Friday, August 30, 2013
Section 724(a) provides that unrealized receivables contributed by a partner to a partnership generate ordinary income when the partnership sells them, even if held by the partnership as an investment, no matter when the sale takes place. Section 724(b) provides that inventory contributed by a partner to a partnership generates ordinary income when the partnership sells it, even if held by the partnership as an investment, if sold within five years of the distribution. Section 724(c) provides that a capital asset contributed by a partner to a partnership that has an adjusted basis exceeding fair market value generates capital loss to the extent of the inherent loss when the partnership sells it, even if held by the partnership as inventory, if sold within five years of the distribution.
It is easy to see the lack of symmetry. There is no section 724(c) equivalent in section 724(a). The reason probably is explained by the fact that section 724 was enacted decades after section 735 was enacted and nothing was done to bring section 735 up to date. There needs to be a section 724(a)(3), to provide that a capital asset distributed by a partnership to a partner that has an adjusted basis exceeding fair market value generates capital loss to the extent of the inherent loss when the partner sells it, even if held by the partner as inventory, if sold within five years of the distribution.
Wednesday, August 28, 2013
The basis adjustments under sections 734(b) and 743(b) resolve problems that exist because of the manner in which subchapter K applies both entity and aggregate approaches to different provisions. Those problems affect all partnerships. Now that pencil and paper calculations have been replaced by computer software, there is no good reason to make those adjustments optional. If making them mandatory in certain situations is acceptable, making them mandatory across the board is no less justifiable. If the adjustments are mandatory, the need for section 732 disappears and it can be repealed.
Monday, August 26, 2013
Until 1997, inventory items were classified as ordinary income items, for purposes of both sale and distribution transactions, only if they were substantially appreciated. In 1997, the definition of ordinary income items was amended so that inventory items are treated as ordinary income items for sale transactions but are not treated as ordinary income items for distribution purposes unless they are substantially appreciated.
Finding a sensible reason for the change, and for the different treatment, is difficult if not impossible. I tell students that Congress has created a trap for the unwary. I also tell students that Congress has also created an examination question that indicates the extent to which students are paying attention, being precise, and recognizing the twists and turns of tax law. Making matters worse, unrealized receivables are treated as inventory items, the practical effect of which is that because they already are ordinary income items, they play a role in determining whether inventory is substantially appreciated. It works both ways. For example, inventory with an adjusted basis of $100 and a value of $105 is not substantially appreciated standing alone, but if the partnership also has unrealized receivables with an adjusted basis of zero and a value of $50, the inventory is substantially appreciated because the total adjusted basis is $100 and the total value is $155. As another example, inventory with an adjusted basis of $100 and a value of $130 is substantially appreciated standing alone, but if the partnership also has realized receivables with an adjusted basis and a value of $100, the inventory is not substantially appreciated because the total adjusted basis is $200 and the total value is $230.
This complexity is unwarranted and unnecessary. Inventory is an ordinary income asset, period. Whether or not it is substantially appreciated is irrelevant to its nature as an ordinary income asset. Congress should repeal the substantial appreciation test and treat all inventory as ordinary income assets for purposes of section 751, whether the transaction is a sale of a partnership interest or a distribution.
Friday, August 23, 2013
A partner must include a guaranteed payment in gross income in the taxable year for which the partnership properly claims the deduction or makes the required increase in the basis of an asset. Thus, if the partnership uses the accrual method and the partner uses the cash method, the partner includes the guaranteed payment in gross income even if it has not been paid. A mechanism is required to prevent the partner from including the guaranteed payment in gross income when it is eventually paid. This mechanism is basis.
The question is whether the basis acquired by reason of including the guaranteed payment in gross income is a stand-alone basis in the guaranteed payment or is added to the partner’s adjusted basis in the partnership interest. Though one might expect something to be found in section 705 or even section 707(c), or the regulations interpreting those sections, there is no answer there or in revenue rulings, notices, or court opinions. There is dictum in one case suggesting that the partner increases adjusted basis in the partnership interest, but there are inferences in the regulations that the partner does not increase adjusted basis in the partnership interest, though the reasoning is quite attenuated.
An example illustrates why the question matters. Assume that at the beginning of year 5, A’s adjusted basis in the partnership interest is $100. During year 5, the partnership accrues a $400 guaranteed payment to A but does not pay it. After deducting the guaranteed payment, the partnership breaks even, so there are no partnership items to allocate among the partners. During year 6, the partnership again breaks even, but there is no guaranteed payment. During year 6, the partnership sells a capital asset in which its adjusted basis is $1,000. It sells the asset for $1,000, and distributes $200 to each partner, including A. During year 7, the partnership again breaks even, and again there is no guaranteed payment, but the partnership pays to A the $400 guaranteed payment accrued during year 5.
If the inclusion of the guaranteed payment in gross income for year 5 increases A’s adjusted basis in the partnership interest, the results are as follows. The basis of A’s partnership interest at the end of year 5 is $500 ($100 plus $400). The sale of the asset during year 6 has no effect on A’s adjusted basis in the partnership interest. The distribution of $200 reduces A’s adjusted basis in the partnership interest to $300 ($500 minus $200). The payment of the guaranteed payment of $400 in year 7 reduces A’s adjusted basis in the partnership interest to zero, and generates gain of $100 under section 731(a)(1) ($400 minus $100).
If the inclusion of the guaranteed payment in gross income for year 5 creates a stand-alone basis in an item that could be called, for ease of reference, guaranteed payment receivable, the results are as follows. The basis of A’s partnership interest at the end of year 5 remains $100, and A also has a basis of $400 in the guaranteed payment receivable. The sale of the asset during year 6 has no effect on A’s adjusted basis in the partnership interest. The distribution of $200 reduces A’s adjusted basis in the partnership interest to zero, and generates gain of $100 under section 731(a)(1) ($200 minus $100). The payment of the guaranteed payment of $400 in year 7 reduces A’s adjusted basis in the guaranteed payment receivable to zero, but does not generate any gain.
The difference, therefore, essentially is one of timing. Either way, A must report ordinary income of $400 in year one, and gain of $100. If the inclusion of the guaranteed payment in gross income for year 5 increases A’s adjusted basis in the partnership interest, the gain is reported in year 7. If the inclusion of the guaranteed payment in gross income for year 5 creates a stand-alone basis in a guaranteed payment receivable, the gain is reported in year 6. Put another way, the issue is whether the basis obtained from including the guaranteed payment in gross income can be used to offset distributions and not just payment of the guaranteed payment.
However the question is resolved, clarifying amendments to the Internal Revenue Code or the regulations are necessary. Even if the situation arises only for partners with zero or relatively low adjusted basis in their partnership interests, taxpayers deserve an answer.
Wednesday, August 21, 2013
There are better ways to accomplish what section 704(e)(2) is designed to accomplish. In addition, the principles of section 704(e)(2) ought to apply across the board, and not merely in the limited circumstances to which it applies. Unlike sections 704(c) and 737, which also deal with assignment of income concerns but do not have subchapter S equivalents, section 704(e)(2) has a subchapter S equivalent, so this aspect of assignment of income apparently is of greater concern to the Congress.
With section 704(b) having been amended and regulations issued under section 704(b) in the years after section 704(e)(2) was enacted, it makes more sense to incorporate the concerns of section 704(e)(2) in section 704(b). In determining a partner’s interest in a partnership, including a partner’s interest in the income, gain, loss, deduction, and credit items of a partnership, the extent to which a partner’s services or capital generates the partnership’s income is a factor that needs to be taken into account. The repeal of section 704(e)(2), and its accompanying section 704(e)(3), needs to be done in tandem with the enactment of language in section 704(b) that states, “In determining a partner’s interest in a partnership, including a partner’s interest in the income, gain, loss, deduction, and credit items of a partnership, the extent to which a partner’s services or capital generates the partnership’s income is a factor that must be taken into account.”
Monday, August 19, 2013
Section 704(e)(1) provides that “a person shall be recognized as a partner . . . if he owns a capital interest in a partnership in which capital is a material income-producing factor. . .” Section 704(e)(1) was enacted in response to the Supreme Court’s decision in Culbertson, which essentially tagged the question of whether a person is a partner as a factual question. To the extent section 704(e)(1) was intended to reduce the amount of factual analysis necessary to answer the question, it has failed. First, it only applies to certain partnerships, and is of no value for partnerships in which capital is not a material income-producing factor. Second, section 704(e)(1) takes one factual question, namely, does the person in question intend to be a partner, and turns it into two questions, namely, when is capital a material income-producing factor in a partnership and what does it mean to own a capital interest.
The process of determining whether a partnership exists should also determine who the partners are. This is true even if two persons are identified as partners and the status of a third person is in question. The reason is that the technical question is whether a partnership exists among all three persons, not whether the third person is a member of a partnership between the first two persons.
In any event, no matter how the issue of whether a person is a partner is resolved, section 704(e)(1) is of no help whatsoever. Its repeal not only would remove useless language from the Internal Revenue Code, it would eliminate the need to answer the two questions of when is capital a material income-producing factor in a partnership and what does it mean to own a capital interest.
Friday, August 16, 2013
If an S corporation shareholder contributes appreciated or depreciated property to the S corporation, the gain or loss recognized by the corporation, which includes the gain or loss inherent in the property when contributed, is allocated among all the shareholders. Thus, the inherent gain or loss is shifted to other shareholders. Why is there no section 704(c) and section 737 equivalents in subchapter S? Apparently, preventing the shifting of the gain or loss isn’t as terribly important as one might have guessed. The practical explanation probably is that enacting section 704(c) and section 737 equivalents in subchapter S would make subchapter S “too complicated.” So why is it acceptable to have a “too complicated” subchapter K when it comes to contributed property?
Until and unless subchapter S is graced with section 704(c) and section 737 equivalents, subchapter K ought to be relieved of a computational and interpretational complexity that does not afflict subchapter S. Surely the shifting of income and loss either is good or bad, but whatever it is, it ought to be the same whether it is being done by partners or by subchapter S shareholders.
Wednesday, August 14, 2013
When I taught Partnership Taxation, I did not try to provide the students with an answer to the question of whether a section 704(d) loss carryforward is available to the transferee of a partnership interest, though some students reacted negatively to the lack of a definite answer. Instead, I encouraged them to look at other provisions in the tax law that deal with the transfer of losses, an approach which also bothered some students who considered forays outside of subchapter K to be “irrelevant” to the course. I pointed out to them that there are provisions that prohibit or discourage the transfer of losses. I also pointed out to them that there are provisions that permit the transfer of losses. Finally, I directed them to examine the language of section 1366(d)(2)(A), which provides that the corresponding S corporation loss carryover is available “with respect to that shareholder,” referring to the shareholder who owned the stock when the loss pass-through was disallowed.
So why, I asked and continue to ask, does the language “with respect to that partner” not appear in section 704(d)? Should its absence be interpreted as an intent by Congress to permit the 704(d) loss carryforward to be available to the transferee? There are canons of statutory construction that would permit that conclusion. From a policy perspective, is there any reason to treat section 704(d) losses and section 1366(d) losses differently when it comes to the treatment of the transferee? I use this issue to demonstrate the difference between the issue of what the law should be and the issue of what the law is as demonstrated by the question of what one tells the client.
The answer to this one is easy. Section 704(d) and section 1366(d) loss carryforwards, in terms of availability to the transferee, must be treated in the same manner. Preferably, section 704(d) should be amended to include the language “with respect to that partner.”
Monday, August 12, 2013
For example, consider X, who contributed $100 to a partnership at the beginning of year 1. X’s distributive share of the partnership’s taxable income for year 1 is $50, for year 2 is $60, for year 3 is $30, and for year 4 is $80. There are no other partnership items and no distributions. Following the statute, X’s adjusted basis at the end of year 1 is $150 ($100 plus $50). Following the statute, X’s adjusted basis at the end of year 2 is $210 ($100 plus $50 plus $60). Following the statute, X’s adjusted basis at the end of year 3 is $240 ($100 plus $50 plus $60 plus $30). Following the statute, X’s adjusted basis at the end of year 4 is $320 ($100 plus $50 plus $60 plus $30 plus $80). This example, of course, is too simple. Imagine what the computation looks like in the fifteenth or twentieth year, and imagine, as likely is the case, that there are items of tax-exempt income, losses, distributions, and non-deductible items not chargeable to capital account.
What happens in practice, of course, is that practitioners begin with adjusted basis as of the end of the previous year, and then add the items for the current year to compute adjusted basis as of the end of the current year. Thus, in the example, X’s adjusted basis at the end of year 3 would be computed by adding $30 to $210.
Is it possible to rewrite section 705 to reflect practical reality? Of course. The model already exists. Section 1367, which provides for the computation of a shareholder’s adjusted basis in S corporation stock, provides that basis “shall be increased for any period by the sum of [the various items] determined with respect to that shareholder for such period.” Section 1367 is a newer provision than section 705 and reflects advances in technical drafting that took place during the intervening years. There is no good reason not to clean up section 705 so that it parallels section 1367.
Friday, August 09, 2013
My guess is that those drafting the original subchapter K worked in isolation and did not view subchapter K as part of a larger tapestry. Even to this day, it is not uncommon to observe proposed tax legislation, and even enacted tax legislation, that demonstrates a lack of cohesion with other provisions in the tax law. Granted, my suggestion would not change the law, and thus would not simplify tax compliance and practice, but it would make the Internal Revenue Code shorter and more concise. Every little bit helps.
Wednesday, August 07, 2013
The justification for these provisions is simplification of what would otherwise be complicated computations for these large partnerships. Yet partnerships with fewer than 100 partners are not relieved of these computational complexities and challenges. It is odd that the large partnerships, in a better position to afford the professional assistance or software to do the computations, are afforded relief unavailable to smaller partnerships generally not in quite the same position to afford the tax preparation help.
These special provisions were added sixteen years ago, before tax preparation software had evolved into the relatively sophisticated programs that are now available. If a partnership with 97 partners is required to comply with sections 702 and 703, there is no reason that a partnership with 103 partners ought not be in the same position.
There are two possible solutions to this disparate treatment. One is to repeal the special provisions. The other is to make them available to all partnerships. Technically, the better solution is to repeal the special provisions. That is what I would advocate. The existing caste system for partnerships is simply wrong.
Monday, August 05, 2013
Separating the charitable contribution deduction from the computation of taxable income also adds complexity to the computation of the partner’s adjusted basis in the partnership interest. Rather than being included in the increase on account of taxable income, charitable contributions must be taken into account separately under section 705.
There is no reason not to leave charitable contribution deductions as part of taxable income, just as the capital loss deduction is part of taxable income. The separate statement of items requiring particularized treatment by partners is sufficient to preserve the character and other attributes of charitable contributions in the same way it preserves the character and other attributes of capital losses, and the other hundreds of items that require separate statement treatment.
A simple repeal of section 703(a)(2)(C) solves the problem. Section 702(a)(7) and the regulations under section 702 already contain language that would require the separate statement of the charitable contribution deduction.
Friday, August 02, 2013
As an example, consider a partnership formed by three individuals, A, B, and C. A and B each contribute $100, which is used to purchase several assets that are not depreciable and that are not ordinary income assets. C contributes services and is promised one-third of the partnership’s value after subtracting the $200 contributed by A and B. C is not entitled to any income generated by partnership operations, and is not responsible for partnership losses. The partnership earns $500 of income each year, which is allocated to A and B and which is distributed to them. At the end of five years, the partnership terminates by selling its assets to X for $2,600. The partnership section 1231 gain is $2,400. It is allocated equally among the partners. Of the $2,600, $900 is distributed to A, $900 to B, and $800 to C. Under current law, C reports $800 of section 1231 gain, and in the absence of any other 1231 transactions, treats the $800 as capital gain, thus avoiding ordinary income taxation for amounts that reflect services provided by C.
Alternatively, assume that instead of selling its assets to X, the partnership distributes $100 to each of A and B, so that the partnership has a value of $2,400 and each partnership interest is worth $800. X acquires the partnership by paying each partner $800 for each one-third partnership interest. Under section 741, C reports long-term capital gain of $800. Again, under current law, C is obtaining capital gain treatment for amounts received for performing services.
It is possible that the services performed by C are worth only, say, $500, and that the other $300 is a result of appreciation in the assets of the partnership in which C has an interest. That is why the proposal is not to treat all of C’s gain as ordinary income, but only a portion reflecting the value of the services that C has performed. Though determining that the services are worth $500 requires factual analysis particular to each case, that sort of analysis already is done with respect to the same sort of issue in other areas of the tax law, for example, reasonable compensation determinations.