Chapter 16 Distributions Treated As Section 751(b) Exchanges Receipt of Excess Cold Assets 1)If Excess Cold Assets Are Distributed: then the partnership is treated as if it made a hypothetical distribution of the partner's proportionate share of Hot assets followed by a fictional sale of these Hot assets by the partner back to the partnership at fair market value in exchange for the excess Cold assets actually received in the distribution. 2 Receipt of Excess Hot Assets 2) If Excess Hot Assets Are Distributed: then the partnership is treated as if it made a hypothetical distribution of the partner's proportionate share of Cold assets followed by a fictional sale of these Cold assets by the partner back to the partnership at fair market value in exchange for the excess Hot assets actually received in the distribution. 3 Example 16-1 16-3 4
Example 16-1 Jack and Jill Liquidate JJ Partnership Assets Tax Basis FMV Cash To Jack $100,000 100,000 Accts. Rec. To Jill $0 100,000 Inventory To Jill $40,000 100,000 Land To Jack $60,000 $100,000 Totals $200,000 $400,000 5 Example 16-1 6 Four Steps Step One: Determine the Deemed Distribution a current distribution. Step Two: The Deemed Exchange by the Distributee Partner 7 Step Three: The Deemed Exchange by the Partnership Step Four: The Remaining Proportionate Distribution (current or liquidating). 8
Example 16-2 16-5 Example 16-2 16-5 9 10 Example 16-2 16-6 Example 16-2 16-6 11 12
Example 16-3 Not a Service Partnership 16-6 ABC Partnership ABC Partnership January 1, 2005 Partner's 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 Four Steps Illustrated 13 Example 16-3 $26,000 Cash to Agnes Not a Service Php. So No IRC sec. 736(a) Pyt. 14 Example 16-4 Not a Service Php All A/R to Agnes Even if a Service Php. IRC sec. 736(a) is not triggered. 16-7 15 Example 16-5 16-9 Partner X is liquidated for $25,000 cash 16
Example 16-5 Basis Value Cash $25,000 $25,000 Inventory 15,000 25,000 Land 8,000 25,000 TOTAL $48,000 $75,000 Capital Accounts Partner X $16,000 $25,000 Partner Y 16,000 25,000 Partner Z 16,000 25,000 TOTAL $48,000 $75,000 17 FMV of Partnership Assets Example 16-5 1 2 3 4 5 6 X s Interest X s Interest Actual Before After Distribution Distribution Distribution Fictional Proportionate Distribution 2 3 = 4 Difference 5 4 = 6 Hot Assets: Inventory $25,000 $8,333 $0 $8,333 $0 ($8,333) Cold Assets: Cash $25,000 $8,333 $0 $8,333 $25,000 $16,667 Land $25,000 $8,333 $0 $8,333 $0 ($8,333) Net $8,333 18 Summary of Tax Consequences to Partner X: Ordinary income of $3,333 on the deemed exchange. Capital gain of $5,667 on the proportionate distribution of money. 19 Tax Consequences to Partnership/Continuing Partners: The partnership increases its inside basis in the inventory by $3,333. If a Sec. 754 election were in effect, then the Partnership would increase the inside basis in the Land by $5,667 Partner X s Sec. 731(a)(1) gain. 20
Distributee Partner Reporting Reporting Section 751(b) Exchanges The distributee partner shall submit with the partner s return a statement showing the computation of any income, gain, or loss to the partner. 16-12 Partnership Reporting A partnership which distributes [disproportionately] shall submit with its return for the year of the distribution a statement showing the computation of any income, gain, or loss to the partnership under the provisions of section 751(b). 16-12
Example 16-8 (Reg. 1.751-1(g) Example (5) Modified) Partnership ABC makes a distribution to partner C which reduces C s interest in capital and profits from one-third to onefifth. The current distribution consists of: $5,000 in cash, and $7,500 of accounts receivable (basis $7,500). The partnership uses the accrual method of accounting. 1 Before Distribution to C ABC Partnership Partner's Cash $ 15,000 $ 15,000 Basis Accounts Receivable $ 9,000 $ 9,000 Inventory $ 21,000 $ 30,000 Land Parcel #1 $ 42,000 $ 48,000 Land Parcel #2 $ 9,000 $ 9,000 Total Assets $ 96,000 $ 111,000 Current Liabilities $ 15,000 $ 15,000 Mortage Payable $ 21,000 $ 21,000 Total Debt $ 36,000 $ 36,000 A (1/3) $ 20,000 $ 25,000 $ 32,000 B (1/3) $ 20,000 $ 25,000 $ 32,000 C (1/3) $ 20,000 $ 25,000 $ 32,000 Total Debt and Equity $ 96,000 $ 111,000 2 After the distribution, C's share of the partnership liabilities is reduced by $4,800 from $12,000 (1/3 of $36,000) to $7,200 (1/5 of $36,000). 3 Presence of section 751 property. The partnership has no unrealized receivables; however, both the inventory and accounts receivables are Section 751 inventory items. The inventory items of the partnership, in the aggregate, have appreciated substantially in value. (Sec. 751(d)(1)) The fair market value of all partnership inventory items, $39,000 (inventory $30,000, and accounts receivable $9,000), exceeds 120 percent of the $30,000 adjusted basis of such items to the partnership. 4
Four General Steps in a Section 751 Exchange 1) Step One: Identify the fictional current distribution, if any. 2) Step Two: Calculate the tax impact of the fictional exchange on the distributee partner. 3) Step Three: Calculate the tax impact of the fictional exchange on the partnership. 4) Step Four: Calculate the tax impact of the remaining actual proportionate distribution to the distributee partner (current or liquidating). Exchange Table 1 2 3 4 5 Beginning C's Interest C's Interest Fictional Actual Difference Partnership Before After Proportionate Distribution 5 = 4-3 Assets at Distribution Distribution Distribution FMV 33% 20% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 9,000 $ 3,000 $ 300 $ 2,700 $ 7,500 $ 4,800 Inventory $ 30,000 $ 10,000 $ 6,000 $ 4,000 $ - $ (4,000) Total $ 39,000 $ 13,000 $ 6,300 $ - $ 800 Non-751 Asts. Cash $ 15,000 $ 5,000 $ 2,000 $ 3,000 $ 9,800 $ 6,800 Parcel #1 $ 48,000 $ 16,000 $ 9,600 $ 6,400 $ - $ (6,400) Parcel #2 $ 9,000 $ 3,000 $ 1,800 $ 1,200 $ - $ (1,200) Total $ 72,000 $ 19,000 $ 13,400 $ (800) 5 6 Debt Relief is Treated Like a Cash Distribution In Column 4, the distribution of cash includes C s $4,800 reduction of debt. (Sec. 752) Total money Distributed = $9,800 (Actual cash of $5,000 + debt relief of $4,800.) Step One: Identify the fictional current distribution. Column 5 shows that C received $800 of excess 751 assets accounts receivable. Therefore, the fictional distribution involves a distribution of $800 of cold assets. The partners can agree which cold assets (worth $800) are fictionally distributed to the partner. Here the partnership agrees that the cold asset fictionally distributed is Parcel #1 worth $800: 7 8
Exchange Table 1 2 3 4 5 Beginning C's Interest C's Interest Fictional Actual Difference Partnership Before After Proportionate Distribution 5 = 4-3 Assets at Distribution Distribution Distribution FMV 33% 20% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 9,000 $ 3,000 $ 300 $ 2,700 $ 7,500 $ 4,800 Inventory $ 30,000 $ 10,000 $ 6,000 $ 4,000 $ - $ (4,000) Total $ 39,000 $ 13,000 $ 6,300 $ - $ 800 Non-751 Asts. Cash $ 15,000 $ 5,000 $ 2,000 $ 3,000 $ 9,800 $ 6,800 Parcel #1 $ 48,000 $ 16,000 $ 9,600 $ 6,400 $ - $ (6,400) Parcel #2 $ 9,000 $ 3,000 $ 1,800 $ 1,200 $ - $ (1,200) Total $ 72,000 $ 19,000 $ 13,400 $ (800) Step One: Parcel #1, by agreement, worth $800 is fictionally distributed: Inside Basis FMV Parcel #1 $700 * $800 * (42,000 48,000 X 800 = 700) 9 10 Step One: C s outside basis is reduced by $700 in the fictional distribution from $32,000 to $31,300*. *($32,000 700 = $31,300) Step Two: Calculate the tax impact of the fictional exchange on the distributee partner C recognizes $100 on his fictional exchange of $800 value ($700 basis) of parcel #1 in exchange for the $800 of accounts receivable (800 700). C s basis in the $800 of purchased A/R is $800 (cost). 11 12
Step Three: Calculate the tax impact of the fictional exchange on the partnership No gain to the partnership because it is treated as receiving $800 value of parcel #1 in exchange for accounts receivable with an $800 basis (value = basis for the A/R). The partnership s basis in Parcel #1 increases to $800 (up $100). 13 Step Four: Calculate the tax impact of the remaining actual proportionate distribution: Total Fictional Distribution - Purchase = Balance Cash $9,800 - = $9,800 Accts Rec 7,500-800 = $6,700 C s Beginning outside basis: $32,000 Fictional Distribution of Parcel #1 <700> Cash Distribution <$9,800> Accounts Rec. (value = basis) < 6,700> Ending Outside basis 14,800 14 Example: Balance Sheet Before Distribution Before Distribution to C ABC Partnership Partner's Cash $ 15,000 $ 15,000 Basis Accounts Receivable $ 9,000 $ 9,000 Inventory $ 21,000 $ 30,000 Land Parcel #1 $ 42,000 $ 48,000 Land Parcel #2 $ 9,000 $ 9,000 Total Assets $ 96,000 $ 111,000 Current Liabilities $ 15,000 $ 15,000 Mortage Payable $ 21,000 $ 21,000 Total Debt $ 36,000 $ 36,000 A (1/3) $ 20,000 $ 25,000 $ 32,000 B (1/3) $ 20,000 $ 25,000 $ 32,000 C (1/3) $ 20,000 $ 25,000 $ 32,000 Total Debt and Equity $ 96,000 $ 111,000 15 Tax Basis Partnership Accounting Entries Debit: Parcel #1 $100 C s Equity $12,400 Credit: Cash $5,000 Accounts Receivable $7,500 16
Example: Balance Sheet After Distribution After Distributions to C ABC Partnership Partner's Cash $ 10,000 $ 10,000 Basis Accounts Receivable $ 1,500 $ 1,500 Inventory $ 21,000 $ 30,000 Land Parcel #1 $ 42,100 $ 48,000 Land Parcel #2 $ 9,000 $ 9,000 Total Assets $ 83,600 $ 98,500 Current Liabilities $ 15,000 $ 15,000 Mortage Payable $ 21,000 $ 21,000 Total Debt $ 36,000 $ 36,000 A (40%) $ 20,000 $ 25,000 $ 34,400 B (40%) $ 20,000 $ 25,000 $ 34,400 C (20%) $ 7,600 $ 12,500 $ 14,800 Total Debt and Equity $ 83,600 $ 98,500 17 Example 16-9 Section 751(b) All Cash Liquidating Distribution 18 See balance sheet on next slide. Assume that Josey is liquidated for $400,000 cash. The partnership is not a professional service partnership. 19 Before Liquidation of Josey for $400,000 Cash MLSJ Partnership January 1, 2004 Partner's Cash $ 1,400,000 $ 1,400,000 Basis Accounts Receivable $ - $ 200,000 Total Assets $ 1,400,000 $ 1,600,000 Liabilities $ - Moe $ 350,000 $ 400,000 $ 350,000 Larry $ 350,000 $ 400,000 $ 350,000 Shirley $ 350,000 $ 400,000 $ 350,000 Josey $ 350,000 $ 400,000 $ 350,000 Total Debt and Equity $ 1,400,000 $ 1,600,000 20
Before Liquidation of Josey for $400,000 Cash MLSJ Partnership January 1, 2004 Partner's CashGain of $50,000 $ 1,400,000 $ 1,400,000 Basis Accounts Receivable $ - $ 200,000 Total Assets $ 1,400,000 $ 1,600,000 Liabilities $ - $400,000 cash - $350,000 O.B. Moe $ 350,000 $ 400,000 $ 350,000 Larry $ 350,000 $ 400,000 $ 350,000 Shirley $ 350,000 $ 400,000 $ 350,000 Josey= $50,000 $ 350,000 $ 400,000 $ 350,000 Total Debt and Equity $ 1,400,000 $ 1,600,000 The entire distribution falls under Code Sec. 736(b) because it represents Josey s interest in partnership property. The distribution is disproportionate so Code Sec. 751(b) applies. 21 22 1 2 3 4 5 Beginning J's Interest J's Interest Fictional Actual Difference Partnership Before After Proportionate Distribution 5 = 4-3 Assets at Distribution Distribution Distribution FMV 25% 0% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 200,000 $ 50,000 $ - $ 50,000 $ - $ (50,000) Non-751 Asts. Cash $ 1,400,000 $ 350,000 $ - $ 350,000 $ 400,000 $ 50,000 Note that the 751 Exchange is based upon FMV Reading the table: The positive $50,000 cash in column 5 indicates that Josey received excess cold assets (cash) in the distribution. 23 Steps One and Two 1 2 3 4 5 Beginning J's Interest J's Interest Fictional Actual Difference Partnership Before After Proportionate Distribution 5 = 4-3 Assets at Distribution Distribution Distribution FMV 25% 0% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 200,000 $ 50,000 $ - $ 50,000 $ - $ (50,000) Non-751 Asts. Cash $ 1,400,000 $ 350,000 $ - $ 350,000 $ 400,000 $ 50,000 Step One: Josey is fictionally treated as if she received $50,000 of accounts receivable (her proportionate share of 751 assets). Step Two: Josey fictionally sells the accounts receivable to the partnership in exchange for cash of $50,000. Josey recognizes ordinary income of $50,000 on the sale. 24
Step Three 1 2 3 4 5 Beginning J's Interest J's Interest Fictional Actual Difference Partnership Before After Proportionate Distribution 5 = 4-3 Assets at Distribution Distribution Distribution FMV 25% 0% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 200,000 $ 50,000 $ - $ 50,000 $ - $ (50,000) Non-751 Asts. Cash $ 1,400,000 $ 350,000 $ - $ 350,000 $ 400,000 $ 50,000 Step Three: The partnership fictionally pays cash for the accounts receivable and does not recognize gain. The partnership has a $50,000 cost basis in the acquired accounts receivables. 25 Step Four Step Four: The Remaining Distribution Total distribution of $400,000 cash: $50,000 of the cash received in the fictional exchange. The remaining $350,000 (400,000 50,000): Josey s remaining outside basis $350,000 Proportionate Cash Distribution.. <350,000> Remaining Outside Basis 0 26 Ending Balance Sheet After Liquidation of Josey for $400,000 Cash MLSJ Partnership January 2, 2004 Partner's Cash $ 1,000,000 $ 1,000,000 Basis Accounts Receivable $ 50,000 $ 200,000 Total Assets $ 1,050,000 $ 1,200,000 Liabilities Moe $ 350,000 $ 400,000 $ 350,000 Larry $ 350,000 $ 400,000 $ 350,000 Shirley $ 350,000 $ 400,000 $ 350,000 Total Debt and Equity $ 1,050,000 $ 1,200,000 Example 16-10 Section 751(b) Liquidating Distribution with Cash and Debt Relief 27 28
Example 16-10 See balance sheet on next slide. Assume that Josey is liquidated for: $150,000 of cash. $250,000 of debt relief The partnership is not a service partnership Before Liquidation of Josey for $150,000 Cash + Debt Relief MLSJ Partnership January 1, 2004 Partner's Cash $ 1,400,000 $ 1,400,000 Basis Accounts Receivable $ - $ 200,000 Total Assets $ 1,400,000 $ 1,600,000 Liabilities $ 1,000,000 $ 1,000,000 Moe $ 100,000 $ 150,000 $ 350,000 Larry $ 100,000 $ 150,000 $ 350,000 Shirley $ 100,000 $ 150,000 $ 350,000 Josey $ 100,000 $ 150,000 $ 350,000 Total Debt and Equity $ 1,400,000 $ 1,600,000 29 30 Before Liquidation of Josey for $150,000 Cash + Debt Relief MLSJ Partnership January 1, 2004 Partner's Gain of $50,000 Cash $ 1,400,000 $ 1,400,000 Basis Accounts Receivable $ - $ 200,000 Total Assets $ 1,400,000 $ 1,600,000 Liabilities $ 1,000,000 $ 1,000,000 $150,000 cash + $250,000 deemed cash Moe $ 100,000 $ 150,000 $ 350,000 Larry $ 100,000 $ 150,000 $ 350,000 Shirley - $350,000 $ 100,000 O.B. $ 150,000 $ 350,000 Josey $ 100,000 $ 150,000 $ 350,000 Total Debt and Equity $ 1,400,000 $ 1,600,000 = $50,000 31 The entire distribution falls under Code Sec. 736(b) because it represents Josey s interest in partnership property. The distribution is disproportionate so Code Sec. 751(b) applies. 32
Steps One and Two 1 2 3 4 5 Beginning J's Interest J's Interest Fictional Actual Difference Partnership Before After Proportionate Distribution 5 = 4-3 Assets at Distribution Distribution Distribution FMV 25% 0% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 200,000 $ 50,000 $ - $ 50,000 $ - $ (50,000) Non-751 Asts. Cash $ 1,400,000 $ 350,000 $ - $ 350,000 $ 400,000 $ 50,000 Josey s debt relief of $250,000 is treated like an actual distribution of cash (150K + 250K = 400K). Reading the table: The positive $50,000 cash in column 5 indicates that Josey received excess cold assets (cash) in the distribution. 33 1 2 3 4 5 Beginning J's Interest J's Interest Fictional Actual Difference Partnership Before After Proportionate Distribution 5 = 4-3 Assets at Distribution Distribution Distribution FMV 25% 0% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 200,000 $ 50,000 $ - $ 50,000 $ - $ (50,000) Non-751 Asts. Cash $ 1,400,000 $ 350,000 $ - $ 350,000 $ 400,000 $ 50,000 Step One: Josey is fictionally treated as if she received $50,000 of accounts receivable (her proportionate share of 751 assets). Step Two: Josey fictionally sells the accounts receivable to the partnership in exchange for cash of $50,000. Josey recognizes ordinary income of $50,000 on the sale. 34 Step Three 1 2 3 4 5 Beginning J's Interest J's Interest Fictional Actual Difference Partnership Before After Proportionate Distribution 5 = 4-3 Assets at Distribution Distribution Distribution FMV 25% 0% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 200,000 $ 50,000 $ - $ 50,000 $ - $ (50,000) Non-751 Asts. Cash $ 1,400,000 $ 350,000 $ - $ 350,000 $ 400,000 $ 50,000 Step Three: In the fictional exchange, the partnership pays cash for the accounts receivable and does not recognize gain. The partnership has a $50,000 cost basis in the purchased accounts receivable. Step Four Step Four: The Remaining Distribution She received a total distribution of $400,000 cash (including $250,000 of debt relief as money): $50,000 of the cash is deemed to be received in the deemed exchange. The remaining $350,000 (400,000 50,000): Josey s remaining outside basis $350,000 Proportionate Cash Distribution.. <350,000> Remaining Outside Basis 0 35 36
Ending Balance Sheet After Liquidation of Josey for $150,000 Cash + Debt Relief MLSJ Partnership January 2, 2004 Partner's Cash $ 1,250,000 $ 1,250,000 Basis Accounts Receivable $ 50,000 $ 200,000 Total Assets $ 1,300,000 $ 1,450,000 Liabilities $ 1,000,000 $ 1,000,000 Moe $ 100,000 $ 150,000 $ 433,333 Larry $ 100,000 $ 150,000 $ 433,333 Shirley $ 100,000 $ 150,000 $ 433,333 Total Debt and Equity $ 1,300,000 $ 1,450,000 Example 16-11: Section 751(b) Liquidating Distribution involving both Sec 736(a) and (b) 37 38 See balance sheet on next slide. Assume that Josey is liquidated for $1,300,000 of cash. The partnership is not a service partnership. 39 Before Liquidation of Josey for $1,300,000 Cash MLSJ Partnership January 1, 2004 Partner's Cash $ 1,400,000 $ 1,400,000 Basis Accounts Receivable $ - $ 200,000 Unstated Goodwill $ - $ 2,400,000 Total Assets $ 1,400,000 $ 4,000,000 Liabilities $ - Moe $ 350,000 $ 1,000,000 $ 350,000 Larry $ 350,000 $ 1,000,000 $ 350,000 Shirley $ 350,000 $ 1,000,000 $ 350,000 Josey $ 350,000 $ 1,000,000 $ 350,000 Total Debt and Equity $ 1,400,000 $ 4,000,000 40
Before Liquidation of Josey for $1,300,000 Cash MLSJ Partnership January 1, 2004 Partner's Gain of $950,000 Cash $ 1,400,000 $ 1,400,000 Basis Accounts Receivable $ - $ 200,000 Unstated Goodwill $ - $ 2,400,000 Total Assets $ 1,400,000 $ 4,000,000 $1,300,000 cash Liabilities $ - - $350,000 O.B. Moe $ 350,000 $ 1,000,000 $ 350,000 Larry $ 350,000 $ 1,000,000 $ 350,000 Shirley = $950,000 $ 350,000 $ 1,000,000 $ 350,000 Josey $ 350,000 $ 1,000,000 $ 350,000 Total Debt and Equity $ 1,400,000 $ 4,000,000 41 Assume that Josey receives a premium of $300,000, which the partnership agreement characterizes as a payment for prior services, in addition to her $1,000,000 share of partnership property. 42 Sec. 736(a) Payment $300,000 of the distribution is a Sec. 736(a) payment (a premium over the partner s $1,000,000 share of partnership property). Reg. 1.736-1(a)(3). The payment is fixed, therefore: $300,000 of ordinary income to Josey; Sec. 736(b) Payment The remaining $1,000,000 distribution ($1,300,000 - $300,000) is a Sec. 736(b) payment in exchange for Josey s interest in partnership property. The Section 736(b) distribution is disproportionate (too much cash) and Sec. 751(b) applies. $300,000 deduction to the continuing partners. 43 44
The Sec 751(b) Exchange Table 1 2 3 4 5 Beginning J's Interest J's Interest Fictional Actual Difference Partnership Before After Proportionate Sec 736(b) 5 = 4-3 Assets at Distribution Distribution Distribution Distribution FMV 25% 0% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 200,000 $ 50,000 $ - $ 50,000 $ - $ (50,000) Non-751 Asts. Cash $ 1,400,000 $ 350,000 $ - $ 350,000 $ 1,000,000 $ 650,000 Goodwill $ 2,400,000 $ 600,000 $ 600,000 $ - $ (600,000) Total $ 3,800,000 $ 950,000 $ 50,000 Reading the table: The positive $50,000 cash in column 5 indicates that Josey received $50,000 excess cold assets (cash) in the distribution. 45 Sec. 751(b) Exchange Table Question: Given that Josey already received $300,000 of the cash under Code Sec 736(a), how can Josey s predistribution share of the cash be $350,000 (25% X $1,400,000) in calculating the Sec 751 exchange (the Sec 736(b) portion)? Answer: The $300,000 Sec 736(a) payment is treated as paid exclusively from the other partners share of the cash (an expense to the other partners). Therefore, Josey s share of the cash can be regarded as $350,000. 46 Steps One and Two 1 2 3 4 5 Beginning J's Interest J's Interest Fictional Actual Difference Partnership Before After Proportionate Distribution 5 = 4-3 Assets at Distribution Distribution Distribution FMV 25% 0% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 200,000 $ 50,000 $ - $ 50,000 $ - $ (50,000) Non-751 Asts. Cash $ 1,400,000 $ 350,000 $ - $ 350,000 $ 1,000,000 $ 650,000 Goodwill $ 2,400,000 $ 600,000 $ 600,000 $ - $ (600,000) Total $ 3,800,000 $ 950,000 $ 50,000 Step One: Josey is fictionally treated as if she received $50,000 of accounts receivable (her proportionate share of 751 assets). Step Two: Josey fictionally sells the accounts receivable to the partnership in exchange for cash of $50,000. Josey recognizes ordinary income of $50,000 on the sale. 47 Step Three 1 2 3 4 5 Beginning J's Interest J's Interest Fictional Actual Difference Partnership Before After Proportionate Distribution 5 = 4-3 Assets at Distribution Distribution Distribution FMV 25% 0% 3 = 1-2 Sect 751 Asts: Accts. Rec. $ 200,000 $ 50,000 $ - $ 50,000 $ - $ (50,000) Non-751 Asts. Cash $ 1,400,000 $ 350,000 $ - $ 350,000 $ 1,000,000 $ 650,000 Goodwill $ 2,400,000 $ 600,000 $ 600,000 $ - $ (600,000) Total $ 3,800,000 $ 950,000 $ 50,000 Step Three: In the fictional exchange, the partnership pays cash for the accounts receivable and does not recognize gain. The partnership has a $50,000 cost basis in the accounts receivable. 48
Step Four Step Four: Josey received a total Sec 736(b) distribution of $1,000,000 cash: $50,000 of the cash is deemed to be received in the fictional sale under Section 751 (Josey recognized ordinary income of $50,000 on the fictional sale of zero basis A/R) 49 Step Four The remaining $950,000 (1,000,000 50,000) is analyzed under the normal proportionate liquidating distribution rules: Josey s pre-distrib. outside basis $350,000 Proportionate Cash Distribution.. <950,000> Section 731(a) Gain (LTCG) 600,000 Assuming the partnership makes a timely Sec 754 election, the partnership increases its basis in the goodwill by $600,000 (per Code Sec 734) and the partnership can amortize that basis increase over 15 years (a Sec. 197 intangible). 50 Summary of Tax Impact on Josey Josey received a liquidating cash distribution of $1,300,000. Tax Treatment: $300,000 of ordinary income ( 736(a) and 707(c)) $ 50,000 of ordinary income per Sec 751(b) $350,000 tax free return of outside basis (Sec 731) $600,000 LTCG per Code Sec 731(a). 51 Balance Sheet Before Before Liquidation of Josey for $1,300,000 Cash MLSJ Partnership January 1, 2004 Partner's Cash $ 1,400,000 $ 1,400,000 Basis Accounts Receivable $ - $ 200,000 Unstated Goodwill $ - $ 2,400,000 Total Assets $ 1,400,000 $ 4,000,000 Liabilities $ - Moe $ 350,000 $ 1,000,000 $ 350,000 Larry $ 350,000 $ 1,000,000 $ 350,000 Shirley $ 350,000 $ 1,000,000 $ 350,000 Josey $ 350,000 $ 1,000,000 $ 350,000 Total Debt and Equity $ 1,400,000 $ 4,000,000 52
Tax Basis Partnership Accounting Entries Sec 736(a) Transaction Debit: Credit: Guaranteed Pyt. $300,000* Cash $300,000 * The guaranteed payment reduces the equity of Moe, Larry and Shirley (each) by $100,000. 53 Tax Basis Partnership Accounting Entries Sec 736(b) Transaction Debit: Accounts Rec $50,000 Goodwill $600,000* Josey s Equity $350,000 Credit: Cash $1,000,000 * Assuming a Section 754 election is made 54 Balance Sheet After After Liquidation of Josey for $1,300,000 Cash MLSJ Partnership January 1, 2004 Partner's Cash $ 100,000 $ 100,000 Basis Accounts Receivable $ 50,000 $ 200,000 Unstated Goodwill $ 600,000 $ 2,400,000 Total Assets $ 750,000 $ 2,700,000 Liabilities $ - Moe $ 250,000 $ 900,000 $ 250,000 Larry $ 250,000 $ 900,000 $ 250,000 Shirley $ 250,000 $ 900,000 $ 250,000 Example 16-12: Liquidating Distribution involving a service partnership with unstated goodwill and unrealized receivables Sec 736(a) and (b) Total Debt and Equity $ 750,000 $ 2,700,000 55 56
See balance sheet on next slide. Assume that Josey is liquidated for $1,300,000 of cash. Josey is a general partner in a service partnership 57 Before Liquidation of Josey for $1,300,000 Cash MLSJ Partnership January 1, 2004 Partner's Cash $ 1,400,000 $ 1,400,000 Basis Accounts Receivable $ - $ 200,000 Unstated Goodwill $ - $ 2,400,000 Total Assets $ 1,400,000 $ 4,000,000 Liabilities $ - Moe $ 350,000 $ 1,000,000 $ 350,000 Larry $ 350,000 $ 1,000,000 $ 350,000 Shirley $ 350,000 $ 1,000,000 $ 350,000 Josey $ 350,000 $ 1,000,000 $ 350,000 Total Debt and Equity $ 1,400,000 $ 4,000,000 58 Before Liquidation of Josey for $1,300,000 Cash MLSJ Partnership January 1, 2004 Partner's Gain of $950,000 Cash $ 1,400,000 $ 1,400,000 Basis Accounts Receivable $ - $ 200,000 Unstated Goodwill $ - $ 2,400,000 Total Assets $ 1,400,000 $ 4,000,000 $1,300,000 cash Liabilities $ - - $350,000 O.B. Moe $ 350,000 $ 1,000,000 $ 350,000 Larry $ 350,000 $ 1,000,000 $ 350,000 Shirley = $950,000 $ 350,000 $ 1,000,000 $ 350,000 Josey $ 350,000 $ 1,000,000 $ 350,000 Total Debt and Equity $ 1,400,000 $ 4,000,000 59 Sec. 736(a) Payment $950,000 of the distribution is a Sec. 736(a) payment. The payment is fixed, therefore: $950,000 of ordinary income to Josey; $950,000 deduction to the continuing partners. 60
Section 736(a) Portion The $950,000 ($1,300,000 - $350,000) Sec. 736(a) portion consists of: 1) $300,000, a premium (Reg. 1.736-1(a)(3)). 2) $600,000, Josey s share of unstated goodwill. 3) $50,000, Josey s share of unrealized receivables. (Code Sec. 736(b)(2)) 61 Sec. 736(b) Payment The remaining $350,000 distribution ($1,300,000 - $950,000) is a Sec. 736(b) payment for Josey s interest in partnership property. The Section 736(b) distribution is proportionate (so Sec 751(b) does not apply) and the distribution simply reduces Josey s outside basis--tax free--from $350,000 to zero. 62 Summary of Tax Impact on Josey Josey received a liquidating cash distribution of $1,300,000. Tax Treatment: $950,000 of ordinary income ( 736(a) and 707(c)) $350,000 tax free return of outside basis 63 Balance Sheet Before Before Liquidation of Josey for $1,300,000 Cash MLSJ Partnership January 1, 2004 Partner's Cash $ 1,400,000 $ 1,400,000 Basis Accounts Receivable $ - $ 200,000 Unstated Goodwill $ - $ 2,400,000 Total Assets $ 1,400,000 $ 4,000,000 Liabilities $ - Moe $ 350,000 $ 1,000,000 $ 350,000 Larry $ 350,000 $ 1,000,000 $ 350,000 Shirley $ 350,000 $ 1,000,000 $ 350,000 Josey $ 350,000 $ 1,000,000 $ 350,000 Total Debt and Equity $ 1,400,000 $ 4,000,000 64
Tax Basis Partnership Accounting Entries Sec 736(a) Transaction Debit: Credit: Guaranteed Pyt. $950,000* Cash $950,000 Tax Basis Partnership Accounting Entries Sec 736(b) Transaction Debit: Josey s Equity $350,000 Credit: Cash $350,000 * The guaranteed payment reduces the equity of Moe, Larry and Shirley (each) by $316,667. 65 The Section 754 election is now irrelevant 66 Balance Sheet After After Liquidation of Josey for $1,300,000 Cash MLSJ Partnership January 1, 2004 Partner's Cash $ 100,000 $ 100,000 Basis Accounts Receivable $ 200,000 Unstated Goodwill $ 2,400,000 Total Assets $ 100,000 $ 2,700,000 Liabilities $ - Self-Study Problem 14 Moe $ 33,333 $ 900,000 $ 33,333 Larry $ 33,333 $ 900,000 $ 33,333 Shirley $ 33,334 $ 900,000 $ 33,334 Total Debt and Equity $ 100,000 $ 2,700,000 67 68
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