Publication 541: Partnerships; Main Contents

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Table of Contents

Forming a Partnership

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.

Family Partnership

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 owner withdraws from the partnership.
The partnership liquidates.

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.

Partnership Agreement

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)

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e-file

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, discussed under Tax Year, later.

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.

Tax Year

Taxable income is figured on the basis of a tax year. A “tax year” is the accounting period used for keeping records and reporting income and expenses.

Partnership. A partnership determines its tax year as if it were a taxpayer. However, there are limits on the year it can choose. In general, a partnership must use its required tax year. A required tax year is a tax year that is required under the Internal Revenue Code and Income Tax Regulations. For a partnership, the required tax year is the tax year determined under section 706 of the Internal Revenue Code and section 1.706 of the regulations. See Required Tax Year, later. Exceptions to this rule are discussed under Exceptions to Required Tax Year, later.

Partners. Partners can change their tax year only if they receive permission from the IRS. This also applies to corporate partners, who are usually allowed to change their accounting periods without prior approval if they meet certain conditions.

Closing of tax year. Generally, the partnership's tax year is not closed because of the sale, exchange, or liquidation of a partner's interest, the death of a partner, or the entry of a new partner. However, if a partner sells, exchanges, or liquidates his or her entire interest, or a partner dies, the partnership's tax year is closed for that partner. See Distributive share in year of disposition under Partner's Income or Loss, later.

Required Tax Year

A partnership generally must conform its tax year to its partners' tax years. The rules for determining the required tax year are as follows.

Majority interest tax year. If one or more partners having the same tax year own an interest in partnership profits and capital of more than 50% (a majority interest), the partnership must use the tax year of those partners.

Testing day. The partnership determines if there is a majority interest tax year on the testing day, which is usually the first day of the partnership's current tax year.

Change in tax year. If a partnership's majority interest tax year changes, it will not be required to change to another tax year for 2 years following the year of change.
Principal partner. If there is no majority interest tax year, the partnership must use the tax year of all its principal partners. A principal partner is one who has a 5% or more interest in the profits or capital of the partnership.
Least aggregate deferral of income. If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use a tax year that results in the least aggregate deferral of income to the partners.

Least aggregate deferral of income. The tax year that results in the least aggregate deferral of income is determined as follows.

Figure the number of months of deferral for each partner using one partner's tax year. Count the months from the end of that tax year forward to the end of each other partner's tax year.
Multiply each partner's months of deferral figured in step (1) by that partner's interest in the partnership profits for the year used in step (1).
Add the results in step (2) to get the total deferral for the tax year used in step (1).
Repeat steps (1) through (3) for each partner's tax year that is different from the other partners' years.

The partner's tax year that results in the lowest total number in step (3) is the tax year that must be used by the partnership. If the calculation results in more than one year qualifying as the tax year that has the least aggregate deferral, the partnership can choose any one of those tax years as its tax year. However, if one of the years that qualifies is the partnership's existing tax year, the partnership must retain that tax year.

Example.

Rose and Irene each have a 50% interest in a partnership that uses a fiscal year ending June 30. Rose uses a calendar year while Irene has a fiscal year ending November 30. The partnership must change its tax year to a fiscal year ending November 30 because this results in the least aggregate deferral of income to the partners. This was determined as shown in the following table.

Year End 12/31:	Year End	Profits Interest	Months of Deferral	Interest × Deferral
Rose	12/31	0.5	-0-	-0-
Irene	11/30	0.5	11	5.5
Total Deferral				5.5
Year End 11/30:	Year End	Profits Interest	Months of Deferral	Interest × Deferral
Rose	12/31	0.5	1	0.5
Irene	11/30	0.5	-0-	-0-
Total Deferral				0.5

Special de minimis rule. If the tax year that results in the least aggregate deferral produces an aggregate deferral that is less than 0.5 when compared to the aggregate deferral of the current tax year, the partnership's current tax year is treated as the tax year with the least aggregate deferral.

When determination is made. Generally, determination of the partnership's required tax year under the least aggregate deferral rules is made at the beginning of the partnership's current tax year. However, the IRS can require the partnership to use another day or period that will more accurately reflect the ownership of the partnership. This could occur, for example, if a partnership interest was transferred for the purpose of qualifying for a particular tax year.

Procedures. A newly formed partnership is not required to request approval from the IRS if it adopts its required tax year. A partnership can get an automatic approval to change to a required tax year by filing Form 1128 with the Service Center where it files its federal income tax returns. Form 1128 must be filed by the due date (including extensions) for filing the short period tax return. If a partnership does not qualify for automatic approval to adopt, change, or retain a tax year, it can request a ruling. See Publication 538 for more information on automatic approval and ruling request procedures.

Short period return. When a partnership changes its tax year, a short period return must be filed. The short period return covers the months between the end of the partnership's prior tax year and the beginning of its new tax year.

If a partnership changes to the tax year resulting in the least aggregate deferral, it must file a Form 1128 with the short period return showing the computations used to determine that tax year. The Form 1128 should also be attached to the partnership tax return.

Exceptions to Required Tax Year

There are certain exceptions to the required tax year rule.

Business purpose tax year. If a partnership establishes an acceptable business purpose for having a tax year different from its required tax year, the different tax year can be used. Administrative and convenience business reasons such as the deferral of income to the partners are not sufficient to establish a business purpose for a particular tax year.

See Business Purpose Tax Year in Publication 538 for more information.

Section 444 election. A partnership can elect under section 444 of the Internal Revenue Code to use a tax year different from its required tax year. Certain restrictions apply to this election. In addition, the electing partnership may be required to make a payment representing the value of the extra tax deferral to the partners.

See Form 8716, Election To Have a Tax Year Other Than a Required Tax Year, and Section 444 Election in Publication 538 for more information.

52-53-week tax year. A partnership can use a tax year other than its required tax year if it elects a 52-53-week tax year that ends with reference to either its required tax year or a tax year elected under section 444 (discussed earlier). See 52-53-Week Tax Year under Fiscal Year in Publication 538 for information on the 52-53-week tax year.

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.

Due date. Form 1065 generally must be filed by April 15 following the close of the partnership's tax year if its accounting period is the calendar year. A fiscal year partnership generally must file its return by the 15th day of the 4th month following the close of its fiscal year.

If a partnership needs more time to file its return, it should file Form 8736 by the regular due date of its Form 1065. The automatic extension is 3 months.

If the partnership has made a section 444 election to use a tax year other than a required year, an automatic extension of time for filing a return will run concurrently with any extension of time allowed by the section 444 election. The filing of an application for extension does not extend the time for filing a partner's personal income tax return or for paying any tax due on a partner's personal income tax return.

If the due date for filing a return falls on a Saturday, Sunday, or legal holiday, the due date is extended to the next business day.

Schedule K–1 due to partners. The partnership must furnish copies of Schedule K–1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions.

Penalties

To help ensure that returns are filed correctly and on time, the law provides penalties for failure to do so.

Failure to file. A penalty is assessed against any partnership that must file a partnership return and fails to file on time, including extensions, or fails to file a return with all the information required. The penalty is $50 times the total number of partners in the partnership during any part of the tax year for each month (or part of a month) the return is late or incomplete, up to 5 months.

The penalty will not be imposed if the partnership can show reasonable cause for its failure to file a complete or timely return. Certain small partnerships (with 10 or fewer partners) meet this reasonable cause test if:

All partners are individuals (other than nonresident aliens), estates, or C corporations,
All partners have timely filed income tax returns fully reporting their shares of the partnership's income, deductions, and credits, and
The partnership has not elected to be subject to the rules for consolidated audit proceedings (explained later under Partner's Income or Loss, in the discussion under Reporting Distributive Share).

The failure to file penalty is assessed against the partnership. However, each partner is individually liable for the penalty to the extent the partner is liable for partnership debts in general.

If the partnership wants to contest the penalty, it must pay the penalty and sue for refund in a U.S. District Court or the U.S. Court of Federal Claims.

Failure to furnish copies to the partners. The partnership must furnish copies of Schedule K–1 (Form 1065) to the partners. A penalty for each statement not furnished will be assessed against the partnership unless the failure to do so is due to reasonable cause and not willful neglect.

Trust fund recovery penalty. A person responsible for withholding, accounting for, or depositing or paying withholding taxes who willfully fails to do so can be held liable for a penalty equal to the tax not paid.

“Willfully” in this case means voluntarily, consciously, and intentionally. Paying other expenses of the business instead of the taxes due is considered willful behavior.

A responsible person can be a partner, an employee of the partnership, or an accountant. This may also include someone who signs checks for the partnership or otherwise has authority to cause the spending of partnership funds.

Other penalties. Criminal penalties can be imposed for willful failure to file, tax evasion, or making a false statement.

Other penalties can be imposed for the following actions.

Not supplying a taxpayer identification number.
Not furnishing information returns.
Underpaying tax due to a valuation misstatement.
Not furnishing information on tax shelters.
Promoting abusive tax shelters.

However, certain penalties may not be imposed if there is reasonable cause for noncompliance.

Partnership Income or Loss (Form 1065 Only)

A partnership computes its income and files its return in the same manner as an individual. However, certain deductions are not allowed to the partnership.

Separately stated items. Certain items must be separately stated on the partnership return and included as separate items on the partners' returns. These items, listed on Schedule K (Form 1065), are the following.

Ordinary income or loss from trade or business activities.
Net income or loss from rental real estate activities.
Net income or loss from other rental activities.
Gains and losses from sales or exchanges of capital assets.
Gains and losses from sales or exchanges of property described in section 1231 of the Internal Revenue Code.
Charitable contributions.
Dividends (passed through to corporate partners) that qualify for the dividends-received deduction.
Taxes paid or accrued to foreign countries and U.S. possessions.
Other items of income, gain, loss, deduction, or credit, as provided by regulations. Examples include nonbusiness expenses, intangible drilling and development costs, and soil and water conservation expenses.

Elections. The partnership makes most choices about how to figure income. These include choices for the following items.

Accounting method.
Depreciation method.
Method of accounting for specific items, such as depletion or installment sales.
Nonrecognition of gain on involuntary conversions of property.
Amortization of certain organization fees and business start-up costs of the partnership.

However, each partner chooses how to treat the partner's share of foreign and U.S. possessions taxes, certain mining exploration expenses, and income from cancellation of debt.

More information. For more information on a specific election, see the listed publication.

Accounting methods: Publication 538.
Depreciation methods: Publication 946.
Installment sales: Publication 537.
Amortization and depletion: Publication 535, chapters 9 and 10.
Involuntary conversions: Publication 544 (condemnations) and Publication 547 (casualties and thefts).

Organization expenses and syndication fees. Neither the partnership nor any partner can deduct, as a current expense, amounts paid or incurred to organize a partnership or to promote the sale of, or to sell, an interest in the partnership.

The partnership can choose to amortize certain organization expenses over a period of not less than 60 months. The period must start with the month the partnership begins business. This election is irrevocable and the period the partnership chooses in this election cannot be changed. If the partnership elects to amortize these expenses and is liquidated before the end of the amortization period, the remaining balance in this account is deductible as a loss.

Making the election. The election to amortize organization expenses is made by attaching a statement to the partnership's return for the tax year the partnership begins its business. The statement must provide all the following information.

A description of each organization expense incurred (whether or not paid).
The amount of each expense.
The date each expense was incurred.
The month the partnership began its business.
The number of months (not less than 60) over which the expenses are to be amortized.

Expenses less than $10 need not be separately listed, provided the total amount is listed with the dates on which the first and last of the expenses were incurred. A cash basis partnership must also indicate the amount paid before the end of the year for each expense.

Amortizable expenses. Amortization applies to expenses that are:

Incident to the creation of the partnership,
Chargeable to a capital account, and
The type that would be amortized if they were incurred in the creation of a partnership having a fixed life.

To satisfy (1), an expense must be incurred during the period beginning at a point that is a reasonable time before the partnership begins business and ending with the date for filing the partnership return (not including extensions) for the tax year in which the partnership begins business. In addition, the expense must be for creating the partnership and not for starting or operating the partnership trade or business.

To satisfy (3), the expense must be for a type of item normally expected to benefit the partnership throughout its entire life.

Organization expenses that can be amortized include the following.

Legal fees for services incident to the organization of the partnership, such as negotiation and preparation of a partnership agreement.
Accounting fees for services incident to the organization of the partnership.
Filing fees.

Expenses not amortizable. Expenses that cannot be amortized (regardless of how the partnership characterizes them) include expenses connected with the following actions.

Acquiring assets for the partnership or transferring assets to the partnership.
Admitting or removing partners other than at the time the partnership is first organized.
Making a contract relating to the operation of the partnership trade or business (even if the contract is between the partnership and one of its members).
Syndicating the partnership. Syndication expenses, such as commissions, professional fees, and printing costs connected with the issuing and marketing of interests in the partnership, are capitalized. They can never be deducted by the partnership, even if the syndication is unsuccessful.

Partner's Income or Loss

A partner's income or loss from a partnership is the partner's distributive share of partnership items for the partnership's tax year that ends with or within the partner's tax year. These items are reported to the partner on Schedule K–1 (Form 1065).

Gross income. When it is necessary to determine the gross income of a partner, the partner's gross income includes his or her distributive share of the partnership's gross income. For example, the partner's share of the partnership gross income is used in determining whether an income tax return must be filed by that partner.

Estimated tax. Partners may have to make payments of estimated tax during the year as a result of partnership income.

Generally, estimated tax for individuals is the smaller of the following amounts, reduced by any expected withholding and credits.

90% of the tax expected to be shown on the current year's tax return.
100% of the total tax shown on the prior year's tax return.

Different rules apply to certain higher income individuals and individuals who receive at least two-thirds of their gross income from farming or fishing.

See Publication 505 for more information.

Self-employment income. A partner is not an employee of the partnership. The partner's distributive share of ordinary income from a partnership is generally included in figuring net earnings from self-employment. However, a limited partner generally does not include his or her distributive share of income or loss in computing net earnings from self-employment. This exclusion does not apply to guaranteed payments made to a limited partner for services actually rendered to or on behalf of a partnership engaged in a trade or business.

Self-employment tax. If an individual partner has net earnings from self-employment of $400 or more for the year, the partner must figure self-employment tax on Schedule SE (Form 1040). For more information on self-employment tax, see Publication 533.

Alternative minimum tax. To figure alternative minimum tax, a partner must separately take into account any distributive share of items of income and deductions that enter into the computation of alternative minimum taxable income. For information on which items of income and deductions are affected, see the Form 6251 instructions.

Partners of electing large partnerships should see the Partner's Instructions for Schedule K–1 (Form 1065–B), for information on alternative minimum tax.

Figuring Distributive Share

Generally, the partnership agreement determines a partner's distributive share of any item or class of items of income, gain, loss, deduction, or credit. However, the allocations provided for in the partnership agreement or any modification will be disregarded if they do not have substantial economic effect. If the partnership agreement does not provide for an allocation, or an allocation does not have substantial economic effect, the partner's distributive share of the partnership items is generally determined by the partner's interest in the partnership. For special allocation rules for items attributable to built-in gain or loss on property contributed by a partner, see Contribution of Property under Transactions Between Partnership and Partners, later.

Substantial economic effect. An allocation has substantial economic effect if both of the following tests are met.

There is a reasonable possibility that the allocation will substantially affect the dollar amount of the partners' shares of partnership income or loss independently of tax consequences.
The partner to whom the allocation is made actually receives the economic benefit or bears the economic burden corresponding to that allocation.

Allocation attributable to a nonrecourse liability. An allocation of a loss, deduction, or expense attributable to a partnership nonrecourse liability does not have any economic effect because the partner does not bear the economic burden corresponding to that allocation. (See Effect of Partnership Liabilities under Basis of Partner's Interest, later.) Therefore, the partner's distributive share of the item must be determined by his or her interest in the partnership. For more information, see section 1.704–2 of the regulations.

Partner's interest in partnership. If a partner's distributive share of a partnership item cannot be determined under the partnership agreement, it is determined by his or her interest in the partnership. The partner's interest is determined by taking into account all the following items.

The partners' relative contributions to the partnership.
The interests of all partners in economic profits and losses (if different from interests in taxable income or loss) and in cash flow and other nonliquidating distributions.
The rights of the partners to distributions of capital upon liquidation.

Varying interests. A change in a partner's interest during the partnership's tax year requires the partner's distributive share of partnership items to be determined by taking into account his or her varying interests in the partnership during the tax year. Partnership items are allocated to the partner only for the portion of the year in which he or she is a member of the partnership.

This rule applies to a partner who sells or exchanges part of an interest in a partnership, or whose interest is reduced or increased (whether by entry of a new partner, partial liquidation of a partner's interest, gift, additional contributions, or otherwise).

Example.

ABC is a calendar year partnership with three partners, Alan, Bob, and Cathy. Under the partnership agreement, profits and losses are shared in proportion to each partner's contributions. On January 1 the ratio was 90% for Alan, 5% for Bob, and 5% for Cathy. On December 1 Bob and Cathy each contributed additional amounts. The new profit and loss sharing ratios were 30% for Alan, 35% for Bob, and 35% for Cathy. For its tax year ended December 31, the partnership had a loss of $1,200. This loss occurred equally over the partnership's tax year. The loss is divided among the partners as follows:

Partner	Profit or Loss %	x	Part of Year Held	x	Total Loss	=	Share of Loss
Alan	90	x	11/12	x	$1,200	=	$990
	30	x	1/12	x	1,200	=	30
Bob	5	x	11/12	x	$1,200	=	$55
	35	x	1/12	x	1,200	=	35
Cathy	5	x	11/12	x	$1,200	=	$55
	35	x	1/12	x	1,200	=	35

Certain cash basis items prorated daily. If any partner's interest in a partnership changes during the tax year, each partner's share of certain cash basis items of the partnership must be determined by prorating the items on a daily basis. That daily portion is then allocated to the partners in proportion to their interests in the partnership at the close of each day. This rule applies to the following items for which the partnership uses the cash method of accounting.

Interest.
Taxes.
Payments for services or for the use of property.

Distributive share in year of disposition. If a partner's entire interest in a partnership is disposed of, whether by sale, exchange, liquidation, the partner's death, or otherwise, his or her distributive share of partnership items must be included in the partner's income for the tax year in which membership in the partnership ends. To compute the distributive share of these items, the partnership's tax year is considered ended on the date the partner disposed of the interest. To avoid an interim closing of the partnership books, the partners can agree to estimate the distributive share by taking the prorated amount the partner would have included in income if he or she had remained a partner for the entire partnership tax year.

Self-employment income of deceased partner. A different rule applies in computing a deceased partner's self-employment income for the year of death. The partner's self-employment income includes the partner's distributive share of income earned by the partnership through the end of the month in which the partner's death occurs. This is true even though the deceased partner's estate or heirs may succeed to the decedent's rights in the partnership. For this purpose, partnership income for the partnership's tax year in which a partner dies is considered to be earned equally in each month.

Example.

Larry, a partner in WoodsPar, is a calendar year taxpayer. WoodsPar's fiscal year ends June 30. For the partnership year ending June 30, 2003, Larry's distributive share of partnership profits is $2,000. On August 18, 2003, Larry dies and his estate succeeds to his partnership interest. For the partnership year ending June 30, 2004, Larry and his estate's distributive share is $3,000.

Larry's self-employment income to be reported on Schedule SE (Form 1040) for 2003 is $2,500. This consists of his $2,000 distributive share for the partnership tax year ending June 30, 2003, plus $500 (2/12 × $3,000) of the distributive share for the tax year ending June 30, 2004.

Reporting Distributive Share

A partner must report his or her distributive share of partnership items on his or her tax return, whether or not it is actually distributed. (However, a partner's deduction for his or her distributive share of a loss may be limited. See Limits on Losses, later.) These items are reported to the partner on Schedule K–1 (Form 1065).

The following discussions explain how partnership items are treated on a partner's return.

See the Partner's Instructions for Schedule K–1 (Form 1065) for more information.

Character of items. The character of each item of income, gain, loss, deduction, or credit included in a partner's distributive share is determined as if the partner realized the item directly from the same source as the partnership or incurred the item in the same manner as the partnership.

For example, a partner's distributive share of gain from the sale of partnership depreciable property used in the trade or business of the partnership is treated as gain from the sale of depreciable property the partner used in a trade or business.

Inconsistent treatment of items. Partners must generally treat partnership items the same way on their individual tax returns as they are treated on the partnership return. If a partner treats an item differently on his or her individual return, the IRS can immediately assess and collect any tax and penalties that result from adjusting the item to make it consistent with the partnership return. However, except for partners in an electing large partnership, this rule will not apply if a partner identifies the different treatment by filing Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), with his or her return.

Consolidated audit procedures. In a consolidated audit proceeding, the tax treatment of any partnership item is generally determined at the partnership level rather than at the individual partner's level. After the proper treatment is determined at the partnership level, the IRS can automatically make related adjustments to the tax returns of the partners, based on their share of the adjusted items.

The consolidated audit procedures do not apply to electing large partnerships or certain small partnerships (with 10 or fewer partners) if all partners are one of the following.

An individual (other than a nonresident alien).
A C corporation.
An estate of a deceased partner.

However, small partnerships can make an election to have these procedures apply.

Limits on Losses

Partner's adjusted basis. A partner's distributive share of partnership loss is allowed only to the extent of the adjusted basis of the partner's partnership interest. The adjusted basis is figured at the end of the partnership's tax year in which the loss occurred, before taking the loss into account. Any loss more than the partner's adjusted basis is not deductible for that year. However, any loss not allowed for this reason will be allowed as a deduction (up to the partner's basis) at the end of any succeeding year in which the partner increases his or her basis to more than zero. See Basis of Partner's Interest, later.

Example.

Mike and Joe are equal partners in a partnership. Mike files his individual return on a calendar year basis. The partnership return is also filed on a calendar year basis. The partnership incurred a $10,000 loss last year and Mike's distributive share of the loss is $5,000. The adjusted basis of his partnership interest before considering his share of last year's loss was $2,000. He could claim only $2,000 of the loss on last year's individual return. The adjusted basis of his interest at the end of last year was then reduced to zero.

The partnership showed an $8,000 profit for this year. Mike's $4,000 share of the profit increases the adjusted basis of his interest by $4,000 (not taking into account the $3,000 excess loss he could not deduct last year). His return for this year will show his $4,000 distributive share of this year's profits and the $3,000 loss not allowable last year. The adjusted basis of his partnership interest at the end of this year is $1,000.

Not-for-profit activity. Deductions relating to an activity not engaged in for profit are limited. For a discussion of the limits, see chapter 1 in Publication 535.

At-risk limits. At-risk rules apply to most trade or business activities, including activities conducted through a partnership. The at-risk rules limit a partner's deductible loss to the amounts for which that partner is considered at risk in the activity.

A partner is considered at risk for all the following amounts.

The money and adjusted basis of any property the partner contributed to the activity.
The partner's share of net income retained by the partnership.
Certain amounts borrowed by the partnership for use in the activity if the partner is personally liable for repayment or the amounts borrowed are secured by the partner's property (other than property used in the activity).

A partner is not considered at risk for amounts protected against loss through guarantees, stop-loss agreements, or similar arrangements. Nor is the partner at risk for amounts borrowed if the lender has an interest in the activity (other than as a creditor) or is related to a person (other than the partner) having such an interest.

For more information on determining the amount at risk, see Publication 925, the instructions for Form 6198, At-Risk Limitations, and the Partner's Instructions for Schedule K–1 (Form 1065).

Passive activities. Generally, section 469 of the Internal Revenue Code limits the amount a partner can deduct for passive activity losses and credits. The passive activity limits do not apply to the partnership. Instead, they apply to each partner's share of income, loss, or credit from passive activities. Because the treatment of each partner's share of partnership income, loss, or credit depends on the nature of the activity that generated it, the partnership must report income, loss, and credits separately for each activity.

Generally, passive activities include a trade or business activity in which the partner does not materially participate. The level of each partner's participation must be determined by the partner.

Rental activities. Generally, passive activities also include rental activities, regardless of the partner's participation. However, a rental real estate activity in which the partner materially participates is not considered a passive activity. An individual partner materially participated in a rental real estate activity if the partner was a “real estate professional” for the tax year. The partner qualifies as a real estate professional if he or she met both the following conditions for the tax year.

More than half of the personal services the partner performs in any trade or business are in a real property trade or business in which the partner materially participates.
The partner performs more than 750 hours of services in real property trades or businesses in which the partner materially participates.

Limited partners. Limited partners are generally not considered to materially participate in trade or business activities conducted through partnerships.

More information. For more information on passive activities, see Publication 925, the instructions for Form 8582 (for individual partners) and the instructions for Form 8810 (for corporate partners).

Partner's Exclusions and Deductions

To determine the allowable amount of any exclusion or deduction subject to a limit, a partner must combine any separate exclusions or deductions on his or her income tax return with the distributive share of partnership exclusions or deductions before applying the limit.

Cancellation of qualified real property business debt. A partner other than a C corporation can elect to exclude from gross income the partner's distributive share of income from cancellation of the partnership's qualified real property business debt. This is a debt (other than a qualified farm debt) incurred or assumed by the partnership in connection with real property used in its trade or business and secured by that property. A debt incurred or assumed after 1992 qualifies only if it was incurred or assumed to acquire, construct, reconstruct, or substantially improve such property. A debt incurred to refinance a qualified real property business debt qualifies, but only up to the refinanced debt.

A partner who elects the exclusion must reduce the basis of his or her depreciable real property by the amount excluded. For this purpose, a partnership interest is treated as depreciable real property to the extent of the partner's share of the partnership's depreciable real property. However, a partnership interest cannot be treated as depreciable real property unless the partnership makes a corresponding reduction in the basis of its depreciable real property with respect to that partner.

To elect the exclusion, the partner must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, with his or her original income tax return. However, if the partner timely filed the return without making the election, he or she can still make the election by filing an amended return within six months of the due date of the original return (excluding extensions). The election must be attached to the amended return with “Filed pursuant to section 301.9100–2” written on the election statement. The amended return should be filed at the same address as the original return.

Exclusion limit. The partner's exclusion cannot be more than the smaller of the following two amounts.

The partner's share of the excess (if any) of:
1. The outstanding principal of the debt immediately before the cancellation, over
2. The fair market value (as of that time) of the property securing the debt, reduced by the outstanding principal of other qualified real property business debt secured by that property (as of that time).
The total adjusted bases of depreciable real property held by the partner immediately before the cancellation (other than property acquired in contemplation of the cancellation).

Effect on partner's basis. Because of offsetting adjustments, the cancellation of a partnership debt does not usually cause a net change in the basis of a partnership interest. Each partner's basis is:

Increased by his or her share of the partnership income from the cancellation of debt (whether or not the partner excludes the income), and
Reduced by the deemed distribution resulting from the reduction in his or her share of partnership liabilities.

(See Adjusted Basis under Basis of Partner's Interest, later.) The basis of a partner's interest will change only if the partner's share of income is different from the partner's share of debt.

As explained earlier, however, a partner's election to exclude income from the cancellation of qualified real property business debt may reduce the basis of the partner's interest to the extent the interest is treated as depreciable real property.

Basis of depreciable real property reduced. If the basis of depreciable real property is reduced and the property is disposed of, then the following rules apply for purposes of determining the ordinary income from recapture of depreciation under section 1250 of the Internal Revenue Code.

Any such basis reduction is treated as a deduction allowed for depreciation.
The determination of what would have been the depreciation adjustment under the straight line method is made as if there had been no such reduction.

Therefore, the basis reduction recaptured as ordinary income is reduced over the time the partnership continues to hold the property, as the partnership forgoes depreciation deductions due to the basis reduction.

Section 179 deduction. A partnership can elect to deduct all or part of the cost of certain assets under section 179 of the Internal Revenue Code. The deduction is passed through to the partners as a separately stated item.

Limits. The section 179 deduction is subject to certain limits that apply to the partnership and to each partner. The partnership determines its section 179 deduction subject to the limits. It then allocates the deduction among its partners.

Each partner adds the amount allocated from the partnership (shown on Schedule K–1) to his or her other nonpartnership section 179 costs and then applies the maximum dollar limit to this total. To determine if a partner has exceeded the $400,000 investment limit, the partner does not include any of the cost of section 179 property placed in service by the partnership. After the maximum dollar limit and investment limit are applied, the remaining cost of the partnership and nonpartnership section 179 property is subject to the taxable income limit.

Figuring partnership's taxable income. For purposes of the taxable income limit, taxable income of a partnership is figured by adding together the net income (or loss) from all trades or businesses actively conducted by the partnership during the tax year.

Figuring partner's taxable income. For purposes of the taxable income limit, the taxable income of a partner who is engaged in the active conduct of one or more of a partnership's trades or businesses includes his or her allocable share of taxable income derived from the partnership's active conduct of any trade or business.

Basis adjustment. A partner who is allocated section 179 expenses from the partnership must reduce the basis of his or her partnership interest by the total section 179 expenses allocated, regardless of whether the full amount allocated can be currently deducted. See Adjusted Basis under Basis of Partner's Interest, later. If a partner disposes of his or her interest in a partnership, the partner's basis for determining gain or loss is increased by any outstanding carryover of disallowed deductions of section 179 expenses allocated from the partnership.

The basis of a partnership's section 179 property must be reduced by the section 179 deduction elected by the partnership. This reduction of basis must be made even if any partner cannot deduct his or her entire allocable share of the section 179 deduction because of the limits.

More information. See Publication 946 for more information on the section 179 deduction.

Amortization deduction for reforestation costs. A partnership can elect to amortize certain reforestation costs for qualified timber property over an 84-month period. The amortizable costs are passed through to the partners as a separately stated item.

Annual limit. The election can be made for no more than $10,000 of qualified costs each tax year. Both the partnership and partner are subject to this limit. The partnership applies the $10,000 limit in determining the amount of its amortizable costs and allocates that amount among its partners. The partner adds the amount allocated from the partnership to his or her qualified costs from other sources and then applies the $10,000 limit ($5,000 limit, if married filing a separate return).

More information. See chapter 9 of Publication 535 for more information.

Partnership expenses paid by partner. In general, a partner cannot deduct partnership expenses paid out of personal funds unless the partnership agreement requires the partner to pay the expenses. These expenses are usually considered incurred and deductible by the partnership.

If an employee of the partnership performs part of a partner's duties and the partnership agreement requires the partner to pay the employee out of personal funds, the partner can deduct the payment as a business expense.

Interest expense for distributed loan. If the partnership distributes borrowed funds to a partner, the partnership should list the partner's share of interest expense for these funds as “Interest expense allocated to debt-financed distributions” under “Other deductions” on the partner's Schedule K–1. The partner deducts this interest on his or her tax return depending on how the partner uses the funds. See chapter 5 in Publication 535 for more information on the allocation of interest expense related to debt-financed distributions.

Debt-financed acquisitions. The interest expense on loan proceeds used to purchase an interest in, or make a contribution to, a partnership must be allocated as explained in chapter 5 of Publication 535.

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, as explained later under Adjusting the Basis of Partnership 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.

Partner's Gain or Loss

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:
1. The fair market value of the property received in the distribution, over
2. 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, discussed later under Adjusting the Basis of Partnership Property, 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.
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.

Performing services for or transferring property to a partnership if—
1. There is a related allocation and distribution to a partner, and
2. 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.
Transferring money or other property to a partnership if—
1. There is a related transfer of money or other property by the partnership to the contributing partner or another partner, and
2. 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

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 and are not deductible by the partnership. (See Organization expenses and syndication fees under Partnership Income or Loss (Form 1065 Only), earlier). However, these payments must be included in the partners' individual income tax returns.

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.

For 2003, 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 deduc