Jean & Karl Retirement Plan
September 1, 2010
Last Revised: May 23, 2012 4:50 PM
This page concerns a retirement plan for the founders, a plan that can be referred to as a Section 736 (b) plan.
The LAW, not Regulations, covering this type of plan is within this legal context:
This source includes a link to "updates" where is found the following result (note in black text):
An empty table [as was found] indicates that we see no relevant changes listed in the classification tables since Feb.1, 2010. If you suspect that our system may be missing something, please double-check at http://uscode.house.gov/classification/tables.shtml source
HERE is a link to a convenient copy of an IRS page with explanations of how to treat questions on the Form 1065.
The most authoritative reference about this law and the related retirement plan, in addition to the actual IRC and IRS publications, is a BOOK, referenced here.
CLICK HERE for a 17 page PDF version of the Publisher's Table of Contents for this Book. This Book is available for sale currently on Amazon.com for $1,795.00.
This entire page contains further useful information, but at the end of all this research and publishing of references, one link is probably most useful. It is a Florida Bar Assn article, link to PDF copy of their article here. Study of a combination of these references should be sufficient to prepare someone to create or to review the actual plan for future use for Vibrant Life and those individuals who will make use of such a plan.
Vibrant Life has been and will continue to make retirement payments to the Founders, Karl and Jean.
These payments CAN be structured in such a way that they are taxable as capital gain, rather than regular income to them and not cost any more to Vibrant Life. With care and understanding these same references can allow a future chief executive officer (presumably a General Partner or Managing Member) to create good will which can also be a source of his retirement pay in the future, assuming tax laws don't change, also then taxed at capital gains rates.
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The actual Partnership Resolution to implement this plan is drafted for submission to the IRS, for approval, and is HERE.
A useful IRS reference in this regard is HERE. This link includes the following excerpt:
The fact that a partner may be “retiring” does not necessarily refer to a departure from the partnership due to age or disability.  A "retirement" occurs when the partnership, as an entity, acquires or redeems the partner’s interest, as opposed to a purchase of a partnership interest when a person or entity other than the partnership acquires the partner’s interest. IRC section 736 does not apply to payments made to continuing partners. It also does not apply when the partnership is liquidated. (Treas. Reg. section 1.736-1(a)(1)(i)).*
[Karl Note: There may be a conflict between the founders formal indication and intention that Clifford Woods is to inherit their interests in the partnership at the time of their deaths, that intention, and the Section 732 (b) retirement plan which contemplates the re-acquisition of those interests by the partnership.
One solution to this could be to make a gift of some part of the founders capital interest in the partnership to Mr. Woods, while the founders still live, so that Mr. Woods' then-portion of the partnership interest is not changed by their death other than to leave him as the only living General Partner. Further research is needed here. Click Here for a PDF document on history of Section 736 (b) and click here for further IRS reference to liquidating a partner's interest. Click here for PDF Tax implications for a "gift" of partnership interest from Karl & Jean to Mr. Woods. Click here for a more straightforeward PDF article on Gift Tax. There is actually a private document that outlines this matter.]
. . . . .
IRC section 736(a) can provide favorable treatment for situations in which a general partner retires from a service partnership. Payments made to a general partner retiring from a service partnership for his/her share of unrealized receivables or unstated goodwill will fall into either of two categories: 1) the retiring partner’s distributive share of income, gain, deduction or loss of the partnership or 2) guaranteed payments - an IRC section 736(a) payment is a "guaranteed payment" if it is determined without regard to the partnership’s income. See IRC section 707(c).
These “IRC section 736(a) payments” are desirable from the point of view of the continuing partners because such payments actually or effectively provide the continuing partners with deductions. Distributive share payments (those determined with regard to the income of the partnership) shift income away from the remaining partners to the retiring partner. Guaranteed payments, unless required to be capitalized, are deductible by the partnership and reduce the amount of income (or increase the loss) passed through to the remaining partners. However, IRC section 736(a) payments usually result in ordinary income to the retiring partner and are includible in income by the recipient for the partnership’s taxable year that ends within or with the partner’s taxable year.
The direct result of VL making payments this way is that the Founders get cash which is taxable at capital gain rates, generally the lowest tax rate. Also, the other partners get an expense deduction on the partnership tax Form 1065 for those same payments.
This is a rationale tax treatment to cover the very common situation where:
There is a question of whether or not this favorable tax handling is also available to an LLC or to a partnership which establishes such a retirement plan and AFTER that plan is in operation converts its form from a partnership to an LLC.
This subject is discussed on THIS site and an excerpt printed here:
The underlying purpose of Sec. 736 is to classify payments made to withdrawing partners in liquidation of their entire partnership interests. Once the character of the liquidation payments has been determined, other provisions of subchapter K control the tax consequences to both the withdrawing and continuing partners. Sec. 736 classifies payments made to withdrawing partners in one of three categories: (1) payments in consideration for the liquidating partner's interest in the underlying partnership property; (2) payments considered a distributive share of the partnership income; or (3) payments considered Sec. 707 guaranteed payments. The income tax treatment of the payments, by both the withdrawing and remaining partners, depends on which of these three categories the payments belong to. The income tax consequences of such categorization include (1) whether income will be recognized by the withdrawing partner, and what the character of such income would be; (2) whether the remaining partners will be able to reduce their share of the partnership's income for the payments made to the withdrawing partner; (3) whether the remaining partners will be required to adjust the remaining partnership assets under Sec. 734(b) when a Sec. 754 election is in effect; and (4) what the timing of the income tax consequences, to both the withdrawing and remaining partners, will be.
This same subject (treating an LLC like a Partnership) is covered directly in Dr. Friedland's Book:
§1.01 Overview of Rules Governing Taxation of
Partnerships and Limited Liability Companies
Subchapter K of the Internal Revenue Code contains the rules governing the taxation of partners and partnerships. Ordinarily, a limited liability company (LLC) with more than one member is treated as a partnership for tax purposes. Therefore, Subchapter K generally governs the taxation of LLCs and their members.
Unless otherwise noted [in this Book], references to partnerships and partners throughout this text also refer to LLCs and their members.
There is another question that needs research. This Section 736 retirement plan is for the "general partners" in a partnership, but the "type" of partnership is illustrated as one providing mostly "service" such as law firms and medical services, or is "capital intensive" such as a bank or mutual fund.
I have not yet found web references to this issue, but presumably VL would fit more into the "service" type of partnership without objection. In a bank, the lack of capital would render the entity with no means of operation. In a medical office, the lack of any licensed practitioners would seem to make that office incapable of being a "medical partnership."
In a Company like Vibrant Life, the products we sell are apparently important, but in fact it is also true that without the "services" of "researchers," "writers," "sales and marketing services," there would be no operations.
There is another question: Whether a General Partner in a General Partnership (Karl and Jean) who receive retirement pay (subject to capital gains treatment by them) and then the partnership converts to an LLC (which may or may not be able to "originate" a Section 636(b) retirement plan), will the earlier established plan be eligible for continuation under the administration of the LLC rules?
One web source that examines one of these rarely-treated subjects is HERE and an excerpt is below:
This item explores the two main methods used when terminating a partnership interest: purchase and liquidation. A terminating partner may sell his or her interest to one or more of the remaining partners, or the partnership may liquidate his or her interest. The tax issues associated with these two methods, such as whether the change generates ordinary income or ordinary deductions or capital gain treatment for the partnership and for the terminating partner, should be considered in detail. How the partnership treats the termination is important to both parties in order to receive the tax treatment intended.
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Liquidation of Partner's Interest
The second method this item will discuss is where the partnership liquidates the terminating partner's interest. The partnership may use its assets to liquidate the partner's interest, or it can take on debt to liquidate the partner's interest. The remaining partners cannot fund the liquidation, nor may these partners make the liquidating payments on behalf of the partnership. If they do, the transaction is treated as a sale as described above. The remaining partners should also be careful in making capital calls so that the substance of the capital calls cannot be construed as being used as a payment to liquidate the partner's interest.
All payments to a partner in liquidation are treated as either Sec. 736(a) or Sec. 736(b) payments. Sec. 736(a) payments are for a continuing share of partnership income or for guaranteed payments. Sec. 736(a) payments also include payments for unrealized receivables and for goodwill when goodwill payments are not called for in the partnership agreement. This treatment for unrealized receivables and goodwill applies only to general partners in partnerships where capital is not a material income-producing factor. Payments for goodwill are treated as payments under Sec. 736(b) for all capital-intensive partnerships or where the partnership agreement specifies that terminating payments may be made for goodwill (Sec. 736(b)(2)(B)).
Sec. 736(a) payments are deductible by the partnership and are ordinary income to the liquidating partner, subject to self-employment tax. A cash-basis partner should be aware that if the partnership accrues a payment to the partner in its tax year, the partner must recognize that income in the same tax year.
. . . .
The above discussion demonstrates that while both the purchase and liquidation methods of terminating a partnership interest are viable, the liquidation method affords the parties more flexibility. In some cases, a liquidation can be structured to allow the partnership a current deduction for a portion of the payments. Similarly, a terminating partner might prefer a liquidation because of the ability to defer income until his or her basis is recovered. Whichever method is chosen, care must be taken to ensure that all parties receive the tax treatment that is intended.
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From Cynthia L. Dulworth, CPA, Sanford, Baumeister & Frazier, PLLC, Ft. Worth, TX
It seems clear that we will choose the "liquidation" form of handling Karl & Jean's retirement payments.
Likewise, Clifford has built up his own goodwill source, by managing VL at a salary less than his worth. Recognizing that "Clifford Goodwill" as the source for retirement pay to Clifford should be easy to establish.
The standard IRS Instruction Book for Form 1065 is here and includes reference to the Section 636(b) retirement plan. See page 11 for the Section 736(b)
It seems clear that as long as Karl and Jean receive payments that qualify for the Section 736(b) they will receive the favorable capital gain treatment on those payments.
That plan has to be established, presumably during 2010 to apply to any / all payments to Karl & Jean during 2010.
It had been the expectation by Karl to convert VL partnership to an LLC perhaps with the filing of the 2011 Form 1065. The LLC form of operation provides a well-known increased flexibility over a partnership form of operation.
It will be a consideration on the issue of when and if VL converts from the partnership form to the LLC form as to whether that conversion would allow the retirement plan for Karl & Jean to continue within the LLC and / or whether the conversion would adversely affect their capital gain treatment.
It is further vital to understand these matters because another use of the qualified partner retirement plan [636(b)] would be for the benefit of Clifford Woods. This use contemplates Clifford continuing to operate VL, to increase its viability, sales and profits, and to, himself, retire with benefits similar to those received by Karl & Jean. That would mean that the retirement plan for Jean & Karl would be, then, attractive to Clifford.
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(Note: economic and political changes might well affect these laws. Operation out of the US Tax-jurisdiction will certainly bring new challenges that need handling with new tools and newly trained management.)
Presumably the time for Clifford to retire would be when he successfully completes one of the final responsibilities of ownership / management: the selection and training of successor top management.
I see no reason why Clifford can't retire at any age he wishes, presumably when HE is comfortable that HIS successor will preserve what Clifford had created.
I, personally, look forward to coming up with further plans to use tax laws and such to make it possible and easy to implement some of the management steps within our operations.
One apparently excellent resource is here and an excerpt is below. THIS source seems to say that a "partner" or a "member" can receive "liquidating payments to a Retiring Partner."
Note: The book in its paper back form, only the Table of Contents, linked above is some 500+ pages, PDF connected to THIS web site, published by Lexis Nexis by the Law Professor, Jerold A. Friedland, J.D., LL.M.
I have purchased a copy of this book, 2 Volumes. It is in my hands at the time I add this line to this page on October 8, 2010.
When you open this Table of Contents for the Book, PDF version, in Acrobat, you can use the usual "page find" feature to go to any of the below page numbers in the actual Book. The entire Book is NOT at this site.
Professor Friedland is Director of the Asian Legal Studies Institute, leads DePaul’s Constitutional and Comparative Law Program in China, and Directs the Master of Laws in International Business, Commercial and Trade Law program. He specializes in the areas of international business and taxation, and is a well-known expert on partnerships, limited liability companies, and international joint ventures. Professor Friedland has been quite active in the Fulbright International Exchange program, serving as a Fulbright Scholar at Beijing Foreign Studies University in 1998, Masaryk University in the Czech Republic in 2005, and Vienna University of Economics and Business Administration in 2006. Friedland has served as President of the Chicago Fulbright Association and as a member of the Fulbright Advisory Board to the International Visitors’ Center of Chicago. In 2001, Friedland was designated the Katherine A. Ryan Distinguished Visiting Professor at the Institute for World Legal Problems (of St. Mary’s University), in Innsbruck, Austria, where he had the opportunity to work with an outstanding faculty that included Supreme Court Justices William Rehnquist and Sandra Day O’Conner. He has been a visiting professor of law at the University of Illinois, Brigham Young University and Shandong University in Jinan, China . Professor Friedland’s recent publications include Understanding International Business and Financial Transactions (Lexis Publishing, 2nd Edition 2005), Understanding Taxation of Partnerships and LLCs (2nd Edition, Lexis Publishing, 2002) and Tax Planning for Partners, Partnerships and LLCs (2 Volumes) (Matthew Bender, 1998).
Based on his treatise Tax Planning for Partners, Partnerships, and LLCs, the author offers a comprehensive analysis of one of the most complex and confusing areas of the Internal Revenue Code. Using examples and computational illustrations, this Understanding Partnership & LLC Taxation treatise is designed for ease of use by law students. In addition to clear, to-the-point explanations of law, Understanding Partnership and LLC Taxation includes practice and planning notes plus extensive citation to relevant cases, statutes, and regulations, thereby making it also an excellent quick reference for practitioners. Source
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Chapter 10 Liquidating Payments to a Retiring Partner/
Member or a Decedent’s Successor . . . . . . . . 439
§ 10.01 Overview of Liquidating Payments—I.R.C.
Section 736 . . . . . . . . . . . . . . . . . . . . . . . . . . . 439
[Karl Note: I have read the part of this section of the book which makes it clear that an LLC as well as a partnership may use these sections of the regulations.
Further text within this same area cover the rules for determining whether the withdrawing partner treats the income to him as a capital gain or regular income and makes it clear that the partnership, by agreement of the partners, can make that determination (page 441).]
[A] Payments Governed by
I.R.C. Section 736 . . . . . . 440
[B] Classification of Liquidating Payments . . . . . 441
[C] Payments for Partner’s/Member’s Interest in Partnership/LLC Property—I.R.C.
Section 736(b) Payments . . . . . . . . . . . . . . . 442
 Valuing Partner’s/Member’s Share of
Partnership/LLC Property . . . . . . . . . 442
 Limited Exclusion for Unrealized Receivables and Goodwill . . . . . . . . . 443
 Taxation of I.R.C. Section 736(b)
Payments . . . . . . . . . . . . . . . . . . . . 446
[D] Payments Exceeding Partner’s/Member’s Interest in Partnership/LLC Property—I.R.C.
Section 736(a) Payment . . . . . . . . . . . . . .
 Determining the Amount of I.R.C. Section 736(a) Payments .. . . . . . . . . 451
 Taxation of I.R.C. Section 736(a)
Payments . . . . . . . . . . . . . .. . . . . . . . 452
 Summary—Steps In Determining Taxation Of Lump-Sum Liquidating Payment . . . . . . . . . 454
§ 10.02 Series of Cash Liquidating Payments . . . . . . . . . . . . 455
[A] Determining the I.R.C. Section 736(a) and I.R.C. Section 736(b) Portions of Each Payment . .. 455
[B] Computing Gain or Loss Recognized on the I.R.C. Section 736(b) Portion . . . . . . . . . . . . 460
[C] Computing Gain or Loss Recognized on the I.R.C. Section 736(a) Portion . . . . . . . . . . . . 464
§ 10.03 Noncash Liquidating Payments . . . . . . . . . . . . . . . 466
One further source of data on this is:
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[Code of Federal Regulations] [Title 26, Volume 8] [Revised as of April 1, 2008] From the U.S. Government Printing Office via GPO Access [CITE: 26CFR1.736-1] [Page 559-563] Click here to read. An excerpt follows:
For the purposes of section 736(b) and this paragraph, payments made to a retiring partner or to a successor in interest of a deceased partner in exchange for the interest of such partner in partnership property shall not include any amount paid for the partner's share of good will of the partnership in excess of its partnership basis, including any special basis adjustments for it to which such partner is entitled, except to the extent that the partnership agreement provides for a reasonable payment with respect to such good will. Such payments shall be considered as payments under section 736(a). To the extent that the partnership agreement provides for a reasonable payment with respect to good will, such payments shall be treated under section 736(b) and this paragraph. Generally, the valuation placed upon good will by an arm's length agreement of the partners, whether specific in amount or determined by a formula, shall be regarded as correct.
(6) A retiring partner or a deceased partner's successor in interest receiving payments under section 736 is regarded as a partner until the entire interest of the retiring or deceased partner is liquidated.
Therefore, if one of the members of a 2-man partnership retires under a plan whereby he is to receive payments under section 736, the partnership will not be considered terminated, nor will the partnership year close with respect to either partner, until the retiring partner's entire interest is liquidated, since the retiring partner continues to hold a partnership interest in the partnership until that time.
Similarly, if a partner in a 2-man partnership dies, and his estate or other successor in interest receives payments under section 736, the partnership shall not be considered to have terminated upon the death of the partner but shall terminate as to both partners only when the entire interest of the decedent is liquidated. See section 708(b).
RE Quoting part of just above:
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A retiring partner or a deceased partner's successor in interest
receiving payments under section 736 is regarded as a partner until the entire interest of the retiring or deceased partner is liquidated.
This part may mean that a "general partner" in a general partnership may be considered STILL to be a partner in that partnership until some "entire" amount of termination payment is paid, that would be a debt of the partnership -- which debt would certainly carry over as the partnership became taxed as an LLC. In any event, an LLC is treated like a partnership relative to tax laws and regulations unless separately stated to the contrary.
Also note that in one part the word "member" is seemingly used to also mean "partner." (colored in red above).
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In an IRS publication the following paragraph seems to indicate their approval of using both "member" and "partner" in the same way:
The Firm is a professional limited liability partnership engaged in the practice of law.
The Firm is classified as a partnership for federal income tax purposes. The members of the Firm are treated as partners for federal income tax purposes, and are hereafter referred to as partners. The Firm files income tax returns based upon a calendar year.
All partners in the Firm are individuals and are calendar year taxpayers. Source: Internal Revenue Code section1402(a)(10)
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Here is another web source, reasonably simple, to explain this:
Payments made by a law partnership to buy out a retiring partner's entire ownership interest are generally subject to self employment tax. Careful planning can change that.
We'll explain how, but first, here is some background information.
Payments made by a law partnership to buy out a retiring partner's entire ownership interest are covered by Section 736 of the Internal Revenue Code. These payments can be made in a single lump-sum or they can be made in installments over a number of years. In any case, all Section 736 payments are classified as either:
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Section 736(a) payments are treated as guaranteed payments to the retired partner. The partnership is allowed to deduct them, which means tax savings for the remaining partners. However, the retired partner must treat guaranteed payments as ordinary income
(subject to a federal income tax rate of up to 35 percent). In addition to income tax, guaranteed payments are generally subject to the federal self-employment (SE) tax too, even if the retired partner no longer works for the firm. (Sources: Internal Revenue Code Section 1402(a) and Treasury Regulation 1.1402(a)-1)
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For 2010, the first $106,800 of SE income is hit with the maximum 15.3 percent SE tax rate; the rate on any additional SE income is 2.9 percent (unchanged from 2009). As you can see, the SE tax hit on a retired partner can really add up and is therefore something to avoid when possible.
Section 736(b) payments are treated as liquidating distributions made by the partnership to pay for the retired partner's share of partnership assets. As such, the retired partner treats the difference between the total Section 736(b) payments received and his or her tax basis in the partnership interest as capital gain or loss. No SE tax is due on Section 736(b) payments. This tax treatment is beneficial for the retired partner, but the partnership cannot deduct Section 736(b) payments. Amounts paid to buy out the entire interest of a retired partner that are not Section 736(b) payments are Section 736(a) payments.
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As you can see, both Section 736(a) and Section 736(b) payments have their tax disadvantages. With proper planning, however, your partnership can set up a supplemental arrangement to funnel additional cash to retired partners and get better tax results for all concerned. This article briefly explains how this strategy works.
Set Up a Written Retirement Plan That Qualifies for Exemption
If your partnership makes payments to retired partners under a written partnership retirement plan that meets specified tax-law requirements, the payments are exempt from the SE tax. (Sources: Internal Revenue Code Section 1402(a)(10) and Treasury Regulation 1.1402(a)-17)[Click on the government references to view as PDF.]
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While the payments are still subject to income tax at regular rates on the retired partner's personal return, the SE tax exemption is a big advantage. To be exempt, the plan must provide for bona fide retirement payments on a periodic basis to partners generally, or to a class or classes of partners, that continue at least until the retired partner's death. Bona fide retirement payments mean payments that are made on account of the partner's retirement. The amounts of such payments must be based on objective factors such as the partner's years of service and compensation received from the partnership. Eligibility to begin receiving bona fide retirement payments generally must be based on the retired partner's age, physical condition, and years of service.
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Three additional requirements must also be met for the SE tax exemption to apply:
The retired partner cannot render services to the partnership during the year in which retirement payments are received.
The partnership cannot have any obligations to the retired partner at the end of the year in which payments are received - except for the obligation to make additional payments under the written retirement plan or the obligation (if any) to make payments for sickness, accident, hospitalization, medical expenses, or death.
The retired partner's share of partnership capital must be fully paid out to him or her before the end of the year in which retirement payments are received (therefore, any Section 736(b) payments due to the partner must be received by then).
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If all three of these rules are met for the year, all payments received in that year under the written partnership retirement plan are exempt from SE tax. If all three of the rules are not met, all payments received in the year are subject to SE tax. Trickier timing rules apply if the partnership and/or the retired partner use a non-calendar tax year.
Note: The type of retirement program discussed here is not a tax-favored partnership retirement plan such as a 401(k) plan, Keogh plan, or SEP plan. Instead, we are talking about a relatively simple written arrangement (generally unfunded) under which payments are made by the partnership directly to its retired partners. Such an arrangement is not subject to any of the complicated funding and nondiscrimination rules that can potentially apply to a tax-favored partnership retirement plan.
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I referred to the link for the PDF document, next below, as the possibly most useful reference, but the above reference to Dr. Friedland's Book is probably the best reference, only in print form, in my office.
Here is another web source of legal opinion on this. The web page is HERE, a PDF version is HERE. This is a legal advice from the Florida State Bar Association. It is worth study, however the title of it is: "When to Report Ordinary Income If a Partnership with Hot Assets
Redeems a Partnership Interest and the Liquidating Distributions Are Made Over Several Tax Years." The phrase "hot assets" is actually used in IRS text and needs to be understood in order to implement the retirement plan of interest.
I have studied "hot assets" and it certainly does NOT seem that Vibrant Life has ever recognized or used the concept during its entire existence. Once you understand the concept of "hot assets" and determine that Vibrant Life does not have and has not had such, you can then use Dr. Friedland's Book and the IRS regulations to implement the desired retirement plan.
(Incidentally, "hot assets" do not prevent this retirement plan from being used, they only provide for a different method of implementation.)
IRS references include these:
Section 751 IRC Txt Version
Hot Assets Section 751(a) & 751(b) PDF
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