultural or horticultural cooperative which its patrons have so manufactured, produced, grown, or extracted. (5) Definitions and Special Rules.-- (A) Special Rule for Affiliated Groups.-- (i) In General.--All members of an expanded affiliated group shall be treated as a single corporation for purposes of this subsection. (ii) Partnerships Owned by Expanded Affiliated Groups.--For purposes of paragraph (3)(D), if all of the interests in the capital and profits of a partnership are owned by members of a single expanded affiliated group at all times during the taxable year of such partnership, the partnership and all members of such group shall be treated as a single taxpayer during such period. (iii) Expanded Affiliated Group.--For purposes of this subsection, the term expanded affiliated group means an affiliated group as defined in section 1504(a), determined-- (I) by substituting more than 50 percent for at least 80 percent each place it appears, and (II) without regard to paragraphs (2) and (4) of section 1504(b). (iv) Allocation of Deduction.--Except as provided in regulations, the deduction under paragraph (1) shall be allocated among the members of the expanded affiliated group in proportion to each member's respective amount (if any) of qualified production activities income. (B) Special Rule for Cooperative Partners.--In the case of a specified agricultural or horticultural cooperative which is a partner in a partnership, rules similar to the rules of subsection (f)(1) shall apply for purposes of this subsection VOGEL.SEM/SP&LPROB.18

236 (C) Trade or Business Requirement.--This subsection shall be applied by only taking into account items which are attributable to the actual conduct of a trade or business. (D) Unrelated Business Taxable Income.--For purposes of determining the tax imposed by section 511, this section shall be applied by substituting unrelated business taxable income for taxable income each place it appears in this section (other than this subparagraph). (E) Special Rule for Cooperative with Oil Related Qualified Production Activities Income.-- (i) In General.--If a specified agricultural or horticultural cooperative has oil related qualified production activities income for any taxable year, the amount otherwise allowable as a deduction under paragraph (1) shall be reduced by 3 percent of the least of-- (I) the oil related qualified production activities income of the cooperative for the taxable year, (II) the qualified production activities income of the cooperative for the taxable year, or (III) taxable income. (ii) Oil Related Qualified Production Activities Income.--For purposes of this subparagraph, the term oil related qualified production activities income means for any taxable year the qualified production activities income which is attributable to the production, refining, processing, transportation, or distribution of oil, gas, or any primary product thereof (within the meaning of section 927(a)(2)(C), as in effect before its repeal) during such taxable year. (6) Regulations.--The Secretary shall prescribe such regulations as are necessary to carry out the purposes of this subsection, including regulations which prevent more than 1 taxpayer from being allowed a deduction under this subsection with respect to any activity described in paragraph (3)(D)(i). Such regulations shall be based on the regulations applicable to cooperatives and their patrons under section 199 (as in effect before its repeal). (h) Anti-Abuse Rules.--The Secretary shall-- (1) apply rules similar to the rules under section 179(d)(2) in order to prevent the manipulation of the depreciable period of qualified property using transactions between related parties, and (2) prescribe rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions. (i) Termination.--This section shall not apply to taxable years beginning after December 31, VOGEL.SEM/SP&LPROB.18

237 199A Deduction The Tax Cuts and Jobs Act provides a 20% deduction for qualified trade or business income of pass-through entities and sole proprietors that yields a maximum rate on such income of 29.6%. (Qualified Business Income (QBI), Specified Service Business (SSB) & Qualified Trade or Business (QTB) 199A) SSB QBI What do these terms mean? QTB RPE UBIA Section 199A is effective for taxable years beginning after December 31, This means that if an individual is a partner or shareholder in a fiscal year S corporation or partnership, the individual will qualify for the 199 deduction of 9% of QPAI. See Form SP&LPROB A Deduction Choice of Entity Even though the corporate tax rate is a flat 21%, it remains advantageous to operate a qualified trade or business as an S corporation or a partnership if the business qualifies for the deduction under 199A. Would you advise an LLC or S corporation to convert to a C corporation since a C corporation is subject to a flat tax of 21% My ANS: No, even if the business is a SSB (Specified Service Business). Would you advise a C corporation to convert to an S corporation? My ANS: Maybe SP&LPROB

238 199A Deduction 199A: Terms: QBI SSB How to calculate QTB H QTB W QTB RPE UBIA SP&LPROB A Deduction See Schedule E: Note When is someone in the business of leasing personal property? (See Reg (c)(5)(ii)(B).) Lease construction equipment to a third party at a profit of $60,000. Box A & Box B Is someone with a Schedule E required to issue a Form 1099? See 179 T/B Is someone with a rental property on Schedule E entitled to a 179 deduction for the cost of replacing the roof? SP&LPROB

239 Reg (c)(5)(ii)(B) Rents as Trade or Business (B) Rents. (1) In General Rents means amounts received for the use of, or right to use, property (whether real or personal) of the corporation. (2) Rents Derived in the Active Trade or Business of Renting Property- Rents does not include rents derived in the active trade or business of renting property. Rents received by a corporation are derived in an active trade or business of renting property only if, based on all the facts and circumstances, the corporation provides significant services or incurs substantial costs in the rental business. Generally, significant services are not rendered and substantial costs are not incurred in connection with net leases. Whether significant services are performed or substantial costs are incurred in the rental business is determined based upon all the facts and circumstances including, but not limited to, the number of persons employed to provide the services and the types and amounts of costs and expenses incurred (other than depreciation). (Much more important today with the 199A deduction.) SP&LPROB A Deduction Simple as Postcard Section 199A makes an S corporation or a partnership a more attractive choice in operating a tradeorbusiness. The deduction under 199A is (but never more than 20% of taxable income) the lesser of: 2(A) or 2(B) 1. 20% of QBI with respect to each qualified T/B; or (See P ) 2. Wage limit which is the greater of: (a) 50% of the W-2 wages of the qualified T/B; or (b) the sum of 25% of the W-2 wages of the T/B, plus 2.5% of the unadjusted basis of all qualified property immediately after acquisition. The deduction is not as simple as it seems, as there are three different categories of taxable income before the deduction which determines how much is deductible. (But 96% of all individuals have an AGI $200,000, so it might be easy. See 2017 Data Book.) SP&LPROB

240 Section 199A Deduction Form 8905? Deduction for Qualified Business Income under 199A. Tax deduction for qualified business income ( QBI ). 1) The deduction is available to a shareholder of an S corporation or a partner in a partnership (and either by the trust or estate of the heir Form 8905 or beneficiary) in calculating his/her taxable income subject to tax. & (The deduction is determined after calculating taxable income for L.42 an individual. An individual s taxable income is calculated deducting the greater of itemized deductions or the standard But NOL C.F. 172 deduction and then the 199A deduction is taken. The deduction under 199A is then deducted and the taxable income after the 199A deduction is subject to the individual tax rates.) 2) Calculate T.I. and then deduct 199A deduction. (Section 172(d)(8) states that the 199A deduction does not create a NOL. It seems that NOL deduction applies before the 199A deduction.) SP&LPROB How to Calculate Taxable Income for an Individual (Yes) 61 G.I. 62 DforAGI 63 AGI Less P.E. of $0 Less I.D. (Sch. A) or Std. Ded. ($24,000, $18,000 and $12,000*) Taxable Income before 199A Deduction Less Deduction for QBI under 199A Taxable Income * If blind and age 65, additional standard deduction of $1,300 (if MFJ) & $1,600 (if not married). SP&LPROB

241 Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. The deduction is (but never more than 20% of taxable income) the lesser of: 2(A) or 2(B) 1) 20% of QBI with respect to each qualified TB; or 2) Wage limit which is the greater of: (a) 50% of the W-2 wages of the qualified T/B; or (b) the sum of 25% of the W-2 wages of the T/B, plus 2.5% of the unadjusted d basis of all qualified property immediately after acquisition. SP&LPROB Section 199A Deduction Deduction for Qualified Business Income under 199A. If an S corporation, does the 199A deduction encourage you to pay more wages or less wages to employee/shareholders? (If T.I. $207,500 or T.I. $415,000) For example, if an S corporation which qualifies for the deduction under 199A generates a net profit of $2,000,000, and is wholly hll owned by Ms. A, how much compensation should the S corporation pay Ms. A to maximize the deduction under 199A? ANS: $571,000 Huh? (SE tax of $37,400 for a tax savings of $128,400.) (See Slide 330 for equation.) SP&LPROB

242 Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. Taxpayers other than corporations may deduct 20% of domestic qualified business income ( QBI ). This results in a maximum rate of 29.6% on such income (80% of the high rate of 37%). (See Page ) QBI means the net amount of qualified items of income, gain deduction and loss with respect to any qualified trade or business ( qualified T/B ). QBI also includes qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income (all defined in detail in new 199A). (See Page ) 1) Any loss of a qualified T/B is carried over to the next year. (See Page ) SP&LPROB Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. Qualified items of income, etc. are items effectively connected with the conduct of a T/B within the U.S. within the meaning of 864(c) (which uses the 162 definition of a T/B) and included or allowed in determining taxable income. (See Page ) The following investment items are not included: 1. Capital gains or losses (long-term or short-term); 2. Dividends, income equivalent to a dividend, or a payment in lieu of dividends described in 954(c)(1)(G). 3. Interest income other than that properly allocable to the T/B. 4. Annuity income and certain income described in 954(c)(1). SP&LPROB

243 Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. QBI shall not include (do not add back): 1. Reasonable compensation paid to the taxpayer by any qualified T/B of the taxpayer for services rendered with respect to the T/B (Schedule C, Schedule F or Form 1065 and Form 1120S (no compensation or too little)); 2. Any guaranteed payment described in 707(c) paid to a partner for services rendered with respect to the T/B (more as a distribution and less as a guaranteed payment);and 3. To the extent provided in regulations, any payment described in 707(a) to a partner for services rendered with respect to the T/B (e.g., to a partner not acting in the capacity as a partner). SP&LPROB Section 199A Deduction Assume that a single person will have T.I. of $250,000 before the 199A deduction. The individual owns 100% of anscorporation which is engaged in QTB. The individual is the only EE of the S corporation, the S corporation has O.I. of $200,000 and no wages have been paid to the owner/ee. What is the 199A deduction if the TRP enters $55,000 on L.7 of the Form 1120S as wages paid and has the individual owner include the $55,000 on a Schedule C on the Form 1040? What is the QBI from the Form 1120S and what is the QBI from the individual s Schedule C? SP&LPROB

244 Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. A qualified T/B means any T/B (within the meaning of 162) other than a specified service T/B ; or the T/B of performing services as an employee (QTB). A specified service T/B (SSB) is a T/B involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any other T/B where the principal asset is the reputation or skill of one or more employees or owners ( 1202(e)(3)(A) definition, but deleting engineering and architecture. 1. A SSB also includes performance of services that consist of investing and investment management, or trading or dealing in securities, partnership interests, or commodities. 2. A SSB does not include banking or insurance See 1202(e)(3)(B). SP&LPROB Section 199A Deduction The confusing part is the definition of a QTB. The Committee Reports to TCJA use transaction entered into for profit when discussing the limit of taxes on Schedule A. What definition of a T/B which is being used for 199A, as there is a different definition of a T/B for: Schedule C & 179 The definition used in these Code Sections is the 162 definition of regular, continuous or substantial basis. Think of B & B vs. Airbnb vs. Hotel or Inn Think of taking a 179 deduction in replacing the roof of a building used in a trade or business versus taking a 179 deduction for replacing the roof on a Schedule E property. SP&LPROB

245 Section 199A Deduction The confusing part is the definition of a QTB. What definition of a T/B which is being used for 199A, as there is a different definition of at/bfor: Schedule E If sell one rental property at a gain or loss, the character is 1231 gain or loss. See Form Is this a QTB within the meaning of 162 or is this a transaction entered into for profit within the meaning of 212? SP&LPROB Section 199A Deduction The confusing part is the definition of a QTB. What definition of a T/B which is being used for 199A, as there is a different definition of at/bfor: PAL of 469 The definition of a trade or business that is generally used for 469 is APCU 7 days. If the APCU 7 days, the activity is a trade or business activity in which an individual may materially participate. An individual may not materially participate in a rental activity and only a REP may materially participate in a rental real estate activity. 199A uses the 162 definition of a trade or business. SP&LPROB

246 Question on Specified Service Business Which of the following fits the definition of a SSB? (No) 1. Stylist or barber, (Yes) 2. Member of Board of Directors, (No) 3. Specialty contractor Framer, drywaller, electrician, formwork carpenter, (No) 4. Auto mechanic, (Yes) 5. Attorney, (Yes) 6. Doctor, o (No) 7. Architect, (No) 8. Engineer, (Yes) 9. Accountant, Fracking or providing administrative functions See Reg (c) where a SSB includes administrative and support services that are provided to a personal service business. (A SSB includes any T/B with at least a 50% common ownership that provides 80% or more of its property or services to a SSB.) 10. Husband operating a retail business and wife is an actuary. SP&LPROB Question on Specified Service Business Which of the following fits the definition of a SSB? (No) (No) 11. State Farm insurance agent 12. Headhunter (Maybe) 13. IT specialist Consultant and develops software (10% gross receipts) (No) (No) (No) 14. Chef Cliff Young 15. Personal trainer 16. Photographer 17. Professional athlete: (?) John Elway (No) Lyle Alzado, (No) Dante Bichette SP&LPROB

247 Question on Specified Service Business Which of the following fits the definition of a SSB? (No) 18. Painter (No) 19. Plumber (No) 20. Electrician (Yes) 21. Singer (No) 22. Singer s manager (No) 23. Printing business (No) 24. Manufacturer or wholesaler or retailer of medical equipment or supplies (No) 25. Health Club (?) 26. Nursing home (? But if skilled nursing, Yes, or assisted living) SP&LPROB Question on Specified Service Business Which of the following fits the definition of a SSB? (Yes) 27. Veterinarian (Yes) 28. Lobbyist (No) 29. Real estate broker/agent (No) 30. Radio Station (Yes) 31. Boston Bruins & Jacobs (No) 32. Career counselor (No) 33. Construction business (No) 34. Make-up artist (No) 35. Analysts (No) 36. PEO SP&LPROB

248 Question on Specified Service Business Which of the following fits the definition of a SSB? (?) (Yes) (No) (No) (No) (No) (Yes) (Yes) 37. Business that protects property tax 38. Occupational Therapist 39. Independent business that provides billing services 40. Venture capitalist 41. Valuation expert or appraiser 42. Health insurance provider 43. Surgery center 44. Health care clinic (Yes) 45. Hospice business SP&LPROB Question on Specified Service Business Which of the following fits the definition of a SSB? 46. What result if a SSB is engaged in separate activities One activity which is a SSB and another activity which is a QTB? Is this one activity or will it depend upon the amount of gross receipts for each or will it depend on how the two activities were grouped under 469? (See Reg ) See Reg A-1(c)(1) & -1(c)(3) for 10% and 5% test Less than 10% or 5% of gross receipts from SSB. (See also Reg A-5(c) for de minimis rules that if less than 10% of gross receipts from a business are from SSB activities, then not a SSB as long as gross receipts for the taxable year are $25 million or less.) SP&LPROB

249 Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. W-2 wages means the amounts described in 6051(a)(3) and (8) paid by any person with respect to employment of employees by such person during the calendar year ending during the person s taxable year. (What wages and are wages Box 1, Box 3 or Box 5? Leased employees See Reg (a)(2). See Notice ) 1. Such terms shall not include any amount which is not properly allocable to QBI. 2. Such term shall not include any amount not properly included in a return filed with the Social Security Administration on or before the 60 th day after the due date (including extensions) for such return. (Means filing a W-3.) SP&LPROB Section 199A Deduction Wages (See Page ) What Wages: Option #1 Option #2 W-2: W-2: Box 1 $120,000 Box 1 $100,000 Box 3 $100,000 Box 3 $120,000 Box 5 $100,000 Box 5 $120,000 How do you allocate the wages of leased employees, the wages of a management company and the operating companies, the wages that are paid by an S corporation using a common pay master arrangement? (See Reg Appropriate Economic Unit.) SP&LPROB

250 Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. The term qualified property means tangible property of a character subject to depreciation under 167 (goodwill is not qualified property): 1. Which is held by and available for use in a qualified T/B at the close of the taxable year; 2. Which is used at any point during the taxable year in the production of QBI; and 3. The depreciable period for which has not ended before the close of the taxable year. SP&LPROB Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. The term qualified property means tangible property of a character subject to depreciation under 167 (goodwill is not qualified property): 1. Which is held by and available for use in a qualified T/B at the close of the taxable year; 2. Which is used at any point during the taxable year in the production of QBI; and 3. The depreciable period for which has not ended before the close of the taxable year. SP&LPROB

251 Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. The term depreciable period means the period beginning on the date the property was first place in service by the taxpayer and ending on the later of: 1. The date that is ten years after such date; or 2. The last day of the last full year in the applicable recovery period that would apply to the property under 168, determined without regard to 168(g) (the alternative depreciation system rules). Place property in service in June 2012, five-year property, depreciate or 179 deduction, the last year that is qualified property is But special rules apply if contribute property to a partnership under 721 or to a corporation under 351 UBIA. SP&LPROB Section 199A Deduction Qualified Business Income What if a partner has a 754 basis adjustment that is attributable to qualified property? Does the basis adjustment affect the calculation under the wage limit for qualified property? K-1 from a 1065: Line 1 Ordinary Income $120,000 Line 2 Rental Real Estate $110,000 Line 3 Other Rental $90,000 Line Gain $15,000 Line Deduction $25,000 What is QBI? Each K-1 for 2018 will have to provide QBI, W-2 & UBIA for each activity of the S corporation, partnership or trust & estate. SP&LPROB

252 Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. Special rules: 1. For partnerships or S corporations, 199A shall be applied at the partner or shareholder level, and they shall take into account their allocable share of each qualified item of income, gain, deduction and loss, and be treated as having their allocable share of W-2 wages and unadjusted basis of qualified property of the entity, as determined under regulations. a. If the activity is passive, also qualifies. SP&LPROB Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. Special rules: 2. For trusts and estates, rules similar to old 199(d)(1)(B)(i) shall apply as to apportionment of W-2 wages and basis. a. For example, assume that a simple trust has an interest in a tax partnership which is engaged in a QTB. The partnership issues a K-1 to the trustt which h indicates thatt the trust st share of the QBI is $100,000, W-2 wages is $60,000 and unadjusted basis of the qualified property is $500,000. The Schedule K-1 to the trust indicates that the trust s shares of the ordinary income is $100,000 and that the money distributed is $40,000 on Line 19(a). How would you allocate the 199A deduction between the trust and the beneficiary? SP&LPROB

253 Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. Special rules: 3. The deduction is not allowed to compute AGI (not above the line). 4. The deduction is allowed to non-itemizers, and is allowed to itemizers without limits on itemized deductions. 5. The definition of a substantial understatement of tax under 6662(d)(1) (is understatement if amount exceeds the greater of 10% of the correct tax or $5,000), is amended by substituting 5% for 10%. SP&LPROB Section 199A Deduction (See Page ) Deduction for Qualified Business Income under 199A. Issues: 1. The Act does not define a qualified trade or business other than by excluding (and applying special rules and phaseouts for) specified service businesses, and excluding the T/B of being an employee (now a 162 T/B). 2. A qualified T/B does include a trade or business where the taxpayer treats the activity as a passive activity. Thus, if an individual owns an interest in an S corporation and the activity is a passive activity because the taxpayer does not materially participate, the taxpayer is entitled to a 20% deduction for qualified business income (QBI) if otherwise qualified. SP&LPROB

254 Section 199A Deduction Rental of Real Property and Rental of Personal Property as a QTB Deduction for Qualified Business Income under 199A. See Sch. E. Issues: 3. Rental Activity as a QTB Iftheactivityisarentalactivityas defined in 469, it is not clear when such rental activity qualifies as a trade or business ( T/B ) since the term passive activity includes any rental activity, regardless of material participation. It is possible for a rental activity to rise to the level of a T/B, but there is no clear guidance on that issue. Various regulations (see, e.g. Reg (c)(5)(ii)(B) [who is required to maintain, insure, repair, and pay the taxes on the property] and regulations under 1411) suggest a net lease usually is not a T/B, and that a factor test applies. (See Schedule E Note.) SP&LPROB Section 199A Deduction Deduction for Qualified Business Income under 199A. Issues: 4. If the activity is a rental real estate activity, when does the activity rise to the level of qualifying as a T/B? One position is that the activity rises to the level of a T/B only if the taxpayer qualifies as a real estate professional and materially participates in the activity. Under the regulations to 1411, if the taxpayer is a REP, materially participates i t and spends more than 500 hours per activity, it the REP is engaged in the trade or business of renting real property within the QTB meaning as 162 and as a result is not subject to the 3.8% tax on NII. One logical conclusion might be that if the taxpayer is a REP and is not subject to the 3.8% tax on NII, then the individual is entitled to the deduction under 199A. (See Schedule E, Box A & Box B.) SP&LPROB

255 Section 199A Deduction Deduction for Qualified Business Income under 199A. Issues: Sch. E, Box A Yes 5. Regarding when a rental real estate activity rises to the level of a T/B, another position is that under the preamble to regulations under 1411 (the 3.8% net investment income tax), the IRS declined to provide a definition of a trade or business and said to apply 162 rules. In response to commentators desire for guidance in the context of rental real estate (where commentators were citing cases that rental of a single property could be a T/B) the IRS stated that it agreed that, in certain circumstances, the rental of a single property may require regular and continuous involvement such that the rental activity is a trade or business within the meaning of 162. However, [it] does not believe that the rental of a single piece of property rises to the level of a trade or business in every case as a matter of law. It noted that in Reg (h), rental of real property is given as an example of a for-profit activity under 212 as opposed to a trade or business. SP&LPROB Section 199A Deduction Deduction for Qualified Business Income under 199A. Issues: 6. The IRS goes on to cite the key factual elements that are relevant to whether an activity is a trade or business under 162: (a) type of Facts & property (commercial versus residential versus personal); (b) Circumstances number of properties rented; (c) day-to-day involvement of the Test owner or an agent; (d) type of rental (net lease versus traditional; short term versus long term). Therefore, due to the large number of actual combinations that exist in determining whether a rental activity rises to the level of a 162 trade or business, bright-line definitions are impractical and would be imprecise. SP&LPROB

256 Section 199A Deduction Deduction for Qualified Business Income under 199A. Issues: 7. Finally, the IRS stated that it would closely scrutinize situations where taxpayers claim that an activity is a trade or business for 1411 purposes, but not for other purposes. In such a case, the IRS will take into account the taxpayer s determination of a trade or business for other purposes, such as whether the taxpayer complies with any information reporting requirements for the rental activity imposed by 6041 (Form 1099 s See Schedule E, Box A and Box B). If pay a plumber $800 for a repair on Sch. E rental property, is your client required to issue a Form 1099? ANS: No. Why? SP&LPROB Section 199A Deduction Deduction for Qualified Business Income under 199A. Issues: 1,200 & Section 199A itself leaves the issue of when a rental activity rises to the level of a QTB unclear, just as did the 1411 regulations, which provide no bright-line test or rule. As a practical matter, it is probably the unusual case that a rental activity rises to the level of a 162 QTB if the T does not materially participate, as the 162 standard is regular and continuous. But failure to be a REP is not the test. For example, assume you work 1,200 hours at a regular job and work 800 hours on a rental activity. You would not be a REP, but there is case law that finds that someone has a trade or business with a lot less than that. (How are self-rentals treated?) SP&LPROB

257 Section 199A Deduction (See Page ) Qualified Business Income Qualified business income is determined for each qualified trade or business of the taxpayer. For any taxable year, qualified business income means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. The determination of qualified items of income, gain, deduction, and loss takes into account these items only to the extent included or allowed in the determination of taxable income for the year. SP&LPROB Section 199A Deduction (See Page ) 1. Which of the following affect QBI? a. Pension contribution K-1: QBI b. Health insurance premium W-2 Wages UBIA c. Deduction for ½ of SE tax d. Nondeductible expenses e. Separately stated items of income, gain, loss and deduction on Schedule K-1 f. Unreimbursed out-of-pocket expenses of partner and S corporation shareholder See Craft. SP&LPROB

258 Section 199A Deduction Qualified Business Income. 1. For example, if in a taxable year, a qualified business has $100,000 of ordinary income from inventory sales, and makes an expenditure of $25,000 that is required to be capitalized and amortized over five years under applicable tax rules, the qualified business income is $100,000 minus $5,000 (current-year ordinary amortization deduction), or $95,000. The qualified business income is not reduced by the entire amount of the capital expenditure, only by the amount deductible in dt determining ii taxable income for the year. 2. If the $25,000 were deducted under 179 or qualified for 100% bonus depreciation, QBI would be $75,000 ($100,000 $25,000). SP&LPROB Section 199A Deduction (See Page ) Qualified Business Income and Loss. 1. If the net amount of qualified business income from all qualified trades or businesses during the taxable year is a loss, it is carried forward as a loss from a qualified trade or business in the next taxable year. Similar to a qualified trade or business that has a qualified business loss for the current taxable year, any deduction allowed in a subsequent year is reduced (but not below zero) by 20 percent of any carryover qualified business loss. a. For 2018, will have an NOL for: 1) Regular tax 2) AMT 3) NII 4) QBI b. Special rules for suspended losses under 469, 465 & 461(l). SP&LPROB Remember Simple as a Postcard!

259 Section 199A Deduction Qualified Business Income and Loss. 2. For example, T has qualified business income of $20,000 from qualified business A and a qualified business loss of $50,000 from qualified business B in Year 1. T is not permitted a deduction for Year 1 and has a carryover qualified business loss of $30,000 to Year 2. In Year 2, T has qualified business income of $20,000 from qualified business A and qualified business income of $50,000 from qualified business B. To determine the deduction for Year 2, T reduces the 20 percent deductible amount dt determined dfor the qualified business income of $70, from qualified businesses A and B by 20 percent of the $30,000 carryover qualified business loss. The deduction is $8,000 (20% X $70,000 20% X ($30,000). SP&LPROB Section 199A Deduction (See Page 260-2, -1 & -5.) How to Make the Calculation Under 199A: EASY EASY UGH 1. There are three categories of taxable income (computed before the 199A dd deduction) which h are used to dt determine the amount thatt is dd deductible under 199A. These include: a. Category 1 Taxpayer has taxable income (computed before the 199A deduction) equal to or less than the threshold amounts ($315,000 for joint returns and $157,500 for other returns). (See Page ) b. Category 2 Taxpayer has taxable income (computed before the 199A deduction) equal to or greater than the end of the phaseout range (greater than or equal to $415,000 for joint returns and $207,500 for other returns). (See Page ) c. Category 3 Taxpayer has taxable income (computed before the 199A deduction) greater than the threshold amounts ($315,000 for joint returns and $157,500 for other returns), but not equal to or greater than the end of the phaseout range ($415,000 for joint returns and $207,500 for other returns). (See Page 260-2; if SSB, see Page ) 2. Note: For all three categories, the deduction may not exceed 20% of taxable income reduced by net capital gain. SP&LPROB

260 Section 199A Deduction Category 1 Calculation Basic Facts: Schedule C $180,000 SSB & QBI W-2 Wages $90,000 T.I. $150,000 (or $300,000 if MFJ) What happens if LT / Qual. Divid. of $40,000? What is the 199A deduction if SSB? ANS: $30,000 (or $36,000) Remember that 96% of all individuals have an AGI $200,000. What is the point to this comment? SP&LPROB Section 199A Deduction Category 1 Calculation Basic Facts: Schedule C $180,000 QTB & QBI W-2 Wages $90,000 T.I. $150,000 (or $300,000 if MFJ) What is the 199A deduction if QTB? ANS: $30, (or $36,000) Point: Deduction is the same. SP&LPROB

261 Section 199A Deduction Category 2 Calculation Basic Facts: Schedule C $180,000 SSB & QBI W-2 Wages $90,000 T.I. $450,000 MFS Spouse T.P. $500,000 QBI $180,000 I.D. (230,000) (0) T.I. $270,000 $180,000 What is the 199A deduction if SSB? ANS:$0 Should the individual file a separate return if married? Based on these numbers, and my assumptions, saved over $10,000 in tax by filing MFSep. SP&LPROB Section 199A Deduction Category 2 Calculation Basic Facts: Schedule C $180,000 QTB & QBI W-2 Wages $90,000 T.I. $450,000 What is the 199A deduction if QTB? (Lesser of 2(A) $36,000 or 2(B) $45,000) ANS: $36,000 SP&LPROB

262 Section 199A Deduction Category 3 Calculation 2(A) < 2(B) & Only % of QBI, W-2 & UBIA Basic Facts: Schedule C $250,000 SSB & QBI W-2 Wages $120,000 T.I. $187,500 40% of: QBI $100,000 W-2 $48,000 UBIA $0 2(A) 20% x $100,000 = $20,000 2(B) 50% x $48,000 = $24,000 What is the 199A deduction if SSB? ANS: $20,000 SP&LPROB Section 199A Deduction Category 3 Calculation 2(A) > 2(B) & Only % of QBI, W-2 & UBIA Basic Facts: Schedule C $250,000 QBI & SSB W-2 Wages $80,000 T.I. $187,500 40% of: QBI $100,000 W-2 $32,000 2(A) 20% x $100,000 = $20,000 2(B) 50% x $32,000 = $16,000 What is the 199A deduction if SSB? ANS: $17,600 Deduction is 2(A) $20,000 Less 60% x ((2(A) 2(B)) ($4,000 x 60%) ($2,400) Deduction $17,600 SP&LPROB

263 Section 199A Deduction Category 3 Calculation QTB & 2(A) < 2(B) Basic Facts: Schedule C $250,000 QBI & QTB 2(A) - $50,000 W-2 Wages $120,000 & T.I. $187,500 2(B) - $60,000 What is the 199A deduction if QTB? ANS: $50,000 SP&LPROB Section 199A Deduction Category 3 Calculation QTB & 2(A) > 2(B) Basic Facts: Schedule C $250,000 QBI & QTB 2(A) - $50,000 W-2 Wages $80,000 & T.I. $187,500 2(B) - $40,000 What is the 199A deduction if QTB? ANS: $44,000 Deduction is 2(A) $50,000 Less 60% x ((2(A) 2(B)) (60% x $10,000) ($6,000) Deduction $44,000 SP&LPROB

264 Section 199A Deduction How to Make the Calculation Under 199A: 3. Category 1. Taxpayer has taxable income (computed before the 199A deduction) equal to or less than the threshold amounts ($315,000 for joint returns and $157,500 for other returns). a. Each specified service business (SSB) qualifies for the deduction and there is no phase-out of the deduction for such a business. b. The wage limitit does not apply to anyqtb if the taxpayer is in this category. There is no phase-in of the wage limit. c. The taxpayer is entitled to a deduction equal to 20% of qualified business income (QBI) from each QTB. SP&LPROB Section 199A Deduction How to Make the Calculation Under 199A: Good Example 3. Category 1. Example 1: Taxpayer is a married person filing a joint return and has taxable income of $300,000 before the 199A deduction. Assume that the taxpayer has QBI of $250,000 from his Schedule C accounting trade or business (a specified service business). There are no wages paid to employees. The taxpayer s deduction is 20% of his QBI of $250,000 or $50,000. Since the $50,000 does not exceed 20% of his taxable income before the deduction, the taxpayer is entitled to a deduction of $50,000 and the taxable income for the taxpayer is $250,000 ($300,000 - $50,000). SP&LPROB

265 Section 199A Deduction How to Make the Calculation Under 199A: 3. Category 1. Example 2: Assume the same facts as in Example 1, exceptthatthe Schedule C business is not a specified service business. Since the taxpayer s taxable income before the deduction is at or below the threshold amount of $315,000, the taxpayer s 199A deduction is 20% of QBI of $250,000 or $50,000. The taxpayers taxable income is again $250, ($300, A dd deduction of $50,000). 000) SP&LPROB Section 199A Deduction How to Make the Calculation Under 199A: 4. Category 2. Taxpayer has taxable income (computed before the 199A deduction) of amount equal to or greater than the end of the phase-out range (equal to or greater than $415,000 for joint returns and $207,500 for other returns). a. For a SSB, no deduction is allowed. b. For each QTB, the wage limitit fully applies. Therefore T s deductiond is the lesser of (1) 20% of QBI; or (2) wage limit which is the greater of 50% of W-2 wages, or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property. SP&LPROB

266 Section 199A Deduction How to Make the Calculation Under 199A: 4. Category 2. Example 3: Assume that a single taxpayer has taxable income before the 199A deduction of $250,000, of which $200,000 is QBI attributable to her Schedule C accounting trade or business. Wages paid to employees in the trade or business are $90,000. Since the taxpayer s py taxable income before the 199A deduction exceeds the $207,500 amount, the taxpayer s 199A deduction is $0 since the deduction for a SSB is fully phased out for a single person once the taxable income for the year equals or exceeds $207,500. SP&LPROB Section 199A Deduction How to Make the Calculation Under 199A: Good Example 4. Category 2. Example 4: Assume the same facts as in Example 3, where the taxable income before the deduction for a single filer is $250,000, $200,000 is QBI from a Schedule C retail business (not a specified service business) and wages paid to employees in the trade or business are $90,000. The taxpayer s 199A deduction is the lesser of: 1) 20% of QBI of $200,000 or $40,000, or 2) The wage limit which is 50% of the W-2 wages paid of $90,000 or $45,000. In this situation, the taxpayer s 199A deduction is $40,000 and her taxable income after the deduction is $210,000 ($250,000 $40,000). SP&LPROB

267 Section 199A Deduction How to Make the Calculation Under 199A: 5. Category 3. Taxpayer has taxable income greater than the threshold amounts ($315,000 for joint returns and $157,500 for other returns), but less than the end of the phaseout range ($415,000 for joint returns and $207,500 for other returns). a. For a SSB, T must reduce QBI pro rata, and also reduce allocable wages and unadjusted basis of property pro rata, to determine the deduction. b. For each qualified trade or business, the wage limit is phased in pro-rata if 20% of QBI is greater than the wage limit. This means that if the taxpayer s deduction for 20% of QBI is greater than the wage limit, the taxpayer s initial deduction is 20% of QBI and that amount must be reduced by a percentage of the difference, if any, of 20% QBI in excess of the wage limit. The percentage is the taxpayer s taxable income before the 199A deduction in excess of the threshold amount of $315,000 for joint returns ($157,500 for others) divided by $100,000 for joint returns (and $50,000 for others). SP&LPROB Section 199A Deduction How to Make the Calculation Under 199A: 5. Category 3. See Page c. If the business is a SSB and taxable income before the 199A deduction is greater than $157,500 for single filers ($315,000 for joint returns), but less than $207,500 for single filers ($415,000 for joint filers), the pro rata reduction in QBI, W-2 wages and unadjusted basis in qualified property is 100% minus taxable income before 199A deduction in excess of $157,500 ($315,000 for joint returns) divided by $50,000 for single filers ($100,000 for joint returns). The equation is: 1 xx & xx = the pro-rata % $50,000 $100,000 (for singles) (for marrieds) XX is equal to taxable income before the 199A deduction in excess of the threshold amount of $157,500 ($315,000 for joint returns). SP&LPROB

268 Section 199A Deduction How to Make the Calculation Under 199A: 5. Category 3. c. 1) For example, if taxable income before the 199A deduction for a single individual is $187,500 and the taxpayer is engaged in a SSB, the phaseout is (1 $30,000/$50,000) = 40%. Only 40% of QBI, 40% of W-2 wages and 40% unadjusted basis of qualified property is taken into account for the deduction under 199A. SP&LPROB Section 199A Deduction How to Make the Calculation Under 199A: 5. Category 3. See Pages & d. For all businesses (including SSBs) where the taxable income before the 199A deduction is more than $157,500 ($315,000 for joint filers) and less than $207,500 ($415,000 for joint filers), the deduction is 20% of QBI. 1) But there is a reduction in the 199A deduction of 20% QBI if 20% of QBI is greater than the wage limit. 2) This means that if taxable income before the 199A deduction is greater than $157,500 and less than or equal to $207,500 ($315,000 to $415,000 for joint returns) and the amount determined under the wage limit is less than 20% of QBI, then the 20% deduction for QBI must be reduced by the excess of 20% QBI less the wage limit multiplied by the percentage of taxable income in excess of $157,500 ($315,000 for joint returns) divided by $50,000 ($100,000 for joint returns). SP&LPROB

269 Section 199A Deduction How to Make the Calculation Under 199A: 5. Category 3. d. 3) For example, if the taxpayer is single, has taxable income before the 199A deduction of $187,500, 20% of QBI of $200,000 is $40,000 and 50% of W-2 wages is $30,000, the taxpayer s 199A deduction is 20% of QBI of $200,000 or $40,000. Since 20% of QBI or $40,000 is greater than the wage limit of $30,000, the $40,000 deduction must be reduced by a percentage of taxable income before the 199A deduction of $187,500 in excess of the threshold amount of $157,000 or $30,000 ($187,500 $157,500) divided by $50,000 which is 60% (30,000/50,000). The 60% is then multiplied by the difference between the $40,000 deduction and the wage limit of $30,000 or $10,000. Therefore, 60% times the difference of $10,000 ($40,000 $30,000) is $6,000 and the taxpayer s 199A deduction of 20% of QBI or $40,000 is reduced by $6,000. The taxpayer s 199A deduction, therefore, is $34,000 ($40,000 $6,000) and the taxpayer s taxable income is $153,500 ($187,500 $34,000). SP&LPROB Section 199A Deduction How to Make the Calculation Under 199A: 5. Category 3. d. 4) If in the above example, 50% of the W-2 wages is $50,000 and 20% QBI is $40,000, the taxpayer s deduction under 199A would be $40,000. Since 20% of QBI or $40,000 is not greater than the wage limitit of $50,000, 000 the 20% dd deduction is not required to be reduced. The taxpayer s taxable income after the deduction is $147,500 ($187,500 $40,000). SP&LPROB

270 Section 199A Deduction How to Make the Calculation Under 199A: 5. Category 3. Example 5: T, a single person, has taxable income of $187,500, of which $150,000 is QBI attributable to his Schedule C accounting T/B. Wages paid to employees of the T/B are $100,000. T has an applicable percentage of 40% [100% minus 60% ($30,000 excess TI over T s $157,500 threshold amount / $50,000 phaseout range = 60%)]. T s allowable QBI is $60, ($150, X 40%). Wages for the wagelimit it are $40,000 ($100,000 X 40%). T s deduction for QBI is $12,000 (20% X $60,000 QBI). Therefore, T s deduction is $12,000. (Note: The modification for taxable income between $157,500 to $207,500 does not apply since 20% of QBI or $12,000 is not greater than 50% of the reduced W-2 wage limit of $20,000.) SP&LPROB Section 199A Deduction How to Make the Calculation Under 199A: 5. Category 3. Example 6: Same facts as Example 5, T is a single person, has taxable income of $187,500, QBI of $150,000 which is attributable to his accounting business. T has paid no wages. T has an applicable percentage of 40% [100% minus 60% ($30,000 excess TI over T s $157,000 threshold amount / $50,000 phaseout range = 60%)]. T s allowable QBI is $60, ($150, X 40%). Since T s taxable income is $187,500, T is required to reduce the $12,000 deduction as the wage limit is phased in. The difference between 20% of QBI ($12,000) and 50% of W-2 wages ($0) is $12,000. This $12,000 amount is reduced by the percentage of TI in excess of $157,500 or $30,000 divided by $50,000, or 60% (60% X the difference of $12,000 is $7,200). The 20% of QBI of $12,000 must be reduced by $7,200 and the deduction is therefore $4,800. SP&LPROB

271 Section 199A Deduction How to Make the Calculation Under 199A: 5. Category 3. Example 7: T is single and owns and operates a Schedule C T/B that is not a specified service business. The T/B pays $100,000 in W-2 wages to employees and has $350,000 in QBI. Assume the T/B has no qualified property, and T has TI of $360,000. T s deduction for QBI is $50,000, which is the lesser of (1) $70,000 (20% X $350,000 QBI); or (2) $50,000 [the greater of (a) $50, (50% of W-2 wages), or(b) $25,000 (25% of W-2 wages plus 2.5% of qualified property of $0)]. Therefore, T s deduction is $50,000. (Note: The phaseout of the 20% deduction does not apply since T s taxable income is greater than $207,500, more than $50,000 plus $157,000 threshold.) SP&LPROB Section 199A Deduction Deduction for Qualified Business Income under 199. Think about a plumbing contractor with no employees whose QBI is $250,000. What tax effect if the contractor makes an S election for the Good business? How much would the contractor need to pay as compensation in order to generate a 199Adeduction if the contractor is single and his or her taxable income is $210,000 before the deduction. The equation is: [(Net business income before wages) x.2 /.7] = wages to be paid. SP&LPROB

272 Section 199A Deduction Deduction for Qualified Business Income under 199. This means that the shareholder should pay wages of about $71,250 to maximize the deduction under 199A if taxable income is in excess of the threshold amount of $157,500 ($315,000 for joint returns) by at least $50,000 (or $100,000 for joint returns) If taxable income is less than or equal to the threshold amount of $157,500 (or $315,000 for joint returns), then the age old problem of too little compensation will come into play. The technical answer is reasonable compensation. SP&LPROB A Issues Relating to QTB Assume that A & B lease a building to an S corporation (a tax partnership or C corporation). The S corporation is owned by A and B. What result if A and B lease the building to the S corporation: a. At a profit. b. At a loss (see Reg (d)(1)). What is the appropriate economic unit? See Reg A-4 for aggregation rules and Reg A- 1(b)(13) where rental rises to the level of a T/B where the business is commonly controlled. SP&LPROB

273 199A Issues Relating to QTB LLC S Co. (Mfrs Product) Land & Bldg (1120S/1065) Lease Bldg 50% 50% 50% 50% A B A B $300,000 $300,000 TorB 1. Lease building at profit of $150,000 Not passive income and not NII Reg (f)(6) and Reg (b)(2). What is QBI from a QTB? (See Reg A-1(b)(13).) 2. Lease building at loss of $80,000 Loss is passive Exception Reg (d)(1) (appropriate economic unit). What is QBI from a QTB? SP&LPROB A Issues Relating to QTB LLC Land & Bldg C Co. (Mfrs Product) Lease Bldg 50% 50% 50% 50% A B A B TorB 1. Lease building at profit of $150,000 Not passive income Reg (f)(6). What is QBI from a QTB? 2. Lease building at loss of $80,000 Loss is passive Exception Reg (d)(1) N/A. What is QBI from a QTB? SP&LPROB

274 Form 1065 (Yes) TZX is a calendar year partnership which is owned by A (a two-thirds interest with a $12,000 basis) and B (a one-third interest with a $6,000 basis). During the current year, TZX will have the following income and expenses: Business income 92,000 Tax-exempt interest 1,000 Dividend and interest 2,000 Salary expense 44,000 Depreciation 8,000 Property taxes 7,000 Supplies 1,000 Interest expense paid on a margin account maintained with the partnership s stock broker 6,000 Gain from thesaleof machinery 1245 gain 7, gain 12,000 STCG from the sale of AT&T stock 7,500 LTCG from the sale of Chrysler stock 15,000 LTCL from the sale of investment real estate (9,000) Meal & Entertainment Expenses 12,000 Recovery of a bad debt previously deducted 4,500 SP&LPROB Form (Yes) TZX is a calendar year partnership which is owned by A (a two-thirds interest with a $12,000 basis) and B (a one-third interest with a $6,000 basis). During the current year, TZX will have the following income and expenses: Page 1 Business income $92,000 Tax-exempt interest 1,000 Dividend and interest 2,000 Salary expense 44,000 Depreciation 8,000 Property taxes 7,000 Supplies 1,000 Meal & entertainment expenses 6,000 Interest expense paid on a margin account maintained with X Co. s stock broker 6,000 Gain from the sale of machinery: 1245 gain 7,000* 1231 gain 12,000 STCG from the sale of AT&T stock 7,500 LTCG from the sale of Chrysler stock 15,000 LTCL from the sale of investment real estate (9,000) Disallowed entertainment & meal expense 6,000 Recovery of a bad debt previously deducted 4,500 Sch. K * But see treatment for 179 deduction SP&LPROB

275 Form (Yes) TZX is a calendar year partnership which is owned by A (a two-thirds interest with a $12,000 basis) and B (a one-third interest with a $6,000 basis). During the current year, TZX will have the following income and expenses: Page 1 Sch. K Business income $92,000 Tax-exempt interest 1,000 Dividend and interest 2,000 Salary expense (44,000) Depreciation (8,000) Property taxes (7,000) Supplies (1,000) Meal & entertainment expenses (6,000) Interest expense paid on a margin account maintained with X Co. s stock broker 6,000 Gain from the sale of machinery: 1245 gain 7, gain 12,000 STCG from the sale of AT&T stock 7,500 LTCG from the sale of Chrysler stock 15,000 LTCL from the sale of investment real estate (9,000) Disallowed entertainment & meal expense 6,000 Recovery of a bad debt previously deducted 4,500 SE Income 30,500 SP&LPROB Form 1065 (Yes) Whose accounting method will control the timing of income and deduction? If TZX sells property for an installment obligation, who makes the election under 453 to report the entire gain in the year of sale? Would it matter if the machinery would have been property described in 1221(1) (i.e., inventory), if held by A? How much of the income allocated to each partner is self-employment income? Would it make a difference if B were a limited partner or A and B were members of an LLC? (See Prop. Reg (a)-2(g) 1402(a) 2(g) & Prop. Reg ). If the partnership is engaged in an activity that qualifies for the 199A deduction, what is the partnership s QBI, W-2 wages & adjusted basis of qualified property? SP&LPROB

276 Form 1065 (Yes) How much of the income might be subject to the 3.8% Medicare Tax under 1411? For the 199A deduction, what is each partner s share of: QBI? W-2 wages? Unadjusted basis of qualified property? SP&LPROB

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