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.

1. 90% of the tax expected to be shown on the current year's tax return.
2. 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:

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, 2001, Larry's distributive share of partnership profits is $2,000. On August 18, 2001, Larry dies and his estate succeeds to his partnership interest. For the partnership year ending June 30, 2002, Larry and his estate's distributive share is $3,000.

Larry's self-employment income to be reported on Schedule SE (Form 1040) for 2001 is $2,500. This consists of his $2,000 distributive share for the partnership tax year ending June 30, 2001, plus $500 ( 2/12 × $3,000) of the distributive share for the tax year ending June 30, 2002.

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, 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 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. 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. The partner must also meet both of 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 and the Partner's Instructions for Schedule K-1 (Form 1065).

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.

1. 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).
2. 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:

1. Increased by his or her share of the partnership income from the cancellation of debt (whether or not the partner excludes the income), and
2. 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 $200,000 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.

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