| Pub. 541, Partnerships |
2006 Tax Year |
Publication 541 - Main Contents
The following sections contain general information about partnerships.
Organizations Classified as Partnerships
An unincorporated organization with two or more members is generally classified as a partnership for federal tax purposes
if its members carry on a
trade, business, financial operation, or venture and divide its profits. However, a joint undertaking merely to share expenses
is not a partnership.
For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services
to the tenants.
The rules you must use to determine whether an organization is classified as a partnership changed for organizations formed
after 1996.
Organizations formed after 1996.
An organization formed after 1996 is classified as a partnership for federal tax purposes if it has two or more members
and it is none of the
following.
-
An organization formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate,
or body
politic.
-
An organization formed under a state law that refers to it as a joint-stock company or joint-stock association.
-
An insurance company.
-
Certain banks.
-
An organization wholly owned by a state or local government.
-
An organization specifically required to be taxed as a corporation by the Internal Revenue Code (for example, certain publicly
traded
partnerships).
-
Certain foreign organizations identified in section 301.7701-2(b)(8) of the regulations.
-
A tax-exempt organization.
-
A real estate investment trust.
-
An organization classified as a trust under section 301.7701-4 of the regulations or otherwise subject to special treatment
under the
Internal Revenue Code.
-
Any other organization that elects to be classified as a corporation by filing Form 8832.
For more information, see the instructions for Form 8832.
Limited liability company.
A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC.
Unlike a partnership, none of
the members of an LLC are personally liable for its debts. An LLC may be classified for federal income tax purposes as either
a partnership, a
corporation, or an entity disregarded as an entity separate from its owner by applying the rules in regulations section 301.7701-3.
See Form 8832 and
section 301.7701-3 of the regulations for more details.
A domestic LLC with at least two members that does not file Form 8832 is classified as a partnership for federal income tax
purposes.
Organizations formed before 1997.
An organization formed before 1997 and classified as a partnership under the old rules will generally continue to
be classified as a partnership as
long as the organization has at least two members and does not elect to be classified as a corporation by filing Form 8832.
Community property.
A husband and wife who own a qualified entity (defined later) can choose to classify the entity as a partnership for
federal tax purposes by filing
the appropriate partnership tax returns. They can choose to classify the entity as a sole proprietorship by filing a Schedule
C (Form 1040) listing
one spouse as the sole proprietor. A change in reporting position will be treated for federal tax purposes as a conversion
of the entity.
A qualified entity is a business entity that meets all the following requirements.
-
The business entity is wholly owned by a husband and wife as community property under the laws of a state, a foreign country,
or a
possession of the United States.
-
No person other than one or both spouses would be considered an owner for federal tax purposes.
-
The business entity is not treated as a corporation.
For more information about community property, see Publication 555, Community Property. Publication 555 discusses
the community property laws of
Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
Members of a family can be partners. However, family members (or any other person) will be recognized as partners only if
one of the following
requirements is met.
-
If capital is a material income-producing factor, they acquired their capital interest in a bona fide transaction (even if
by gift or
purchase from another family member), actually own the partnership interest, and actually control the interest.
-
If capital is not a material income-producing factor, they joined together in good faith to conduct a business. They agreed
that
contributions of each entitle them to a share in the profits, and some capital or service has been (or is) provided by each
partner.
Capital is material.
Capital is a material income-producing factor if a substantial part of the gross income of the business comes from
the use of capital. Capital is
ordinarily an income-producing factor if the operation of the business requires substantial inventories or investments in
plants, machinery, or
equipment.
Capital is not material.
In general, capital is not a material income-producing factor if the income of the business consists principally of
fees, commissions, or other
compensation for personal services performed by members or employees of the partnership.
Capital interest.
A capital interest in a partnership is an interest in its assets that is distributable to the owner of the interest
in either of the following
situations.
The mere right to share in earnings and profits is not a capital interest in the partnership.
Gift of capital interest.
If a family member (or any other person) receives a gift of a capital interest in a partnership in which capital is
a material income-producing
factor, the donee's distributive share of partnership income is subject to both of the following restrictions.
-
It must be figured by reducing the partnership income by reasonable compensation for services the donor renders to the
partnership.
-
The donee's distributive share of partnership income attributable to donated capital must not be proportionately greater than
the donor's
distributive share attributable to the donor's capital.
Purchase.
For purposes of determining a partner's distributive share, an interest purchased by one family member from another
family member is considered a
gift from the seller. The fair market value of the purchased interest is considered donated capital. For this purpose, members
of a family include
only spouses, ancestors, and lineal descendants (or a trust for the primary benefit of those persons).
Example.
A father sold 50% of his business to his son. The resulting partnership had a profit of $60,000. Capital is a material income-producing
factor. The
father performed services worth $24,000, which is reasonable compensation, and the son performed no services. The $24,000
must be allocated to the
father as compensation. Of the remaining $36,000 of profit due to capital, at least 50%, or $18,000, must be allocated to
the father since he owns a
50% capital interest. The son's share of partnership profit cannot be more than $18,000.
Husband-wife partnership.
If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they
have a formal partnership
agreement. If so, they should report income or loss from the business on Form 1065. They should not report the income on a
Schedule C (Form 1040) in
the name of one spouse as a sole proprietor.
Each spouse should carry his or her share of the partnership income or loss from Schedule K-1 (Form 1065) to their
joint or separate Form(s) 1040.
Each spouse should include his or her respective share of self-employment income on a separate Schedule SE (Form 1040), Self-Employment
Tax. This
generally does not increase the total tax on the return, but it does give each spouse credit for social security earnings
on which retirement benefits
are based.
The partnership agreement includes the original agreement and any modifications. The modifications must be agreed to by all
partners or adopted in
any other manner provided by the partnership agreement. The agreement or modifications can be oral or written.
Partners can modify the partnership agreement for a particular tax year after the close of the year but not later than the
date for filing the
partnership return for that year. This filing date does not include any extension of time.
If the partnership agreement or any modification is silent on any matter, the provisions of local law are treated as part
of the agreement.
Terminating a Partnership
A partnership terminates when one of the following events takes place.
-
All its operations are discontinued and no part of any business, financial operation, or venture is continued by any of its
partners in a
partnership.
-
At least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period, including
a sale or
exchange to another partner.
Unlike other partnerships, an electing large partnership does not terminate on the sale or exchange of 50% or more of the
partnership interests
within a 12-month period.
See section 1.708-1(b) of the regulations for more information on the termination of a partnership. For special rules that
apply to a merger,
consolidation, or division of a partnership, see sections 1.708-1(c) and 1.708-1(d) of the regulations.
Date of termination.
The partnership's tax year ends on the date of termination. For the event described in (1), earlier, the date of termination
is the date the
partnership completes the winding up of its affairs. For the event described in (2), earlier, the date of termination is the
date of the sale or
exchange of a partnership interest that, by itself or together with other sales or exchanges in the preceding 12 months, transfers
an interest of 50%
or more in both capital and profits.
Short period return.
If a partnership is terminated before the end of the tax year, Form 1065 must be filed for the short period, which
is the period from the beginning
of the tax year through the date of termination. The return is due the 15th day of the fourth month following the date of
termination. See
Partnership Return (Form 1065), later, for information about filing Form 1065.
Conversion of partnership into limited liability company (LLC).
The conversion of a partnership into an LLC classified as a partnership for federal tax purposes does not terminate
the partnership. The conversion
is not a sale, exchange, or liquidation of any partnership interest, the partnership's tax year does not close, and the LLC
can continue to use the
partnership's taxpayer identification number.
However, the conversion may change some of the partners' bases in their partnership interests if the partnership has
recourse liabilities that
become nonrecourse liabilities. Because the partners share recourse and nonrecourse liabilities differently, their bases must
be adjusted to reflect
the new sharing ratios. If a decrease in a partner's share of liabilities exceeds the partner's basis, he or she must recognize
gain on the excess.
For more information, see Effect of Partnership Liabilities under Basis of Partner's Interest, later.
The same rules apply if an LLC classified as a partnership is converted into a partnership.
IRS e-file (Electronic Filing)
Certain partnerships with more than 100 partners are required to file Form 1065, Schedules K-1, and related forms and schedules
electronically
(e-file). Other partnerships generally have the option to file electronically. For details about IRS e-file, see the Form 1065
instructions.
Exclusion From Partnership Rules
Certain partnerships that do not actively conduct a business can choose to be completely or partially excluded from being
treated as partnerships
for federal income tax purposes. All the partners must agree to make the choice, and the partners must be able to compute
their own taxable income
without computing the partnership's income. However, the partners are not exempt from the rule that limits a partner's distributive
share of
partnership loss to the adjusted basis of the partner's partnership interest. Nor are they exempt from the requirement of
a business purpose for
adopting a tax year for the partnership that differs from its required tax year.
Investing partnership.
An investing partnership can be excluded if the participants in the joint purchase, retention, sale, or exchange of
investment property meet all
the following requirements.
-
They own the property as co-owners.
-
They reserve the right separately to take or dispose of their shares of any property acquired or retained.
-
They do not actively conduct business or irrevocably authorize some person acting in a representative capacity to purchase,
sell, or
exchange the investment property. Each separate participant can delegate authority to purchase, sell, or exchange his or her
share of the investment
property for the time being for his or her account, but not for a period of more than a year.
Operating agreement partnership.
An operating agreement partnership group can be excluded if the participants in the joint production, extraction,
or use of property meet all the
following requirements.
-
They own the property as co-owners, either in fee or under lease or other form of contract granting exclusive operating rights.
-
They reserve the right separately to take in kind or dispose of their shares of any property produced, extracted, or used.
-
They do not jointly sell services or the property produced or extracted. Each separate participant can delegate authority
to sell his or her
share of the property produced or extracted for the time being for his or her account, but not for a period of time in excess
of the minimum needs of
the industry, and in no event for more than one year.
However, this exclusion does not apply to an unincorporated organization one of whose principal purposes is cycling, manufacturing,
or
processing for persons who are not members of the organization.
Electing the exclusion.
An eligible organization that wishes to be excluded from the partnership rules must make the election not later than
the time for filing the
partnership return for the first tax year for which exclusion is desired. This filing date includes any extension of time.
See section 1.761-2(b) of
the regulations for the procedures to follow.
Partnership Return (Form 1065)
Every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing
its income,
deductions, and other required information. The partnership return must show the names and addresses of each partner and each
partner's distributive
share of taxable income. The return must be signed by a general partner. If a limited liability company is treated as a partnership,
it must file Form
1065 and one of its members must sign the return.
A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year
in which it neither
receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes.
See the instructions for Form 1065 for more information about who must file Form 1065.
Partnership Distributions
Partnership distributions include the following.
-
A withdrawal by a partner in anticipation of the current year's earnings.
-
A distribution of the current year's or prior years' earnings not needed for working capital.
-
A complete or partial liquidation of a partner's interest.
-
A distribution to all partners in a complete liquidation of the partnership.
A partnership distribution is not taken into account in determining the partner's distributive share of partnership income
or loss. If any gain or
loss from the distribution is recognized by the partner, it must be reported on his or her return for the tax year in which
the distribution is
received. Money or property withdrawn by a partner in anticipation of the current year's earnings is treated as a distribution
received on the last
day of the partnership's tax year.
Effect on partner's basis.
A partner's adjusted basis in his or her partnership interest is decreased (but not below zero) by the money and adjusted
basis of property
distributed to the partner. See Adjusted Basis under Basis of Partner's Interest, later.
Effect on partnership.
A partnership generally does not recognize any gain or loss because of distributions it makes to partners. The partnership
may be able to elect to
adjust the basis of its undistributed property.
Certain distributions treated as a sale or exchange.
When a partnership distributes the following items, the distribution may be treated as a sale or exchange of property
rather than a distribution.
-
Unrealized receivables or substantially appreciated inventory items distributed in exchange for any part of the partner's
interest in other
partnership property, including money.
-
Other property (including money) distributed in exchange for any part of a partner's interest in unrealized receivables or
substantially
appreciated inventory items.
See Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later.
This treatment does not apply to the following distributions.
-
A distribution of property to the partner who contributed the property to the partnership.
-
Payments made to a retiring partner or successor in interest of a deceased partner that are the partner's distributive share
of partnership
income or guaranteed payments.
Substantially appreciated inventory items.
Inventory items of the partnership are considered to have appreciated substantially in value if, at the time of the
distribution, their total fair
market value is more than 120% of the partnership's adjusted basis for the property. However, if a principal purpose for acquiring
inventory property
is to avoid ordinary income treatment by reducing the appreciation to less than 120%, that property is excluded.
A partner generally recognizes gain on a partnership distribution only to the extent any money (and marketable securities
treated as money)
included in the distribution exceeds the adjusted basis of the partner's interest in the partnership. Any gain recognized
is generally treated as
capital gain from the sale of the partnership interest on the date of the distribution. If partnership property (other than
marketable securities
treated as money) is distributed to a partner, he or she generally does not recognize any gain until the sale or other disposition
of the property.
For exceptions to these rules, see Distribution of partner's debt and Net precontribution gain, later. Also, see
Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later.
Example.
The adjusted basis of Jo's partnership interest is $14,000. She receives a distribution of $8,000 cash and land that has an
adjusted basis of
$2,000 and a fair market value of $3,000. Because the cash received does not exceed the basis of her partnership interest,
Jo does not recognize any
gain on the distribution. Any gain on the land will be recognized when she sells or otherwise disposes of it. The distribution
decreases the adjusted
basis of Jo's partnership interest to $4,000 [$14,000 - ($8,000 + $2,000)].
Marketable securities treated as money.
Generally, a marketable security distributed to a partner is treated as money in determining whether gain is recognized
on the distribution. This
treatment, however, does not generally apply if that partner contributed the security to the partnership or an investment
partnership made the
distribution to an eligible partner.
The amount treated as money is the security's fair market value when distributed, reduced (but not below zero) by
the excess (if any) of:
-
The partner's distributive share of the gain that would be recognized had the partnership sold all its marketable securities
at their fair
market value immediately before the transaction resulting in the distribution, over
-
The partner's distributive share of the gain that would be recognized had the partnership sold all such securities it still
held after the
distribution at the fair market value in (1).
For more information, including the definition of marketable securities, see section 731(c) of the Internal Revenue
Code.
Loss on distribution.
A partner does not recognize loss on a partnership distribution unless all the following requirements are met.
-
The adjusted basis of the partner's interest in the partnership exceeds the distribution.
-
The partner's entire interest in the partnership is liquidated.
-
The distribution is in money, unrealized receivables, or inventory items.
There are exceptions to these general rules. See the following discussions. Also, see Liquidation at Partner's Retirement or Death under
Disposition of Partner's Interest, later.
Distribution of partner's debt.
If a partnership acquires a partner's debt and extinguishes the debt by distributing it to the partner, the partner
will recognize capital gain or
loss to the extent the fair market value of the debt differs from the basis of the debt (determined under the rules discussed
in Partner's Basis
for Distributed Property, later).
The partner is treated as having satisfied the debt for its fair market value. If the issue price (adjusted for any
premium or discount) of the
debt exceeds its fair market value when distributed, the partner may have to include the excess amount in income as canceled
debt.
Similarly, a deduction may be available to a corporate partner if the fair market value of the debt at the time of
distribution exceeds its
adjusted issue price.
Net precontribution gain.
A partner generally must recognize gain on the distribution of property (other than money) if the partner contributed
appreciated property to the
partnership during the 7-year period before the distribution.
A 5-year period applies to property contributed before June 9, 1997, or under a written binding contract:
-
That was in effect on June 8, 1997, and at all times thereafter before the contribution, and
-
That provides for the contribution of a fixed amount of property.
The gain recognized is the lesser of the following amounts.
-
The excess of:
-
The fair market value of the property received in the distribution, over
-
The adjusted basis of the partner's interest in the partnership immediately before the distribution, reduced (but not below
zero) by any
money received in the distribution.
-
The “net precontribution gain” of the partner. This is the net gain the partner would recognize if all the property contributed by the
partner within 7 years (5 years for property contributed before June 9, 1997) of the distribution, and held by the partnership
immediately before the
distribution, were distributed to another partner, other than a partner who owns more than 50% of the partnership. For information
about the
distribution of contributed property to another partner, see Contribution of Property, under Transactions Between Partnership and
Partners, later.
The character of the gain is determined by reference to the character of the net precontribution gain. This gain is
in addition to any gain the
partner must recognize if the money distributed is more than his or her basis in the partnership.
For these rules, the term “money” includes marketable securities treated as money, as discussed earlier.
Effect on basis.
The adjusted basis of the partner's interest in the partnership is increased by any net precontribution gain recognized
by the partner. Other than
for purposes of determining the gain, the increase is treated as occurring immediately before the distribution. See Basis of Partner's Interest,
later.
The partnership must adjust its basis in any property the partner contributed within 7 years (5 years for property
contributed before June 9, 1997)
of the distribution to reflect any gain that partner recognizes under this rule.
Exceptions.
Any part of a distribution that is property the partner previously contributed to the partnership is not taken into
account in determining the
amount of the excess distribution or the partner's net precontribution gain. For this purpose, the partner's previously contributed
property does not
include a contributed interest in an entity to the extent its value is due to property contributed to the entity after the
interest was contributed to
the partnership.
Recognition of gain under this rule also does not apply to a distribution of unrealized receivables or substantially
appreciated inventory items if
the distribution is treated as a sale or exchange, as discussed earlier.
Partner's Basis for Distributed Property
Unless there is a complete liquidation of a partner's interest, the basis of property (other than money) distributed to the
partner by a
partnership is its adjusted basis to the partnership immediately before the distribution. However, the basis of the property
to the partner cannot be
more than the adjusted basis of his or her interest in the partnership reduced by any money received in the same transaction.
Example 1.
The adjusted basis of Beth's partnership interest is $30,000. She receives a distribution of property that has an adjusted
basis of $20,000 to the
partnership and $4,000 in cash. Her basis for the property is $20,000.
Example 2.
The adjusted basis of Mike's partnership interest is $10,000. He receives a distribution of $4,000 cash and property that
has an adjusted basis to
the partnership of $8,000. His basis for the distributed property is limited to $6,000 ($10,000 - $4,000, the cash he receives).
Complete liquidation of partner's interest.
The basis of property received in complete liquidation of a partner's interest is the adjusted basis of the partner's
interest in the partnership
reduced by any money distributed to the partner in the same transaction.
Partner's holding period.
A partner's holding period for property distributed to the partner includes the period the property was held by the
partnership. If the property
was contributed to the partnership by a partner, then the period it was held by that partner is also included.
Basis divided among properties.
If the basis of property received is the adjusted basis of the partner's interest in the partnership (reduced by money
received in the same
transaction), it must be divided among the properties distributed to the partner. For property distributed after August 5,
1997, allocate the basis
using the following rules.
-
Allocate the basis first to unrealized receivables and inventory items included in the distribution by assigning a basis to
each item equal
to the partnership's adjusted basis in the item immediately before the distribution. If the total of these assigned bases
exceeds the allocable basis,
decrease the assigned bases by the amount of the excess.
-
Allocate any remaining basis to properties other than unrealized receivables and inventory items by assigning a basis to each
property equal
to the partnership's adjusted basis in the property immediately before the distribution. If the allocable basis exceeds the
total of these assigned
bases, increase the assigned bases by the amount of the excess. If the total of these assigned bases exceeds the allocable
basis, decrease the
assigned bases by the amount of the excess.
Allocating a basis increase.
Allocate any basis increase required in rule (2), above, first to properties with unrealized appreciation to the extent
of the unrealized
appreciation. (If the basis increase is less than the total unrealized appreciation, allocate it among those properties in
proportion to their
respective amounts of unrealized appreciation.) Allocate any remaining basis increase among all the properties in proportion
to their respective fair
market values.
Example.
Julie's basis in her partnership interest is $55,000. In a distribution in liquidation of her entire interest, she receives
properties A and B,
neither of which is inventory or unrealized receivables. Property A has an adjusted basis to the partnership of $5,000 and
a fair market value of
$40,000. Property B has an adjusted basis to the partnership of $10,000 and a fair market value of $10,000.
To figure her basis in each property, Julie first assigns bases of $5,000 to property A and $10,000 to property B (their adjusted
bases to the
partnership). This leaves a $40,000 basis increase (the $55,000 allocable basis minus the $15,000 total of the assigned bases).
She first allocates
$35,000 to property A (its unrealized appreciation). The remaining $5,000 is allocated between the properties based on their
fair market values.
$4,000 ($40,000/$50,000) is allocated to property A and $1,000 ($10,000/$50,000) is allocated to property B. Julie's basis
in property A is $44,000
($5,000 + $35,000 + $4,000) and her basis in property B is $11,000 ($10,000 + $1,000).
Allocating a basis decrease.
Use the following rules to allocate any basis decrease required in rule (1) or rule (2), earlier.
-
Allocate the basis decrease first to items with unrealized depreciation to the extent of the unrealized depreciation. (If
the basis decrease
is less than the total unrealized depreciation, allocate it among those items in proportion to their respective amounts of
unrealized
depreciation.)
-
Allocate any remaining basis decrease among all the items in proportion to their respective assigned basis amounts (as decreased
in (1)).
Example.
Tom's basis in his partnership interest is $20,000. In a distribution in liquidation of his entire interest, he receives properties
C and D,
neither of which is inventory or unrealized receivables. Property C has an adjusted basis to the partnership of $15,000 and
a fair market value of
$15,000. Property D has an adjusted basis to the partnership of $15,000 and a fair market value of $5,000.
To figure his basis in each property, Tom first assigns bases of $15,000 to property C and $15,000 to property D (their adjusted
bases to the
partnership). This leaves a $10,000 basis decrease (the $30,000 total of the assigned bases minus the $20,000 allocable basis).
He allocates the
entire $10,000 to property D (its unrealized depreciation). Tom's basis in property C is $15,000 and his basis in property
D is $5,000 ($15,000
- $10,000).
Distributions before August 6, 1997.
For property distributed before August 6, 1997, allocate the basis using the following rules.
-
Allocate the basis first to unrealized receivables and inventory items included in the distribution to the extent of the partnership's
adjusted basis in those items. If the partnership's adjusted basis in those items exceeded the allocable basis, allocate the
basis among the items in
proportion to their adjusted bases to the partnership.
-
Allocate any remaining basis to other distributed properties in proportion to their adjusted bases to the partnership.
Partner's interest more than partnership basis.
If the basis of a partner's interest to be divided in a complete liquidation of the partner's interest is more than
the partnership's adjusted
basis for the unrealized receivables and inventory items distributed, and if no other property is distributed to which the
partner can apply the
remaining basis, the partner has a capital loss to the extent of the remaining basis of the partnership interest.
Special adjustment to basis.
A partner who acquired any part of his or her partnership interest in a sale or exchange or upon the death of another
partner may be able to choose
a special basis adjustment for property distributed by the partnership. To choose the special adjustment, the partner must
have received the
distribution within 2 years after acquiring the partnership interest. Also, the partnership must not have chosen the optional
adjustment to basis when
the partner acquired the partnership interest.
If a partner chooses this special basis adjustment, the partner's basis for the property distributed is the same as
it would have been if the
partnership had chosen the optional adjustment to basis. However, this assigned basis is not reduced by any depletion or depreciation
that would have
been allowed or allowable if the partnership had previously chosen the optional adjustment.
The choice must be made with the partner's tax return for the year of the distribution if the distribution includes
any property subject to
depreciation, depletion, or amortization. If the choice does not have to be made for the distribution year, it must be made
with the return for the
first year in which the basis of the distributed property is pertinent in determining the partner's income tax.
A partner choosing this special basis adjustment must attach a statement to his or her tax return that the partner
chooses under section 732(d) of
the Internal Revenue Code to adjust the basis of property received in a distribution. The statement must show the computation
of the special basis
adjustment for the property distributed and list the properties to which the adjustment has been allocated.
Example.
Bob purchased a 25% interest in X partnership for $17,000 cash. At the time of the purchase, the partnership owned inventory
having a basis to the
partnership of $14,000 and a fair market value of $16,000. Thus, $4,000 of the $17,000 he paid was attributable to his share
of inventory with a basis
to the partnership of $3,500.
Within 2 years after acquiring his interest, Bob withdrew from the partnership and for his entire interest received cash of
$1,500, inventory with
a basis to the partnership of $3,500, and other property with a basis of $6,000. The value of the inventory received was 25%
of the value of all
partnership inventory. (It is immaterial whether the inventory he received was on hand when he acquired his interest.)
Since the partnership from which Bob withdrew did not make the optional adjustment to basis, he chose to adjust the basis
of the inventory
received. His share of the partnership's basis for the inventory is increased by $500 (25% of the $2,000 difference between
the $16,000 fair market
value of the inventory and its $14,000 basis to the partnership at the time he acquired his interest). The adjustment applies
only for purposes of
determining his new basis in the inventory, and not for purposes of partnership gain or loss on disposition.
The total to be allocated among the properties Bob received in the distribution is $15,500 ($17,000 basis of his interest
- $1,500 cash
received). His basis in the inventory items is $4,000 ($3,500 partnership basis + $500 special adjustment). The remaining
$11,500 is allocated to his
new basis for the other property he received.
Mandatory adjustment.
A partner does not always have a choice of making this special adjustment to basis. The special adjustment to basis
must be made for a distribution
of property, (whether or not within 2 years after the partnership interest was acquired) if all the following conditions existed
when the partner
received the partnership interest.
-
The fair market value of all partnership property (other than money) was more than 110% of its adjusted basis to the
partnership.
-
If there had been a liquidation of the partner's interest immediately after it was acquired, an allocation of the basis of
that interest
under the general rules (discussed earlier under Basis divided among properties) would have decreased the basis of property that could not
be depreciated, depleted, or amortized and increased the basis of property that could be.
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The optional basis adjustment, if it had been chosen by the partnership, would have changed the partner's basis for the property
actually
distributed.
Required statement.
Generally, if a partner chooses a special basis adjustment and notifies the partnership, or if the partnership makes
a distribution for which the
special basis adjustment is mandatory, the partnership must provide a statement to the partner. The statement must provide
information necessary for
the partner to compute the special basis adjustment.
Marketable securities.
A partner's basis in marketable securities received in a partnership distribution, as determined in the preceding
discussions, is increased by any
gain recognized by treating the securities as money. See Marketable securities treated as money under Partner's Gain or Loss,
earlier. The basis increase is allocated among the securities in proportion to their respective amounts of unrealized appreciation
before the
basis increase.
Transactions Between Partnership and Partners
For certain transactions between a partner and his or her partnership, the partner is treated as not being a member of the
partnership. These
transactions include the following.
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Performing services for or transferring property to a partnership if—
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There is a related allocation and distribution to a partner, and
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The entire transaction, when viewed together, is properly characterized as occurring between the partnership and a partner
not acting in the
capacity of a partner.
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Transferring money or other property to a partnership if—
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There is a related transfer of money or other property by the partnership to the contributing partner or another partner,
and
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The transfers together are properly characterized as a sale or exchange of property.
Payments by accrual basis partnership to cash basis partner.
A partnership that uses an accrual method of accounting cannot deduct any business expense owed to a cash basis partner
until the amount is paid.
However, this rule does not apply to guaranteed payments made to a partner, which are generally deductible when accrued.
Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership's income.
A partnership
treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner.
This treatment is for
purposes of determining gross income and deductible business expenses only. For other tax purposes, guaranteed payments are
treated as a partner's
distributive share of ordinary income. Guaranteed payments are not subject to income tax withholding.
The partnership generally deducts guaranteed payments on line 10 of Form 1065 as a business expense. They are also listed
on Schedules K and K-1 of
the partnership return. The individual partner reports guaranteed payments on Schedule E (Form 1040) as ordinary income, along
with his or her
distributive share of the partnership's other ordinary income.
Guaranteed payments made to partners for organizing the partnership or syndicating interests in the partnership are capital
expenses. Generally,
organizational and syndication expenses are not deductible by the partnership. However, a partnership can elect to deduct
a portion of its
organizational expenses and amortize the remaining expenses (see Business start-up and organizational costs in the instructions for Form
1065). Organizational expenses (if the election is not made) and syndication expenses paid to partners must be reported on
the partners' Schedule K-1
as guaranteed payments.
Minimum payment.
If a partner is to receive a minimum payment from the partnership, the guaranteed payment is the amount by which the
minimum payment is more than
the partner's distributive share of the partnership income before taking into account the guaranteed payment.
Example.
Under a partnership agreement, Sandy is to receive 30% of the partnership income, but not less than $8,000. The partnership
has net income of
$20,000. Sandy's share, without regard to the minimum guarantee, is $6,000 (30% × $20,000). The guaranteed payment that can
be deducted by the
partnership is $2,000 ($8,000 - $6,000). Sandy's income from the partnership is $8,000, and the remaining $12,000 of partnership
income will be
reported by the other partners in proportion to their shares under the partnership agreement.
If the partnership net income had been $30,000, there would have been no guaranteed payment since her share, without regard
to the guarantee, would
have been greater than the guarantee.
Self-employed health insurance premiums.
Premiums for health insurance paid by a partnership on behalf of a partner for services as a partner are treated as
guaranteed payments. The
partnership can deduct the payments as a business expense and the partner must include them in gross income. However, if the
partnership accounts for
insurance paid for a partner as a reduction in distributions to the partner, the partnership cannot deduct the premiums.
A partner who qualifies can deduct 100% of the health insurance premiums paid by the partnership on his or her behalf
as an adjustment to income.
The partner cannot deduct the premiums for any calendar month or part of a month in which the partner is eligible to participate
in any subsidized
health plan maintained by any employer of the partner or the partner's spouse. For more information on the self-employed health
insurance deduction,
see chapter 7 in Publication 535.
Including payments in partner's income.
Guaranteed payments are included in income in the partner's tax year in which the partnership's tax year ends.
Example 1.
Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without regard to the income
of the partnership.
Her distributive share of the partnership income is 10%. The partnership has $50,000 of ordinary income after deducting the
guaranteed payment. She
must include ordinary income of $15,000 ($10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share) on her individual
income tax
return for her tax year in which the partnership's tax year ends.
Example 2.
Mike is a calendar year taxpayer who is a partner in a partnership. The partnership uses a fiscal year that ended January
31, 2005. Mike received
guaranteed payments from the partnership from February 1, 2004, until December 31, 2004. He must include these guaranteed
payments in income for 2005
and report them on his 2005 income tax return.
Payments resulting in loss.
If guaranteed payments to a partner result in a partnership loss in which the partner shares, the partner must report
the full amount of the
guaranteed payments as ordinary income. The partner separately takes into account his or her distributive share of the partnership
loss, to the extent
of the adjusted basis of the partner's partnership interest.
Sale or Exchange of Property
Special rules apply to a sale or exchange of property between a partnership and certain persons.
Losses.
Losses will not be allowed from a sale or exchange of property (other than an interest in the partnership) directly
or indirectly between a
partnership and a person whose direct or indirect interest in the capital or profits of the partnership is more than 50%.
If the sale or exchange is between two partnerships in which the same persons directly or indirectly own more than
50% of the capital or profits
interests in each partnership, no deduction of a loss is allowed.
The basis of each partner's interest in the partnership is decreased (but not below zero) by the partner's share of
the disallowed loss.
If the purchaser later sells the property, only the gain realized that is greater than the loss not allowed will be
taxable. If any gain from the
sale of the property is not recognized because of this rule, the basis of each partner's interest in the partnership is increased
by the partner's
share of that gain.
Gains.
Gains are treated as ordinary income in a sale or exchange of property directly or indirectly between a person and
a partnership, or between two
partnerships, if both of the following tests are met.
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More than 50% of the capital or profits interest in the partnership(s) is directly or indirectly owned by the same person(s).
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The property in the hands of the transferee immediately after the transfer is not a capital asset. Property that is not a
capital asset
includes accounts receivable, inventory, stock-in-trade, and depreciable or real property used in a trade or business.
More than 50% ownership.
To determine if there is more than 50% ownership in partnership capital or profits, the following rules apply.
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An interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered to be owned
proportionately by
or for its shareholders, partners, or beneficiaries.
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An individual is considered to own the interest directly or indirectly owned by or for the individual's family. For this rule,
“family”
includes only brothers, sisters, half-brothers, half-sisters, spouses, ancestors, and lineal descendants.
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If a person is considered to own an interest using rule (1), that person (the “constructive owner”) is treated as if actually owning
that interest when rules (1) and (2) are applied. However, if a person is considered to own an interest using rule (2), that
person is not treated as
actually owning that interest in reapplying rule (2) to make another person the constructive owner.
Example.
Individuals A and B and Trust T are equal partners in Partnership ABT. A's husband, AH, is the sole beneficiary of Trust T.
Trust T's partnership
interest will be attributed to AH only for the purpose of further attributing the interest to A. As a result, A is a more-than-50%
partner. This means
that any deduction for losses on transactions between her and ABT will not be allowed, and gain from property that in the
hands of the transferee is
not a capital asset is treated as ordinary, rather than capital, gain.
More information.
For more information on these special rules, see Sales and Exchanges Between Related Persons in chapter 2 of Publication 544.
Usually, neither the partner nor the partnership recognizes a gain or loss when property is contributed to the partnership
in exchange for a
partnership interest. This applies whether a partnership is being formed or is already operating. The partnership's holding
period for the property
includes the partner's holding period.
The contribution of limited partnership interests in one partnership for limited partnership interests in another partnership
qualifies as a
tax-free contribution of property to the second partnership if the transaction is made for business purposes. The exchange
is not subject to the rules
explained later under Disposition of Partner's Interest.
Disguised sales.
A contribution of money or other property to the partnership followed by a distribution of different property from
the partnership to the partner
is treated not as a contribution and distribution, but as a sale of property, if both of the following tests are met.
All facts and circumstances are considered in determining if the contribution and distribution are more properly characterized
as a sale. However,
if the contribution and distribution occur within 2 years of each other, the transfers are presumed to be a sale unless the
facts clearly indicate
that the transfers are not a sale. If the contribution and distribution occur more than 2 years apart, the transfers are presumed
not to be a sale
unless the facts clearly indicate that the transfers are a sale.
Form 8275 required.
A partner must attach Form 8275, Disclosure Statement, (or other statement) to his or her return if the partner contributes property to
a partnership and, within 2 years (before or after the contribution), the partnership transfers money or other consideration
to the partner. For
exceptions to this requirement, see section 1.707-3(c)(2) of the regulations.
A partnership must attach Form 8275 (or other statement) to its return if it distributes property to a partner, and,
within 2 years (before or
after the distribution), the partner transfers money or other consideration to the partnership.
Form 8275 must include the following information.
-
A caption identifying the statement as a disclosure under section 707 of the Internal Revenue Code.
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A description of the transferred property or money, including its value.
-
A description of any relevant facts in determining if the transfers are properly viewed as a disguised sale. (See section
1.707-3(b)(2) of
the regulations for a description of the facts and circumstances considered in determining if the transfers are a disguised
sale.)
Contribution to investment company.
Gain is recognized when property is contributed (in exchange for an interest in the partnership) to a partnership
that would be treated as an
investment company if it were incorporated.
A partnership is generally treated as an investment company if over 80% of the value of its assets is held for investment
and consists of certain
readily marketable items. These items include money, stocks and other equity interests in a corporation, and interests in
regulated investment
companies and real estate investment trusts. For more information, see section 351(e)(1) of the Internal Revenue Code and
the related regulations.
Whether a partnership is an investment company under this test is ordinarily determined immediately after the transfer of
property.
This rule applies to limited partnerships and general partnerships, regardless of whether they are privately formed
or publicly syndicated.
Contribution to foreign partnership.
A domestic partnership that contributed property after August 5, 1997, to a foreign partnership in exchange for a
partnership interest may have to
file Form 8865 if either of the following apply.
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Immediately after the contribution, the partnership owned, directly or indirectly, at least a 10% interest in the foreign
partnership.
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The fair market value of the property contributed to the foreign partnership, when added to other contributions of property
made to the
partnership during the preceding 12-month period, is greater than $100,000.
The partnership may also have to file Form 8865, even if no contributions are made during the tax year, if it owns
a 10% or more interest in a
foreign partnership at any time during the year. See the form instructions for more information.
Basis of contributed property.
If a partner contributes property to a partnership, the partnership's basis for determining depreciation, depletion,
and gain or loss for the
property is the same as the partner's adjusted basis for the property when it was contributed, increased by any gain recognized
by the partner at the
time of contribution.
Allocations to account for built-in gain or loss.
The fair market value of property at the time it is contributed may be different from the partner's adjusted basis.
The partnership must allocate
among the partners any income, deduction, gain, or loss on the property in a manner that will account for the difference.
This rule also applies to
contributions of accounts payable and other accrued but unpaid items of a cash basis partner.
The partnership can use different allocation methods for different items of contributed property. A single reasonable
method must be consistently
applied to each item, and the overall method or combination of methods must be reasonable. See section 1.704-3 of the regulations
for allocation
methods generally considered reasonable.
If the partnership sells contributed property and recognizes gain or loss, built-in gain or loss is allocated to the
contributing partner. If
contributed property is subject to depreciation or other cost recovery, the allocation of deductions for these items takes
into account built-in gain
or loss on the property. However, the total depreciation, depletion, gain, or loss allocated to partners cannot be more than
the depreciation or
depletion allowable to the partnership or the gain or loss realized by the partnership.
Example.
Sara and Gail formed an equal partnership. Sara contributed $10,000 in cash to the partnership and Gail contributed depreciable
property with a
fair market value of $10,000 and an adjusted basis of $4,000. The partnership's basis for depreciation is limited to the adjusted
basis of the
property in Gail's hands, $4,000.
In effect, Sara purchased an undivided one-half interest in the depreciable property with her contribution of $10,000. Assuming
that the
depreciation rate is 10% a year under the General Depreciation System (GDS), she would have been entitled to a depreciation
deduction of $500 per
year, based on her interest in the partnership, if the adjusted basis of the property equaled its fair market value when contributed.
(To simplify
this example, the depreciation deductions are determined without regard to any first-year depreciation conventions.)
However, since the partnership is allowed only $400 per year of depreciation (10% of $4,000), no more than $400 can be allocated
between the
partners. The entire $400 must be allocated to Sara.
Distribution of contributed property to another partner.
If a partner contributes property to a partnership and the partnership distributes the property to another partner
within 7 years of the
contribution, the contributing partner must recognize gain or loss on the distribution.
A 5-year period applies to property contributed before June 9, 1997, or under a written binding contract:
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That was in effect on June 8, 1997, and at all times thereafter before the contribution, and
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That provides for the contribution of a fixed amount of property.
The recognized gain or loss is the amount the contributing partner would have recognized if the property had been
sold for its fair market value
when it was distributed. This amount is the difference between the property's basis and its fair market value at the time
of contribution. The
character of the gain or loss will be the same as the character of the gain or loss that would have resulted if the partnership
had sold the property
to the distributee partner. Appropriate adjustments must be made to the adjusted basis of the contributing partner's partnership
interest and to the
adjusted basis of the property distributed to reflect the recognized gain or loss.
Disposition of certain contributed property.
The following rules determine the character of the partnership's gain or loss on a disposition of certain types of
contributed property.
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Unrealized receivables. If the property was an unrealized receivable in the hands of the contributing partner, any gain or loss
on its disposition by the partnership is ordinary income or loss. Unrealized receivables are defined later under Payments for Unrealized
Receivables and Inventory Items. When reading the definition, substitute “partner” for “partnership.”
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Inventory items. If the property was an inventory item in the hands of the contributing partner, any gain or loss on its
disposition by the partnership within 5 years after the contribution is ordinary income or loss. Inventory items are defined
later in Payments
for Unrealized Receivables and Inventory Items.
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Capital loss property. If the property was a capital asset in the contributing partner's hands, any loss on its disposition by
the partnership within 5 years after the contribution is a capital loss. The capital loss is limited to the amount by which
the partner's adjusted
basis for the property exceeded the property's fair market value immediately before the contribution.
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Substituted basis property. If the disposition of any of the property listed in (1), (2), or (3) is a nonrecognition transaction,
these rules apply when the recipient of the property disposes of any substituted basis property (other than certain corporate
stock) resulting from
the transaction.
A partner can acquire an interest in partnership capital or profits as compensation for services performed or to be performed.
Capital interest.
A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were
sold at fair market value and
the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time
of receipt of the
partnership interest. The fair market value of such an interest received by a partner as compensation for services must generally
be included in the
partner's gross income in the first tax year in which the partner can transfer the interest or the interest is not subject
to a substantial risk of
forfeiture. The capital interest transferred as compensation for services is subject to the rules for restricted property
discussed in Publication 525
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