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.

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.

A capital interest in a partnership is an interest in its assets that is distributable to the owner of the interest in either of the following situations.

The mere right to share in earnings and profits is not a capital interest in the partnership.

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.

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).

If spouses carry on a business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. If so, they should report income or loss from the business on Form 1065. They should not report the income on a Schedule C (Form 1040) in the name of one spouse as a sole proprietor.

Each spouse should carry his or her share of the partnership income or loss from Schedule K–1 (Form 1065) to their joint or separate Form(s) 1040. Each spouse should include his or her respective share of self-employment income on a separate Schedule SE (Form 1040), Self-Employment Tax. This generally does not increase the total tax on the return, but it does give each spouse credit for social security earnings on which retirement benefits are based.

The partnership'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.

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.

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.

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.

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.

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.

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.

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 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.

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.

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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:

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.

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.

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.

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.

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

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.

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

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.

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

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.

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.

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.

Amortization applies to expenses that are:

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.

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

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.

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.

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.

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.

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.

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.

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

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.

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.

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).

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.

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.

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.

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.

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.

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.

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

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.

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 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.

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).

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.

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.

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

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).

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.

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

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:

(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.

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.

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.

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.

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.

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.

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.

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.

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

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.

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).

See chapter 9 of Publication 535 for more information.

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.

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.

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.

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.

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.

When a partnership distributes the following items, the distribution may be treated as a sale or exchange of property rather than a distribution.

See Payments for Unrealized Receivables and Inventory Items under Disposition of Partner's Interest, later.

This treatment does not apply to the following distributions.

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.

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:

For more information, including the definition of marketable securities, see section 731(c) of the Internal Revenue Code.

A partner does not recognize loss on a partnership distribution unless all the following requirements are met.

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.

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.

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:

The gain recognized is the lesser of the following amounts.

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.

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.

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.

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.

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.

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 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.

Use the following rules to allocate any basis decrease required in rule (1) or rule (2), earlier.

For property distributed before August 6, 1997, allocate the basis using the following rules.

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.

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.

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.

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.

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.

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.

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.

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 deduct the premiums for any calendar month or part of a month in which the partner is eligible to participate in any subsidized health plan maintained by any employer of the partner or the partner's spouse. For more information on the self-employed health insurance deduction, see chapter 7 in Publication 535.

Guaranteed payments are included in income in the partner's tax year in which the partnership's tax year ends.

If guaranteed payments to a partner result in a partnership loss in which the partner shares, the partner must report the full amount of the guaranteed payments as ordinary income. The partner separately takes into account his or her distributive share of the partnership loss, to the extent of the adjusted basis of the partner's partnership interest.

Losses will not be allowed from a sale or exchange of property (other than an interest in the partnership) directly or indirectly between a partnership and a person whose direct or indirect interest in the capital or profits of the partnership is more than 50%.

If the sale or exchange is between two partnerships in which the same persons directly or indirectly own more than 50% of the capital or profits interests in each partnership, no deduction of a loss is allowed.

The basis of each partner's interest in the partnership is decreased (but not below zero) by the partner's share of the disallowed loss.

If the purchaser later sells the property, only the gain realized that is greater than the loss not allowed will be taxable. If any gain from the sale of the property is not recognized because of this rule, the basis of each partner's interest in the partnership is increased by the partner's share of that gain.

Gains are treated as ordinary income in a sale or exchange of property directly or indirectly between a person and a partnership, or between two partnerships, if both of the following tests are met.

To determine if there is more than 50% ownership in partnership capital or profits, the following rules apply.

For more information on these special rules, see Sales and Exchanges Between Related Persons in chapter 2 of Publication 544.

A contribution of money or other property to the partnership followed by a distribution of different property from the partnership to the partner is treated not as a contribution and distribution, but as a sale of property, if both of the following tests are met.

All facts and circumstances are considered in determining if the contribution and distribution are more properly characterized as a sale. However, if the contribution and distribution occur within 2 years of each other, the transfers are presumed to be a sale unless the facts clearly indicate that the transfers are not a sale. If the contribution and distribution occur more than 2 years apart, the transfers are presumed not to be a sale unless the facts clearly indicate that the transfers are a sale.

A partner must attach Form 8275, Disclosure Statement, (or other statement) to his or her return if the partner contributes property to a partnership and, within 2 years (before or after the contribution), the partnership transfers money or other consideration to the partner. For exceptions to this requirement, see section 1.707–3(c)(2) of the regulations.

A partnership must attach Form 8275 (or other statement) to its return if it distributes property to a partner, and, within 2 years (before or after the distribution), the partner transfers money or other consideration to the partnership.

Form 8275 must include the following information.

Gain is recognized when property is contributed (in exchange for an interest in the partnership) to a partnership that would be treated as an investment company if it were incorporated.

A partnership is generally treated as an investment company if over 80% of the value of its assets is held for investment and consists of certain readily marketable items. These items include money, stocks and other equity interests in a corporation, and interests in regulated investment companies and real estate investment trusts. For more information, see section 351(e)(1) of the Internal Revenue Code and the related regulations. Whether a partnership is an investment company under this test is ordinarily determined immediately after the transfer of property.

This rule applies to limited partnerships and general partnerships, regardless of whether they are privately formed or publicly syndicated.

A domestic partnership that contributed property after August 5, 1997, to a foreign partnership in exchange for a partnership interest may have to file Form 8865 if either of the following apply.

The partnership may also have to file Form 8865, even if no contributions are made during the tax year, if it owns a 10% or more interest in a foreign partnership at any time during the year. See the form instructions for more information.

If a partner contributes property to a partnership, the partnership's basis for determining depreciation, depletion, and gain or loss for the property is the same as the partner's adjusted basis for the property when it was contributed, increased by any gain recognized by the partner at the time of contribution.

The fair market value of property at the time it is contributed may be different from the partner's adjusted basis. The partnership must allocate among the partners any income, deduction, gain, or loss on the property in a manner that will account for the difference. This rule also applies to contributions of accounts payable and other accrued but unpaid items of a cash basis partner.

The partnership can use different allocation methods for different items of contributed property. A single reasonable method must be consistently applied to each item, and the overall method or combination of methods must be reasonable. See section 1.704–3 of the regulations for allocation methods generally considered reasonable.

If the partnership sells contributed property and recognizes gain or loss, built-in gain or loss is allocated to the contributing partner. If contributed property is subject to depreciation or other cost recovery, the allocation of deductions for these items takes into account built-in gain or loss on the property. However, the total depreciation, depletion, gain, or loss allocated to partners cannot be more than the depreciation or depletion allowable to the partnership or the gain or loss realized by the partnership.

If a partner contributes property to a partnership and the partnership distributes the property to another partner within 7 years of the contribution, the contributing partner must recognize gain or loss on the distribution.

A 5-year period applies to property contributed before June 9, 1997, or under a written binding contract:

The recognized gain or loss is the amount the contributing partner would have recognized if the property had been sold for its fair market value when it was distributed. This amount is the difference between the property's basis and its fair market value at the time of contribution. The character of the gain or loss will be the same as the character of the gain or loss that would have resulted if the partnership had sold the property to the distributee partner. Appropriate adjustments must be made to the adjusted basis of the contributing partner's partnership interest and to the adjusted basis of the property distributed to reflect the recognized gain or loss.

The following rules determine the character of the partnership's gain or loss on a disposition of certain types of contributed property.

A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest. The fair market value of such an interest received by a partner as compensation for services must generally be included in the partner's gross income in the first tax year in which the partner can transfer the interest or the interest is not subject to a substantial risk of forfeiture. The capital interest transferred as compensation for services is subject to the rules for restricted property discussed in Publication 525 under Employee Compensation.

The fair market value of an interest in partnership capital transferred to a partner as payment for services to the partnership is a guaranteed payment, discussed earlier.

A profits interest is a partnership interest other than a capital interest. If a person receives a profits interest for providing services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the receipt of such an interest is not a taxable event for the partner or the partnership. However, this does not apply in the following situations.

A profits interest transferred as compensation for services is not subject to the rules for restricted property that apply to capital interests.

If a partner acquires an interest in a partnership by gift, inheritance, or under any circumstance other than by a contribution of money or property to the partnership, the partner's basis must be determined using the basis rules described in Publication 551.

A partner's basis is increased by the following items.

The partner's basis is decreased (but never below zero) by the following items.

If contributed property is subject to a debt or if a partner's liabilities are assumed by the partnership, the basis of that partner's interest is reduced (but not below zero) by the liability assumed by the other partners. This partner must reduce his or her basis because the assumption of the liability is treated as a distribution of money to that partner. The other partners' assumption of the liability is treated as a contribution by them of money to the partnership. See Effect of Partnership Liabilities, later.

The adjusted basis of a partner's interest is determined without considering any amount shown in the partnership books as a capital, equity, or similar account.

The adjusted basis of a partner's partnership interest is ordinarily determined at the end of the partnership's tax year. However, if there has been a sale or exchange of all or part of the partner's interest or a liquidation of his or her entire interest in a partnership, the adjusted basis is determined on the date of sale, exchange, or liquidation.

In certain cases, the adjusted basis of a partnership interest can be figured by using the partner's share of the adjusted basis of partnership property that would be distributed if the partnership terminated.

This alternative rule can be used in either of the following situations.

Adjustments may be necessary in figuring the adjusted basis of a partnership interest under the alternative rule. For example, adjustments would be required to include in the partner's share of the adjusted basis of partnership property any significant discrepancies that resulted from contributed property, transfers of partnership interests, or distributions of property to the partners.

If a partner's share of partnership liabilities increases, or a partner's individual liabilities increase because he or she assumes partnership liabilities, this increase is treated as a contribution of money by the partner to the partnership.

If a partner's share of partnership liabilities decreases, or a partner's individual liabilities decrease because the partnership assumes his or her individual liabilities, this decrease is treated as a distribution of money to the partner by the partnership.

A partner or related person is considered to assume a partnership liability only to the extent that:

Related persons, for these purposes, includes all the following.

If property contributed to a partnership by a partner or distributed by the partnership to a partner is subject to a liability, the transferee is treated as having assumed the liability to the extent it does not exceed the fair market value of the property.

A partnership liability is a recourse liability to the extent that any partner or a related person, defined earlier, has an economic risk of loss for that liability. A partner's share of a recourse liability equals his or her economic risk of loss for that liability. A partner has an economic risk of loss if that partner or a related person would be obligated (whether by agreement or law) to make a net payment to the creditor or a contribution to the partnership with respect to the liability if the partnership were constructively liquidated. A partner who is the creditor for a liability that would otherwise be a nonrecourse liability of the partnership has an economic risk of loss in that liability.

Generally, in a constructive liquidation, the following events are treated as occurring at the same time.

A limited partner generally has no obligation to contribute additional capital to the partnership and therefore does not have an economic risk of loss in partnership recourse liabilities. Thus, absent some other factor, such as the guarantee of a partnership liability by the limited partner or the limited partner making the loan to the partnership, a limited partner generally does not have a share of partnership recourse liabilities.

A partnership liability is a nonrecourse liability if no partner or related person has an economic risk of loss for that liability. A partner's share of nonrecourse liabilities is generally proportionate to his or her share of partnership profits. However, this rule may not apply if the partnership has taken deductions attributable to nonrecourse liabilities or the partnership holds property that was contributed by a partner.

For more information on the effect of partnership liabilities, including rules for limited partners and examples, see sections 1.752–1 through 1.752–5 of the regulations.

A loss incurred from the abandonment or worthlessness of a partnership interest is an ordinary loss only if both of the following tests are met.

If the partner receives even a de minimis actual or deemed distribution, the entire loss generally is a capital loss. However, see Payments for Unrealized Receivables and Inventory Items, later.

Generally, a partnership's basis in its assets is not affected by a transfer of an interest in the partnership, whether by sale or exchange or because of the death of a partner. However, the partnership can elect to make an optional adjustment to basis in the year of transfer. See Adjusting the Basis of Partnership Property, later, for information on making the election.

An exchange of partnership interests generally does not qualify as a nontaxable exchange of like-kind property. This applies regardless of whether they are general or limited partnership interests or interests in the same or different partnerships. However, under certain circumstances, such an exchange may be treated as a tax-free contribution of property to a partnership. See Contribution of Property under Transactions Between Partnership and Partners, earlier.

An interest in a partnership that has a valid election in effect under section 761(a) of the Internal Revenue Code to be excluded from the partnership rules of the Code is treated as an interest in each of the partnership assets and not as a partnership interest. See Exclusion From Partnership Rules, earlier.

A partner who sells a partnership interest at a gain may be able to report the sale on the installment method. For requirements and other information on installment sales, see Publication 537.

Part of the gain from the installment sale may be allocable to unrealized receivables or inventory items. See Payments for Unrealized Receivables and Inventory Items, later. The gain allocable to unrealized receivables and inventory items must be reported in the year of sale. The gain allocable to the other assets can be reported under the installment method.

Unrealized receivables include any rights to payment not already included in income for the following items.

These rights must have arisen under a contract or agreement that existed at the time of sale or distribution, even though the partnership may not be able to enforce payment until a later date. For example, unrealized receivables include accounts receivable of a cash method partnership and rights to payment for work or goods begun but incomplete at the time of the sale or distribution of the partner's share.

The basis for any unrealized receivables includes all costs or expenses for the receivables that were paid or accrued but not previously taken into account under the partnership's method of accounting.

Unrealized receivables include potential gain that would be ordinary income if the following partnership property were sold at its fair market value on the date of the payment.

The income or loss realized by a partner upon the sale or exchange of its interest in unrealized receivables and inventory items, discussed below, is the amount that would have been allocated to the partner if the partnership had sold all of its property for cash at fair market value, in a fully taxable transaction, immediately prior to the partner's transfer of interest in the partnership. Any gain or loss recognized that is attributable to the unrealized receivables and inventory items will be ordinary gain or loss.

Inventory items are not just stock-in-trade of the partnership. They also include the following property.

If a partner exchanges a partnership interest attributable to unrealized receivables or inventory for money or property, he or she must notify the partnership in writing. This must be done within 30 days of the transaction or, if earlier, by January 15 of the calendar year following the calendar year of the exchange. A partner may be subject to a $50 penalty for each failure to notify the partnership about such a transaction, unless the failure was due to reasonable cause and not willful neglect.

When a partnership is notified of an exchange of partnership interests involving unrealized receivables or inventory items, the partnership must file Form 8308. Form 8308 is filed with Form 1065 for the tax year that includes the last day of the calendar year in which the exchange took place. If notified of an exchange after filing Form 1065, the partnership must file Form 8308 separately, within 30 days of the notification.

On Form 8308, the partnership states the date of the exchange and the names, addresses, and taxpayer identification numbers of the partnership filing the return and the transferee and transferor in the exchange. Also, the partnership provides their telephone number. The partnership must provide a copy of Form 8308 (or a written statement with the same information) to each transferee and transferor by the later of January 31 following the end of the calendar year or 30 days after it receives notice of the exchange.

The partnership may be subject to a penalty of up to $50 for each failure to timely file Form 8308 and a $50 penalty for each failure to furnish a copy of Form 8308 to a transferor or transferee, unless the failure is due to reasonable cause and not willful neglect. If the failure is intentional, a higher penalty may be imposed. See the form instructions for details.

If a partner sells or exchanges any part of an interest in a partnership having unrealized receivables or inventory, he or she must file a statement with his or her tax return for the year in which the sale or exchange occurs. The statement must contain the following information.

In general, any gain or loss on a sale or exchange of unrealized receivables or inventory items a partner received in a distribution is an ordinary gain or loss. For this purpose, inventory items do not include real or depreciable business property, even if they are not held more than 1 year.

If a distributee partner sells inventory items held for more than 5 years after the distribution, the type of gain or loss depends on how they are being used on the date sold. The gain or loss is capital gain or loss if the property is a capital asset in the partner's hands at the time sold.

If a distributee partner disposes of unrealized receivables or inventory items in a nonrecognition transaction, ordinary gain or loss treatment applies to a later disposition of any substituted basis property resulting from the transaction.

Payments made in liquidation of the interest of a retiring or deceased partner in exchange for his or her interest in partnership property are considered a distribution, not a distributive share or guaranteed payment that could give rise to a deduction (or its equivalent) for the partnership.

Payments made for the retiring or deceased partner's share of the partnership's unrealized receivables or goodwill are not treated as made in exchange for partnership property if both of the following tests are met.

However, this rule does not apply to payments for goodwill to the extent that the partnership agreement provides for a reasonable payment to a retiring partner for goodwill.

Payments for unrealized receivables or goodwill are not treated as made in exchange for partnership property under any circumstance if the partner retired or died before January 5, 1993 (or retired on or after that date if a written contract to buy the partner's interest in the partnership was binding on January 4, 1993, and at all times thereafter).

Unrealized receivables are defined earlier under Payments for Unrealized Receivables and Inventory Items. However, for this purpose, they do not include the items listed in that discussion under Other items treated as unrealized receivables.

Generally, the partners' valuation of a partner's interest in partnership property in an arm's-length agreement will be treated as correct. If the valuation reflects only the partner's net interest in the property (total assets less liabilities), it must be adjusted so that both the value of and the basis for the partner's interest include the partner's share of partnership liabilities.

Upon the receipt of the distribution, the retiring partner or successor in interest of a deceased partner will recognize gain only to the extent that any money (and marketable securities treated as money) distributed is more than the partner's adjusted basis in the partnership. The partner will recognize a loss only if the distribution is in money, unrealized receivables, and inventory items. No loss is recognized if any other property is received. See Partner's Gain or Loss under Partnership Distributions, earlier.

Payments made by the partnership to a retiring partner or successor in interest of a deceased partner that are not made in exchange for an interest in partnership property are treated as distributive shares of partnership income or guaranteed payments. This rule applies regardless of the time over which the payments are to be made. It applies to payments made for the partner's share of unrealized receivables and goodwill not treated as a distribution.

If the amount is based on partnership income, the payment is taxable as a distributive share of partnership income. The payment retains the same character when reported by the recipient that it would have had if reported by the partnership. For more information, see Partner's Income or Loss, earlier.

If the amount is not based on partnership income, it is treated as a guaranteed payment. The recipient reports guaranteed payments as ordinary income. For additional information on guaranteed payments, see Transactions Between Partnership and Partners, earlier.

These payments are included in income by the recipient for his or her tax year that includes the end of the partnership tax year for which the payments are a distributive share or in which the partnership is entitled to deduct them as guaranteed payments.

Former partners who continue to make guaranteed periodic payments to satisfy the partnership's liability to a retired partner after the partnership is terminated can deduct the payments as a business expense in the year paid.

When there is a distribution of partnership property to a partner, the partnership makes the optional adjustment by:

If a partnership completely liquidates the interest of a partner by making a series of cash payments treated as distributions of the partner's interest in partnership property, the basis adjustments to partnership property must correspond in timing and amount with the recognition of gain or loss by the retiring partner, or a deceased partner's successor in interest, with respect to those payments.

When there is a transfer of a partnership interest because of a sale or exchange or a partner's death, the partnership makes the optional adjustment by:

These adjustments affect the basis of partnership property for the transferee partner only. They become part of his or her share of the common partnership basis.

The optional adjustment to basis is made by filing a written statement with Form 1065 for the tax year in which the distribution or transfer occurs. For the election to be valid, the return must be filed on time, including extensions. The statement must include the name and address of the partnership, be signed by one of the partners, and state that the partnership elects under section 754 to apply sections 734(b) and 743(b) of the Internal Revenue Code. Once a valid election has been made, it applies in succeeding years until it is revoked.

If the election cannot be made with the return, a partner or the partnership can request an automatic extension of 12 months to make the election. See section 301.9100–2 of the regulations for more information.

Generally, the election can be revoked only with the approval of the IRS. An application to revoke the election must be filed with the IRS director for your area. This application must be filed within 30 days after the close of the partnership tax year for which the change is to be effective. The application must be signed by one of the partners and state why the partnership wishes to revoke the election.

Examples of sufficient grounds for approving the application include the following.

However, the IRS will not approve an application to revoke the election if its primary purpose is to avoid decreasing the basis of partnership assets upon a transfer or distribution.

Gross sales of $409,465 are entered on line 1a. Returns and allowances of $3,365 are entered on line 1b, resulting in net sales of $406,100, entered on line 1c.

Cost of goods sold, $267,641, from Schedule A, line 8, is entered here.

Gross profit of $138,459 is shown on this line.

Interest income on accounts receivable, $559, is entered on this line. The schedule that must be attached for this line is not shown.

Total income, $139,018 (lines 3 through 7), is shown here.

All salaries and wages are included here except guaranteed payments to partners (shown on line 10). Frank enters the $29,350 wages paid to the partnership's employees. The partnership had no employment credits to reduce that amount.

Guaranteed payments of $25,000 to partners Frank ($20,000) and Susan ($5,000) are entered here.

Repairs of $1,125 made to partnership equipment are entered on this line.

During the year, $250 owed to the partnership was determined to be a wholly worthless business bad debt. The $250 is shown on this line. (If this had been a nonbusiness bad debt, it would have been reported in Part I of Schedule D (Form 1065) and included separately on Schedules K and K–1, line 7, as a stated short-term capital loss.)

Rent paid for the business premises, $20,000, is listed on this line.

Deductible taxes of $3,295 are entered on this line.

Interest paid to suppliers during the year totaled $1,451. This is business interest, so it is entered here.

Depreciation of $1,174 claimed on assets used in the partnership's business is entered on these lines. (Line 16b is left blank because there is no depreciation listed elsewhere on the return.) Frank does not need to attach Form 4562 because the partnership did not place property in service during 2003 or depreciate or claim a deduction for a car or other listed property.

Other allowable deductions of $8,003 not listed elsewhere on the return and for which a separate line is not provided on page 1 are included on this line. Frank attaches a schedule that lists each deduction and the amount included on line 20. This schedule is not shown.

The total of all deductions, $89,648 (lines 9 through 20), is entered on this line.

The amount on line 21 is subtracted from the amount on line 8. The result, $49,370, is entered here and on line 1 of Schedule K. The amount allocated to each partner is listed on line 1 of Schedule K–1.

This line shows the net income per books of $48,920. This amount is from the profit and loss account (not shown in this example).

This line shows the guaranteed payments to partners.

This is the total of lines 1 through 4 of $73,920.

Shown here is the $50 tax-exempt interest income from municipal bonds recorded on the books but not included on Schedule K, lines 1 through 7. This interest is reported on Schedule K, line 19.

This is line 5 less line 8, $73,870. This line is the same as line 1 of the Analysis of Net Income (Loss) section of Schedule K at the top of page 4.

As of January 1, the total of the partners' capital accounts was $27,550 (Frank—$14,050; Susan—$13,500). This amount should agree with the beginning balance shown on line 21 of Schedule L for the partners' capital accounts.

This is the net income per books.

This is the total of lines 1 through 4.

Each partner withdrew $26,440 (totaling $52,880) from the partnership. These withdrawals are shown here and on Schedule K, line 22. The partners' guaranteed payments, which were actually paid, are not included because they were deducted when figuring the amount shown on line 3.

This shows the total equity of all partners as shown in the books of record as of December 31. This amount should agree with the year-end balance shown on line 21 of Schedule L for the partners' capital accounts.

Item J on Schedule K–1 reflects each partner's share of the amounts shown on lines 1 through 9 of Schedule M–2.

This line on Schedule K–1 shows Frank's share ($24,685) of the income from the partnership shown on Form 1065, page 1, line 22. The total amount of income to both partners is shown on line 1, Schedule K.

Dividends must be separately stated. They are not included in the income (loss) of the partnership on Form 1065, page 1, line 22. Line 4b(2) on Schedule K shows the total ordinary dividends of $150. All these ordinary dividends are qualified dividends so they are also shown on line 4b(1).These lines on Schedule K–1 show Frank's share, $75.

This line on Schedule K–1 shows only the guaranteed payments to Frank of $20,000. This line on Schedule K shows the total guaranteed payments to both partners of $25,000.

During the year, the partnership made a $650 cash contribution to the American Lung Association. Each partner may be able to deduct his or her share of the partnership's charitable contribution on his or her individual income tax return if the partner itemizes deductions. Frank's share of the contribution, $325, is entered on this line of Schedule K–1. This line on Schedule K shows the total contribution. The partnership will show on an attachment the dollar amount of contributions subject to each of the 50%, 30%, and 20% of adjusted gross income limits.

The partnership had no interest expense on investment debts so there is no entry on line 14b(2). The partnership had total ordinary dividends of $150 as shown on line 4b(2). The $150 total ordinary dividends are also shown on line 14b(1) of Schedule K and the partners' share is shown on line 14b(1) of Schedule K–1. However, because all of the total ordinary dividends are qualified dividends (shown on line 4b(1)), the partners will not be able to treat their share of these dividends as investment income unless they elect to treat qualified dividends as not eligible for the reduced tax rates. See the instructions for Form 4952, Investment Interest Expense Deduction, for details.

Net earnings (loss) from self-employment are figured using the worksheet in the Form 1065 instructions for Schedule K (not shown). Frank and Susan's net earnings from self-employment are the total of the partnership income shown on line 1 of Schedule K and the guaranteed payments shown on line 5. This total, $74,370, is entered on Schedule K, and each individual partner's share is shown on his or her Schedule K–1. Each partner uses his or her share to figure his or her self-employment tax on Schedule SE (Form 1040), Self-Employment Tax (not shown).

Frank enters the $50 municipal bond interest received by the partnership on this line of Schedule K and $25 on this line of each partner's Schedule K–1.

Frank enters the $52,880 cash withdrawals made by the partners during the year on this line of Schedule K. He enters the amount each partner withdrew on this line of the partner's Schedule K–1.

Form 1065 page 1

Form 1065 page 2

Form 1065 page 3

Form 1065 page 4

Schedule K–1 page 1

Schedule K–1 page 2

If you have attempted to deal with an IRS problem unsuccessfully, you should contact your Taxpayer Advocate.

The Taxpayer Advocate independently represents your interests and concerns within the IRS by protecting your rights and resolving problems that have not been fixed through normal channels. While Taxpayer Advocates cannot change the tax law or make a technical tax decision, they can clear up problems that resulted from previous contacts and ensure that your case is given a complete and impartial review.

To contact your Taxpayer Advocate:

For more information, see Publication 1546, The Taxpayer Advocate Service of the IRS.

To find out what services are available, get Publication 910, Guide to Free Tax Services. It contains a list of free tax publications and an index of tax topics. It also describes other free tax information services, including tax education and assistance programs and a list of TeleTax topics.