Background:
Your client, Jimmy Smith (“Smith”), Amelia Wang (“Wang”) and Sammy Cortez (“Cortez”) formed a partnership to provide advertising services in 2019 and called the partnership Smith Wang Cortez Icons (“SWCI”). Jimmy and Amelia provide services to the partnership for their share of the partnership (35% each) and Sammy provided cash of $200,000 for his 30% interest. In 2019 and 2020 Jimmy and Amelia received guaranteed payments of $350,000 each in 2019 and $40,000 each in 2020. The partnership made a loss of $6500,000 in 2019 and a loss of $1 million in 2020. The losses were allocated to each of the partners in accordance with their percentage ownership interests in SWCI, i.e. Smith was allocated 35% of the losses, Wang was allocated 35% of the losses and Cortez was allocated 30% of the losses.
Due to the continual losses experienced by SWCI Cortez had to continue to inject funds into the partnership to keep it afloat. After the initial cash of $200,000 by Cortez in 2019, he injected further funds in 2019 of $500,000 and in 2020 two additional amounts of $400,000 and $600,000 and in 2021 an amount of $10,000. The funds injected in 2019 ($700,000) and 2020 ($1 million) were recorded as loans from Cortez to SWCI and reflected on the balance sheet and on the tax return as amount due to partner. The debt was recourse debt and reflected as allocated to the three partners in the same percentages as the loss allocations for the partners.
Smith included the guaranteed payment of $350,000 and loss from the partnership of $227,500 on Form 1040 for the 2019 tax year and included the guaranteed payment of $400,000 and loss from the partnership of $350,000 on Form 1040 for the 2020 tax year. Wang included the same information on her Form 1040 for 2019 and 2020.
The capital accounts for all three partners showed 0 as the initial contribution for 2019, i.e. none of them had any initial contribution recorded, and the losses allocated to them resulted in negative capital accounts. The capital accounts for the three partners at the end of 2020 also reflected negative capital accounts that had been increased by the amount of the losses allocated to them in 2020.
In 2021, SWCI ceased operations and had neither a profit or a loss. SWCI would now like to reclassify the debt due to Cortez as a capital contribution by Cortez and file a final federal return for the partnership as the partnership has terminated.
You can safely assume that there was a signed partnership agreement and there were terms specified for what needs to occur for an item to be considered a contribution to capital.
SWCI needs advice for the following for the 2021 income tax year:
- Is it possible in 2021 to reclassify the debt due to the partner Cortez as capital contributions from the partner Cortez?
- Is there any income that should be realized and recognized for the partnership in 2021?
- What gain or loss will the partner Smith realize and recognize on the termination of the partnership, including the character of that gain or loss?
You research should consider the following (but it is not an exhaustive list):
-Hohl et al. v Commissioner (T.C. Memo 2021-5)
-IRC §61(a)(12)
Your responsibility:
Prepare a tax research memo addressing the question that has been raised. Please note that if the tax memo is not in the required format and/or contains very little analysis you will receive a zero (0) for the assignment. All good faith efforts are capable of receiving a minimum of 60% but less than a good faith effort will be awarded zero points.
You will need to support your conclusion using primary sources of tax law. Your textbook is NOT primary authority nor are IRS Publications. Please refer to Chapter 2 for primary authorities. CCH AnswerConnect is not a primary authority, nor is Google Scholar nor are any other websites you may access. The primary authorities are legislative, administrative and judicial.
You must use proper citation form in your memo (see Chapter 2 for help with citation form). The form for this communication should be professional and in the form of a tax research memo (examples posted on Canvas and a similar example in your textbook). You will see that citations are within the text of the document in the example. Once a court case has been cited in full, it can be referred to using simply the name in italics.
Do yourself a favor and look at the grading rubric before you submit.
This memo should be whatever length you feel is appropriate to resolve the issues. We do NOT use a bibliography or list of references in a tax research memo. We do not include Background in a tax memo. The Background is provided so you can identify the facts.
