Reference no: EM132950666

Substantial Economic Effect Issues With Nonrecourse Debt

• Dubal Partners is a limited partnership engaged in real estate activities in New Orleans, Louisiana. It has only two partners, Theopile Boudreau and Marcelle Sonnier. Theopile is the general partner, and Marcelle is a limited partner. Theopile had made a contribution of $40,000 to Dubal Partners, and Marcelle had contributed $160,000. Dubal Partners then located a valuable crawfish farm near Lafitte, Louisiana and purchased it for $1,000,000, paying $200,000 cash and borrowing $800,000 nonrecourse. The loan required payment of only interest for the first five years, with a balloon payment after that time.
• Dubal Partners allocated its income and deduction items 20% to Theopile and 80% to Marcelle, until such time as the partnership makes enough money to have broken even over the course of its life (i.e., at such time that total profits equal or exceed total losses). Once that happens, all future income and loss items will be allocated 50-50. It does appear reasonably likely-even at the beginning of the partnership-that over the course of its lifetime the partnership is very likely to make money and be profitable.
• Theopile and Marcelle visit a tax lawyer, Hyppolite Arceneau, to make sure things are set up correctly. Hyppolite advises them to ensure that the partnership agreement requires all income and loss allocations will be reflected in the capital accounts and that liquidation distributions must be tied to capital account balances. Of course, only Theopile is required to make up any deficits, since Marcelle is a limited partner. At Hyppolite's advice, they also make sure that the partnership has a qualified income offset for Marcelle and also a minimum gain chargeback provision.
• The partnership agreement states that all non-liquidating distributions will be 20% to Theopile and 80% to Marcelle, until $200,000 total has been distributed. Thereafter, all distributions will be made 50-50. Assume that the crawfish farm is a depreciable asset, and for simplicity's sake, assume it will be depreciated over 10 years straight line. Also assume that for its farm operations, income each year over the next three years exactly equals expenses other than depreciation expense, so the loss each year is equal to the amount of depreciation taken each year.

With these facts in mind, answer the following questions:

Problem 1. How will the depreciation on the property in each of the first three years of operations be allocated?

Problem 2. At the end of three years, what will be each partner's capital account balance?

Problem 3. Would your answer change if the partnership agreement provided that Marcelle would be allocated 99% and Theopile 1% of depreciation? Explain and give authority for your response.