Partnership Distribution Rules - Review

1. Partnership Distribution Rules - Review 1. No gain or loss on non-liquidating distribution, except to extent money distributed exceeds partner’s basis before distribution. 731. 2. Decrease is partner’s share of liabilities deemed distribution of cash equal to amount of decrease. 3. Partner’s basis reduced by amount of money distributed and the partner’s basis of property distributed, as determined under 732. 4. Partner’s basis of property other than money distributed in non-liquidating distribution is partnership’s adjusted basis, but can’t exceed partner’s basis in partnership less money distributed in same transaction. 732 Corporate & Partner Tax Instructor: Dwight Drake

2. Special Allocation Items 1. Bottom line losses of partnership 2. Bottom line income of partnership 3. Specialty income items: - Tax-exempt interest - Built-in gain on contributed items per 704(c) - Gains or losses on specific assets - Royalties or special income items 4. Special deduction items: - Depreciation - Charitable contributions - R&D and other extraordinary expense items. Corporate & Partner Tax Instructor: Dwight Drake

3. Special Allocations Big Question: When will they work for tax purposes? Corporate & Partner Tax Instructor: Dwight Drake

4. The 704 Rules 704(a): Partner’s share of income, gain, loss deduction or credit determined by partnership agreement unless otherwise provided in Subchapter K 704(b): Partner’s share of all items determined by partner’s interest in partnership, based on all facts and circumstances, if: - The partnership agreement does not spell out allocations, or - Partnership agreement lays out allocation, but it does not have “substantial economic effect”. Hence, big issue: What is “substantial economic effect”? Corporate & Partner Tax Instructor: Dwight Drake

5. Economic Effect – Safe Harbor Three elements: 1. Capital accounts maintained for each partner per Reg. 1.704-1(b)(2)(iv). 2. Upon liquidation of partnership or any partner’s interest, distributions made in accordance with positive balances in capital accounts. 3. Partner with negative balance in account after liquidation has unconditional obligation to restore by later of end of year or 90 days after liquidation. Corporate & Partner Tax Instructor: Dwight Drake

6. Capital Account Maintenance Per 704 Regs. Increase by: - Amount of money contributed by partner - FMV of property contributed by partner - Allocations of partnership income or gain, including tax-exempt income. Decrease by: - Amount of money distributed to partner - FMV of property distributed to partner - Allocations to partner of expenditures that are neither deductible not capitalized (gambling losses, bribes, charitable contributions, related-party losses, etc) - Allocations of partnership losses and deduction items Note: Looks like outside basis, but not the same. Corporate & Partner Tax Instructor: Dwight Drake

7. Example of Three Element Safe Harbor Basic Facts: A & B contribute 15k cash to AB partnership. Starting balance sheet and capital accounts as follows: Assets: Cash 30k Total Assets 30k Liabilities 0 A Capital account 15k B Capital account 15k Total Capital 30k Corporate & Partner Tax Instructor: Dwight Drake

8. Example of Three Element Safe Harbor Basic Facts: Year 1, partnership losses 10k; Year 2, partnership losses 10k. Agreement provides losses allocated 90% to A, 10% to B. Assets: Starting Year 1 Year 2 Cash 30k 20k 10k Total Assets 30k 20k 10k Liabilities 0 A Capital account 15k 6k (15-9) -3k (6-9) B Capital account 15k 14k (15-1) 13k (14-1) Total Capital 30k 20k 10k Corporate & Partner Tax Instructor: Dwight Drake

9. Example of Three Element Safe Harbor If liquidate at the end of year 2 with agreement that says allocate all liquidation proceeds 50-50, what happens? - A & B each get 5k? - A books losses of 18k, but really only lost 10k (15-5). Thus, 8k of A’s losses never had any “economic effect”. They never cost A anything. So, those losses not allowed under 704(b). If liquidate at end of year two with safe harbor clauses: - All 10k of assets paid to B because B is only partner with positive capital account. - A would have to contribute 3k to make up deficit. - 3k contributed by A would be paid to B to zero B capital account. Thus, B ends up getting 13k, full capital account balance. - 18k losses allocated to A had “economic effect” because A paid in end. Corporate & Partner Tax Instructor: Dwight Drake

10. The Alternative to Deficit Restoration Situation: Partner wants special allocation, but no deficit restoration risk Alternative Safe Harbor: - First two elements of present: Maintain capital accounts and distribute liquidation proceeds in accordance with positive capital account balances. - Agreement contains “Qualified Income Offset”. Corporate & Partner Tax Instructor: Dwight Drake

11. Qualified Income Offset Sample Provision: “If at the end of any taxable year any Partner shall have a negative balance in such Partner’s Deemed Capital Account, then notwithstanding anything herein to the contrary, there shall be reallocated to each such Partner each item of Company gross income (unreduced by any deductions) and gain in proportion to such negative balance until the Deemed Capital Account of such Partner is increased to zero.” So what is “Deemed Capital Account”? Capital account adjusted by “reasonably expected” future distributions that exceed corresponding capital account increases – and other items to come. Corporate & Partner Tax Instructor: Dwight Drake

12. Example Under Alternative with Qualified Income Offset Year One: Capital accounts all positive, so no problem. Year Two: A’s account goes negative by 3k. Gross income of 3k reallocated to A to take A’s account to zero. Effect on B is a bigger share of loss by 3k, so B’s capital account goes to 10k from 13k. Economic effect test: If liquidate at end of Year 2, all 10k assets would go to B, only partner with positive balance. This would equal balance in A’s account. A would not have to restore a deficit. Extra losses allocated to A would have had economic effect because A gets nothing on liquidation. Corporate & Partner Tax Instructor: Dwight Drake