Reference no: EM132663134

Problem - Why Use a Partnership, Anyway?

For 15 years, Maria has owned and operated a seaside bakery and café called The Beachsider. Each morning, customers line up on the boardwalk in front of the building and enjoy fresh coffee and croissants while waiting for a table. "The building is too small," Maria commented to her landlord, Kyle. "Is there any way we can expand?" The Beachsider occupies one of several buildings on three acres of a 10-acre parcel that Kyle inherited several years ago. The remaining seven acres are undeveloped.

Kyle and Maria talked to Josh, a real estate developer, and he proposed an expansion to The Beachsider and upgrades to the other buildings. The improvements would preserve the character of the original retail center, and the remaining acreage would be available for future expansion.

They liked his ideas, so Kyle, Maria, and Josh agreed to form a partnership to own and operate The Beachsider and to improve and lease the other buildings. Josh summarized the plan as follows: "Kyle and Maria will each contribute one-half of the capital we need. Kyle's real estate is valued at about $2,000,000. Maria's bakery equipment and the café furnishings are valued at about $500,000. The improvements will cost about $1,500,000 of cash, which Maria has agreed to contribute to the partnership."

Josh continued, "You have agreed that I do not need to contribute any capital to the partnership. I will oversee the construction, and when it is complete, I will vest in a 5 percent interest in the partnership's capital. On an ongoing basis, I will oversee the partnership's operations in exchange for a fixed salary and 20 percent of the partnership's ongoing profits. The construction should be completed in June of this year, and my capital interest is estimated to be valued at $200,000 at that time."

What are the tax consequences if the trio forms Beachside Properties as a partnership to own and operate the retai center? What issues might arise later in the life of the entity?