 Hello and welcome to the session in which we will discuss the contribution to a partnership, and specifically the tax consequences for a contribution to a partnership. Generally speaking, neither the partner nor the partnership record any profit or loss, gain or loss, when money or property is contributed in return for partnership interests. What does that mean? It means when the partner contributed money or property to a partnership and in return they get some sort of an ownership interest, there are no gain and losses. So when you contribute that property, well that property could be the fair value of that property could be greater than the adjusted basis as a result you have a gain. Well you cannot recognize the gain or the fair value could be less than the adjusted basis which means you have a loss, you cannot record that loss. Now why? Well you want to record the loss if you can but the government does not allow you and you don't want to record the gain because you don't want it to be taxable. So simply put it's very similar to the to the contribution to a to a corporation S or C where it's considered a continuation of ownership. So the Congress doesn't want to burden you with paying taxes when you form partnership, form businesses, therefore that type of contribution is tax-free. Now the gain or the loss, any potential gain or loss is not realized, we don't have to account for it now, until a taxable event occurs. Simply put it's deferred, the gain or the loss is deferred. When the partnership disposes of the property, well how it's time for the partnership to do what? Recognize the gain or the loss or when the partner sells their partnership interest they will have a gain or a loss. However the basis of the partner's interest in a partnership equal to the basis of the property they contributed. So simply put the basis of the property you contributed is transferred to the partnership which is really really good because there are no tax consequences and the good news is you don't have to worry about section 351, there's no section 351 for partnership where you have to determine whether you have an 80% control or not for the transaction to be tax-free. What should we do now? Start with a simple example to illustrate these concepts. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead start your free trial today. Start with partner A contributed cash of 25,000. Well, do we have a gain or a loss for partner A? Well if you contributed cash, cash is a cash so it doesn't have a higher or lower fair value than its face value for that matter therefore there's no gain no loss. Basis in partnership interest you contributed 25,000 that's your basis in the partnership interest and the 25,000 sitting in the bank account represent the 25,000 property basis in the partnership. Now you contribute be contributed land with the basis of 8,000 fair market value of 18. What we have here is a gain and what I'm going to call this we're going to see it later in this recording pre-contribution gain. In other words there is a gain embedded in that property and it's a pre-contribution before you contributed this land. Well, what are the tax consequences? No tax consequences notice we have a $10,000 gain no tax consequences for now. The basis in the partnership interest for B the basis in the partnership interest is 8,000 the basis of the land for the partnership also 8,000 so simply put the basis transferred went from the partner to the partnership. Let's take a look at the third scenario partner C contributed equipment with the basis of 24 fair market value of 22. What we have here is a pre-contribution loss this equipment if partner C sells it they would they would realized a loss well they contributed there is no loss no gain the basis the basis of the partner becomes the basis of the partner and the partnership interest 24,000 and the basis of the original basis of the equipment becomes the partnership property basis which is 24,000 simply put the basis transfer. Now let's talk more a little bit more about the tax consequences for section 1231 and capital asset the partnership takes the place of the contributing partner holding period so as far as the holding period whatever how long you've been holding it for five years well it's going to be five years with the partnership they steps into the shoes of the partner it's a continuation so if you have this building you used to own it now it's the building in the partnership if you bought it 10 years ago well it's 10 years ago purchased for the partnership it carries the same cost recovery and amortization computation as before so whatever you are using for depreciation will keep on going and if it's an intangible asset same amortization now bear in mind partnership cannot deduct section 179 just know this how about if you contributed services rather than property or money sometime what happened is you want to join a partnership but you don't have money or you don't have property to contribute it but you have a set of skills the skills that's needed for the partnership so what they would say is this why don't you provide the service for us and in return will give you part ownership 20% 30% whatever we agreed upon now so when a partner receive a fully vested interest for providing services the value of the interest whatever you received in value of the interest this amount is taxable and usually should be the value of the services whatever you whatever you gave them in terms of services it's considered compensation income simply put it's wages to you ordinary income so services cannot be transferred without tax implications so you do have tax implication let's take a look at an example to illustrate this concept Arthur was giving one third capital and profit interest in Delhi LLC with one-third valued at 20 000 why well this payment was given to him for providing tax planning services to the Delhi so that's all what can Arthur do they provide the tax services they gave them one-third of the company so as a result of this Arthur would recognize 20 000 in compensation income which is basically you know w2 or 1099 however you want to call it but they recognize this and they have a basis in the LLC of 20 000 that's how much they the value of the services think of it this way as of the LLC as of the LLC they gave them a check for 20 000 to Arthur Arthur turned around and wrote the check back to the LLC and got got one-third one-third interest in the partnership same thing but simply put there was no money exchange simply put they gave them the partnership interest but the point is it's as it's as it's as it's as if they did this and that's why the 20 000 is compensation income that's taxable and the basis is 20 000 now as far as the LLC is concerned the 20 000 is an amortizable startup cost which is in expense we'll talk about startup and organizational cost shortly how about if you contributed ordinary asset what are we looking at here we're looking at receivable inventory so any asset other than capital asset in section 1231 okay the holding period for this asset start from the date the partner acquires the partnership interest so you're the the holding period doesn't start it's not a continuation it's from the time you contributed to the partnership so when a partnership sells unrealized receivable or property that's qualify as inventory by the contributing partner providing that's sold within five years the gain or loss is treated as ordinary income those are ordinary assets therefore the income is treated as ordinary tax and ordinary rate now we're going to look at few examples to illustrate the contribution to a partnership versus scenarios where we have pre-contribution loss pre-contribution gain and we're looking at a partnership we're going to call it AB partnership so we have two partners that form AB partnership they are equal partners 50% each partner a contributed a piece of land has a fair market value of 20 adjusted basis of 12 what can we do we can we would know we know for now that we have pre-contribution gain of 8 000 excellent just just make a note of it it's not recognized it's not it's not shown anywhere just make a note of it okay one year later AB partnership sells the land for 21 000 so let's see what happened now the land was sold so the consideration received is 21 000 the basis of the property is the same basis as the partner 12 000 which has transferred so we have no actually it was sold for 21 000 200 not 21 000 so we have what we called now a realized gain realized slash recognized gain of 9 200 okay what do we need to do with this what do we need to do with this game how are we going to allocate the gain now remember what i told you earlier to make a note of this 8 000 because this 8 000 belongs to a belongs to partner a because partner a contributed the land so when we allocate the gain or the loss the 8 000 it stills it's still it would still be with a would it's it's would still be with partner a it doesn't go away the additional gain which is the the 1200 because we had a gain total of 9 200 that's the total gain now 8 000 of it belongs to a belongs to a so what how much left is 1200 now the 1200 will be distributed between a and b so the 1200 so it's going to be the 1200 times 50 percent and 1200 to be times 0.5 0.5 so this is the post contribution fair market value let's write here actually i wrote it down post contribution increase in fair market value so the post contribution was 1200 okay so this was 8 000 the total let me just have the total here maybe it will help total the total gain the the pre contribution gain total is 8 000 this is the pre contribution gain and the post contribution is 1200 so the total is allocated as 9 200 okay which is which is 600 to be in 8 600 to a okay and this will prevent partner a from avoiding the taxes on the 8 000 so so this way they don't just contribute it appreciable property to the partnership and what do they do they turn around and they sell it in the hope that other partners will pick up their gain that that doesn't happen you pick up your own gain and a and a partnership you pick up your own gain and a partnership okay let's look at a different scenario a little bit different again the same partnership partner a and partner b equal partners here partner a contributed a property for has a fair market value of 20 cost basis of 30 okay what do we have here hopefully you see we have a a pre contribution loss what do we do this pre contribution loss absolutely nothing we just know it's a pre contribution loss the basis of 30 000 will be transferred to the partnership as the basis in the property now one year later a b partnership sells the land for 16 000 now we sold the land for 16 000 okay so consideration received is 16 000 minus the adjusted basis the adjusted basis is 30 000 so we have a loss of 14 000 so the pre contribution loss was 10 000 the pre contribution loss was 10 000 now the pre contribution loss this 10 000 belongs to a it doesn't it doesn't change belongs to a so so this belongs to a so what's going to happen when we go down to allocate the gain and the loss after we make the sale the 10 000 would still go to a the 10 000 would still go to a now the question is what about the total 14 000 because the total gain is 14 000 the additional 4000 let me just put the additional 4000 we said the 14 000 was the total loss 10 000 this is the total loss of this 14 10 000 is a's losses so we are left is what we call this the post contribution gain loss post contribution loss so we post contribution loss is 4 000 so since it's a post contribution each one of them will get 2000 so negative 2000 to a negative 2000 to b and now we this is the total the total is 10 000 losses uh pre contribution and 4 000 losses post contribution 4 000 we accounted for the 4 000 12 000 is covered or absorbed absorbed by a and uh and uh and 2000 is absorbed by b now what happened if the subsequent sale if we sell it and it's between the fair market value in the adjusted basis so what happened if we sold this property here uh for 22 000 or for 23 000 so it's in between the fair market value and the adjusted basis okay so how do we contribute any gain or loss well here's the rule for you so write it down copy it so we're going to go ahead and do it if subsequent losses if subsequent sales prices between the fair market value and the adjusted basis at the contribution date the contributing partner which is a in this situation the contributing partner the contributing partner will will have a gain or a loss equal to the lesser of lesser of let me just built in gain or built in loss originally or the partner gain or loss so we'll have to figure out what is the built in gain or loss and what's the partnership gain or loss overall and the contributing partner will absorb the lesser of these two the lesser of these two and the best way to do this is to work an example obviously so again we have two partners a and b a and b equal partners um a contributed land the fair fair market value is 20 adjusted basis is 30 again here hopefully you see we have a um built in loss pre-contribution loss of 10 000 what do we do with this just make a note of it it's a loss the partnership will take the basis of 30 000 and your basis and the property is 30 000 one year later uh one year later the partnership sold the land sold the land for 22 and hopefully you know what we're going with this 22 000 is what 22 000 is in between the fair market value and the adjusted basis so we sold the land for 22 so consideration received is 22 000 the adjusted basis in the land is 30 which will give us a loss of 8 000 which will give us a loss of 8 000 now how much how much gain and loss is allocated to each partner first of all before we proceed hopefully you know that the 10 000 contribution loss doesn't go away the 10 000 contribution loss by by the first partner the pre-contribution okay this loss doesn't go away it would still belong to a so a a will have to absorb will have to absorb this loss it it doesn't go away okay now what's going to happen is this since the uh since the since the contribution was made since the contribution was made um we have to determine what is the gain or the loss for the partnership now the gain or the loss for the partnership actually is 8 000 okay how do we how do we know it's 8 000 look they sold it for 22 the partnership sold it for 22 minus 30 which is 8 000 the pre-contribution is 10 000 now the partnership gain or loss the partnership gain or loss is 8 000 is 8 000 now we have two figures to choose from two figures to choose from we have the 8 000 and we have the 10 000 losses well obviously the losses all the losses belongs to a so base b should not absorb any losses we have less losses but we still have the losses we used to have 10 now we have 8 how much would with with partner a count as losses well it's the lesser of these two because it's the lesser of is what i told you in the rule it's the lesser of the built-in gain or loss or the partnership gain or loss the partnership gain or loss is lesser 8 000 therefore partner a will absorb 8 000 what do partner b get nothing partner b has nothing to do with these losses all the losses belongs to a nothing belongs to partner b okay now let's take a look at one more example we have we have two partners a and b okay partner a contributed land contributed land fair market value of 20 adjusted basis of 30 so now we have a loss again this is a what do we call this loss a we call it a pre-contribution loss we don't we don't do anything with it we just let it go for now until we sell the property so we sold the property for 36 000 okay consideration received 36 000 the partners minus the partnership adjusted basis the partnership adjusted basis will be the same as the partner basis which is 30 000 now let's figure out what do we have we have realized a realized gain of 6000 a realized gain of 6000 now we have adjusted basis i'm sorry a pre-contribution loss of 10 000 okay this is the pre-contribution loss of 10 000 and we have a realized gain of 6000 now what's going to happen is this the loss doesn't go away the loss would still be absorbed by a so the pre-contribution built-in loss would still be absorbed by a okay now we have to look at the post contribution increase and fair market value how much was the post contribution increase well the fair market value post contribution was 36 000 pre-contribution was 20 000 so the post contribution increase is 16 000 this is called post contribution increase in fair market value now the post contribution increase belongs to both of them belongs to a as well as b so this post contribution increase belongs to both of them because this happened after a contributed the property so i contributed the land so any increase in the land will belong to both will belong to both so if it belongs to both so 50 percent goes to a and 50 percent goes to b 0.5 okay so the total allocated losses for a will be 2000 and the total allocated gain to b will be 8 000 and total 6000 which is we accounted for the 6000 always double check and make sure the total gain allocated to both partners equals to the partnership just to make sure you are on the right track at the end of this recording i'm going to remind you again to do what go to far hat lectures look at additional resources multiple choice true false questions that's going to help you understand the concept of contributing to a partnership what are the tax consequences for those contribution whether you are a cpa candidate enrolled agent or an accounting student this topic is important invest in yourself good luck and stay safe