The Neeley Services Group is owned equally by Norma, Irene, and Carole. The entity is a calendar-year, cash-basis partnership that was organized in Indiana about ten years ago. Neeley Services operates a same-day trucking service out of the Indianapolis airport, taking small packages of hazardous materials to customers when national delivery companies will not handle the shipped goods.
Neeley Services has been highly profitable since its inception, as profit margins are high – Neeley is one of the few local businesses that can charge “what the traffic will bear.” In fact, delivery fees are raised as needed to cover increases in insurance, maintenance, licenses, and fuel costs. Neeley’s drivers are not unionized, but the Group provides adequate salaries and generous fringe benefits to its employees. Neeley operates essentially as a cash-only business – no services are delivered until the customer remits the invoice in full, almost always by electronic funds transfer.
Rumors circulated that DHL was about to move into the market and present some aggressive competition, but that company no longer operates in the US, so those rumors have died down, and none of the other potential competitors seem interested.
Carole wants to move permanently back to Fort Wayne so as to care for her aging parents. The time required to meet these needs means that Carole will retire from the entity at the end of the current year, Year One. No additional capital is needed by Neeley to carry on at its existing service levels, and Norma and Irene have no current expansion plans. They are open to bringing in a new partner in the future, say when they themselves decide to retire, or when new market opportunities, perhaps in Dayton OH and Evansville IN, pop up.
The projected end-of-Year-One balance sheet and capital accounts for Neeley Services and its owners is presented below. All parties agree that Carole’s one-third interest then will be worth $700,000, taking into account any potential goodwill. The retirement agreement calls for cash payments to Carole of $300,000 per year at the end of each of Years One, Two, and Three. Norma and Irene will assume all of Neeley’s entity liabilities.
Myrna, Neeley’s long-time accountant, has prepared the Group’s financial statements and Forms 1065 for seven years running, but she feels that a third-party like you should analyze the retirement agreement and its tax effects on Carole. According to Myrna, each partner’s interest basis for federal income tax purposes is the same as the total in her capital account.
Required: Prepare a spreadsheet in good form, to compute and characterize Carole’s gain realized and recognized from the retirement payments that Neeley Services makes to her.
Neeley Services Group
Projected Balance Sheet
End of Year One
Neeley Services Group.
Keep these in mind as you work this case.
??? Start by determining the Amount Realized for each of the three payments. How is the debt relief treated for this purpose?
??? Now compute the Gain Realized with each payment received. What is Carole’s interest basis at the end of Year One?
??? For the total of the cash payments to Carole, how much is designated a §736(b) payment? A §736(a) payment?
??? Remember that Neeley is classified as a service partnership – its asset holdings are not so capital-intensive as to find otherwise. Its greatest financial asset is its guaranteed cash flow from the service contracts.
??? Now find the amounts of capital and ordinary income that Carole recognizes with each payment.
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