Question

Carrie D'Lake, Reed A. Green, and Doug A. Divot share a passion for golf and decide to go into the golf club manufacturing business together. On January 2, 2017, D'Lake, Green, and Divot form the Slicenhook Partnership, a general partnership. Slicenhook's main product will be a perimeter-weighted titanium driver with a patented graphite shaft. All three partners plan to actively plan participate in the business. The partners contribute the following property to form Slicenhook: Partner Contribution Carrie D'Lake Land, FMV $460,000 Basis $460,000, Mortgage $60,000 Reed A. Green $400,000 Doug A. Divot $400,000 Carrie had recently acquired the land with the idea that she would contribute it to the newly formed partnership. The partners agree to share in profits and losses equally. Slicenhook elects a calendar-year-end and the accrual method of accounting. In addition, Slicenhook received a $1,500,000 recourse loan from BigBank at the time the contributions were made. Slicenhook uses the proceeds from the loan and the cash contributions to build a state-of-the -art manufacturing facility ($1,200,000), purchase equipment ($600,000), and produce inventory ($400,000). With the remaining cash, Slicenhook invests $45,000 in the stock of a privately owned graphite research company and retains $55,000 as working cash. Slicenhook operates on a just-in-time inventory system so it sells all inventory and collects all sales immediately. That means that at the end of the year, Slicenhook does not carry any inventory or accounts receivable balances. During 2017, Slicenhook has the following operating results: Sales $1,126,000 Cost of Goods Sold 400,000 Interest Income from tax-exempt bonds 900 Qualified dividend income from stock 1,500 Operating Expenses 126,000 Depreciation (tax) 179 on equipment $39,000 Equipment 81,000 Building 24,000 144,000 Interest expense on debt 120,000 The partnership is very successful in its first year.The success allows Slilcenhook to use excess cash from operations to purchase $15,000 of tax-exempt bonds (you can see the interest income already reflected in the operating results). The partnership also makes a principal payment on its loan from Big Bank in the amount of $300,000 and a distribution of $100,000 to each of the partners on December 31, 2017. The partnership continues its success in 2018 with the following operating results: Sales $1,200,000 COGS 420,000 Interest Income from tax-exempt bonds 900 Qualified dividend income from stock 1,500 Operating Expenses 132,000 Depreciation (tax) Equipment 147,000 Building 30,000 177,000 Interest Expense on debt 96,000 The operating expenses include a $1,800 trucking fine that one of their drivers incurred for reckless driving and speeding and meals and entertainment expense of $6,000. By the end of 2018, Reed has had a falling out with Carrie and Doug and has decided to leave the partnership. He has located a potential buyer for his partnership interest, Indie Ruff. Indie has agreed to purchase Reed's interest in Slicenhook for $730,000 in cash and the assumption of Reed's share of Slicenhook's debt. Carrie and Doug, however, are not certain that admitting Indie to the partnership is such a good idea. They want at least to consider having Slicenhook liquidate Reed's interest on January 1, 2019. As of January 1, 2019, Slicenhook has the following assets: Tax Basis FMV Cash $876,800 $876,800 Investment - tax exempts 15,000 18,000 Investment Stock 45,000 45,000 Equipment - net of dep. 333,000 600,000 Building - net of dep. 1,146,000 1,440,000 Land 460,000 510,000 Total $2,845,800 $3,489,800 Carrie and Doug propose that Slicenhook distribute the following to Reed in complete liquidation of his partnership interest: Tax Basis FMV Cash $485,000 $485,000 Investment Stock 45,000 45,000 Equipment - net of dep. 111,000 200,000 Total $641,000 $730,000 Slicenhook has not purchased or sold any equipment since its original purchase just after formation. REQUIRED: i) If Slicenhook distributes the assets proposed by Carrie and Doug in complete liquidation of Reed's partnership interest, what is the amount and character of Reed's recognized gain or loss? What is Reed's basis in the distributed assets?

Answer 1

1.Reed will recognises neither loss or gain,

2. Reed basis in distributed assets,

Cash                                      485000

Investment in stock        15462

Equipment                          38,138

Workings:

Reed does not recognize any gain or loss on the distribution.

Rather he adjusts the basis in the distributed assets.

Reed’s outside basis in Slicenhook at the distribution is $958,600, including his $420,000 share of partnership liabilities.

Reed will need to allocate this basis to the distributed assets.

Reed first reduces his basis for the deemed cash distribution relating to his reduction in Slicenhook debt ($420,000) leaving an outside basis of $538,600 ($958,600 ? $420,000) to allocate to the distributed assets.

He determines his basis in the distributed assets as follows:

1. First he assigns a carryover basis to the distributed assets.

Cash485,000

Potential recapture0

Investment45,000

Equipment111,000

                Total                                      641,000

Adjusted basis of the distributed assets is greater than his allocable basis 538,600.

Reed required to Decrease of $102,400. (Since the basis reduction is not at least $250,000, the distribution does not meet the definition of a “substantial basis reduction”, which would require a mandatory special basis adjustment.)

1. The recapture potential inherent in the equipment should be assigned a basis of zero and treated as a hot asset.

Reed reduces the basis in the cold assets (investment and equipment) distributed.

The required decrease is allocated between the investment and equipment according to their relative tax basis amounts.

Accordingly,

the basis of investment should be reduced by $29,538 ($102,400 × $45,000/$156,000),

and the basis of equipment should be reduced by $72,862 ($102,400 × $111,000/$156,000). After completing the allocation Reed’s bases in the distributed assets are,

Cash485,000

Potential Recapture0

Investment in stock(45000-29538)15462

Equipment (111000-72862)38,138