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Author: ripwest Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 7258  
Subject: Re: accounting software Date: 12/21/1999 6:08 PM
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"Version 3.0 of Valuation Accountant will support payoff of members
in stock. This version is a couple of weeks away. I would be pleased to
hear the explanation of the doubling up on income recognition?"

Can you comment on their query re: the "doubling up on income
recognition"?


Glad to hear that Clester is going to accommodate payoffs in stocks, soon. First, I would like to emphasize that the 'doubling up of income recognition' is not something that is software specific. It is just a quirk in the IRS regulations concerning partnerships.

Here is a simple example (at least as simple as I can make it). Able, Baker and Charlie form an investment club, and each puts in 10,000. The club buys HiFlier Stock - 150 shares at 100 for a total of 15,000. So the club has 15,000 in cash and stock worth 15,000. Now the stock skyrockets and the share price doubles, so the stock is now worth 30,000. The club then has 30,000 in stock and 15,000 in cash for a total value of 45,000. Charlies share is 15,000 (1/3 or 45,000). He is delighted and wants out. The club has the cash to buy him out and does so.

So Charlie put in 10,000 originally and gets 15,000 back. He has a gain of 5,000 reportable in the year received. The club has no gain to report at this point.

Now the club decides that they should sell the HiFlier stock. They do so for 30,000. Since they paid 15,000, they have a gain of 15,000, which will be allocated equally to Able and Baker - 7,500 each.

Now consider what has happened to this point. Charlie has reported a gain of 5,000. Able and Baker will be reporting 7,500 each. That is a total gain of 20,000. But the only real, economic gain has been the stock increase from 15,000 to 30,000 or a gain of 15,000.

That is why I say there has been a 'doubling up' of recognized income. 20,000 has been reported and there is really only 15,000 that has been
earned. This situation will correct itself when Able and Baker leave the
club. After they report their gain of 7,500 each, the basis for tax purposes becomes 17,500 (original investment of 10,000 plus 7,500 gain
recognized). But there is only 30,000 left in the club to distribute to them. So if the club is disbanded, they will receive 15,000 each and have a 'loss' of 2,500 each, thus correcting the problem. But that
correction could take years to happen.

There are two ways to get around this problem. The first is offered by the IRS in the form of a '754 election'. Unfortunately, none of the club software presently on the market can accommodate this election, so we won't discuss it here. The other way would be to issue stock when paying out a partner. If the club had paid Charlie off with 5,000 in cash and 10,000 in stock, he would realize no gain until he sells the stock, at which time he realizes 5,000. Then the club sells the remaining shares of stock, they will realize a 10,000 gain on the remaining shares which will be split equally. No prerecognition of gain in that case.

Note that the same thing happens if the club decides to sell the stock and use the proceeds to pay Charlie off. I won't go through all the gory details. This post is long enough. Sorry about that, but it's a tough
subject to cover briefly.

Rip

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