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Tax Case Study
Tax code section 721 "provides that no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership." Both parties agreed to contribute personal assets to the partnership, and they, nor the LLC, suffers any tax consequences as a result of the conversion of the property to the partnership. Because both contributed equal property to the LLC when it was formed (or so they thought) they both have a 50% ownership of the partnership.
The initial basis of both is not actually 50%. Tax code section 722 "provides that the basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of the money and the adjusted basis of the property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under § 721(b) to the contributing partner at such time." This initial basis is figured only according to the money he contributed ($200,000). The value of the land Erik contributed was $250,000. Thus, the value of the partnership according to this data is $450,000.
However, also according to tax code section 722, Erik's land appreciated by $30,000 (this is added to his stake in the partnership) and Clark contributed $50,0000 in equipment (after depreciation and amount owed on the equipment were taken into account. Thus, the basis of LLC in the land and equipment it received is $330,000.
According to tax code section 704 the tax consequences from the gain of the fair market value (FMV) of the property is the responsibility of the contributing partner. Thus, since Erik contributed the property to the LLC, he is responsible for the increased tax as a result of the higher sale value. This provision is made to make sure that the tax distribution is fair to all parties concerned.
If the property had been sold for $240,000 instead of the actual $280,000 the responsibility of that basis would be the same. Because Erik contributed the $250,000 he gains from the lower tax of a lower sale than the FMV, just as he would be responsible for the increased tax of a sale higher than the FMV.
Tax code section 167 says that "There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)
(1) of property used in the trade or business, or (2) of property held for the production of income.
This means that the firm is allowed to take a deduction on the equipment and it further says that the tax can be calculated using the traditional method (section 167(g)).
The traditional method that is referenced in this requirement is called straight-line depreciation. In this method, the company knows how much the asset is worth now and how much they will be able to sell the item for in a certain number of years. The equipment was contributed by Clark, but since it was added to the partnership (part of his buy-in) it becomes part of the partnership and both partners receive benefit of the depreciation. This is handled under tax code section 1250 because of the accelerated depreciation taken in the $100,000 of the top. This section of the tax code says that this should be treated as ordinary income instead of capital gains. The total is $114,290 and the life is 7 years. All the traditional method requires is that the total of the depreciated amount be divided by the number of years it will be viable to the company. Thus, $16,327 per year would be expensed.
Because the two, Clark and Erik, are equal partners, they would share equally in all of the profits and losses of the company assets. Of course, this does not include such things as added tax liability from the sale of property which is sold for more than the fair market value, but it does include depreciation of the equipment that is a part of the partnership agreement.
Separately stated items are not a part of the partnership. According to tax code section 702 these are "(1) gains and losses from sales or exchanges of capital assets held for not more than 1 year; (2) gains and losses from sales or exchanges of capital assets held for more than 1 year; (3) gains and losses from sales or exchanges of property described in section 1231 (relating to certain property used in a trade or business and involuntary conversions); (4) charitable contributions (as defined in section 170(c)); (5) dividends with respect to which section 1(h)(11) or part VIII of subchapter B applies; (6) taxes, described in section 901, paid or accrued to foreign countries and to possessions of the United States; (7) other items of income, gain, loss, deduction, or credit, to the extent provided by regulations prescribed by the Secretary; and (8) taxable income or loss, exclusive of items requiring separate computation under other paragraphs of this subsection." Looking at the list, the ones that apply to Clark and Erik would be (1) because of the land that sold for more than it was originally appraised for, and any of the others that apply to business of a private nature that is not a part of the partnership.
According to the tax code the three loss limitations are that "Under IRC section 704(d), (1) the loss must not exceed the amount of the partner's basis in the partnership interest; (2) the loss is the subject of the at-risk rules of the IRC section 465; (3) the loss is subject to the passive activity rules or IRC section 469." These rules are set in place for fairness sake. One partner cannot stick the other partner with a greater tax liability that has nothing to do with the partnership. These limitations were set in place for just such a partnership as Clark and Erik have. The answer to the last question is yes. The first loss limitation states that the loss cannot be greater than the initial outlay that the partner made for the partnership to exist. Both parties contributed $250,000 so the $125,000 is acceptable.
However, as far as the fairness principle goes, the separately stated items will mean that the two may have to pay different taxes. Basically, if the net capital gain is a certain amount that the partners will split, but one partner has a net capital gain or loss separate from that amount, then the two will have to pay different amounts. These two partners have a net capital loss of $250,000, so they split it and each has a net loss of $125,000 apiece which they have to declare. However, if Erik has a gain from another source of $30,000, his net loss would decrease to $95,000. Thus, even though the two are in the business together, they do have lives outside of the LLC which are affected by gains and losses from their outside endeavors (which the capital gain Erik experienced from the sale of the property would be). This can all be found in section 702 (a) (1-6).
Tax code section 174 allows the partners options regarding deducting the research and design costs. The code says that the partners can use one of the following methods: expense treatment, capitalization/amortization, project by project, election or default. The last two methods are not advised because the partnership would not be able to realize the tax savings immediately. This is a simple partnership and a relatively small operation. The expense treatment method only allows R & D. To be expensed one time, and the product that the partners are producing will require more research and development as technology improves. Thus, the first method is not advisable. It is difficult to understand the project by project allowance, but since the partners have only one product, they may not want to incur the difficulty inherent in this one either. It also seems that the capitalization/amortization method can actually be the same as a project by project method. It seems that this company should use the capitalization/amortization method since they will not realize any gains from the R&D for a few years.
The second type of cost is incurred from getting ready to sell the product are covered in tax code section 195 under startup costs. This section of the tax code states "Section 195(a) provides that, except as otherwise provided in § 195, no deduction is allowed for start-up expenditures. Section 195(b) provides that start-up expenditures may, at the election of the taxpayer, be treated as deferred expenses that are allowed as a deduction prorated equally over a period of not less than 60 months (beginning with the month in which the active trade or business begins). Section 195(c)(1) defines "start-up expenditure," in…[continue]
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