Important Change for 2002

Tax shelter disclosure statement.   A partnership must file a disclosure statement for each reportable tax shelter transaction in which it participated, directly or indirectly, if the transaction is reasonably expected to affect any partner's federal income tax liability. For more information, see the tax shelter disclosure statement discussion in the Form 1065 instructions under Other Forms, Returns, and Statements That May Be Required.

A partner must file a disclosure statement for each reportable tax shelter transaction in which the partner participated, directly or indirectly, if the partner's federal income tax liability was affected by the transaction. For more information, see the tax shelter disclosure statement discussion in the Schedule E (Form 1040) instructions.

Important Change for 2003

Reportable transactions.   New disclosure rules require partnerships and partners to file Form 8886, Reportable Transaction Disclosure Statement, to report certain transactions entered into after 2002. For more information, see the tax shelter disclosure statement discussion in the Form 1065 instructions under Other Forms, Returns, and Statements That May Be Required and the Instructions for Form 8886.

Important Reminder

Photographs of missing children.   The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843-5678) if you recognize a child.

Introduction

This publication explains how the income tax law applies to partnerships and to partners. Generally, a partnership does not pay tax on its income but passes through any profits or losses to its partners. Partners must include partnership items on their tax returns.

For a discussion of business expenses a partnership can deduct, see Publication 535, Business Expenses. Members of oil and gas partnerships should read about the deduction for depletion in chapter 10 of that publication.

Certain partnerships must have a tax matters partner (TMP) who is also a general partner. For information on the rules for designating a TMP, see the instructions for Schedule B of Form 1065 and section 301.6231(a)(7)-1 of the regulations.

Many rules in this publication do not apply to partnerships that file Form 1065-B, U.S. Return of Income for Electing Large Partnerships. For the rules that apply to these partnerships, see the instructions for Form 1065-B. However, the partners of electing large partnerships can use the rules in this publication except as otherwise noted.

Withholding on foreign partner or firm.   If a partnership acquires a U.S. real property interest from a foreign person or firm, the partnership may have to withhold tax on the amount it pays for the property (including cash, the fair market value of other property, and any assumed liability). If a partnership has income effectively connected with a trade or business in the United States, it must withhold on the income allocable to its foreign partners. A partnership may have to withhold tax on a foreign partner's distributive share of fixed or determinable income not effectively connected with a U.S. trade or business. A partnership that fails to withhold may be held liable for the tax, applicable penalties, and interest. For more information, see Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.

Comments and suggestions.   We welcome your comments about this publication and your suggestions for future editions.

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Internal Revenue Service
Tax Forms and Publications
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Useful Items You may want to see:

Publication

• 505   Tax Withholding and Estimated Tax
• 533   Self-Employment Tax
• 535   Business Expenses
• 537   Installment Sales
• 538   Accounting Periods and Methods
• 544   Sales and Other Dispositions of Assets
• 551   Basis of Assets
• 925   Passive Activity and At-Risk Rules
• 946   How To Depreciate Property

Form (and Instructions)

• 1065   U.S. Return of Partnership Income
• Schedule K-1 (Form 1065)   Partner's Share of Income, Credits, Deductions, etc.
• 8308   Report of a Sale or Exchange of Certain Partnership Interests
• 8582   Passive Activity Loss Limitations
• 8736   Application for Automatic Extension of Time To File U.S. Return for a Partnership, REMIC, or for Certain Trusts
• 8832   Entity Classification Election
• 8865   Return of U.S. Persons With Respect to Certain Foreign Partnerships

See How To Get Tax Help near the end of this publication for information about getting publications and forms.

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.
• 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.

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.

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 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.

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.

1. 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.
2. 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.

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)

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.

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