Proportionate v. Disproportionate Distributions

Distributions In General Current Distributions Liquidating Distributions Money 15-4 Property 15-5 Example 15-1 15-5 Proportionate v. Disproportionate Distributions 4

Example 15-1 Partnership Assets Ptr. A Ptr. B Cash $100,000 100,000 Accts. Rec. $0 100,000 Inventory $40,000 100,000 Land $60,000 $100,000 Totals $200,000 $400,000 15-5 Sell all Assets and Distribute Cash 5 Ordinary Income* Capital Gain** Jack $80,000 $20,000 Jill $80,000 $20,000 * $160,000 2 = $80,000 ** $40,000 2 = $20,000 6 Liquidating Distribution Jack Jill Beg. O. B. 100,000 100,000 Income and Gain 100,000 100,000 Money Distrib. -200,000-200,000 Remaining O.B. $0 $0 Sec. 731(a) Gain $0 $0 Example 15-2 Jack and Jill Liquidate JJ 15-6 7 8

Example 15-2 Jack and Jill Liquidate JJ 15-6 Partnership Assets Tax Basis FMV Cash To Jack $100,000 100,000 Accts. Rec. To Jack $0 100,000 Inventory To Jill $40,000 100,000 Land To Jill $60,000 $100,000 Totals $200,000 $400,000 9 Proportionate Liquidating Distribution Jack Jill Beg. O. B. 100,000 Money -100,000 Accts. Rec. 0 Inventory Land Ending O.B. 0 10 Proportionate Liquidating Distribution Jack Jill Beg. O. B. 100,000 100,000 Money -100,000 Accts. Rec. 0 Inventory -40,000 Land -60,000 Ending O.B. 0 0 11 Subsequent Sales of Distributed Assets Ordinary Income Capital Gain Jack $100,000 0 Jill $60,000 $40,000 12

Proportionate Current Distributions Proportionate Current Distributions Gain if money distributed exceeds outside basis. Marketable securities are money 15-7 No loss recognition 15-7 The distributee partner s basis in property received is generally the php s inside basis in that property. 15-8 Example 15-3 Distribution of Money 15-7 16

Example 15-3 Distribution of Money 15-7 Ptr. A Ptr. B Pre-Distribution 2,000 2,000 Outside Basis Money Distributed -1,500-1,500 End. Outside Basis 500 500 15-8 Disguised Sales And Mixing Bowl Transactions 17 Proportionate Distributions of Money (and marketable securities) 15-8 Example 15-4 Gain on Distribution of Money 15-9 20

Example 15-5 15-9 Debt Share Changes Distribution of Marketable Security A net increase in a partner s debt share is a deemed contribution of money. 21 A net decrease in debt share is a deemed distribution of money. Example 15-6 15-6 Example 15-6 15-6 Mary (50% Ptr.) receives $7,500 FMV Property Z (inside basis $4,000). Mary assumes the debt on Prop. Z of $5,000 Net debt increase to Mary of $2,500 Net debt decrease to Larry of $2,500.

Impact on Mary Mary Larry Beg. Outside Basis 2,000 2,000 Debt Change +2,500 Impact on Mary Mary Larry Beg. Outside Basis 2,000 2,000 Debt Change +2,500 Property Dist. -$4,000 Remaining O.B. $500 Sec. 731(a) Gain $0 25 26 Impact on Larry (a stealth distribution) Mary Larry Beg. Outside Basis 2,000 2,000 Debt Change +2,500-2,500 Property Dist. -$4,000 Remaining O.B. $500 $0 Sec. 731(a) Gain $0? 27 Impact on Larry (a stealth distribution) Mary Larry Beg. Outside Basis 2,000 2,000 Debt Change +2,500-2,500 Property Dist. -$4,000 Remaining O.B. $500 $0 Sec. 731(a) Gain $0 500 28

Partnership Level Gain or Loss? None (Absent IRC sec. 751) 15-11 Basis of Distributed Property 15-11 General Rule Distributed Property The basis of property distributed by the partnership to a partner is the partnership s inside basis immediately before the distribution; Exception If I.B. > O.B. the distributee s partner s basis in the distributed property is limited to outside basis reduced by any money received in the same transaction.

Allocation/ Ordering Rules Allocation/Ordering Rules Reduce outside basis by: 1) Money, including relief of liabilities, and the fair market value of marketable securities. 2) Sec. 751 assets hot assets, and 3) Other assets (cold assets). See IRC sec. 732(c) Example 15-7 Distribution of $90,000 Money and Land with I.B. of $60,000 Ptr. B Beg. Outside Basis 100,000 Money Distributed -90,000 Example 15-7 Distribution of $90,000 Money and Land with I.B. of $60,000 Ptr. B Beg. Outside Basis 100,000 Money Distributed -90,000 Land -10,000 Ending Outside Basis $0 15-10 35 B s basis in the land is $10,000 36

Example 15-8 Distribution of $101,000 Money and Land with I.B. of $60,000 Ptr. B Beg. Outside Basis 100,000 Money Distributed -101,000 Gain $1,000 Example 15-8 B s basis in the land is Zero 15-10 37 38 15-12 Decrease in Distributee Basis with Multiple Assets in the same class 15-12 First, the decrease is allocated among properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation Next in proportion to their respective adjusted bases. See Examples 15-9 and 15-10

Character and Holding Period of Distributed Property 15-13 15-16 Section 754 Election See Examples 15-11 and 15-12 15-16 Two Sec. 734 Upward Adjustment Triggers 1) If distributee recognizes Sec. 731(a) gain. 15-16 2) If partnership inside basis of distributed property exceeds the distributee s basis in the property. Sec. 734

Example 15-13 Distribution of Money 15-17 Ptr. A Ptr. B Beg. Outside Basis 2,000 2,000 Money Distributed -2,500-2,500 Sec. 731(a) Gain 500 500 With a Sec. 754 Election, the partnership s capital gain property basis is increased by $1,000 ($500 + $500). 45 Example 15-14 Distribution of $90,000 Money and Land with I.B. of $60,000 Ptr. B Beg. Outside Basis 100,000 Money Distributed -90,000 46 Example 15-14 Distribution of $90,000 Money and Land with I.B. of $60,000 Ptr. B Beg. Outside Basis 100,000 Money Distributed -90,000 Land -10,000 Ending Outside Basis $0 B s basis in the land is $10,000 47 Example 15-14 The inside basis of partnership capital gain property is increased by $50,000. ($60,000 - $10,000) 48

If the partnership has no capital gain property, then the Sec. 734 adjustment is carried over until capital gain property is acquired. 49 Example 15-14 Variation If the distributed property were inventory (same basis and value), then the inside basis of partnership ordinary income assets is increased by $50,000 ($60,000 - $10,000). 50 Increases in Basis of Depreciable Property Increased portion is treated as newly-purchased recovery property placed in service when the distribution occurs. 51 Reporting IRC sec. 734 Adjustments to the IRS. 15-18 52

Attach a statement to the partnership return for the year of the distribution setting forth the computation of the adjustment and the partnership properties to which the adjustment has been allocated 53 IRC sec. 732(d) Election by Distributee Partner 15-19 54 Available when a transferee partner receives a distribution of property (other than money) from the partnership within 2 years after the partnership interest is acquired--by purchase or inheritance. 55 Example 15-15 15-19 When Partner T purchased T s 25% partnership interest, if a Sec. 754 election were in effect, T would have been entitled to an upward Sec. 743(b) adjustment of $500 for Property Z (common I.B. $14,000; FMV $16,000). 56

Example 15-15 Property Z is distributed to T within 2 years of T s purchase. $14,000 common partnership + $500 Sec. 732(d) Adj. $14,500 T s Inside Basis in Z. 57 15-21 The partnership must provide the transferee with such information as is necessary for the transferee properly to compute the transferee's basis adjustments under Sec. 732(d). Reg. Sec. 1.732-1(d)(4) 58 15-25 Proportionate Liquidating Distributions Generally similar to current distributions.

Unlike current distributions, losses can be recognized in certain proportionate liquidating Losses may be recognized when the partner receives assets consisting of one or more of the following (and no other assets): 1) money, 2) unrealized receivables, or 3) Inventory distributions. 61 62 The recognized loss= The distributee s outside basis in excess of the basis of the distributed property. Example 15-16 Liquidating Distribution of Money 15-26 Ptr. Linda Beg. Outside Basis $100,000 Money Distributed $90,000 Sec. 731(a)(2) Cap. Loss? 63 64

Example 15-16 Liquidating Distribution of Money Example 15-17 Liquidating Distribution 15-26 Ptr. Linda Beg. Outside Basis $100,000 Money Distributed $90,000 Sec. 731(a)(2) Cap. Loss $10,000 Ptr. Linda Beg. Outside Basis $100,000 Money Distributed $20,000 Inventory (I.B. $70,000) $70,000 Sec. 731(a)(2) Cap. Loss? 65 66 Example 15-17 Liquidating Distribution Ptr. Linda Beg. Outside Basis $100,000 Money Distributed $20,000 Inventory (I.B. $70,000) $70,000 Sec. 731(a)(2) Cap. Loss $10,000 Loss not on K-1 67 Unlike current distributions, with a liquidating distribution that includes other cold assets (capital assets or Sec. 1231 property), excess outside basis is assigned to the cold assets. 68

If a Example 15-18 Current Distribution Ptr. Linda 15-26 Beg. Outside Basis $100,000 Money Distributed $20,000 Inventory (I.B. $70,000) $70,000 Land (I.B. $400; FMV $1K) $400 Example 15-18 Liquidating Distribution Ptr. Linda Beg. Outside Basis $100,000 Money Distributed $20,000 Inventory (I.B. $70,000) $70,000 Land (I.B. $400; FMV $1k)? Remaining O.B. $9,600 69 Remaining O.B.? 70 Example 15-18 Liquidating Distribution Ptr. Linda Beg. Outside Basis $100,000 Money Distributed $20,000 Inventory (I.B. $70,000) $70,000 Land (I.B. $400; FMV $1k) $10,000 Example 15-19 Linda Uses the Vehicle for Personal Use Ptr. Linda Beg. Outside Basis $100,000 Money Distributed $20,000 Inventory (I.B. $70,000) $70,000 Auto (I.B. $400; FMV $1k) $10,000 Remaining O.B. $0 71 Remaining O.B. $0 72

Example 15-20 15-27 Detailed Review Example of Proportionate Liquidation AB Partnership has two partners, A and B, who share capital and profits equally. A and B decide to liquidate. Is the distribution proportionate? 73 A is distributed: All of the land worth $400,000, ½ of the U/R, and ½ of the inventory B is distributed: All of the cash of $400,000 ½ of the U/R, and ½ of the inventory 15-29 Basis Increases To Distributed Multiple Cold Assets (unique to liquidations)

15-29 First, the increase is allocated among cold assets with unrealized appreciation in proportion to their respective amounts of unrealized appreciation Next in proportion to their respective fair market values (FMV). See Example 15-21 15-30 Ordinary Loss on Abandonment of a Partnership Interest 15-31 Section 754 Election with Liquidating Distribution Same Two Sec. 734 Upward Adjustments as Current Distributions

Two Sec. 734 Upward Adjustment Triggers 1) If distributee recognizes Sec. 731(a) gain. 15-31 2) If partnership inside basis of distributed property exceeds the distributee s basis in the property. Sec. 734 Example 15-22 15-32 Liquidating Distribution Ptr. Linda Beg. Outside Basis $100,000 Money Distributed $20,000 Inventory (I.B. $70,000) $70,000 Sec. 731(a)(2) Cap. Loss $10,000 Two Sec. 734 Downward Adjustment Triggers 1) If distributee recognizes Sec. 731(a) loss. 15-32 2) If the distributee partner s basis in the property (cold assets) exceeds the partnership s inside basis of distributed property. S 734 Example 15-23 Liquidating Distribution 15-33 Ptr. Linda Beg. Outside Basis $100,000 Money Distributed $20,000 Inventory (I.B. $70,000) $70,000 Land (I.B. $400; FMV $1k) $10,000 With a Sec. 754 Election, the partnership s capital gain prop. basis is reduced by $10,000. 83 Remaining O.B. $0 84

Example 15-23 With a Sec. 754 election, the partnership s capital gain property basis is reduced by $9,600. Decreases in Basis of Depreciable Property Decreased portion must be accounted for over the remaining recovery period of the property. 85 86 Mandatory Sec. 734(b) Adjustments if a Substantial Basis Reduction (2004 Act) 15-33 Substantial Basis Reduction A downward adjustment of more than $250,000 that would be made to the basis of partnership assets if a Sec. 754 election were in effect. 88

15-33 Notice 2005-32 Partnership Reporting Obligation (Notice 2005-32) comply with the reporting requirements of Reg. Sec. 1.734-1(d) as if an election under Sec. 754 were in effect 89 90 Example 15-24 15-34 Example 15-24 Mandatory Downward Adjustment 91 92

Tax Basis FMV Outside Assets: January 2011 In Millions Basis Cash $0 Blackacre $3.0 Whiteacre $7.0 Total Assets $10.0 Liabilities: $0 Capital: A $2.5 $2.5 B $2.5 $2.5 C $5.0 $5.0 Debt + Equity $10.0 93 Tax Basis FMV Outside Assets: January 2011 In Millions Basis Cash $0 $0 Blackacre $3.0 $1.0 Whiteacre $7.0 $1.0 Total Assets $10.0 $2.0 Liabilities: $0 $0 Capital: A $2.5 $.5 $2.5 B $2.5 $.5 $2.5 C $5.0 $1.0 $5.0 Debt + Equity $10.0 $2.0 94 Example 15-24 Blackacre (I.B. = $3 mil.) is distributed to C in liquidation of C s Interest. C s basis in Blackacre is $5 million (C s O.B.) Mandatory Sec. 734 Adj. = <$2 million> ($5 - $3) to Whiteacre. 95 Example 15-24 Variation If Blackacre is land held for sale (inventory), then C would claim a Sec. 731(a) capital loss of $2 million. Mandatory $2 million downward Sec. 734 adjustment to Partnership capital gain property. 96

Example 15-25 Example 15-25 15-34 Mandatory Downward Adjustment 97 98 Tax Basis FMV Outside Assets: January 2011 In Millions Basis Cash $2.0 Blackacre $4.0 Whiteacre $4.0 Total Assets $10.0 Liabilities: $0 Capital: A $2.5 $2.5 B $2.5 $2.5 C $5.0 $5.0 Debt + Equity $10.0 99 Tax Basis FMV Outside Assets: January 2011 In Millions Basis Cash $2.0 $2.0 Blackacre $4.0 $1.0 Whiteacre $4.0 $1.0 Total Assets $10.0 $4.0 Liabilities: $0 $0 Capital: A $2.5 $1.0 $2.5 B $2.5 $1.0 $2.5 C $5.0 $2.0 $5.0 Debt + Equity $10.0 $4.0 100

Example 15-25 $2 million cash is distributed to C in liquidation of C s Interest. C recognizes a $3 million capital loss. Mandatory Sec. 734 Adj. = <$3 million> allocated 50/50 to Blackacre and Whiteacre 101 Sec. 732(d) Election With Proportionate Liquidating Distributions See Example 15-26 15-35

Liquidating Payments That Trigger Section 736(a) Sec. 736 Liquidating Payments 15-40 Sec. 736 divides all such liquidating payments into two categories: 1) Payments in exchange for the FMV of php. property--sec. 736(b). 2) Payments in excess of FMV of php. property--sec. 736(a). Distributive Share Guaranteed Payment 2 Special Rule for Service Phps. 15-41 3 Amounts paid for Unstated Goodwill, and Unrealized Receivables are treated as NOT made in exchange for an interest in partnership property 15-41 4

Example 15-27 Service Partnership 15-42 15-42 ABC Partnership ABC Partnership January 1, 2005 Partner's Basis FMV Outside Cash $ 26,000 $ 26,000 Basis Accounts Receivable $ - $ 26,000 Total Assets $ 26,000 $ 52,000 Agnes (50%) $ 13,000 $ 26,000 $ 13,000 Bob (25%) $ 6,500 $ 13,000 $ 6,500 Cao (25%) $ 6,500 $ 13,000 $ 6,500 Total Equity $ 26,000 $ 52,000 Distibute $26,000 cash to Agnes in liquidation 5 6 Example 15-28 Service Partnership 15-42 15-43 ABC Partnership ABC Partnership January 1, 2005 Partner's Basis FMV Outside Cash $ 26,000 $ 26,000 Basis Accounts Receivable $ - $ 26,000 Total Assets $ 26,000 $ 52,000 Agnes (50%) $ 13,000 $ 26,000 $ 13,000 Bob (25%) $ 6,500 $ 13,000 $ 6,500 Cao (25%) $ 6,500 $ 13,000 $ 6,500 Total Equity $ 26,000 $ 52,000 Bob is liquidated for $20,000 cash. 7 8

Tax Consequences to Bob: $13,500 ordinary income per IRC sec. 736(a) (for the U/R) Continuing Partners: Deduction of $13,500 as a guaranteed payment 9 Perspective of Continuing Partners in a Service Partnership. Sec. 736(a) payments are desirable so unstated goodwill and unrealized receivables are desirable 10 Perspective of Retired Partner (or Successor of Deceased Partner) Sec. 736(a) payments are undesirable so unstated goodwill and unrealized receivables are undesirable Example 15-29 Service Partnership Bob is liquidated for $20,000 cash but Bob s share of goodwill is stated at $7,000. 15-43 11 12

ABC Prof. Service Partnership Basis FMV Cash $26,000 $26,000 Accounts Rec. $0 $26,000 Stated Goodwill $0 $28,000 Total Assets $26,000 $80,000 Partner s Outside Basis Agnes (50%) $13,000 $40,000 $13,000 Bob (25%) $ 6,500 $20,000 $ 6,500 Cao (25%) $ 6.500 $20,000 $ 6,500 Total Debt + $26,000 $80,000 Capital 13 14 Summary of Tax Consequences to Bob: $6,500 ordinary income per IRC sec. 736(a) (for the U/R) $7,000 of capital gain per IRC sec. 731(a). 15 16

15-44 17 Distribution versus Sale and Buy/Sell Language 15-44 18 Self-Employment Tax Exception for Payments--for Life--to Retired Partners. See PLR 200403056 15-45 19 Allocation of Installment Payments Between Sec. 736(a) and (b). 15-46 20

The Sec. 736 regulations were last updated in 1965 and thus do not include the 1993 Act changes which limit the applicability of Sec 736(b)(2) to service partnerships. Example 15-31 15-48 Partner A (service partner) retires. Partner A receives payments totaling $30,000: $ 9,000 Year 1 (+ $1,000 of debt relief) $10,000 Year 2 $10,000 Year 3 No stated goodwill 22 Tax Basis FMV Outside Assets: Basis Cash $13,000 $13,000 Unrealized Rec. $0 $30,000 Cap. & 1231 $20,000 $23,000 Total Assets $33,000 $66,000 Liabilities: $3,000 $3,000 Capital: A $10,000 $21,000 $11,000 B $10,000 $21,000 $11,000 C $10,000 $21,000 $11,000 Debt + Equity $33,000 $66,000 23 Hypothetical If all $30,000 were paid in Year 1: (40%) (60%) 12,000 736(b) Pyt for Property (A s Cap. Gain = $1,000) 18,000 736(a)(2) Guaranteed Pyt (ordinary income) 24

Unless Agreed Otherwise Unless Agreed Otherwise 736(b) 736(a)(2) 736(b) 736(a)(2) Yr Pyt. Tax Free 731 Guart. O.B. Gain Pyt. 1 $10,000 4,000 0 6,000 Yr Pyt. Tax Free O.B. 731 Gain Guart. Pyt. 1 $10,000 4,000 0 6,000 2 $10,000 4,000 0 6,000 25 26 Unless Agreed Otherwise Ptr A Option 736(b) 736(a)(2) 736(b) 736(a)(2) Yr Pyt. Tax Free O.B. 731 Gain Guart. Pyt. 1 $10,000 4,000 0 6,000 2 $10,000 4,000 0 6,000 3 $10,000 3,000 1,000 6,000 How reported on Form 1065 K-1? 27 Yr Pyt. Tax Free O.B. 731 Gain Guart. Pyt. 1 $10,000 3,667 333 6,000 2 $10,000 3,667 333 6,000 3 $10,000 3,667 333 6,000 28

Example 15-32 15-49 Unless Agreed Otherwise Same as Example 15-31 except the agreement provides for payments equal to a percentage of annual income. 29 736(b) 736(a)(1) Yr Pyt. Tax Free 731 Dist. O.B. Gain Share 1 $10,000 10,000 0 0 30 Unless Agreed Otherwise Unless Agreed Otherwise 736(b) 736(a)(1) 736(b) 736(a)(1) Yr Pyt. Tax Free O.B. 731 Gain Dist. Share 1 $10,000 10,000 0 0 2 $10,000 1,000 1,000 8,000 31 Yr Pyt. Tax Free O.B. 731 Gain Dist. Share 1 $10,000 10,000 0 0 2 $10,000 1,000 1,000 8,000 3 $10,000 0 0 10,000 How reported on Form 1065 K-1? 32

Example 15-33 Same as Example 15-31 except the partnership has stated goodwill of $9,000 (A s share = $3,000) 15-49 33 Tax Basis FMV Outside Assets: Basis Cash $13,000 $13,000 Unrealized Rec. $0 $30,000 Cap. & 1231 $20,000 $23,000 St. Goodwill $0 $9,000 Total Assets $33,000 $75,000 Liabilities: $3,000 $3,000 Capital: A $10,000 $24,000 $11,000 B $10,000 $24,000 $11,000 C $10,000 $24,000 $11,000 Debt + Equity $33,000 $75,000 34 If all $30,000 were paid in Year 1: (50%) (50%) 15,000 736(b) Pyt for Property (A s Gain = $4,000) 15,000 736(a)(2) Guaranteed Pyt (ordinary income) Unless Agreed Otherwise 736(b) 736(a)(2) Yr Pyt. Tax Free 731 Guart. O.B. Gain Pyt. 1 $10,000 5,000 0 5,000 35 36

Unless Agreed Otherwise Unless Agreed Otherwise 736(b) 736(a)(2) 736(b) 736(a)(2) Yr Pyt. Tax Free O.B. 731 Gain Guart. Pyt. 1 $10,000 5,000 0 5,000 2 $10,000 5,000 0 5,000 Yr Pyt. Tax Free O.B. 731 Gain Guart. Pyt. 1 $10,000 5,000 0 5,000 2 $10,000 5,000 0 5,000 3 $10,000 1,000 4,000 5,000 37 38