Question

Jim has decided to contribute some equipment he previously used in his sole proprietorship in exchange for a 10 percent profits and capital interest in Fast Choppers LLC. Jim originally paid $200,000 cash for the equipment. Since then, the tax basis in the equipment has been reduced to $100,000 because of tax depreciation, and the fair market value of the equipment is now $150,000.

A) Must Jim recognize any of the potential §1245 recapture when he contributes the machinery to Fast Choppers? [Hint: See §1245(b)(3).]

B) What cost recovery method will Fast Choppers use to depreciate the machinery? [Hint: See §168(i)(7).]

C) If Fast Choppers were to immediately sell the equipment Jim contributed for $150,000, how much gain would Jim recognize and what is its character? [Hint: See §1245 and 704(c).]

Answer 1

a. As per Section 1245(b)(3), recapture potential on property contributed to a partnership is only recognized to the extent any gain is recognized from the contribution of property. Because Jim was not relieved of any debt in the transaction,he will not recognize gain from the contribution under Section 721. Hence, Jim does not recognize recapture potential on the equipment at the time of contribution.

b. As per Section 168(i)(7), a transferee partnership will step into the shoes of the transferor partner for purposes of depreciating contributed equipment. Fast Choppers will continue to depreciate the equipment using the same method instituted by Jim over the remaining useful life of the equipment. In other words, the annual depreciation calculation will proceed as if the property were still held by Jim.

c. Under Section 704(c), all $50,000 of gain recognized from the sale of the equipment would be allocated to Jim because this gain was built-in at the time the equipment was contributed. Moreover, the Section 1245 recapture potential remains with the equipment after the contribution; as a result, all $50,000 of gain recognized (the lesser of the $50,000 gain recognized or the $100,000 depreciation taken) must be characterized as Section 1245 recapture income.