Chapter 10



Chapter 11

Digging Deeper

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Contents:

| ELECTING LARGE PARTNERSHIPS | CONCEPTUAL BASIS FOR PARTNERSHIP TAXATION | INITIAL COSTS, ACCOUNTING METHODS, AND TAXABLE YEAR OF A PARTNERSHIP | REPORTING OPERATING RESULTS | PARTNERSHIP DISTRIBUTIONS | PARTNERSHIP ALLOCATIONS | BASIS OF A PARTNERSHIP INTEREST | OTHER TRANSACTIONS BETWEEN A PARTNER AND A PARTNERSHIP | FAMILY PARTNERSHIPS |

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ELECTING LARGE PARTNERSHIPS

1. The number of items that are separately reported to the partners varies and depends upon whether the partnership is an electing large partnership. A partnership qualifies as a large partnership if it had at least 100 partners during its immediately preceding taxable year and elects simplified reporting of its taxable items. Such partnerships separately report as many as 10 different categories of items to their partners. This means that many items are netted at the partnership level. For example, an electing large partnership nets items such as interest, nonqualifying dividends, and royalty income items at the partnership level and reports to each partner only that partner's share of the total. The netting of items at the partnership level makes each partner's tax return easier to complete. Unless otherwise indicated, in this chapter assume the partnership is not an electing large partnership.

CONCEPTUAL BASIS FOR PARTNERSHIP TAXATION

2. The unique tax treatment of partners and partnerships can be traced to two legal concepts that evolved long ago: the aggregate (or conduit) concept and the entity concept. These concepts have been used in both civil and common law and have influenced practically every partnership tax rule.1

Aggregate (or Conduit) Concept. The aggregate (or conduit) concept treats the partnership as a channel through which income, credits, and deductions flow to the partners. Under this concept, the partnership is regarded as a collection of taxpayers joined in an agency relationship with one another. The imposition of the income tax on individual partners reflects the influence of this doctrine. The aggregate concept has also influenced the tax treatment of other pass-through entities, such as S corporations (Chapter 12) and trusts and estates.

Entity Concept. The entity concept treats partners and partnerships as separate units and gives the partnership its own tax “personality” by (1) requiring a partnership to file an information tax return and (2) treating partners as separate and distinct from the partnership in certain transactions between a partner and the entity. A partner’s recognition of capital gain or loss on the sale of the partnership interest illustrates this doctrine.

Combined Concepts. Some rules governing the formation, operation, and liquidation of a partnership contain a blend of both the entity and aggregate concepts.

INITIAL COSTS, ACCOUNTING METHODS, AND TAXABLE YEAR OF A PARTNERSHIP

3. Acquisition Costs of Depreciable Assets. Expenditures may be incurred in changing the legal title in which certain assets are held from that of the contributing partner to the partnership name. These costs include legal fees incurred to transfer assets or transfer taxes imposed by some states. Such costs are depreciable assets in the hands of the partnership. However, since the partnership “steps into the shoes” of contributing partners for determining depreciation on preexisting contributed assets, acquisition costs are treated as a new asset, placed in service on the date the cost is incurred.

Syndication Costs. Syndication costs are capitalized, but no amortization election is available.2 Syndication costs typically include the following expenditures incurred for promoting and marketing partnership interests.

• Brokerage fees.

• Registration fees.

• Legal fees paid to the underwriter, placement agent, and issuer (general partner or the partnership) for security advice or advice on the adequacy of tax disclosures in the prospectus or placement memo for securities law purposes.

• Accounting fees related to offering materials.

• Printing costs of prospectus, placement memos, and other selling materials.

Method of Accounting. Like a sole proprietorship, a newly formed partnership may adopt either the cash or the accrual method of accounting, or a hybrid of these two methods.

However, a few special limitations on cash basis accounting apply to partnerships. The cash method of accounting may not be adopted by a partnership that:

• has one or more C corporation partners or

• is a tax shelter.

A C corporation partner does not preclude cash basis treatment if:

• the partnership meets the $5 million gross receipts test described below,

• the C corporation partner(s) is a qualified personal service corporation, such as an incorporated attorney, or

• the partnership is engaged in the business of farming.

A partnership meets the $5 million gross receipts test if it has not received average annual gross receipts of more than $5 million. ‘‘Average annual gross receipts’’ is the average of gross receipts for the three tax years ending with the tax period in question. For new partnerships, the period of existence is used. Gross receipts are annualized for short taxable periods. A partnership must change to the accrual method the first year after the year in which its average annual gross receipts exceed $5 million and must use the accrual method thereafter.

A tax shelter is a partnership whose interests have been sold in a registered offering or a partnership in which 35 percent of the losses are allocated to limited partners.

Example: Jason and Julia are both attorneys. In 2005, each of them formed a professional personal service corporation to operate their separate law practices. In 2008, the two attorneys decide to form the JJ Partnership, which consists of the two professional corporations. In 2008, JJ’s gross receipts are $6 million. JJ may adopt the cash method of accounting, since it is a partnership consisting of qualified personal service corporations. Because JJ has no C corporate partners that are not personal service corporations, the cash method is available even though JJ’s average annual gross receipts are greater than $5 million. JJ may also adopt the accrual method of accounting or a hybrid of the cash and accrual methods.

Taxable Year of the Partnership. Partnership taxable income (and any separately stated items) flows through to each partner at the end of the partnership’s taxable year. A partner’s taxable income, then, includes the distributive share of partnership income for any partnership taxable

year that ends within the partner’s tax year.

When all partners use the calendar year, it would be beneficial in present value terms for a profitable partnership to adopt a fiscal year ending with January 31. Why? When the adopted year ends on January 31, the reporting of income from the partnership and payment of related taxes can be deferred for up to 11 months. For instance, income earned by the partnership in September 2007 is not taxable to the partners until January 31, 2008. It is reported in the partner’s tax return for the year ended December 31, 2008, which is not due until April 15, 2009. Even though each partner may be required to make quarterly estimated tax payments, some deferral is still possible.

Required Taxable Years. To prevent excessive deferral of taxation of partnership income, Congress and the IRS have adopted a series of rules that prescribe the required taxable year an entity must adopt if no alternative tax years (discussed below) are selected. Three rules are presented in the box below. The partnership must consider each rule in order. The partnership’s required taxable year is the taxable year determined under the first rule that applies.

The first two rules in the box are relatively self-explanatory. Under the least aggregate deferral rule, the partnership tests the year-ends that are used by the various partners to determine the weighted-average deferral of partnership income. The year-end that offers the least amount of deferral is the required tax year under this rule.

|In Order, Partnership Must Use |Requirements |

|Majority partners’ tax year |More than 50% of capital and profits is owned by partners who have the same |

| |taxable year. |

|Principal partners’ tax year |All partners who own 5% or more of capital or profits are principal partners. |

| |All principal partners must have the same tax year. |

|Year with smallest amount of income deferred |‘‘Least aggregate deferral rule’’ (see example below). |

Example: Anne and Bonnie are equal partners in the AB Partnership. Anne uses the calendar year, and Bonnie uses a fiscal year ending August 31. Neither Anne nor Bonnie is a majority partner since neither owns more than 50%. Although Anne and Bonnie are both principal partners, they do not have the same tax year. Therefore, the general rules indicate that the

partnership’s required tax year must be determined by the ‘‘least aggregate deferral rule.’’

The following computations support August 31 as AB’s tax year, since the 2.0 product using

that year-end is less than the 4.0 product when December 31 is used.

|Test for 12/31 Year-End |

|Partner |Year Ends |Profit Interest |

|Test for 8/31 Year-End |

|Partner |Year Ends |Profit Interest |

Alternative Tax Years. If the required tax year is undesirable to the entity, three other alternative tax years may be available.

• Establish to the IRS’s satisfaction that a business purpose exists for a different tax year, usually a natural business year at the end of a peak season or shortly thereafter.

• Elect under § 444 a tax year so that taxes on partnership income are deferred for not more than three months from the required tax year. Then, have the partnership maintain with the IRS a prepaid, non-interest-bearing deposit of estimated deferred taxes.3 This alternative may not be desirable since the deposit is based on the highest individual tax rate plus one percentage point, or 36 percent.

• Elect a 52- to 53-week taxable year that ends with reference to the required taxable year or to the taxable year elected under the three-month deferral rule.

REPORTING OPERATING RESULTS

4. Penalties. Each partner’s share of partnership items should be reported on his or her individual tax return in the same manner as presented on the Form 1065. If a partner treats an item differently, the IRS must be notified of the inconsistent treatment.4 If a partner fails to notify the IRS, a negligence penalty may be added to the tax due.

To encourage the filing of a partnership return, a penalty of $50 per partner per month (or fraction thereof), but not to exceed five months, is imposed on the partnership for failure to file a complete and timely information return without reasonable cause.5 A partnership with 10 or fewer individual and C corporation partners is excluded from these penalties.6 A husband and wife (or their estates) count as one partner in meeting this test.

PARTNERSHIP DISTRIBUTIONS

5. A distribution from the partnership to a partner may consist of cash or partnership property. All distributions, cash and property, fall into two distinct categories.

• Liquidating distributions.

• Nonliquidating distributions.

Whether a distribution is a liquidating or nonliquidating distribution depends solely on whether the partner remains a partner in the partnership after the distribution is made. A liquidating distribution occurs either (1) when a partnership itself liquidates and distributes all of its property to its partners or (2) when an ongoing partnership redeems the interest of one of its partners. This second type of liquidating distribution occurs, for example, when a partner retires from a partnership, or when a deceased partner’s interest is liquidated. The two types of liquidating distributions receive differing tax treatment.

A nonliquidating distribution is any other distribution from a continuing partnership to a continuing partner—that is, any distribution that is not a liquidating distribution. Nonliquidating distributions are of two types: draws or partial liquidations. A draw is a distribution of a partner’s share of current or accumulated partnership profits that have been taxed to the partner in current or prior taxable years of the partnership. A partial liquidation is a distribution that reduces the partner’s

interest in partnership capital but does not liquidate the partner’s entire interest in the partnership. The distinction between the two types of nonliquidating distributions is largely semantic, since the basic tax treatment typically does not differ.

Example: Kay joins the calendar year KLM Partnership on January 1 by contributing $40,000 cash to the partnership in exchange for a one-third interest in partnership capital, profits,

and losses. Her distributive share of partnership income for the year is $25,000. If the partnership

distributes $65,000 ($25,000 share of partnership profits + $40,000 initial capital contribution) to Kay on December 31 the distribution is a nonliquidating distribution as long as Kay continues to be a partner in the partnership. This is true even though Kay receives her share of profits plus her entire investment in the partnership. In this case, $25,000 is considered a draw, and the remaining $40,000 is a partial liquidation of Kay’s interest. If, instead, the partnership is liquidated or Kay ceases to be a partner in the ongoing partnership, the $65,000 distribution is a liquidating distribution.

A payment from a partnership to a partner is not necessarily treated as a distribution. For example, a partnership may pay interest or rent to a partner for use of the partner’s capital or property, make a guaranteed payment to a partner, or purchase property from a partner. If a payment is treated as a distribution, it is not necessarily treated under the general tax deferral rules that apply to most partnership distributions. In certain circumstances, the partner may recognize capital gain (or loss) and ordinary income (or loss) when a distribution is received from the partnership.

Finally, a distribution may be either proportionate or disproportionate. In a proportionate distribution, a partner receives the appropriate share of certain ordinary income-producing assets of the partnership. A disproportionate distribution occurs when the distribution increases or decreases the distributee partner’s interest in certain ordinary income-producing assets. The tax treatment of disproportionate distributions is very complex.

PARTNERSHIP ALLOCATIONS

6. Economic Effect. In general, the economic effect test requires the following.

• An allocation of income or gain to a partner must increase the partner’s capital account, and allocation of a deduction or loss must decrease the partner’s capital account.

• When the partner’s interest is liquidated, the partner must receive net assets that have a fair market value equal to the positive balance in the capital account.

These requirements are designed to ensure that a partner bears the economic burden of a loss or deduction allocation and receives the economic benefit of an income or gain allocation.

BASIS OF A PARTNERSHIP INTEREST

7. Partnership Liabilities. If distributions continue after basis reaches zero, gain recognition occurs. Thus, liability balances should be reviewed carefully near the partnership’s year-end to ensure the partners have no unanticipated tax results.

Example: Assume the same facts as in Example 24 in the text, except the partnership reported an ordinary loss of $100,000 in its first year of operations. Jim and Becky each deduct a $50,000 ordinary loss, and their bases in their respective partnership interests are reduced to $14,250 (including a $34,250 share of liabilities).

In the second year, the partnership generated no taxable income or loss from operations, but repaid the $50,000 construction loan (assume from collection of accounts receivable reported as income in the prior year). The $25,000 reduction of each partner’s share of partnership liabilities is treated as a cash distribution by the partnership to each partner. A cash distribution in excess of basis usually results in a capital gain (in this case $10,750) to each partner. The partners must pay tax on $10,750 of capital gain even though the partnership reported no taxable income. This gain can be thought of as a recapture of loss deductions the partners claimed during the first year. Such gains cause cash-flow difficulties to partners who are unaware that such a gain may occur.

How liabilities are shared among the partners depends upon whether the debt is recourse or nonrecourse and when the liability was incurred. For most debt created before January 29, 1989, the rules are relatively straightforward. Recourse debt is shared among the partners in accordance with their loss sharing ratios while nonrecourse debt is shared among the partners in accordance with the way they share partnership profits. Although questions arise about the calculation of the profit or loss sharing ratios and the treatment of personal guarantees of debt, the rules for sharing this earlier debt are easy to apply.

The rules for sharing partnership debt created after January 29, 1989, are summarized as follows.

Recourse Debt Rules. Recourse debt is shared in accordance with a constructive liquidation scenario. Under this scenario, the following events are deemed to occur at the end of each taxable year of the partnership.

1. Most partnership assets (including cash) become worthless.

2. The worthless assets are sold at fair market value ($0), and losses on the deemed sales are determined.

3. These losses are allocated to the partners according to their loss sharing ratios. These losses reduce the partners’ capital accounts.

4. Any partner with a (deemed) negative capital account balance is treated as contributing cash to the partnership to restore that negative balance to zero.

5. The cash deemed contributed by the partners with negative capital balances is used to pay the liabilities of the partnership.

6. The partnership is deemed to be liquidated immediately, and any remaining cash is distributed to partners with positive capital account balances.

The amount of a partner’s cash contribution that would be used (in step 5 above) to pay partnership recourse liabilities is that partner’s share of these partnership recourse liabilities.

Example: On January 1 of the current year, Nina and Otis each contribute $20,000 cash to the newly created NO General Partnership. Each partner has a 50% interest in partnership capital, profits, and losses. The first year of partnership operations resulted in the following balance sheet as of December 31.

| |Basis | |FMV | |Basis | |FMV |

|Cash |$12,000 | |$12,000 |Recourse payables |$30,000 | |$30,000 |

|Receivables |7,000 | |7,000 |Nina, capital |19,500 | |19,500 |

|Land and buildings |50,000 | |50,000 |Otis, capital |19,500 | |19,500 |

| |$69,000 | |$69,000 | |$69,000 | |$69,000 |

| | | | | | | | |

The recourse debt is shared in accordance with the constructive liquidation scenario. All of the partnership assets (including cash) are deemed to be worthless and sold for $0. This creates a loss of $69,000 ($12,000 + $7,000 + $50,000), which is allocated equally between the two partners. The $34,500 loss allocated to each partner creates negative capital accounts of $15,000 each for Nina and Otis. If the partnership were actually liquidated, each partner

would contribute $15,000 cash to the partnership; the cash would be used to pay the partnership recourse payables; and the partnership would cease to exist.

Because each partner would be required to contribute $15,000 to pay the liabilities, each shares in $15,000 of the recourse payables. Accordingly, Nina and Otis will each have an adjusted basis for their partnership interests of $34,500 ($19,500 + $15,000) on December 31.

Example: Assume the same facts as in the previous example, except that the partners allocate partnership losses 60% to Nina and 40% to Otis. The constructive liquidation scenario results in the $69,000 loss being allocated $41,400 to Nina and $27,600 to Otis. As a consequence, Nina’s capital account has a negative balance of $21,900, and Otis’s account has a negative balance of $8,100. Each partner is deemed to contribute cash equal to these negative capital accounts, and the cash would be used to pay the recourse liabilities under the liquidation scenario.

Accordingly, Nina and Otis share $21,900 and $8,100, respectively, in the recourse debt. Note that the debt allocation percentages (73% to Nina and 27% to Otis) are different from the partners’ 60%/40% loss sharing ratios.

Nonrecourse Debt Rules. Nonrecourse debt is allocated in three stages. First, an amount of debt equal to the amount of minimum gain is allocated to partners who share in minimum gain. The calculation of minimum gain is complex, and details of the calculation are beyond the scope of this text. In general, minimum gain approximates the amount of nonrecourse (mortgage) liability on a property in excess of the ‘‘book’’ basis of the property. Generally, the ‘‘book’’ basis for a property item is the same as the ‘‘tax’’ basis, although sometimes the amounts are different. For example, the ‘‘book’’ basis for contributed property on the date of contribution is its fair market value at that date, not its ‘‘tax’’ basis.

If a lender forecloses on partnership property, the result is treated as a deemed sale of the property for the mortgage balance. Gain is recognized for at least the amount of the liability in excess of the property’s ‘‘book’’ basis—hence, the term minimum gain is used. Allocation of minimum gain among the partners should be addressed in the partnership agreement.

Second, the amount of nonrecourse debt equal to the remaining precontribution gain under

§ 704(c) is allocated to the partner who contributed the property and debt to the partnership. For this purpose, the remaining precontribution gain is the excess of the current nonrecourse debt balance on the contributed property over the current tax basis of the contributed property.7 Note that this calculation is only relevant when the ‘‘book’’ and ‘‘tax’’ bases of the contributed property are different.

Third, any remaining nonrecourse debt is allocated to the partners in accordance with one of several different allocation methods. The partnership agreement should specify which allocation method is chosen. Most often, the profit sharing ratio is used.

Example: Ted contributes a nondepreciable asset to the TK Partnership in exchange for a one-third interest in the capital, profits, and losses of the partnership. The asset has an adjusted tax basis to Ted and the partnership of $24,000 and a fair market value and ‘‘book’’ basis on the contribution date of $50,000. The asset is encumbered by a $35,000 nonrecourse note.

Because the ‘‘book’’ basis exceeds the nonrecourse debt, there is no minimum gain. The first $11,000 of the nonrecourse debt ($35,000 debt ( $24,000 basis) is allocated to Ted. Assume the partnership allocates the remaining $24,000 nonrecourse debt according to the profit sharing ratio, and Ted’s share is $8,000. Therefore, Ted shares in $19,000 ($11,000 + $8,000) of the nonrecourse debt.

Ted’s basis in his partnership interest is determined as follows.

Substituted basis of contributed property $ 24,000

Less: Liability assumed by partnership (35,000)

Plus: Allocation of § 704(c) debt 11,000

Basis before remaining allocation $ –0–

Plus: Allocation of remaining nonrecourse debt 8,000

Basis in partnership interest $ 8,000

The § 704(c) allocation of nonrecourse debt prevents Ted from receiving a deemed distribution ($35,000) in excess of his basis in property he contributed ($24,000). Without this required allocation of nonrecourse debt, in some cases, a contributing partner would be required to recognize gain on a contribution of property encumbered by nonrecourse debt.

OTHER TRANSACTIONS BETWEEN A PARTNER AND A PARTNERSHIP

8. General Rules. The time for deducting a payment by an accrual basis partnership for services rendered by a cash basis partner depends upon whether the amount is a guaranteed payment or a payment to a partner who is treated as an outsider. A guaranteed payment is includible in the partner’s income on the last day of the partnership year when it is properly accrued by the partnership, even though the payment may not be made to the partner until the next taxable year. Conversely, the partner’s method of accounting controls the timing of the deduction if the payment is treated as made to an outsider. This is because a deduction cannot be claimed for such amounts until the recipient partner is required to include the amount in income under the partner’s method of accounting.8 Thus, a partnership cannot claim a deduction until it actually makes the payment to the cash basis partner, but it could accrue and deduct a payment due to an accrual basis partner even if payment was not yet made.

Example: Rachel, a cash basis taxpayer, is a partner in the accrual basis RTC Partnership. On December 31, 2008, the partnership accrues but does not pay $10,000 for deductible services that Rachel performed for the partnership during the year. Both Rachel and the partnership are calendar year taxpayers.

If the $10,000 accrual is a guaranteed payment, the partnership deducts the $10,000 in its calendar year ended December 31, 2008, and Rachel includes the $10,000 in her income for the 2008 calendar year. The facts that Rachel is a cash basis taxpayer and does not actually receive the cash in 2008 are irrelevant.

If the payment is classified as a payment to an outsider, the partnership cannot deduct the payment until Rachel actually receives the cash. If, for example, Rachel performs janitorial services (i.e., not in her capacity as a partner) and receives the cash on March 25, 2009, the partnership deducts the payment and Rachel recognizes the income on that date.

FAMILY PARTNERSHIPS

9. Family partnerships are owned and controlled primarily by members of the same family. Such partnerships may be established for a variety of reasons. A daughter may have a particular expertise that, coupled with her parents’ abilities, allows them to establish a successful business. Often, however, the primary reason for establishing a family partnership is the desire to save taxes. If the parents are in higher marginal tax brackets than the children, family tax dollars are saved by funneling some of the partnership income to the children.

Valid family partnerships are difficult to establish for tax purposes. A basic tenet of tax law is that income must be taxed to the person who performs the services or owns the capital that generates the income. A parent, therefore, cannot transfer only a profits interest to a child and expect the transfer to be recognized for tax purposes.

Capital versus Services. Because of the concern that family partnerships are established primarily for tax avoidance purposes, a family member is recognized as a partner only in the following cases.

• Capital is a material income-producing factor in the partnership, and the family member’s capital interest is acquired in a bona fide transaction (even if by gift or purchase from another family member) in which ownership and control are received.

• Capital is not a material income-producing factor, but the family member contributes substantial or vital services.9

If a partnership derives a substantial portion of its gross income from the use of capital, such as inventories or investments in plant, machinery, or equipment, the capital is considered to be a material income-producing factor. Ordinarily, capital is not a material income-producing factor if the partnership’s income consists principally of fees, commissions, or other compensation for personal services performed by partners or employees.

Children as Partners. When capital is a material income-producing factor and a partnership interest is transferred by gift or sale to a child who is under age 19, the kiddie tax may apply. Under the kiddie tax, some of the dependent child’s distributive share of partnership income may be taxed at the parent’s tax rate, unless the income share constitutes earned income. Regardless of age, if the child provides bona fide services to a partnership and the income share constitutes earned income, the parent-partner’s tax rate is avoided.

Example: Karen operates a first-floor-window-washing business in a summer lakeside resort city. Relatively small amounts of capital are required to operate the sole proprietorship (buckets, sponges, squeegees, etc.). During the summer, Karen normally hires middle and high school students to wash windows. Her 13-year-old daughter and 12-year-old son want to work in the business during the summer to earn money for spending and for college. Each obtains the necessary summer work permit. Karen creates the KDS Partnership and gives each child a 5% interest.

Karen figures that if her children were paid an hourly rate, about 5% of KDS’s profits would be distributed to them as wages. Karen believes that an ownership interest will help the children learn what running a profitable business entails and prepare them for an active business life after their education is completed.

Since capital is not a material income-producing factor in the business, and the children’s profit percentages approximate what they would earn if they were paid an hourly rate, all of the income is classified as earned income. Thus, the kiddie tax is avoided.

Gift of Capital Interest. If a family member acquires a capital interest by gift in a family partnership in which capital is a material income-producing factor, only part of the income may be allocated to this interest. First, the donor of the interest is allocated an amount of partnership income that represents reasonable compensation for services to the partnership. Then, the remaining income is divided among the partners in accordance with their capital interests in the partnership. An interest purchased by one family member from another is considered to be created by gift for this purpose.10

Example: A partnership in which a parent transferred a 50% interest by gift to a child generated a

profit of $90,000. Capital is a material income-producing factor. The parent performed services

valued at $20,000. The child performed no services. As a result, $20,000 is allocated to the parent as compensation. Of the remaining $70,000 of income attributable to capital, at least 50%, or $35,000, is allocated to the parent.

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Notes:

1 T.D. 8588, 12/94, explaining Reg. § 1.701–2.

2 § 709(a).

3 § 7519.

4 § 6222.

5 § 6698.

6 § 6231(a)(1)(B).

7 Reg. § 1.704–3.

8 § 267(a)(2).

9 § 704(e).

10 § 704(e)(3).

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