PORTFOLIO

Partnerships — Formation and Contributions of Property or Services (Portfolio 711)

Tax Management Portfolio, Partnerships — Formation and Contributions of Property or Services, No. 711-2nd, provides a detailed discussion of the federal income tax consequences of contributions of property or services to partnerships by partners on formation of a partnership or thereafter. In general, §721 provides that no gain or loss is recognized by transferors or the partnership upon the transfer of property to a partnership in exchange for a partnership interest. Like other nonrecognition provisions, §721 defers recognition of gain or loss through substituted basis and other rules preserving significant tax attributes inherent in contributed property and obligations at the time of contribution. Despite the breadth of nonrecognition under §721, gain (or, less frequently, loss) may be recognized by the contributing partner or the partnership (remaining partners) on some partnership contributions, including some involving transfers of encumbered property, those determined to be disguised sales rather than contributions, and some involving contributions of services or “sweat equity.”

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DESCRIPTION

Tax Management Portfolio, Partnerships — Formation and Contributions of Property or Services, No. 711-2nd, provides a detailed discussion of the federal income tax consequences of contributions of property or services to partnerships by partners on formation of a partnership or thereafter. In general, §721 provides that no gain or loss is recognized by transferors or the partnership upon the transfer of property to a partnership in exchange for a partnership interest. Like other nonrecognition provisions, §721 defers recognition of gain or loss through substituted basis and other rules preserving significant tax attributes inherent in contributed property and obligations at the time of contribution. Despite the breadth of nonrecognition under §721, gain (or, less frequently, loss) may be recognized by the contributing partner or the partnership (remaining partners) on some partnership contributions, including some involving transfers of encumbered property, those determined to be disguised sales rather than contributions, and some involving contributions of services or “sweat equity.”


This Portfolio explains the basic requirements of a §721 nonrecognition transaction and analyzes: (i) the determination of the contributing partner's and the partnership's basis, holding period, and other tax characteristics for the contributed property and the partnership interest; (ii) allocations of some of the tax consequences to the transferring or other partners of the property and obligations contributed; (iii) preservation of the tax characteristics of contributed property and other issues related to contributions of property with specific tax characteristics; (iv) transfers of fixed or contingent liabilities and other obligations to or from partnerships, particularly in connection with transfers of encumbered property; and (v) transfers to partnerships that are recharacterized as sales. The Portfolio examines the treatment of the receipt of a partnership profits or capital interest for services and the use of both compensatory and noncompensatory partnership options. It also considers partnership tax years, accounting, elections, and initial expenditures. Because of the fundamental role of partnership capital accounting in understanding the tax consequences of the transactions considered, this Portfolio provides a summary of the capital account consequences and the effect under the special allocation regulations.


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AUTHORS

ELLIOTT MANNING
Elliott Manning, A.B. (with honors) Columbia College (1955), J.D., magna cum laude, Harvard Law School (1958). Author of Tax Management Portfolios 710-2nd, Partnerships — Conceptual Overview; 716-2nd, Partnerships — Current and Liquidating Distributions; Death or Retirement of a Partner; 718-2nd, Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination; Choosing the Business Entity (Little Brown 1995); and Corporate Buy-Sell Agreements (Little Brown 1995).

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

Introductory Material

A. Nonrecognition of Gain or Loss on Contribution

B. Capital Accounts and Special Allocations

1. Special Allocations - Basic Test

a. Maintenance of Capital Accounts

b. Deficit Make-up

c. Liquidation Rights

d. Substantiality

2. Other Tests

3. Nonrecourse Deductions

4. Partner's Interest in the Partnership

C. Professional Responsibility

II. Contributions of Property to a Partnership

Introductory Material

A. Nonrecognition of Gain or Loss

1. Preservation of Tax Attributes

a. Basis Consequences

b. Section 704(c)

(1) Ceiling Rule

(a) Curative Allocations

(b) Remedial Allocations

(2) Reverse § 704(c) Adjustments

(3) Mixing Bowl Transactions

(a) Contributed Property Distributed to Another Partner

(b) Other Property Distributed to Contributing Partner

(c) Collateral Consequences

c. Capital Account Consequences

d. Holding Period

(1) Tacking

(2) Limits on Tacking

(3) Split Holding Period

e. Character of Contributed Property

(1) Change in Character on Contribution

(2) Section 724

(a) Unrealized Receivables

(b) Inventory Items

(c) Capital Loss Property

(d) Transferring the § 724 Taint

f. Specific Types of Property

(1) Depreciable Tangible Property

(a) Allocation of Depreciation for Year of Contribution

(i) Tangible Personal Property

(ii) Real Property

(iii) Different Taxable Years of Contributing Partner and Partnership

(b) Effect of § 704(c)

(2) Intangible Property

(3) Contributed Oil and Gas or Mineral Property

(4) Personal Use Property

(5) Recapture Property

(6) Investment Tax Credit Recapture Property

(7) Inventory (Including LIFO Inventory)

(8) Assignment of Income

(9) Tax-Benefit Items

(10) Discount Bond

(11) Section 481 Adjustments

(12) Interest in Passive Activity

(13) Partner's Own Note

(14) Partnership's Own Indebtedness

(a) In General

(b) Background: Corporate Debt Cancellation

(i) Common Law of Corporate Debt Cancellation

(ii) Statutory Stock-for-Debt Exception for Corporations

(A) Tax Effect for Corporation

(B) Tax Effect for Contributing Shareholder

(c) Partnerships: Equity for Debt and Cancellation of Indebtedness

(i) Equity for Debt: Tax Effect for Partnership

(A) Prior Law - Equity-for-Debt Exception for Partnerships?

(B) Statutory Equity-for-Debt Principle

(ii) Cancellation of Indebtedness: Tax Effect for Partnership

(iii) Tax Effect for Contributing Partner or Creditor

(15) Installment Obligations

(a) Partnership as Installment Purchaser

(b) Partnership as Installment Seller

(c) Avoiding Gain Under the Early Disposition Rules

(16) Interest in the Partnership - Recapitalization

(17) Intellectual or Intangible Property

(18) Long-Term Contracts

g. Receipt of Nonqualifying Consideration (“Boot”)

(1) Boot in Nonrecognition Transactions Generally - Consideration for Property Transferred

(2) Boot in Partnership Contributions

(a) Partnership Cash Distributions

(b) Partnership Contribution with Boot

(c) Sections 734 and 743 Basis Adjustments

(i) Sale of Partnership Interests

(ii) Distributions to Partners

(iii) Effect of § 751

2. Liability Transfer

a. Definition of Liability

(1) Accounts Payable and Similar Obligations

(2) Obligations That Are Not Recognized as Genuine

(3) Tax Amount of a Liability

(4) Recourse and Nonrecourse Liabilities

b. Allocating Partnership Liabilities

(1) Sharing Recourse Liabilities

(a) Economic Risk of Loss

(b) Net Payment - Guarantees and Reimbursement Rights

(c) Liability Follows the Loss

(2) Sharing Nonrecourse Liabilities

(a) Partnership Minimum Gain

(b) Section 704(c) Minimum Gain

(c) Profit Shares

(d) Multiple Properties and Multiple Liabilities

(e) Exculpatory Liabilities - LLCs

(f) Partner Nonrecourse Debt

c. Effect of Liability Allocations

d. Meaning of Transfer

(1) Transfer of Liabilities in General

(2) Transfer of Liabilities Between Partners and Partnerships

e. Section 1.752-7 Liabilities

(1) Section 1.752-7 Liabilities Assumed After June 23, 2003

(2) Section 1.752-7 Liabilities Assumed After October 18, 1999, and Before June 24, 2003

3. Encumbered Property

a. Book and Tax Capital Accounts

b. Effect of § 704(c) Adjustments

c. Gain on Contribution of Encumbered Property

d. Contribution of Property Encumbered by Nonrecourse Liabilities

4. Midstream Transfers

a. Transfer of an Operating Business to a Partnership

b. Admission of New Partner to a Continuing Partnership

(1) Reverse § 704(c)

(2) Liability Shifts

(3) Section 751

c. Change in Taxpayer Engaged in Completing Long-Term Contract

B. Exceptions to Nonrecognition

1. Sales

a. Denial of Capital Gain to a Controlling Partner

b. Limitation on Loss for Controlling Partner

2. Disguised Sales

a. Entrepreneurial Risk

b. Guaranteed Payments, Preferred Returns, and Cash Flow Distributions

c. Liabilities

d. Partnership Interests

e. Services

3. Rights to Use Property

4. Partnership Investment Companies

a. Definition of Investment Company

b. Diversification

c. Effect of Taxable Contribution to Partnership Investment Company

5. Foreign Partnerships

6. Long-Term Contracts

C. Partnership Level Accounting - Taxable Years, Elections and Initial Expenditures

1. Taxable Years

a. First Tax Year

(1) Depreciable Property Purchased in First Tax Year

(2) First Tax Year for Depreciation

b. Deferring Tax by Use of Different Taxable Years for Partners and Partnership

c. Section 706(b)(1)(B) Restrictions

(1) Majority Interest Rule

(2) Principal Partner Rule

(3) Least-Aggregate-Deferral Rule

(4) Business Purpose Exception

(a) The 25% Gross Receipts Test

(b) Annual Business Cycle Test

(c) Seasonal Business Test

(d) Facts and Circumstances Test

(5) Prepaid-Deferral Fiscal Year

(a) Eligibility for § 444 Election

(b) Making the § 444 Election

(c) Termination of Deferral

(d) Section 7519 Required Payment

(e) Grandfathered Fiscal Years

2. Methods of Accounting

a. In General

b. Section 448 Restrictions on Use of Cash Method

(1) C Corporation as a Partner

(a) Qualified Personal Service Corporation

(b) Farming Business

(c) Gross Receipts Do Not Exceed $5,000,000

(2) Tax Shelters

3. Involuntary Conversion Election

4. Initial Expenditures

a. In General

b. Organizational Expenses

c. Syndication Costs

d. Acquisition Costs of Partnership Assets

e. Start-up Expenditures

f. Allocation of Professional Fees and Other Initial Expenditures

g. Expenditures Paid by Partners

III. Partnership Interest Received for Services

Introductory Material

A. Overview

1. Intellectual or Intangible Property

2. Part Intellectual Property, Part Services

B. Partnership Interest for Services

1. Capital Interest v. Profits Interest

2. Disguised Capital Interest

3. Conditional Promise (Future Capital Interest) vs. Profits Interest

C. Grant of a Profits Interest for Services

1. Partnership Profits Interest (Rev. Proc. 93-27)

2. The Sol Diamond Case

3. Rev. Proc. 93-27 Exceptions

4. Disguised Compensation - § 707(a)(2)(A)

a. Transfer of a Profits Interest by a Partner

b. Grant of a Profits Interest for Services to the Partnership

c. Profits Interest Received in an Independent Capacity

d. Capitalization

5. Other Factors

a. Past v. Future Services

b. Unfunded, Unsecured Promise

c. Valuation Difficulties

d. Income from Capital

e. Double Taxation

6. Compensatory Options for, and Restricted Grants of, Partnership Profits Interests

D. Receipt of a Capital Interest for Services

1. Grant of an Unrestricted Capital Interest

a. Timing

b. Valuing the Capital Interest

(1) Capitalizable Future Services

(2) Deductible Future Services

(3) Capitalized Past Services

(4) Deductible Past Services

c. Proper Valuation Criteria

2. Grant of a Restricted Capital Interest

a. General Rule - Amount and Timing under § 83(a)

(1) Nonforfeiture Restrictions

(2) Forfeiture Restrictions

b. Amount and Timing under Regs. § 1.721-1(b)(1)

c. Special Election - Amount and Timing under § 83(b)

d. Collateral Differences Between § 83 and Regs. § 1.721-1(b)(1)

(1) Status as a Partner

(2) Section 83(b) Election

(3) Liability Shares

(4) Related Party Rules

3. Partnership Gain Recognition

a. Payment of an Obligation with Appreciated Property

b. Possible Partnership Gain When Capital Interest Is Granted to Service Partner

4. Compensatory Options for Partnership Capital Interests and Other Equity-Based Compensation

a. Capital Interest Appreciation Rights

b. Nonstatutory Options

c. Controlling Corporate Partner Stock

(1) Forfeitable Controlling Corporate Partner Stock - § 83

(2) Nonstatutory Option on Controlling Corporate Partner Stock

(3) Incentive Stock Options


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Disguised Sale Disclosure Statement (Regs. § 1.707–8(b)(1))

Worksheet 2 Election to Deduct and Amortize Partnership Organizational Expenses

Worksheet 3 Section 83(b) Election

Worksheet 4 Preamble to Final Regulations Under § 707, 1992–2 C.B. 126

Worksheet 5 Rev. Proc. 93–27, 1993–2 C.B. 343 (Receipt of Partnership Profits Interest for Services)

Worksheet 6 Representation Letter

Bibliography

OFFICIAL

Federal Statutes:

Regulations:

Legislative Materials:

Treasury Rulings and Procedures:

Cases:

Uniform and State Statutes:

UNOFFICIAL

Texts and Treatises:

Periodicals:

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