Partnership with Service as Contribution

[Gretel]

I just attended the Entity Gear up Seminar and have one example I don't fully understand. Hope someone can explain. It's only the very last sentence I don't understand. The part with the compensation for services is not a problem. Here it goes:

Snap, Crackle and Pop form a partnership to sell milk (Got Cereal, LLC). Each will won 1/3 of the partnership. Snap contributes a vehicle with a FMV of $30,000 and 0 basis, Crackle contributes equipment with an FMV of $30,000 and 0 basis, and Pop contributes his services to market the milk after purchase. The value of Pop’s interest would be determined as follows:

FMV vehicle $30,000
FMV equipment 30,000
Total value at liquidation $60,000

Pop’s share at 1/3 is $20,000 les any minority interest deduction.

Pop would report $20,000 on his 1040 as ordinary, self-employment income.

Got Cereal, LLC, would deduct $20,000 of compensation expense on the Form 1065. Regulation 1.83-6(a) does not require withholding on the compensation. Got Cereal, LLC would record the transaction as a deductible expense of $20,000, with an offsetting credit to Pop’s capital account for $20,000.

The existing partners would also have to record gain (the assets had no basis) as an increase in partnership asset basis of $20,000, and an offsetting gain of $10,000 each.

[Bees Knees]

That example was given in connection to the statement made at Reg. Sec. 1.721-1(b)(1) which says: “Each partner is entitled to be repaid his contributions of money or other property to the partnership (at the value placed upon such property by the partnership at the time of the contribution) whether made at the formation of the partnership or subsequent thereto. To the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services (or in satisfaction of an obligation), section 721 does not apply.”

Section 721 is the one that says a partner does not recognize gain when contributing property to a partnership. So if Section 721 does not apply, then the contribution of property to a partnership would be a taxable gain, similar to a contribution to a corporation that doesn’t qualify for Section 351 treatment.

The example is illustrating a capital interest, not a profits interest. If the guy contributing the services was only entitled to a profits interest, the other two partners do not recognize gain because they did not give him any interest in the capital they just contributed. But because the other two partners are handing over $10,000 worth of their contribution to the guy contributing services, it is as if they just sold him $10,000 worth of stuff. And since they each had zero basis, it is a taxable gain.

Another way to look at it is they each got a $10,000 tax deduction for the services he put into the partnership in exchange for each giving him $10,000 worth of their stuff. But neither had any basis in that $10,000 worth of stuff they gave him, therefore, they have to pay tax on that before they can deduct it. The gain and the deduction cancel each other out, so there really is no tax consequence to it, other than to prevent them from getting a tax deduction for something they never paid for.