Final answer:
In this business scenario, Berk should report $0 income for the current tax year since he was relieved of his liability while receiving payments that did not exceed his basis, and report a $40,000 gain in the following year. As a calendar-year taxpayer, Berk only recognizes gain once the cash payments exceed his adjusted basis in the partnership.
Step-by-step explanation:
Considering Berk's scenario as a calendar-year taxpayer, his capital account is $50,000 and his share of the partnership’s liabilities is $30,000. Upon retirement, he is relieved of his $30,000 share of liabilities and receives cash payments of $5,000 per month for eighteen months. Berk's income related to relief of liabilities is immediate since he won't have to repay the $30,000; this is considered a liquidating payment and is treated as a capital transaction. As for the cash payments, they total $90,000 over eighteen months ($5,000 x 18 months).
Since Berk's outside basis (capital account plus share of liabilities) is $80,000 ($50,000 capital + $30,000 liabilities), we need to determine if any of the cash payments received are more than Berk's basis, which would represent a gain.
First, relieving the liabilities of $30,000 does not result in income, as it essentially reduces his basis in the partnership to $50,000. Next, Berk starts receiving monthly payments. By the end of the year, Berk receives $30,000 ($5,000 x 6 months from July to December). His basis reduces to $20,000 ($50,000 - $30,000). In the following year, Berk receives the remaining $60,000. Since Berk's basis is only $20,000 at the beginning of the second year, he will have a recognized gain of $40,000.
For tax purposes, Berk will report $0 income for the current year and a $40,000 gain in the next year from the monthly retirement payments since no earnings have exceeded his basis in the current tax year. Therefore, the correct reporting would be option 4) — 40,000.