Partner loans: traps for the unwary.Generally, liquidating distributions of property are tax free under the partnership distribution rules. A 2002 letter ruling suggests that an otherwise nontaxable partnership liquidation The collection of assets belonging to a debtor to be applied to the discharge of his or her outstanding debts.
A type of proceeding pursuant to federal Bankruptcy may be taxable when the partnership has an outstanding loan from the continuing owner.
When a partnership terminates, either because one partner purchased all the interests of the partnership or because all but one partner is redeemed, the partnership is deemed to distribute a portion of all its assets and liabilities to the remaining partner in liquidation of the partnership. Letter Ruling 200222026 provides that if a partnership has an outstanding partner loan on the termination date termination date,
n See expiration date. , the termination causes the debtor-creditor relationship to be merged and, as a result, the debt is extinguished ex·tin·guish
tr.v. ex·tin·guished, ex·tin·guish·ing, ex·tin·guish·es
1. To put out (a fire, for example); quench.
2. To put an end to (hopes, for example); destroy. See Synonyms at abolish.
3. . The partnership is viewed as transferring its assets to the creditor-partner in satisfaction of the debt. This treatment may create tax problems for the creditor-partner, but proper tax planning Tax planning
Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. may be able to mitigate them.
Gain recognition and COD income: According to according to
1. As stated or indicated by; on the authority of: according to historians.
2. In keeping with: according to instructions.
3. the letter ruling, the partnership is viewed as making a taxable transfer of its assets to the partner in satisfaction of the debt, rather than a nontaxable distribution. The partnership recognizes gain to the extent the amount realized “Amount Realized” is one of two variables in the formula used to compute gains and losses when determining gross income for tax purposes. The Amount Realized – Adjusted Basis tells the amount of Realized Gain (if positive) or Realized Loss (if negative). exceeds the partnership's basis in the assets transferred.
The partnership also may have cancellation of indebtedness (COD) income, depending on whether the partner loan is recourse or nonrecourse. Under the partnership allocation rules, the COD income should be allocated to the partners who received the benefits of the deductions funded by the cancelled debt. In many cases, the deductions would have been allocated to the creditor-partner, so the COD income should be allocated to the creditor-partner. But to ensure the COD income is properly allocated, prior-year tax returns should be reviewed to determine who received the benefit of the deductions.
The partners will not be able to exclude their share of the COD income if they are solvent, even though the partnership may be insolvent INSOLVENT. This word has several meanings. It signifies a person whose estate is not sufficient to pay his debts. Civ. Code of Louisiana, art. 1980.. A person is also said to be insolvent, who is under a present inability to answer, in the ordinary course of business, the responsibility . The Sec. 108(a) insolvency insolvency
Condition in which liabilities exceed assets so that creditors cannot be paid. It is a financial condition that often precedes bankruptcy. In the context of equity, insolvency is the inability to pay debts as they become due; insolvency under the balance-sheet exclusion applies only when the partner is insolvent (i.e., when the partner has liabilities that exceed the fair market value (FMV FMV - full-motion video ) of his or her assets, excluding the interest in the terminated partnership).
Disallowed loss: If the partnership has any assets with a value less than tax basis, the partnership would recognize a loss on the transfer of those assets to the creditor-partner. Generally, the loss would be allocated to all the partners based on the manner in which the partners agreed to share losses under the partnership agreement. The loss would be deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). and would reduce the partners' bases in their partnership interests. However, if the creditor-partner owns more than 50% of the partnership, the partnership's loss could be disallowed under Sec. 707(b).
The letter ruling specifies how to treat the partnership, but it does not address how to treat the creditor-partner or the other departing partners. Here are some partner-level issues to consider.
Character mismatch mismatch
1. in blood transfusions and transplantation immunology, an incompatibility between potential donor and recipient.
2. one or more nucleotides in one of the double strands in a nucleic acid molecule without complementary nucleotides in the same position on the other : Under Sec. 1271(a)(1), the retirement of a debt may be treated as a sale or exchange of the debt for purposes of determining the tax consequences to the lender. For tax purposes, the receipt of partnership assets by the creditor-partner in cancellation of the loan may be viewed as a payment in "retirement" of the debt instrument. Because the letter ruling does not discuss the tax consequences to the creditor-partner, it is unclear whether Sec. 1271 applies to the cancellation of a partner loan. If Sec. 1271 applies, the creditor-partner would recognize a capital loss equal to the amount by which that partner's basis in the loan exceeds the value of the assets received from the partnership. The partner could not offset this loss against any COD income reported on his or her Schedule K-1. The loss could be permanently disallowed if the partner does not have enough capital gain to offset the capital loss before the expiration of the carryforward period.
Depreciation of acquired assets: The partnership termination should be viewed as partly taxable and partly nontaxable if the value of the partnership's net assets Net assets
The difference between total assets on the one hand and current liabilities and noncapitalized long-term liabilities on the other hand.
See owners' equity. exceeds the balance of the partner loan. The transfer of assets The conveyance of something of value from one person, place, or situation to another.
The law recognizes that persons are generally entitled to transfer their assets to whomever they wish and for whatever reason. The most common means of transfer are wills, trusts, and gifts. to the creditor-partner should be viewed as a taxable transfer of assets in an amount equal to the balance of the loan. The partnership should be viewed as making a distribution of partnership assets and liabilities, to the extent the FMV of the partnership's net assets exceeds the balance of the loan.
In this case, the creditor-partner should have a blended basis in each asset received from the partnership. That partner would take a FMV basis in the assets received in cancellation of the debt, and a substituted basis in the distributed assets (assuming that the Sec. 707 disguised sale rules, the Secs. 704(c)(1)(B) and 737 "mixing bowl" rules and Sec. 751(b) do not apply).To compute To perform mathematical operations or general computer processing. For an explanation of "The 3 C's," or how the computer processes data, see computer. depreciation deductions going forward, the creditor-partner will need to know which portion of each asset was acquired in a taxable exchange and which portion was acquired in the nontaxable distribution. This analysis is complex, particularly when no asset-by-asset appraisal is performed in connection with the partnership termination.
Permanently suspended losses and disappearing depreciable depreciable
Of, relating to, or being a long-term tangible asset that is subject to depreciation. basis: As discussed, if any of the transferred assets have a built-in loss and the creditor-partner is related to the partnership, the loss could be disallowed at the partnership level. Any loss allocated to the departing partners would likely be disallowed permanently. Any loss allocated to the creditor-partner may be permanently disallowed too, if the creditor-partner does not sell the assets to an unrelated person for a gain. Because the disallowed loss reduces the partners' bases in their partnership interests, the partners cannot claim the loss on the liquidation of their interests, and the creditor-partner cannot recover the loss through a higher substituted basis in the distributed assets.
Tax Planning Before Termination
The effect of the termination on the partners, particularly the creditor-partner, should be analyzed an·a·lyze
tr.v. an·a·lyzed, an·a·lyz·ing, an·a·lyz·es
1. To examine methodically by separating into parts and studying their interrelations.
2. Chemistry To make a chemical analysis of.
3. well before the partnership termination, to avoid any unintended tax consequences. The creditor-partner may avoid gain recognition and COD income by making a tax-free transfer of his or her partnership interest or loan receivable to another taxpayer before the termination. A merger of the debtor-creditor relationship occurs only if the same taxpayer holds the receivable and the interest in the partnership. If the partnership interest or the receivable is transferred to another taxpayer before the termination, the tax treatment specified in the letter ruling should not apply. Alternatively, the creditor-partner could convert the loan to equity as far in advance of the termination as possible. However, if the partnership is insolvent, COD income could be triggered at that time under Sec. 108(e)(8).
The creditor-partner may avoid Sec. 1271 capital loss treatment on the loan receivable by writing down the debt in advance of the termination. The partial bad-debt deduction would be treated as an ordinary loss under Sec. 166. This loss reduces the creditor-partner's basis in the loan, so when the partnership terminates, that partner's loss on the loan would be limited to the excess of the basis he or she has in the loan at that time over the FMV of the assets received in satisfaction of the debt.
FROM GRETCHEN FOLEY fo·ley
1. A technical process by which sounds are created or altered for use in a film, video, or other electronically produced work.
2. A person who creates or alters sounds using this process. , CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. , WASHINGTON, DC