Planning for the allocation of cash-basis items to partners whose partnership interests change during the tax year.

• Author: Ellentuck, Albert B.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Partnerships, 15th edition, by Graver A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, Tex., 2001 ((800) 323-8241; www.ppcnet.com).

Facts: Able-Baker Co. is a calendar-year partnership with two equal partners, Able and Baker. Able-Baker Co. uses the cash method of accounting. Able and Baker plan to admit Charles to the partnership on July 1, 2002, as an equal partner. The partnership has a liability for $1.2 million, representing a note given on Oct. 1,2001 for the purchase of real estate. This note bears a simple annual interest rate of 12% (based on a 360-day year). The partners expect to make the first interest payment of $144,000 on Sept. 30, 2002. * Able and Baker have consistently maintained their books using the cash method since the partnership was organized. Accordingly they have never recognized either accrued income or expenses. They intend to require Charles to make a capital contribution equal to each of the other partners' capital accounts as shown on the partnership books on the date Charles is admitted to the partnership. * The partners seek the advice of their tax adviser as to whether any special tax planning is necessary in connection with Charles' capital contribution and partnership admission. Issue: What tax planning can be done for accrued items in a cash-basis partnership when there is a change in the partners' interests during a tax year?

Analysis

Normally, Able-Baker's partnership income or loss items would be allocated in accordance with the partners' respective partnership interests for 2002 (i.e., for the first six months allocated equally to Able and Baker and for the last six months allocated one-third each to the two original partners and Charles). However, Sec. 706(d)(1) requires certain cash-basis items to be apportioned to the period in which they accrued. In turn, these items must be allocated according to the partners' respective ownership interests during the period the cash-basis expenses accrued. Cash-basis items covered by this provision include interest, taxes, payments for services and rents.

In this case, interest on $1.2 million at 12% accrues at the rate of $400 per day. Accordingly, $36,000 accrues as of Jan. 1, 2002. This amount, which accrued in the prior year, is assigned to the first day of 2002...