Smith General Partnership (SGP) operates an extremely profitable plumbing supply business. It is the exclusive supplier for several successful and stable construction firms, and it has an excellent reputation for reliability and service.

Your client, Eli Smith, is planning to sell his interest in SGP to Kevin Jones on June 30, 2017. Jones has offered total consideration of $500,000 ($100,000 cash down at closing and a $400,000 note secured by the partnership interest). The note will bear a 3.5 percent market rate of interest and will be payable in ten annual principal payments of $40,000 each, the first of which is due on January 1, 2016. Accrued interest will be due with each principal payment. (The stated interest rate is adequate for purposes of 483 and 7872, and for the original issue discount rules.) Jones also will assume Smith's share of partnership liabilities outstanding upon date of sale.

The projected balance sheet of the business as of June 30, 2021, is attached. This balance sheet was the basis for negotiation of the terms of the sale between Eli Smith and Kevin Jones.

For several years, SGP has been Eli Smith's main source of income. Eli and his two partners originally founded SGP by making contributions of cash, but Eli also contributed the land at a time when the basis of the land was $40,000 and the agreed upon FMV was $100,000. Additionally, partnership liabilities are allocated to the partners using their pro-rata share of profits and losses (shown below).

SGP uses a cash method of accounting and has reported on a June 30 fiscal year since its formation many years ago. All three partners and Kevin Jones are calendar year taxpayers. Upon formation, SGP made a 444 election to use this fiscal year and has properly made its required payments under 7519. The partnership also has a 754 election in effect.

All profits and losses of the partnership are allocated 60 percent to Eli Smith, 20 percent to Ethan Smith, and 20 percent to Nora Latham. This sharing ratio will continue subsequent to the sale of Eli's interest to Kevin Jones. The amount of guaranteed payment for Kevin Jones's services to the partnership has not yet been negotiated.

According to the partnership agreement, all allocations of profit and loss are reflected in the partners' capital accounts. The capital accounts are maintained in accordance with the 704(b) regulations; upon liquidation of the partnership, all distributions to partners will be made in accordance with the balances in their capital accounts. Upon liquidation, each partner is required to restore any deficit capital account balance to the partnership.

Eli Smith/Kevin Jones- 60%

Ethan Smith- 20%

Nora Latham- 20%

Eli Smith has engaged you to determine the amount and character of any taxable gain generated by the sale as it currently is structured.

Kevin Jones also wants to understand the tax consequences of his becoming a partner. These three individuals have requested that you analyze the transfer of the partnership interest from Eli Smith to Jones from the point of view of the ongoing partnership, providing them with a summary of any significant tax consequences. They would also appreciate any suggestions by which they could minimize or eliminate any tax problems that you uncover.

How would your response to the partners in part II above change if SGP does not have a 754 election in effect prior to the sale of the interest to Kevin Jones?

Smith General Partnership

Projected Balance Sheet

June 30, 2021

Cash and deposits	$ 19,500	$ 19,500
Trade accounts receivable	-	34,000
Land	40,000	100,000
Inventory	462,000	575,000
Furniture and fixtures (net)	77,000	137,000

Liabilities and Partners' Capital Accounts, 6.30.2021

Trade accounts payable			$ 150,000
Equity accounts	Eli Smith	$ 299,100	$ 429,300
	Ethan Smith	149,700	143,100
	Nora Latham	149,700	143,100
Totals		$ 598,500	$ 865,500

Directions: Please hand in a short letter to your client outlining any assumptions you made, any tax issues in I, II, or III above, or any that SGP might have missed and your explanations of those issues. Please attach as appendices to your memo any spreadsheets or other support material you used to make these conclusions.