Partnership Income or Loss

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:

1. Incident to the creation of the partnership,
2. Chargeable to a capital account, and
3. 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.

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:

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, 2002, Larry's distributive share of partnership profits is $2,000. On August 18, 2002, Larry dies and his estate succeeds to his partnership interest. For the partnership year ending June 30, 2003, Larry and his estate's distributive share is $3,000.

Larry's self-employment income to be reported on Schedule SE (Form 1040) for 2002 is $2,500. This consists of his $2,000 distributive share for the partnership tax year ending June 30, 2002, plus $500 (2/12 × $3,000) of the distributive share for the tax year ending June 30, 2003.

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).

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